Japan's "Lost Decade": Implications for the U.S. Economy

Executive Summary

The Japanese economy stagnated for a decade or so following the collapse of its asset price bubbles in the early 1990s. Real GDP growth in Japan, which averaged nearly four percent per annum during the 1980s, dropped to an annual average rate of only one percent during the subsequent decade. Could the U.S. economy experience a "lost decade" in the wake of its own burst asset price bubbles?

Unlike policymakers in Japan, who were quite slow to support the Japanese financial system via monetary easing and direct assistance to financial institutions, U.S. policymakers have responded very aggressively to the current financial crisis in the United States. Not only has the Federal Reserve cut its policy rates significantly, but it has pumped massive amounts of liquidity into the financial system. The Fed has also implemented a number of programs to lend directly to financial and nonfinancial institutions. The Treasury Department is about to embark on a program to recapitalize financial institutions. The quick response of U.S. policymakers should reduce the risk of a downward spiral of bank lending and economic activity.

However, Japan's experience during the 1990s shows that the U.S. economy could experience a few years of subpar economic growth. Corporate deleveraging in Japan weighed on investment spending and restrained Japanese economic growth between 1990 and 2003. Although the nonfinancial sector in the United States is generally financially healthy at present, it is the household sector that has built up leverage over the past decade or so. Therefore, growth in consumer spending and residential investment should be sluggish as consumers reduce leverage. Although the U.S. economy may be spared from a Japan-like "lost decade," it appears that a few "lost years" await.

Japan's "Lost Decade," Not the Great Depression, is the Correct Guidepost

Over the past few months, the press has been filled with stories claiming that current dislocations in credit markets are the most severe financial crisis since the Great Depression. The mere mention of the term "Great Depression" evokes fear and implies that the current credit crunch could easily lead to another depression. In our view, however, another depression is not likely because the plunge in economic activity in the early 1930s was caused by the outright collapse of the financial system. As we argue below, the U.S. government, in conjunction with governments in most advanced economies, has taken aggressive action over the past few weeks to head off a financial collapse á là the early 1930s.

Rather than reaching back decades for a guidepost to the trajectory of the U.S. economy over the next few years, the Japanese experience of the 1990s may be more illustrative than the Great Depression of the early 1930s. The Nikkei stock market index climbed about sixfold between late 1982 and the last trading day in 1989, only to give up most of its gains over the subsequent 14 years. Residential land prices in Japan have dropped about 40 percent since 1990. Not only did Japanese asset prices tumble, but the real economy stagnated. During the high-flying decade that spanned 1980-1990, Japanese real GDP growth averaged nearly four percent per annum (Exhibit 1). Between 1991 and 2003, which coincided with the Nikkei's nadir, the country's average growth rate dropped to only one percent per annum. This period of economic stagnation (some would argue the economy has yet to fully recover) has become known as Japan's "lost decade."

Exhibit 1

Hmmm, bursting of asset price bubbles. Sluggish economic growth. Sound familiar? Although most analysts would not claim the U.S. stock market was in bubble territory a year or two ago, credit markets clearly were frothy. In addition, the 20 percent decline in the Case-Shiller 20 metro market house price index since 2006 is prima facie evidence that residential real estate was overvalued. The incipient recession and illiquidity of mortgage markets strongly suggest that further declines in house prices lie ahead. Is the United States destined for its own "lost decade" á là Japan?

U.S. Policymakers Have Responded Very Aggressively to the Crisis

Although there are apparent similarities between the asset price bubbles in Japan and the American experience of the past few years, there are important differences as well. For starters, the Bank of Japan (BoJ) responded very slowly to the bursting of Japan's asset price bubbles. Indeed, the BoJ hiked its discount rate by 175 basis points following the bursting of the country's stock market bubble in December 1989, and it did not begin to ease policy until July 1991 when economic growth was weakening visibly (Exhibit 2).

Exhibit 2

Moreover, the BoJ left its real policy rate in positive territory (i.e., the nominal discount rate remained above the rate of CPI inflation) despite marked weakness in economic activity. Many central banks fight recessions by cutting their policy rates below the prevailing CPI inflation rate. Taking real interest rates into negative territory encourages borrowing and usually leads to economic recovery. However, the BoJ did not cut rates fast enough, and it eventually lost the ability to stimulate the economy via negative short-term interest rates once the Japanese economy began to experience deflation in the early years of the present decade.1 In short, the BoJ was not aggressive enough in easing monetary policy in the aftermath of the country's burst asset price bubbles.

Although some commentators berated Fed Chairman Bernanke in the summer of 2007 for not cutting rates when the subprime mortgage crisis first surfaced, the Fed has cut rates very aggressively since September 2007. As shown in Exhibit 3, the real Fed funds rate, which is defined as the nominal Fed funds rate less the CPI inflation rate has been in negative territory since last December. Even if the less volatile core rate of CPI inflation is used, the real Fed funds rate has been significantly negative since March.

Exhibit 3

A skeptic would reply that it does not matter how low the FOMC takes the real Fed funds rate if banks are simply unwilling to make loans, either to each other or, perhaps more important, to nonfinancial businesses and consumers. Indeed, LIBOR rates, which reflect interest rates that banks charge each other but also serve as benchmark lending rates on an economywide basis, have jumped higher over the past month even as the Federal Reserve has cut its target for the Fed funds rate. However, even if it takes another year for LIBOR rates to decline to a few basis points above the Fed funds rate, which is "normal," the Fed would still be well ahead of the Bank of Japan in terms of its policy response. As shown in Exhibit 2, it took the BoJ more than two years simply to reverse the tightening it undertook in 1990 (after the bubbles had broken).

Moreover, the Federal Reserve has done much more than simply cut interest rates. It has pumped massive amounts of liquidity into the banking system over the past few months by lending directly to commercial and investment banks. The Fed extended a loan worth $85 billion to American International Group (AIG) when it judged that the company's failure would pose a systemic risk to the international financial system.3 More recently, the Fed created a program that will buy commercial paper directly from companies that issue it.

The Treasury Department has also been quite aggressive in its policy response, at least over the past month or so. When it became apparent that Fannie Mae and Freddie Mac were essentially insolvent, the Treasury placed both agencies into conservatorship and directed the companies to ramp up their purchases of mortgage-backed securities to help support the mortgage market. It proposed a program known as the Troubled Asset Recovery Program (TARP) that would facilitate the deleveraging process in the financial system by buying hundreds of billions of dollars of troubled assets from financial institutions. When investors became convinced that the financial system needed more capital, the Treasury Department announced that it would use its TARP authority to purchase preferred shares in financial institutions.

In contrast, Japanese policymakers were slow to directly support the financial system after the bubbles broke. The first program to attempt to clean up the financial system was not put in place until January 2003, three full years after the stock market had peaked.4 Moreover, the initial program was not very effective because no public sector funds were made available. Public injection of capital into the banking system did not begin in earnest until early 1998. Meanwhile, the Japanese banking system became seriously undercapitalized. Indeed, statistics from the Bank of Japan show that liabilities of the Japanese banking system exceeded assets in 1991-94 and again in 2001-04 when the Japanese economy slipped back into recession. The undercapitalization of the banking system constrained the ability of Japanese banks to make new loans to healthy companies.

Deleveraging by the Corporate Sector Restrained Japanese Economic Growth

U.S. policymakers have taken steps to shore up the financial system against outright collapse, which could easily lead to another depression if allowed to occur. That said, the U.S. economy looks as if it will experience its most severe recession since at least 1981-82. Although the economy should bottom sometime in mid-2009, we believe that the subsequent recovery will be a long drawn-out process. To understand why, let's turn again to the Japanese experience in the 1990s.

As shown in Exhibit 4, the liabilities of Japan's nonfinancial corporate sector rose steadily throughout the 1980s. As Exhibit 4 also makes clear, business fixed investment spending as a percentage of GDP increased quite sharply during that decade. In other words, Japanese businesses financed their capital expansion in the 1980s by increasing their leverage. After the asset price bubbles broke, corporate liabilities (as a percentage of GDP) held steady for a few years before beginning a trend decline that lasted from the mid-1990s to the middle part of this decade. It took about a decade for Japanese companies to get their balance sheets back in order after a binge of borrowing in the 1980s.

Exhibit 4

Investment spending, which had boomed in the 1980s, was quite weak in the subsequent decade. Between 1994 and 2003, real GDP in Japan grew only nine percent, and nonresidential investment spending by the private sector contributed only one percentage point to this overall growth rate.5 Japan's "lost decade" is a story, at least in part, of deleveraging by the corporate sector that led to weak growth in investment spending. In addition, the undercapitalization of the banking system contributed to weakness in investment spending by inhibiting the ability of the banking system to lend.

The Household Sector in the United States Is the Problem

In contrast to the Japanese business sector, which became increasingly leveraged during the 1980s, the nonfinancial business sector in the United States is generally financially healthy at present. Rather, it is the household sector in the United States that has become overly leveraged. As shown in Exhibit 5, the liabilities of the household sector have increased steadily over the past decade or so. Consumer spending and residential investment rose from 71 percent of GDP in 1997 to a peak of 76 percent in 2005.

Although recent data show that the liabilities-to-GDP ratio in the household sector edged lower in the second quarter of this year, deleveraging in the household sector probably has further to run. The debt service ratio, which measures the amount of income households spend servicing debt, currently stands near 14 percent of disposable income, up from the 11 percent ratio that was typical about a decade ago. The abysmally low personal savings rate is likely to trend higher as consumers rebuild their balance sheets.6 To increase the personal savings rate, consumer spending will need to grow slower than income for a period of time.

Exhibit 5

As shown in Exhibit 6, we project that the U.S. economy will contract 0.5 percent in 2009, the weakness annual average growth rate since 1982.7 Although the economy should start to recover in the second half of 2009, the upturn will probably not be very robust due in part to subpar growth in real consumer spending. Indeed, the 1.9 percent GDP growth rate that we forecast for 2010 is well below the 3.1 percent annual growth rate that the U.S. economy averaged between 1992 and 2007. Although our forecast does not extend beyond 2010, another year or two of subtrend growth could easily occur as growth in consumer spending remains in check.

Conclusion

The Japanese economy largely stagnated for a decade or so after its property and stock market bubbles imploded in the early 1990s. Does the recent implosion of asset price bubbles in the United States doom the U.S. economy to its own "lost decade?"

Although we project the United States will experience its most severe recession since the 1981-82 downturn and that the subsequent recovery will not be very robust, we do not believe the U.S. economy will remain stagnant for an entire decade. In contrast to Japanese economic policy in the early 1990s, policymakers in the United States have moved very aggressively to shore up the U.S. financial system. The Federal Reserve has cut its target for the Fed funds rate by 375 basis points since September 2007, and it has undertaken a number of programs to lend directly to the financial and nonfinancial business sectors. The Treasury Department has announced its intention to use its TARP authority to assist in the recapitalization of the U.S. financial system. Although banks remain wary of making new loans at present, the policy steps announced so far should eventually lead to resumption in bank lending. If the financial crisis should continue, we believe policymakers would implement additional programs in an attempt to unfreeze credit markets.

That said, leverage in the U.S. household sector has trended higher over the past decade or two, and we foresee an extended period of deleveraging by American consumers. The U.S. economy appears to be headed for its most severe recession since the early 1980s, although forceful policy actions to date have minimized the probability that the U.S. economy falls into a depression. That said, a few years of subpar GDP growth appear likely as growth in consumer spending and residential construction fall well short of rates that were registered earlier this decade. Although the U.S. economy may be spared from a Japan-like "lost decade," it appears that a few "lost years" await.

Exhibit 6

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