Long-term Stagnation of the Japanese Economy

This article discusses the policy dilemma that Japan faces in order to get the economy out of its decade-long deflation.

After the booming bubble economy of 1980s, the Japanese economy has been stagnant since early 1990.  Beside the crush of the real estate bubble in the first half of 1990s, Japan faced three successive negative shocks: sharp appreciation of the yen in 1994-95, financial crisis in 1997-2002 triggered by the successive failures of big Japanese financial institutions, and the global financial crisis from 2008 to the present.  The first shock was strong enough to start a mild deflation measured by the GDP deflator (Exhibit 1).  But the economy started to recover in 1996-97 after successive increases in fiscal spending and very low interest-rate policy by the Bank of Japan.  However, the second shock, financial crisis in 1997, stopped the recovery and aggravated the deflation.  Japan started to recover again in the mid 2000s due to a weaker yen and very strong export growth to China and other Asian countries.  When many Japanese analysts felt that the long deflation may end soon, the global financial crisis hit Japan in late 2008.  By the end of 2009, Japan's GDP deflator fell by about 15 percent from the peak in 2005 (Exhibit 2).

Exhibit 1

Exhibit 2

Exhibit 3

Because of the falling general prices, the nominal GDP has not grown at all for almost two  decades; the nominal GDP in early 2010 is about the same as the GDP in 1992 (Exhibit 3).  After the global financial crisis, Japanese real GDP started to recover since early 2009.  However, nominal GDP has been almost flat due to continuing deflation. 

Even though Japanese deflation has been a mild one, it has been very damaging for the Japanese economy.  Monetary policy faced the zero-lower-bound of market interest rate. The short-term market interest rate cannot become negative because there is a safe zero-interest rate asset called "bank note."  If the Bank of Japan sets a negative interest rate on cash reserves of private financial institutions, banks can hold yen cash in their vault. If the Bank of Japan sets a negative interest rate on their lending to private banks, banks will not pass this negative interest rate to their borrowers because banks can always invest in yen cash with zero interest rate.  For example, by borrowing money from the Bank of Japan at minus one percent and hording cash with this borrowed money, a bank can make one percent return without any risk involved.  Since the start of Japanese deflation in 1995, the Bank of Japan kept short-term market interest rate (overnight call rate) between 0 and 0.5 percent. 

Exhibit 4

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