Depression In Japan Explained (Unit 3)

How it happens?

Everything began with the Plaza Agreement which was signed by 5 countries namely West Germany, Japan, France, US & UK. As a result, US dollar was depreciated against the Yen & Deutsche Mark by consistent intervention in the foreign exchange. The purpose was to help US to reduce its current account deficit which hit 3.5% of its GDP by the way of lowering the purchasing power of US dollar.

After the 1985 Plaza Accord, yen appreciation has somehow hit the export sector hard as strengthening yen means more expensive to import from Japan. This caused the economic growth to fall from 4.4% (1985) to just 2.9% (1986). Bank of Japan, responded by conducting expansionary monetary policy & interest rates were slashed from 5% (Jan 1986) to 2.5% (Feb 1987).

This caused the asset prices & stock market to inflate to an unprecedented level, creating the biggest bubble in history. The BOJ responded immediately by raising interest rates 5 times to 6% between 1989 & 1990. After the increases, the market collapsed

Nikkei stock market index fell more than 60% from 40, 000 end of 1989 to just under 15, 000 by 1992 & continued to fall below 12, 000 by 2001. Prices of property also plunged by as much as 80% from 1991 to 1998

Why the recession is so long?

(1). Inefficient allocation of government funding. Japan has the Fiscal Investment & Loan Programme (FILP) which gives financial aid to firms. However during that time, much of this money was not allocated to the most efficient projects, but rather to most of those construction firms which had political connections with governments without proper consideration of the costs & benefits of such projects

Shortages of funds then further pushed interest rates higher, thus contracting investment by those most efficient firms & consumption by households

(2). Improper implementation of monetary policy. Perhaps the Bank of Japan could be blamed for contracting the monetary expansion too quickly which caused the economic slowdown. Interest rates were raised 6 times within a year to 5%

(3). People anticipating much lower price. In the period of recession where prices are falling rapidly (deflation) people & firms tend to postpone their expenditure into the economy in an anticipation that the prices will further fall. This explains why recession in Japan is prolong

(4). Banks reluctant to increase borrowing. Because of the increase in bad loans with poor collateral and the fall in other asset values, increased funds injected from the BOJ or additional deposits from savers have been used to hold as cash reserves against bad loans, instead of being used to extend loans to worthy borrowers. Difficulty to obtain loan also helps to explain why households & firms spending into the economy had greatly decreased thus worsening recession