For the past decade, the Japanese economy has performed poorly, much to the surprise of economists who had spent their careers trying to explain why the economy persistently out-performed other industrial nations from the 1950s through the 1980s. Many of the causes of the economy’s problems are now well understood, but areas of considerable disagreement and controversy remain. These disputes matter, since policies to return the economy to a healthy growth path depend on the diagnosis of the causes and severity of the problem. This paper is intended to kick off the discussion at the Trezise symposium by exploring what we know, what we think we know, and what we don’t really know about the problems of the economy.
The Root Cause
The problems of the past decade are the direct consequence of the speculative bubble in the stock market and real estate market. As indicated in figure one, the Nikkei Average of stock market prices tripled in value from the 1985 to its peak at the end of 1989. Real estate values in the six largest urban areas of Japan also tripled in value from 1985 to a peak in 1991. Since the peak, both the stock market and the urban real estate markets have lost all of the gains since 1985. By the end of 2001, the stock market was actually trading below its 1985 close.
In any society, a rise and collapse of asset values of this magnitude would lead to serious economic problems. In the household sector, however, the impact appears to have been muted. Since households do not hold much stock (only about 14 percent of total household financial assets), the wealth effect on consumption spending was minimal. Similarly, turnover in housing is low, so that only about 12 percent of households acquired a dwelling in the three years surrounding the peak in the real estate market. For those who did, slowly rising incomes over the course of the decade implied that they were able to meet their mortgage payments, so that the loss was only a paper one to be realized if they chose to sell—which few do. For those who keep their property and bequeath it to the next generation, the fall was actually a boon, lowering the inheritance tax that the next generation needed to pay. These features of the housing market may help explain why the broad public has accepted the enormous drop in property values so passively.
