"The rebalancing debate has sparked renewed interest in Japan’s experience since the 1980s. Some argue
that this is a cautionary tale, exemplifying the dangers
of reorienting economies through currency appreciation (People’s Daily, 2010). They claim that the
appreciation of the yen after the Plaza Accord forced
the authorities to introduce an offsetting macroeconomic stimulus, which then led to an extraordinary
asset price boom followed by an extraordinarily painful bust. Japan was one of the world’s fastest-growing
economies for three decades but has averaged only
1.1 percent real GDP growth since 1990, while
prices have steadily declined. Consequently, the size
of Japan’s economy today is about the same as in the
early 1990s. The sequence of events is clear and striking. But there are reasons to doubt that it was truly
inevitable, whether the Plaza Accord was really the
direct cause of Japan’s “Lost Decades.”
What Happened?
The events began in September 1985, when
delegates from the G5 countries met at the Plaza
Hotel in New York, declared the U.S. dollar overvalued, and announced a plan to correct the situation.1
The essence of the plan was that the main current
account surplus countries (Japan and Germany)
would boost domestic demand and appreciate
their currencies. In effect, this agreement marked a
major change in policy regime: the Federal Reserve
was signaling that after a long and successful fight
against inflation, it was now prepared to ease policies, allow the dollar to decline, and focus more
on growth. This signal was backed by coordinated
currency market intervention and a steady reduction
in U.S. short-term rates. Accordingly, it triggered an
exceptionally large appreciation of the yen, amounting to 46 percent against the dollar and 30 percent
in real effective terms by the end of 1986. (The
deutsche mark appreciated similarly.)
As a result, Japan’s export and GDP growth
essentially halted in the first half of 1986. With the economy in recession and the exchange rate appreciating rapidly, the authorities were under considerable pressure to respond. They did so by introducing
a sizable macroeconomic stimulus. Policy interest
rates were reduced by about 3 percentage points, a
stance that was sustained until 1989. A large fiscal
package was introduced in 1987, even though a vigorous recovery had already started in the second half
of 1986. By 1987, Japan’s output was booming, but
so were credit growth and asset prices, with stock
and urban land prices tripling from 1985 to 1989.
Then, in January 1990, the stock price bubble burst.
Share prices lost a third of their value within a year,
and two decades of dismal economic performance
followed (Figure 1.4.1). Today, nominal stock and
land prices are back at their early 1980s levels, one-
quarter to one-third of their previous peaks.
The critical question is whether this sequence
was inevitable. In other words, did the appreciation force Japan to introduce a powerful stimulus
to sustain growth, which then triggered a bubble,
which caused the Lost Decades when it collapsed?
Let’s consider each step in turn.
Was Such a Large Stimulus Needed?
Studies suggest that, in fact, the monetary
policy easing may have been excessive. Estimates
by Jinushi, Kuroki, and Miyao (2000) and Leigh
(2010), among others, suggest that the policy rate
was up to 4 percentage points too low during
1986–88 relative to an implicit Taylor rule based
on the output and inflation outlook. Why, then,
did the central bank sustain such a policy? A key
reason is that current inflation remained reasonably
well behaved, which led some economists to argue
that soaring growth rates did not represent a cyclical
boom but rather a “new era” of higher potential
growth. This growth was particularly gratifying
because it was led by domestic demand, a key commitment under Plaza.
But IMF reports at the time suggest another factor was also at work. The authorities worried that
higher interest rates would further strengthen the
yen and feared that appreciation would eventually
have serious effects on the economy. In the end,
external demand did indeed diminish. But it did not collapse. Real exports continued to grow in the
five years after Plaza, by an average of 2½ percent a
year (half the rate of the previous five years), while
the current account surplus diminished by a moderate 2 percentage points of GDP. (Similarly, Germany’s currency appreciation failed to derail its export
or GDP expansion, even with a smaller monetary
response.) Put another way, excessive stimulus was
adopted in part because there was excessive concern
about the impact of appreciation.
Did the Stimulus Cause the Bubble?
Although the monetary easing was certainly large,
it is far from clear that it alone was responsible for
the asset price bubble. Chapter 3 of the October
2009 World Economic Outlook and Posen (2003)
have examined the link between monetary policy
and asset price booms in advanced economies over
the past 25 years. They conclude that policy easing
is neither necessary nor sufficient to generate asset
price booms and busts. In Japan’s case, two other
elements seem to have played a large role. As Hoshi
and Kashyap (2000) explain, financial deregulation
in the 1970s and early 1980s allowed large firms
to access capital markets instead of depending on
bank financing, leading banks to lend instead to real
estate developers and households seeking mortgages.
As a result, bank credit to these two sectors grew by
about 150 percent during 1985–90, roughly twice
as fast as the 77 percent increase in overall bank
credit to the private sector. Finally, because the dangers of real estate bubbles were not well understood
in those years, the Japanese government did not
deploy countervailing regulatory and fiscal policies
until 1990.
Did the Bubble’s Collapse Cause the Lost Decades?
The aftermath of the bubble proved extraordinarily painful for Japan. But the collapse of a bubble
does not inevitably have such powerful and long-lasting effects. What was special about Japan’s case?
A key factor was the buildup of considerable leverage in the financial system, similar to what occurred
in the United States before 2008. Tier 1 capital of
Japanese banks in the 1980s was very low, much
lower than elsewhere, as global standards (the Basel I accord) had not yet gone into effect. Moreover,
much of the collateral for loans was in the form
of real estate, whereas under the keiretsu system a
significant portion of bank assets consisted of shares
in other firms from the same group. So, when real
estate and share prices collapsed, the banking system
was badly damaged.
This underlying vulnerability was exacerbated by a
slow policy response. The authorities delayed forcing
banks to recognize the losses on their balance sheets
and allowed them to continue lending to firms
that had themselves become insolvent, a process
Caballero, Hoshi, and Kashyap (2008) call “zombie lending.” This process continued into the early
2000s, stifling productivity growth and prolonging
Japan’s slump. Why did the authorities not force
faster restructuring? Possibly because restructuring would have required additional bank capital, which
they were not in a position to provide in light of the
strong political backlash after an initial injection of
public capital in 1995. Consequently, the authorities
exercised forbearance instead.
The postbubble slump may also have been exacerbated by the macroeconomic policy response and
adverse external shocks. Some argue that premature
monetary tightening and the lack of a clear commitment to raising inflation led to unduly high real
interest rates (Ito and Mishkin, 2006; Leigh, 2010).
In addition, the tightening of fiscal policy in 1997
may have undercut the nascent 1995–96 recovery
(Posen, 2003; Corbett and Ito, 2010). Finally,
adverse external shocks played a role, including the
1997–98 Asian financial crisis.
In sum, Japan’s experience shows that currency
appreciation does not, in fact, inevitably lead to
“lost decades.” The appreciation did not inevitably require such a large macroeconomic stimulus. The stimulus did not inevitably lead to the
bubble. Nor did the bubble’s collapse inevitably
lead to the Lost Decades. Instead, it was the particular combination of circumstances and choices
that led to that result.
Lessons for Rebalancing Today
Calibrating a policy response to exceptionally
large appreciations and movements in asset prices
remains an extraordinarily difficult task. But some
pointers can be gleaned from Japan’s experience. The
keys are to
• avoid an excessive macroeconomic response to
currency appreciations;
• use prudential policies to prevent vulnerabilities
from building up, especially in the form of leverage;
• address banking problems quickly if they do
materialize; and
• provide significant macroeconomic support when
banking systems and economies come under stress.
An even broader lesson is that bubbles can prove
dangerous. Accordingly, Japan has introduced a two-
perspective framework for monetary policy, with one
pillar focusing on price stability and the other looking
out for financial imbalances such as asset price bubbles.
But even as Japan’s experience offers lessons to
countries considering rebalancing today, the direct
parallels are limited. Most notably, circumstances in
China today differ from those in Japan in the 1980s
in ways that should help it avoid Japan’s disappointing outcomes (Figure 1.4.2). First, the leverage of
households, corporations, and the government in
China is lower now than it was in Japan before the
bubble (N’Diaye, 2010), and the risk of excessive
borrowing may thus be smaller. Second, as Chapter
4 of the April 2010 World Economic Outlook and
Igan, Fabrizio, and Mody (2007) find, climbing the
quality ladder helps offset the impact on growth of
currency appreciation, and China has more room
to climb the export quality ladder than Japan did.
(At the same time, the impact on labor-intensive
industries may be greater.) Third, Japan had a floating
exchange rate regime in the 1980s, but China has
a managed exchange rate supported by vast foreign
currency reserves and strong restrictions on capital
inflows. This difference in currency regimes should
help China avoid the sharp appreciation observed in
Japan. Most important, China should be able to reap
the benefits of learning from Japan’s experience."
