U.S. can learn from Japan's deflated economy in the 1990s

When the bubble finally popped in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. At Monday's close of 13,326, it remains a fraction of its record high.

The end of the easy-money era also took a toll on land prices, which fell 3% to 6% eight years in a row. Japanese banks, which had made loans based on wildly inflated valuations of property held as collateral, came under enormous stress. As the economy flat-lined, Japan's central bank temporized, keeping inflation-adjusted interest rates abnormally high. Among the Bank of Japan's critics was a prominent Princeton University economist, who blamed "exceptionally poor monetary policymaking" for the country's protracted malaise. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral, according to the Princeton academic, Ben Bernanke, who today works to ensure that his Fed does not repeat those mistakes.

In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. (In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1%.)

Eventually, in 1995, Japan began moving toward a policy of keeping inflation-adjusted interest rates near zero. But by 1999, when the zero-rate policy was fully implemented, the economic damage already had been done. Falling prices for goods and services discouraged investment and hiring. Consumers husbanded their cash for fear of what the future held. The economy was trapped.

The Bank of Japan insisted it had done everything it could and, as late as 2000, one central bank governor even insisted that the deflation then racking the economy was actually a good thing. Bernanke rejected such arguments, saying the central bank was "stonewalling" and allowing "trivial considerations" to "block needed policy actions."

Bernanke, who made his mark in academia with his writings on the Great Depression, argued that what Japan lacked was a willingness to experiment the way Franklin Roosevelt had in the 1930s. The economist's 2000 speech provides insight into the creative approach he has employed today: "Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn't absolutely guaranteed to work."

What not to do

In recent years, economists arrived at a consensus on Japan's handling of the bubble's aftermath. Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. And government policy oscillated in ways that blunted the impact of the monetary and fiscal tools it employed.

"Certainly, we can learn what not to do from Japan's experience," said Eric Rosengren, president of the Federal Reserve Bank of Boston, in a speech earlier this month.

Since the credit crunch erupted in August, some have suggested that the Fed has been slow to put into practice the lessons of post-bubble Japan. Last month, when the Fed voted to trim its benchmark federal funds rate by a quarter of a percentage point, Rosengren dissented, arguing for a "more aggressive policy response," according to Fed minutes of the meeting.

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