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

Then, as now, asset values rose to stratospheric heights. Then, as now, the bubble eventually popped. And then, as now, people initially believed the economy would soon regain its bearings.

But in post-bubble Japan, the economy didn't recover as expected. Instead, it stagnated — year after painful year — until the 1990s had earned the chilling sobriquet "the lost decade."

Now, as official Washington mobilizes to head off a possible recession, lessons from Japan's brush with prolonged economic misery are being revisited. They may offer a guidepost for everything from Federal Reserve Chairman Ben Bernanke's handling of interest rates to lawmakers' calls to jump-start a moribund economy with tax cuts or social spending.

"Bernanke has really thought about this. They're very conscious of this (at the Fed)," says Adam Posen, a former visiting scholar at the Fed and an expert on the Japanese economy at the Peterson Institute for International Economics.

The Fed began looking closely at the Japanese experience several years ago, as the end of the technology stock bubble in the USA ignited fears of a Japanese-style implosion. With inflation virtually extinguished in the USA, policymakers then worried about inadvertently tumbling into deflation, in which prices would decline across the board and drag the economy down with them. That never happened. In 2007, the consumer price index jumped 4.1%, the highest annual increase in 17 years.

There are, of course, differences between Japan's experience after its twin stock and property bubbles and today's U.S. economy, struggling to cope with the aftermath of the worst housing downturn in decades and a resulting credit crunch. Japan's corporations were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. U.S. banks also were in stronger financial condition themselves at the outset of the crisis, though they have been forced subsequently to swallow massive, multibillion-dollar losses on mortgage-linked investments.

"If you look back at Japan, and you think to yourself what was their monetary policy like and why did that happen, I don't think this is an analogous situation," says Robert Rubin, chairman of Citigroup's executive committee and U.S. Treasury secretary in the late 1990s.

But the Japanese experience remains relevant, providing a cautionary lesson about the need for decisive action to prevent the economic equivalent of a cold from turning into something far worse. "You gotta be out front and be aggressive with easing monetary policy. If you wait too long, you get not only more downward momentum, but the effectiveness of monetary policy declines if the banking system is in trouble," says Posen, a Japanese government consultant.

Boom and bust

The scale of Japan's 1980s boom and subsequent bust was breathtaking. In the five years before its 1989 peak, the Nikkei stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority.

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.

"The authorities are reactive, not pre-emptive. They keep on underestimating the problem. The main policy option seems to be hoping for the best," says Christopher Wood, an equity strategist for the brokerage CLSA in Hong Kong and author of an authoritative book on Japan's bubble economy.

Despite the complaints, Bernanke's handling of the contemporary crisis has been more decisive than was his Japanese counterpart's. The Fed lowered its benchmark lending rate in September, then followed with two additional cuts, driving the fed funds rate to 4.25%. In a recent speech, Bernanke signaled that the Fed is likely to cut rates by an additional half a percentage point by month's end.

He also introduced an innovative credit auction in December to pump additional funds into the banking system.

"When Bernanke and his colleagues look to the lessons of Japan, the lesson is not to wait too long until you act strongly. … Bernanke knows that lesson terribly well," says Paul Mortimer-Lee, global head of market economics at BNP Paribas bnpin London.

In Japan, deep uncertainty about the health of Japanese banks impeded recovery. A large proportion of banks' assets were loans that had been used to finance commercial real estate, which in the post-bubble era few wanted to buy because property prices were in free fall. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. That made the banks look healthier than they were, at the cost of impairing the flow of credit to new businesses.

Likewise, difficulties in assessing the full extent of losses stemming from mortgage-backed securities are complicating recovery from the current financial tumult. Those securities also have been sold to financial institutions other than banks and have spread to countries worldwide, adding an additional layer of complexity.

"Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future," Bernanke told the House Budget Committee last week.

The good news is that major U.S. banks, unlike their Japanese counterparts in the 1990s, already have swallowed large write-offs for losses on subprime mortgage deals. On Jan. 17, Merrill Lynch wrote off $16.7 billion in losses related to asset-backed securities that went sour, joining Citigroup, Morgan Stanley and UBS in taking massive balance-sheet hits — something Japanese institutions resisted for years.

"Clearly, it is better to take care of problems now (rather) than distort and greatly prolong the needed adjustment process," Rosengren said in the Jan. 8 speech in Hartford, Conn.

Democrats in Congress and President Bush are debating alternative proposals to stimulate the economy and, hopefully, head off a recession. Bernanke has endorsed the idea, so long as any package be enacted quickly enough to affect the economy this year.

Japan, likewise, sought to spur a near-lifeless economy with fiscal adrenaline, ramping up government spending on public works projects, including bridges and river "improvement" programs that literally lined many waterways with cement. So many projects were launched that the share of the workforce employed in construction hit an extraordinary 12% — higher even than the figure reached at the peak of the real estate bubble, according to Posen.

Cleaning up the damage

Though recessionary symptoms are multiplying in the USA, most economists expect a brief recession that will give way to renewed, if anemic, growth in the second half of this year. Few expect to see Japan's "lost decade" replayed here.

That optimism, however, like the cheery forecasts in the early days of Japan's prolonged slump, may prove overly sanguine, according to a significant new study.

The research paper, by Harvard University's Kenneth Rogoff and Carmen Reinhart of the University of Maryland, found widespread parallels among 18 industrial-nation banking crises since World War II.

Such financial train wrecks bleed economies badly, the study found. The tally for cleaning up in Japan, for example, amounted to more than 20% of gross domestic product; if the current U.S. situation deteriorated to that degree, the bill would be a staggering $2.8 trillion.

Rogoff, former chief economist of the International Monetary Fund, says it's more likely that the subprime debacle ultimately will incur costs roughly equal to the mid-1980s savings-and-loan crisis. If so, that would mean still-sizable losses of almost $450 billion.

"If the U.S. escapes with just a mild recession, we'll be lucky," says Rogoff. "There's a chance we'll have no recession, but there's at least an equal chance of a deep and long recession with high direct and indirect costs."