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Japan Bubble and “The Lost Decade”: Monetary policy in a trap.

December 2017


The pur pose of this article is to show how Japanese economy had a perio d of stagnation after a recession in 1989 and how the methodology to c ounter the crisis is the same which is applied in Europe during last few years. The period was characterized by a phenomenon called liquidity trap which occurred in the first Great Depress ion and in Ja pan after the burst of the real estate market bubble. The aim of the research is to link the material studied in class with th e economic situation s that really happened.


The liquidity trap is a n extremely rare phenomenon which only occurred very few t imes in history . The best – known case is the Great Depression . Everyone know s what happened in the USA during the late 2 0s where for the first time a new phenomenon was discovered by John Maynard Keynes : t he inefficiency of monetary policy during situations in which interest rates are low and savings rates are high. The American case was the only time this has happened until the Japan ese depression in the 90s which occurred after the real estate and stock m arket bubble. Before th at , no other case was ever identified and for this reason someone defined the Great Depression as an isolated event. However, this was not the case . During the last 3 0 years, the Japanese economy struggled even if it experienced strong private sector growth during the 1980s and in the early 1990s . Only since late 2013 we have seen a noticeable changi ng trend in the economy of the oriental island. Before the huge crisis, experts believed that Japan could be a successor of the USA a s the world ’s major driving force thanks to the exponential growth that characterized the entire post – war period. However, the engine power of the Japanese economy was essentially policy based . Bi g companies and the Government conducted long – term investments in order to reduce the gap with the USA . Unfortunately , a t the end of 80s , the Japanese business cycle g o t into a negative phase that still has influence in the economy today . We can find one similarity between the Great De pression, the Japanese crisis and what has happened in Europe some years ago : all the scenarios where forerun by a huge real estate bubble. During the Great depression, the real estate bubble was caused by an easy access to credit and by overvaluation of property . T he same happened with the subprime mortgage a decade ago . These causes added up an extremely fast rising price and an elevated aggregate demand growth in Japan had the same effect causing a deep economy drop . Furthermore, overconfidence and the Bank of Japan’s loose monetary policy in the mid – to – late 1980s led to aggressive speculation in domestic stocks and real estate, pushing the prices of these assets to previously unimaginable levels . The peak was reached when the total value of lan d in Japan was over four times the real estate value of the entire United States.

The absolute peak was reached in 1989 when the Nikkei 225 index was at more than 38.500,00 points . Nowadays, in 2017 the same index has 30% fewer points than so many years ago.

When the huge speculative bubble blew up, economic growth in Japan slowed down remarkably . Labour productivity decreased noticeably and the Japanese economy stumbled into 20 years of stagnation. During the two – year period ‘91 – 92, all important economic variables started to drop . GDP growth fell from 6% of the previous years to less than 1,5%. Unemployment strongly and constantly increased while inflation decreased year over yea r ; a long period of deflation and stagnation started.

The “ Lost Decade” is how expert s called th is period of time in Japan during the crisis . It has been one of the most studied economic case s with the goal to learn from past experiences and try to do not repeat the errors committed by Japanese fiscal authorities. Unfortunately, we all know what happened in 2007 with the subprime mortgages and in 2011 in Europe with the sovereign debt crises.

The Japanese GDP slowed down strongly until 1995 and during the two – years period between 2001 and 2002 the economic performance seemed to be one of the worst compared to Europe and the USA. The decrease of gross investments linked with private consumption pushed Japanese unemployment close to 5%. However, t he most important factor seemed the CPI. I n Europe and in the USA the CPI was close to 2% but in Japan the rate was zero or even negative in the same period of time since 1994 . The short – term interest rate became zero in response. T he nominal interest rate usually cannot be negative , however. T his situation was an indicator of the liquidity trap.

The Japanese Fiscal Authority underestimate d the crisis ’ seriousness for a long time . Initially, the authority was too shy and only since 1998 the G overnment decided to increase the expansion. Unfortunately, it was too late.

The problem reached huge dimensions because the Japanese sovereign debt was already too high. According to the Ricardian equivalence mechanism , in a rational scenario, forward – looking taxpayers will anticipate paying for government spending at some time in the future. If the government defers taxation, tax payers will save part of their income to pay higher taxes in the future in order to meet the bond obligations. This higher saving causes private demand to decline when government demand rises which reduces, if not totally eliminates, the demand stimulus created by higher government spending. During a period of liquidity trap, the expansion of the monetary policy made b y the BOJ had no effect because the demand of money is infinitely elastic to the interest rate . A fiscal expansion might have been really efficient . When the gross interest rate is zero, it is impossible to go below that value . In that case we are in a liquidity trap situation which is what happen ed in Japan.

Furthermore, the decisional process of the Central Banks in order to fix the short – term interest rate can be described with the Taylor Rule:

Screen Shot 2017-12-05 at 17.18.19


• 𝑖𝑡 𝑡: : short term interest rate

• (Alfa) 1 : weight of the inflation target

• (Alfa) 2 : weight of output gap

• ρ : non – smoothing willingness of interest rate .

When we have to f aceoff a deflation period ( π < 0) even the output ga p is negative because we have a recession period . Indeed, when 𝑖𝑡 𝑡− − 1 is already equal to zero, the Taylor rule need s to set 𝑖𝑡 𝑡 lower than zero . U sually this is (was) not possible but we have witnessed some years of negative interest rate s in Europe and Japan (this is an unconvention al monetary policy also called NIRP, the results are a collapse in the aggregate demand and an increase of unemployment) . For this reason, the output gap became even more negative and the decrease in prices became stronger causing an instable deflationary spiral. In our case, this is exactly what happen ed in Japan during the last twenty years.

The BOJ tried to counter deflation with Quantitative Easing during 2001. In 2013 , the BOJ conducted Quantitative and Qualitative Easing by increasing the purchase of sovereign bonds with the goal to bring inflation to a level of 2%, as quickly as possible. The QE in Japan has been applied until some month s ago and seemed to have produced effects only at the end of 2015 whe n Europe with Mario Draghi started to address the crisis in the Euro zone with the same policy. Nowadays, there is a fear that QE could generate the same story line as in Japan for more than a decade in Europe. Can we assert that the Jap anese QQE was an evident failure ? Or has it been the only way to emerge from a negative business cycle? All we know for sure is that it is the way taken by Europe for the next years.

Giovanni Accardo
31219 – 3722
Macroeconomic Analysis Essay


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(Banca D’Italia) 207 (1).

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Sgroi, Maurizio. 2016. “Vent’anni di QE e tassi a zero non bastano al Giappone.

Perchè dovrebbero curare noi?” (Il Sole 24 Ore).


Author: studentnovasbe

Master student in Nova Sbe

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