Post-Bubble Blues

©2000 International Monetary Fund

Ordering Information

How Japan Responded to Asset Price Collapse
Editors: Tamim Bayoumi and Charles Collyns
1  Overview
Tamim Bayoumi and Charles Collyns

I.  Explaining the 1990s
2The Morning After: Explaining the Slowdown in Japanese Growth
Tamim Bayoumi
3Identifying the Shocks: Japan's Economic Performance in the 1990s
Ramana Ramaswamy and Christel Rendu
4Explaining the Slump in Japanese Business Investment
Ramana Ramaswamy
5Where Are We Going? The Output Gap and Potential Growth
Tamim Bayoumi

II. Financial and Fiscal Transmission Mechanisms
6Too Much of a Good Thing? The Effectiveness of Fiscal Stimulus
Martin Mühleisen
7Monetary Policy Transmission in Japan
James Morsink and Tamim Bayoumi

III.  The Challenge of Corporate Restructuring
8Financial Reorganization and Corporate Restructuring in Japan
Joachim Levy
9Reform of Japan's Insolvency Laws
Joachim Levy

Tamim Bayoumi and Charles Collyns

The 1990s were very difficult for the Japanese economy. Toward the end of the decade, Japan experienced a recession of a depth and duration virtually unprecedented for a major industrial country since the Second World War, a recession from which it has only recently begun to recover. Moreover, this sharp downturn followed a prolonged period of economic weakness dating back to the bursting of the asset price bubble in 1991. In fact, from 1991 to 1999, output growth averaged only a little over 1 percent, compared with around 4 percent achieved in the 1980s. This experience has led macroeconomic policymaking into uncharted territory and called into question many of the most basic tenets about the behavior of Japan's economy, including the growth rate of potential output, the effectiveness of fiscal and monetary policies, and the strength of the Japanese system of corporate governance.1

The research in this book was undertaken by IMF staff during 1998 and 1999 in response to this rapidly changing and uncertain situation. It provided an analytical framework for the IMF's assessment and policy advice related to the Japanese economy over this period when the difficulties in Japan were an important factor contributing to global economic and financial strains.

The roots of the story lie at least as far back as the overheating of the Japanese economy that occurred during the late 1980s. As is well known, the rapid growth achieved during this period was associated with the development of a major asset price bubble. Economic growth slowed markedly from 1991 as a tightening in monetary policy prompted the collapse of equity and land prices. The continued appreciation of the yen through early 1995 was an additional factor depressing activity, contributing to a period of stagnation that lasted through most of the early 1990s and left the economy significantly below its estimated level of potential output.

Spurred by a combination of fiscal stimulus, a monetary easing, and deregulation initiatives, activity started to recover in late 1995, and in 1996 the Japanese economy grew by 5 percent, the fastest among the Group of Seven industrial countries. Growth was further boosted in early 1997 by anticipation of a hike in the consumption tax rate from 3 percent to 5 percent at the beginning of April--an initial step towards fiscal consolidation--which caused individuals to bring their purchases forward to avoid the additional taxes. Although a temporary lull in activity was anticipated following the introduction of the higher tax rate, most forecasters--including those at the IMF--expected growth to recommence quickly, as would be expected in a normal cyclical recovery.

In the event, however, the economy failed to revive. Although there was an initial recovery in spending as the immediate impact of the consumption tax hike wore off, output fell again in late 1997 and continued to fall through the whole of 1998. This recession, the worst experienced by Japan since quarterly GDP figures started to be published in the mid-1950s, left output in the last quarter of 1998 5 percent below its peak in early 1997. This downturn was by far Japan's worst recession of the postwar period and involved all components of private demand (Figure 1.1).

Fig1.1 The immediate triggers of the downturn in 1997 are readily identified. The initial shock was a larger-than-expected drop in household spending after the April 1997 consumption tax hike. Later in the year, the weakness was exacerbated by financial factors, namely the disruptive impact of the failures of a major bank and two large securities firms in November 1997 and tighter bank credit in advance of a strengthening of bank regulations planned for April 1998. Moreover, the growing crisis in Asian emerging markets hurt external demand, as well as striking a further blow to confidence.

The recession continued through 1998, despite a further shift toward stimulative macroeconomic policies. Short-term interest rates were brought down to virtually zero by early 1999 and repeated doses of fiscal stimulus raised the general government fiscal deficit (excluding social security) to almost 10 percent of GDP. The weakness of business investment was particularly acute, notwithstanding determined government action to reduce risks of further financial disruptions and relieve credit constraints.

Finally, in 1999 the economy again began to recover. The turnaround was initiated by a burst of public investment spending early in the year and a recovery of consumer confidence as forceful action by the government to deal with weak banks and inject public capital into the banking system alleviated fears of financial crisis. However, a rapid rise in the yen from its low point in mid-1998--linked in part to external developments as well as improving sentiment about the Japanese economy--has raised concerns about the impact on the still fragile recovery and led to calls for further easing of monetary policy even though short-term interest rates are already virtually at zero.

Recent experience and the striking contrast between Japan's weak macroeconomic performance during the 1990s and the dynamic performance in some other industrial countries--notably the United States, which completed its eighth year of expansion in 1999--have put a spotlight on deeper structural problems in Japan. Two main themes can be identified:

  • First, the slow pace at which the economy, and more particularly the corporate and financial sectors, worked through the problems of excessive investment and excessive indebtedness that built up during the asset price bubble period. The "post-bubble blues" were thus allowed to linger for the whole decade, rather than being shrugged off after a sharp adjustment as might have occurred if the imbalances had been faced directly at an early point.

  • Second, more fundamental weaknesses in corporate governance. Until recently, Japanese businesses and markets have moved only gradually to make the necessary transition from reliance on heavy capital accumulation and rapid export growth that had successfully delivered high quality growth for 40 years following the Second World War to one placing greater emphasis on innovation, productivity growth, and efficient use of resources. Particular problems include an excessive emphasis on size and market share rather than profitability, an employment system that encouraged an immobile labor force, and still limited competition in many domestic markets for goods and services despite efforts to deregulate.

Against this background, the research presented in this book is aimed at answering three sets of questions. The first issue is to identify the constraining forces underlying the weakness of activity in the 1990s. The work on this is contained in Part I of the book "Explaining the 1990s." The second part, "Financial and Fiscal Transmission Mechanisms," seeks to understand why highly stimulative macroeconomic policies failed to prevent the prolonged stagnation. Finally, Part III "The Challenge of Corporate Restructuring," investigates why, until recently, Japanese businesses have not responded more dynamically to their deteriorating economic performance.

Chapter 2, "The Morning After: Explaining the Slowdown in Japanese Growth," by Tamim Bayoumi, uses vector autoregressions (VARs) to examine the reasons for the fall in Japan's output gap (output relative to potential) since 1991.2 Four possible explanations are considered: the absence of bold and consistent fiscal stimulus, the limited room for expansionary monetary policy because of a liquidity trap, overinvestment and debt overhang, and the disruption of financial intermediation. The results point to disruption of financial intermediation, largely caused by falling asset prices and feeding through into business investment, as the major factor behind the disappointing macroeconomic performance. In addition, the model implies smaller multipliers for macroeconomic policies than has generally been assumed in the past, at least by the IMF, plausibly reflecting the impact of banking problems on the monetary transmission mechanism and the extensive use of temporary fiscal policy tools (both issues are examined in more detail in subsequent chapters).

In Chapter 3, "Identifying the Shocks: Japan's Economic Performance in the 1990s," Ramana Ramaswamy and Christel Rendu also use VARs, but focus on rather different techniques and objectives. Structural VARs are used to identify the underlying shocks to the components of aggregate demand (consumption, business investment, residential investment, exports and imports, and government spending), with the aim of identifying which components of demand showed particular weakness over the last decade. The results indicate that business investment was the main source of weakness, followed (more surprisingly) by government consumption. The stimulative impact of fiscal policy, which is examined through an extension of the basic model, is also found to be quite limited, consistent with the results reported in Chapter 2.

The causes of the weakness in business investment are examined in more detail in "Explaining the Slump in Japanese Business Investment," by Ramana Ramaswamy. The chapter considers a wide range of possible explanations, including overinvestment over the bubble period caused by weak corporate governance, the impact of the debt overhang after the bubble burst, the effects of falling stock prices, and cyclical factors. It first examines underlying theoretical issues associated with each of these explanations, and then uses the insights from this discussion to estimate an investment function designed to differentiate between these hypotheses. The results indicate that past overinvestment is the major factor in explaining the current weakness in business investment, along with falling stock prices and debt overhang. By contrast, cyclical factors and falls in bank lending appear to have had only a smaller impact. The implication is that long-term structural weaknesses may need to be worked out before a strong recovery in business investment is likely to get under way.

The final contribution to the first section of the book is "Where Are We Going? The Output Gap and Potential Growth" by Tamim Bayoumi. This chapter examines the relative roles of reductions in the growth of potential output and an expanding output gap as actual output falls below potential, and finds that they are about equally important in explaining the disappointing macroeconomic performance of Japan since 1991. It also finds that when estimates of economic slack (such as unemployment or excess capacity) are used to estimate the current output gap, the results are consistently smaller than the output gaps derived indirectly from estimates of potential output, but that this result does not hold during the height of the bubble in the early 1990s. It is suggested that this dichotomy of 1­2 percentage points of GDP reflects the temporary effect of problems in financial intermediation on output potential, an effect that can be seen in direct estimates of economic slack but not in estimates of potential output based on physical productive capacity.

The dilemmas posed by fiscal policy over the 1990s are examined in the following chapter. Many commentators have argued that fiscal stimulus has been limited because the headline figures for government stimulus packages are much larger than their real content. The general government deficit, however, has expanded by almost 10 percentage points of GDP over this period. In "Too Much of a Good Thing? The Effectiveness of Fiscal Stimulus," Martin Mühleisen tackles this conundrum by examining the "real water" content of past stimulative packages (that is, the proportion of the packages that have a direct impact on activity). He finds that, although stimulus packages have had significant levels of "real water," their effects on the deficit (and, by implication, activity) have generally been temporary because the institutional structure mitigates against incorporating stimulus packages into future budget baselines. Stimulus packages thus played a relatively minor role in the expansion of the budget deficit in the 1990s, which is largely accounted for by an unexplained fall in tax elasticity in the early 1990s, apparently related to the bursting of the bubble, and the impact of the slump of activity on tax revenues.

The effects of monetary policy on the real economy are examined in detail in Chapter 7, "Monetary Policy Transmission in Japan," by James Morsink and Tamim Bayoumi. Small monetary VARs are used to examine how interest rates and credit variables affect private sector activity. Short-term interest rates are found to have a significant impact on activity, in particular business investment, with the main conduit being private sector bank lending. Indeed, such lending is also found to have an important independent role in explaining output fluctuations, largely reflecting the lack of alternative sources of credit to businesses. The chapter concludes that banking sector problems have exerted significant downward pressure on activity throughout the 1990s and that this has tended to obscure the impact of more stimulative monetary policy.3

Looking to the future, it is clear that Japan's corporate structure is in need of an overhaul. The next chapter, "Financial Reorganization and Corporate Restructuring in Japan," by Joaquim Levy, examines the increasing signs of strain in the corporate sector, the recent steps toward restructuring and how much more will be needed, the institutional constraints on restructuring efforts, and government initiatives that could accelerate the process. It concludes that while genuine restructuring has now begun--particularly in large corporations--plans need to be followed through resolutely and need to extend broadly across the economy. The government can play an important part in this process by establishing an environment conducive to restructuring, and recent initiatives have been in this direction.

As in other Asian countries, unwieldy bankruptcy procedures have been an important impediment in limiting corporate restructuring. The final chapter of the book--"Reform of Japan's Insolvency Laws" also by Joaquim Levy--looks at the existing system and evaluates current plans for reform. It describes how the basis for the traditional out-of-court approach to corporate financial reorganization has been eroded since the 1980s, and how the Japanese government is considering reforms similar to those in other industrial countries to create more workable legal procedures for corporate rehabilitation.

Together, these studies present a compelling and consistent story of the Japanese economy. Financial system problems, largely triggered by the bursting of the asset price bubble in the early 1990s, caused a fall in demand that worsened in 1997 due to increased banking regulation and a premature shift toward fiscal tightening. Banking problems and lack of fiscal transparency blunted the impact of macroeconomic policies aimed at reviving the economy, and the sustained period of weakness exposed latent problems with corporate structure and corporate governance.

The overall message is, in sum, that continued progress with the banking reform now under way and vigorous corporate restructuring are central to any sustained revival of the economy. It is very encouraging that this process now seems to be gathering considerable momentum as a number of major Japanese business corporations and financial institutions have announced ambitious restructuring and merger plans. In the short term, such restructuring may involve transitional costs in terms of higher unemployment and bankruptcies that could imply that the emerging recovery will initially be gradual--as in fact was the case with the U.S. economy as it underwent a similar period of corporate restructuring in the early 1990s. Thus, macroeconomic policies will need to remain supportive of activity (including by avoiding a premature withdrawal of fiscal stimulus or a too early tightening of monetary conditions) during this period.

1The report for the 1999 IMF Article IV consultation with Japan (IMF, 1999) provides the IMF staff's most recent overall assessment of Japanese macroeconomic policies and prospects. It is available on the Internet at
2The VAR approach--an econometric technique used quite heavily in this book--provides a means of assessing a range of competing explanations within a single empirical framework and of examining the often complex interactions among variables without being required to fully specify a formal macroeconometric model of the economy.
3A more detailed examination of bank behavior can be found in Woo (1999), which uses cross-sectional regressions on individual banks to look at bank behavior with respect to capital adequacy. It finds a change in behavior in 1997, when capital adequacy (measured either by the official numbers or market perceptions of the strength of banks) started to affect bank lending. This shows how the microeconomic behavior of banks changed over time and helps explain why the "credit crunch" started in 1997. See references of end of Chapter 7.