Japan's bankers celebrated the end of the 1980s with raucous parties and an all-time high of 38,957 on the Nikkei stock index. It had been a magnificent decade and they all looked forward to another one.
The economy had grown by an average of 4 per cent a year and seemed well set to continue on a similar path. By 1995, forecast Nomura Securities, the Nikkei index would hit 63,700. It was a thrilling, golden era. Foreign officials, financiers and journalists rushed to Tokyo. Everyone wanted to learn the lessons of Japan. They still do. Thirty years on, Japan's economy has not lost its fascination. But rather than the secrets to miraculous economic growth, today's students of Japan want to know how to respond when the good times stop.
"What had been regarded as Japanese problems are now faced more or less by Europeans," says Hiroshi Nakaso, the former deputy governor of the Bank of Japan. "I'm not saying I'm convinced Europe will follow Japan's path but Japan's experience certainly offers hints."
Economically, those lessons include the vital importance of maintaining public confidence in central bank policy, and the need for a strategy to generate economic growth. More broadly, Japan's decades of experience offer a template for how a society can live with low interest rates. Large parts of the developed world are likely to emerge from the coronavirus crisis with economies in that same position.
That prospect is unsettling to some because of the stagnation that Japan has seen over the past three decades. Since 1990, Japan has recorded average annual real growth of 0.8 per cent and inflation of 0.4 per cent. The Nikkei index never again came close to that December 1989 peak. Today it stands at 25,907. In dollars, per capita incomes in Japan are a third lower than in the US.
While the rest of the world enjoyed booming growth in the 1990s and 2000s, Japan's problems seemed unique, and foreign economists lined up to propose radical solutions. But then their own economies began to show an eerie similarity. In the wake of the 2008-09 financial crisis, interest rates fell to zero in Europe and the US, and during the recovery inflation did not bounce back.
No longer an odd economic twilight zone, Japan is now the best case study of what happens in an environment of persistent low inflation and interest rates — a situation much of the developed world may face in the aftermath of the Covid-19 pandemic.
To extract any lessons, however, it is important to understand what actually happened in Japan over the past 30 years. Although the outcomes of low growth, low inflation and low interest rates look similar throughout the period, the economic forces at work changed a lot. There was no single process of "Japanification".
Instead, there were three distinct but mutually reinforcing chapters: the financial crisis in the 1990s; persistent, mild deflation in the 2000s; and then, in the 2010s, an attempt to fight back against Japan's ageing demographics. With three chapters in Japan's post-bubble era, the lessons for the rest of the world are inevitably nuanced.
The 1990s — a banking crisis
In the early years of the 1990s it slowly dawned on people that the heady peak in stock and land markets had been a bubble — one backed by trillions of yen in bank loans, which speculators and property developers had no way to pay back. Rather than foreclose on bad loans, however, corporate Japan and its bankers pretended the assets were still solid and the debts were still good.
Minoru Masubuchi took over the Bank of Japan's financial system department in 1994. "I think we knew quite early that it was an extremely severe problem — that was the understanding I had when I took the post," he says. "However, for the world at large — especially in politics and the media — there wasn't such a realisation."
The technocrats wanted to recapitalise the banks with public money, but they could not persuade the politicians. The banking crisis ground on until the "Dark November" of 1997. "[Hokkaido] Takushoku Bank and Yamaichi Securities went under and there was an atmosphere of confusion," says Mr Masubuchi. "The worst time was that period from November until the end of 1997."
Initial attempts to fix the banks made matters worse. At the start of 1997, the finance ministry said it would step in if capital ratios fell below a certain level, but that prompted banks to slash their lending in an effort to survive. "Many small and medium-sized firms failed," says Hiroshi Yoshikawa, a member of the government's economic council from 2001-06. "1997-98 was truly one of the worst years for postwar Japanese society."
A widespread credit crunch hammered the economy. Scarred by the bubble, the BoJ was slow to cut interest rates, and repeated rounds of fiscal stimulus had little effect. Inflation declined steadily and by 1999 it was below zero. But the underlying cause was not peculiar to Japan or even historically unusual — it was an unresolved banking crisis.
Watching from the other side of the Pacific, US policymakers learnt this lesson thoroughly. When the global financial crisis struck in 2008-09, they were quick to slash interest rates and force public capital on banks through the Troubled asset relief programme. "The bad loan problem and financial trouble was ended by 2003," says Mr Yoshikawa. "If we had any trouble after 2003 we must have a different explanation."
After a great struggle, Japan had resolved the banking crisis and everyone thought things would now go back to normal. "Personally, I thought we'd go back to a regular business cycle. I didn't expect this stagnation scenario to continue for a long time," says Mr Masubuchi.
The 2000s — stagnation
The weakness of the economy was obvious and the Bank of Japan needed to do something. The question was what. All the textbooks assumed positive interest rates. "There were no papers we could consult. I guess what we had was very basic financial theory," says Nobuo Inaba, who was the BoJ's section chief for monetary policy in the mid-1990s and went on to become one of its executive directors.
The resulting period of experimentation wrote the manual for central banks around the world. First, the BoJ cut interest rates to zero. (At the time it did not think negative rates were possible, says Mr Masubuchi.)
Meanwhile, a former businessman on the BoJ's policy board called Nobuyuki Nakahara began to promote the ideas of Bennett McCallum, an American economist. Mr McCallum proposed a rule for how a central bank should increase the money supply when the economy fell short of full employment. The BoJ could not cut interest rates any further, but it could increase the quantity of bank reserves. Mr Nakahara called this "quantitative easing".
Quantitative easing brought down long-term interest rates and had a calming effect on financial markets, but it did not transform inflation or growth, which recovered slowly through the 2000s. The central problem, it slowly became clear, was that the public no longer expected prices or wages to go up, and no matter what the central bank did, their expectations were self-fulfilling.
"In terms of monetary policy, our experience tells us that anchoring inflation expectations is important. In Japan, under the prolonged period of deflation, inflation expectations came to be anchored around zero," says Mr Nakaso.
One of the primary lessons of Japan's experience is the need for aggressive action to pre-empt any fall in inflation expectations — and the limited power of monetary policy if that is not achieved.
But the lesson about expectations has hit home in central banks across developed economies. Jay Powell, US Federal Reserve chairman, has pledged to raise inflation to moderately exceed its 2 per cent target "for some time", expressing "determination" to succeed in ensuring inflation expectations do not fall to zero in the wake of the pandemic.
The European Central Bank and Bank of England have both this autumn revised their guidance to commit to keeping monetary policy as loose or looser than it is now until inflation rises back to target and shows no signs of falling again.
The 2010s — fighting demographics
As the period of low inflation dragged on, however, and other advanced countries adopted zero interest rates after 2008, economists began to consider deeper causes. Towards the end of the decade, the then BoJ governor began to argue that the root cause of Japan's low inflation was weak economic growth, and that was linked to the country's demographics."Nowadays everybody says the Japanese economy has poor future prospects because of population decline. But that kind of view is actually quite new," says Mr Yoshikawa. During the 2000s, when companies were cutting jobs, he says, the debate was about Japan's surplus of workers, not a shortage.
Japan's fertility rate has been low since the 1970s and the working-age population peaked in the 1990s. With ageing workers wanting to save, and little motivation for businesses to invest in a declining economy, the logical result is a low natural interest rate. The US economist Lawrence Summers crystallised this line of thinking in 2014 when he revived the concept of "secular stagnation".
If demographics are the root of Japan's problems, then there is a mixed message for the rest of the world. Fertility rates are higher in Europe and the US and they both have meaningful immigration. Although their populations are ageing, that suggests they have a better chance of escaping persistent zero inflation and interest rates. But other east Asian economies such as China, South Korea and Taiwan are closely following Japan's demographic track.
Many economists think the theory of demographic destiny is oversold, however, and either does not explain the trend towards zero inflation and interest rates or is framed incorrectly.
Mr Yoshikawa is not a fan of the demographic thesis. "A declining population is of course a negative factor for growth. But at least historically, the importance of innovation dominates it by far," he says.
For Charles Goodhart, former BoE chief economist, an ageing population holds the promise of escape from the Japanese trap, since the elderly spend more than they earn in the labour market, diminishing the excess savings that brought the world zero interest rates and problematic low inflation.
If this theory is correct, however, it is yet to manifest itself in Japan. Rather than wait for an improvement, the 2010s in Japan brought the most determined effort yet to shake the nation out of its stagnation: the stimulus known as Abenomics.
The performance of the economy under former Shinzo Abe's premiership improved significantly and public debt stabilised for the first time in years, but the fundamentals of interest rates and inflation were ultimately little changed. Inflation remained low and interest rates were still pinned to the floor, providing little scope to act as a cushion when downturns such as the Covid-19 crisis hit.
Thirty years on from the bursting of the bubble, a common reaction to Japan's predicament is to ask whether there is really a problem at all. The country is stable and prosperous. Per capita growth in output has not been too bad. For many, especially the elderly, low inflation is a good thing, and a large public debt is less daunting when it carries an interest rate of zero.
Such optimism, however, belies difficult problems of economic management. For much of the past three decades, Japan's economy has operated below full capacity, ruining the life chances of millions of people who graduated into a weak labour market. The country's only option when a crisis such as Covid-19 strikes is to run up ever more public debt.
What are the lessons from Japan's experience? One is that the route to zero interest rates and zero inflation does not matter. The crucial requirement is to find a way to stop a temporary plunge to zero interest rates from becoming a self-fulfilling prophecy. So far, the US and UK have avoided falling into the trap of zero inflation expectations, but the ECB is perilously close.
The demographics of Europe and the US are different to Japan, but all advanced countries have ageing populations — which may bring caution in spending — while technological progress is a global and not a national phenomenon.
Most important is the need to look past the specifics of Japan's experience and recognise that whatever the difficulties, countries must not give up on the quest for growth, and do whatever is necessary to raise it to levels that keep employment high, wages rising and inflation from sinking to zero.
"There were two things that we recognised over time. One is how important financial stability is and the second is the importance of a growth strategy," says Mr Nakaso. "Policies to address both the demand and the supply side of the economy are important. Raising Japan's potential growth rate remains essential."
- Financial Times