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Japan’s Great Recession

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The value of Japan’s gross domestic product is today no higher than it was in 1993.  We used to talk of a lost decade and now many talk of two lost decades.

But who is responsible?  Could it all have been avoided?  According to the Bank of England’s Adam Posen, the Great Recession from 1992 to 2002 was the result of policy errors, and it could indeed have been avoided.

In his recent London speech, Posen walks us through the history of Japan’s Great Recession which he describes as a period of economic recoveries that were aborted by a series of macroeconomic and financial policy mistakes.  These recoveries, steady growth for two or three years at a time, were not enormously rapid.  Nor were the recoveries paltry by the standards of an advanced economy.  They could have been sustainable but were cut off by policy mistakes.   

It all started with Japan’s asset bubbles bursting in 1992, which were then followed a recession from 1992 to 1994.  Many might forget that there was then a solid recovery from 1994-1997 driven by private consumption and investment.  This came to a screaming halt with a new recession in 1998-1999 caused by withdrawl of public investment and public consumption, along with banking problems.  Insufficiently loose monetary policy contributed. 

Ironically, Japan actually had a number of structural advantages that made its stagnation all the more avoidable.  There was good reason to think that Japan's underlying potential growth was not only undiminished by the recession, but actually increased due to structural reforms undertaken over the course of the 1990s.  These included energy market deregulation, some better utilization of women in the workforce, new entrants in retail due to the rise of Chinese and East Asian production and telecoms deregulation, as well as financial market liberalization.  

The Japanese economy then recovered strongly in 2000-2001.  At this point, it was mounting financial fragility in the core of Japan’s banking system, exacerbated by fears of monetary tightening, that provided the negative shock leading to a sharp collapse in private investment, driving the economy back into recession in 2001-2002.  Again, Posen paints the picture of a market economy showing some natural tendencies to recovery, but being stymied by policy mistakes.

Once again, the economy turns around when policies were reversed in 2002-03 under the leadership of Prime Minister Koizumi, Economic Minister Takenaka and Bank of Japan Governor Fukui.  They reversed monetary policies that contributed to deflation.  They turned the fiscal impulse to average net zero.  And they forced bad loan write-offs and recapitalization by Japanese banks.  Japan’s recovery from 2002-2008 was the longest unbroken recovery of Japan’s postwar history, and was in fact stronger than the growth of other comparable economies.  And for this period, Japanese total factor productivity growth was the highest or second highest among the G5 countries (US, Japan, Germany, UK, and France) in most of the pre-crisis years of the last decade.

Posen does not explore why Japan has been so hard hit by the current global financial crisis.  While the export crash was a factor, there are many who also argue the policy mistakes are also responsible.  A radical easing of monetary policy would help in part by weakening the yen.  Prime Minister Kan’s talk of an increase in the consumption tax – while no doubt necessary over the medium term – is not helping short term prospects.

Posen’s argument is very important.  It is a strong counter to arguments that the “Japanese model” ran out of steam, or that the ageing and declining population is responsible for economic stagnation.  For Posen, the Great Recession was not an inevitable consequence of the bursting of the Japanese bubble.

So why then did Japan make all these policy mistakes?  What happened to the brilliant Japanese policy makers who engineered Japan’s rise from the ashes of war?

Posen does not explore these questions.  But one has to doubt the capacities of these policy makers.  Japanese bureaucrats are typically law graduates from Tokyo University.  They are rarely economics graduates, and rarely do they undertake postgraduate studies.  Japanese graduates typically have job rotations every two years, which means that they can leave difficult problems to their successors.  The Japanese system is dominated by a management system based more on seniority than meritocracy.  The Japanese are inherently very conservative and very likely to avoid radical action even when it’s necessary.  And lastly, Japan’s elite bureaucrats are deeply arrogant and imagine that they can control many economic outcomes.  They forget that the economy is an organism which can sometimes have its own mind.

It is an immense tragedy that the Japanese economy is in its present awful mess.  The great Japanese people deserve more than this!



The Realities and Relevance of Japan’s Great Recession: Neither Ran Nor Rashomon, Adam S. Posen, External Member, Monetary Policy Committee, Bank of England, and Senior Fellow, Peterson Institute for International Economics.  STICERD Public Lecture, London School of Economics, 24 May 2010.