As in Sweden, Norway, and Finland, Japan’s financial crisis began after the bursting of the real estate bubble that had developed over the 1980s after a period of financial deregulation (Nakaso 2001). However, the crisis was structurally grounded in the real economy rather than just policy based. The crisis began in the early 1990s and culminated in 1997 to 1998, depressing growth for years and earning the period the name, “the lost decade.”
The crisis had roots in the institutions of the economy. After very rapid growth in the 1950s and 1960s due to historically large rates of investment and major government involvement in the funding of large firms and infrastructure creation, Japan was presented with a slowdown in the 1970s due to the oil shocks. The oil shocks strongly affected the US economy and drove down the value of the dollar as the country became increasingly indebted. Japan’s export-oriented economy suffered from a rising yen in relation to the dollar (Brenner 2006). What is more, in Japan, the same institutions that had allowed for unprecedented growth through coordinated competition before the first oil shock, and which embraced the concept of total employment (that is, no unemployment) became a liability as productivity declined and large corporations were forced to continue a policy of guaranteed employment (Gao 2001). A lack of innovation reduced the demand for Japanese goods and therefore profits, and companies looked to reduce costs in order to increase efficiency. Starting in the mid-1970s, companies engaged in the practice of zai’tech, investing in stocks and bonds to increase profits. This, coupled with the liberalization of finance encouraged by the United States (US), drove a period of speculation in real estate, overseas investment, stocks and bonds, and even golf club memberships, that created a growing bubble through the 1980s (Gao 2001).
An increase in US current account deficits and a rise in Japanese current account deficits was rebalanced after the Plaza Accord, which allowed for dollar devaluation (Brenner 2006). Yen appreciation was a shock to the export-oriented economy and set the stage for economic decline in the Japanese economy. Financial deregulation allowed investors to seek other methods of profit generation.
Financial deregulation in the late 1980s consisted of loosening of interest rate controls, lifting of prohibition on short-term euro-yen loans, deregulation of the corporate bond market, creation of commercial paper, and increases in lending ceilings to particular institutions (Kanaya and Woo 2000). Increasing competition in the environment of deregulation led to an expansion of risk-taking activities with poor ongoing risk evaluation. Banks had less monitoring control over loans as they faced decreasing demand from traditional, larger companies and increasing demand from less-known, smaller companies (Gao 2001).
At the same time, Japan continued to lose its comparative advantage in technological innovation. Japan had relatively far fewer computers and websites than the US throughout the late 1980s and 1990s (Gao 2001). Social welfare, once covered by the policy of total employment through both large and small companies, had declined markedly, and the social programs moved into the domain of the government sector. Government spending grew and, in conjunction with loose monetary policy, created an overheated economy.
The Ministry of Finance recognized, at least by 1990, that the lending boom at the end of the 1980s had led to overlending to the real estate sector, and imposed temporary lending restrictions for the real estate sector (Kanaya and Woo 2000). This officially deflated the real estate bubble and led to a decline in economic growth but, as Bernanke (2000) points out, also led to an immediate asset-price crash. The tightening thereafter, until 1994, created continued asset price declines.
The Nikkei 225 stock index plunged at the end of 1989, and economic indicators worsened. GDP contracted over the decade. Over this period, the presence of “zombie” firms crowded out more efficient firms (Caballero et al. 2008). Non-performing loans became a monstrous issue in 1992 through 2000, cumulatively forming 17 percent of GDP (Nakaso 2001).
The safety of the banking system, particularly of large banks, was implicitly guaranteed by the Ministry of Finance. Because of this, and due to the absence of bank failures since World War II, the deposit insurance system was underdeveloped for large financial institutions. Smaller financial institutions began to fail in 1991, but the financial authorities remained optimistic that the fallout of the bursting of the asset price bubble would be contained (Nakaso 2001). In 1992 and afterward, banks restructured failing loans by extending credit lines to imperiled borrowers and reducing loans to new borrowers (Kanaya and Woo 2000).
There were attempts to encourage banks to write off non-performing loans in order to obtain a tax deduction for the loan loss. Few companies wanted to do this, since large write-offs might encourage borrowers to stop repaying loans. The Cooperative Credit Purchasing Company was created to purchase bad assets from banks, but with funds backed by the banks themselves. Therefore cleaning up balance sheets was a slow process in which there was little bank cooperation.
Banks faced a lack of strong corporate governance, and the crisis began to strike harder in 1994. At this time, the Governor of the Bank of Japan, Yasushi Mieno, stated that the government would not save all failing financial institutions (Nakaso 2001). Shortly thereafter, two urban credit co-operatives, Tokyo Kyowa and Anzen, failed. The Ministry of Finance tried to find a buyer for the institutions, but there was none to be had. A new bank, therefore, had to be established to take over the failed banks, and capital was injected from both the public and private sectors. After this move, the Bank of Japan was heavily criticized for bailing out the credit co-operatives.
After 1994, the overnight call rate was lowered by the Bank of Japan and finally reached zero in 1999 in attempts to revive the economy (Hoshi and Kashyap 2004). Fiscal deficits of close to 6 percent per year were used to finance countercyclical measures. However, a lack of aggregate demand continued to produce economic stagnation, as deflation wracked the economy (Bernanke 2000). Lack of aggregate demand resulted in the lay-offs of employees, many of whom were middle-aged women with lower tenure (few years at the same job) (Kato 2001).
Deflation, which started in 1994, continued for years. Yen appreciation was coupled with continuing attempts to stimulate the domestic economy by lowering interest rates, which failed to increase demand or correct for deflation. The deflation problem is illustrated in Figure 5.1.
Deflation caused decreased investment in local industry due to falling prices for goods and services. Consumers held cash due to uncertainty about the future.
During the crisis, there was little time to resolve the proper method of unwinding failed institutions. Several bank failures followed in 1995: Cosmo Credit Cooperative, Kizu Credit Cooperative, and Hyogo Bank, resulting in liquidity transfers from the Bank of Japan and business transfers to other banks (Nakaso 2001). There was no denying, by the mid- 1990s, that the economy would not recover on its own and restore viability to non-performing loans and flagging businesses.
Jusen (real estate) loans to the real estate sector had been established in the 1970s to extend home mortgage loans, but had become large real estate lenders in the 1980s and 1990s (Kanaya and Woo 2000). Concern over the
Figure 5.1 Japan’s deflation problem (CPI)
viability of these institutions incited investigations in the early 1990s, and accumulated losses were uncovered in 1995 (Nakaso 2001). The government had to bail out these banks with taxpayer money. This move was deeply resented by the public, and taxpayer funds were not used to assist failing banks until 1997, when the situation was quite dire.
The financial safety net was enhanced in 1996, with a better plan for unwinding failed institutions. Authorities were then able to assist failed banks without depending on the private sector for additional support. Deposit insurance was extended to fully insure depositors until March 2001 (Fukao 2003). This occurred just in time for the serious banking troubles that were about to hit.
In 1997, major financial companies faced solvency issues. Nissan Life Insurance was suspended by the Ministry of Finance (Kanaya and Woo 2000). Nippon Credit Bank suffered many loan losses from real estate loans (Nakaso 2001). The Ministry of Finance organized a bailout from private financial institutions which were financially interconnected to the bank, and a second bailout from both private and public sources. Despite these efforts, the bank failed in 1998 and was subsequently nationalized. Hokkaido Takushoku Bank attempted a merger with Hokkaido Bank, but this attempt was thwarted by historical rivalry that ended in the collapse of the former.
The crisis then spread in the fall of 1997 to securities houses, resulting in the failures of Sanyo Securities, Yamaichi Securities, and Tokuyo City Bank (Nakaso 2001). Sanyo’s default on unsecured call money resulted in a freeze of the entire interbank market. The Bank of Japan injected large amounts of liquidity into the interbank market, thereby acting as market maker of last resort. Yamaichi Securities failed three weeks after Sanyo’s collapse. Yamaichi was closed down slowly, settling existing contracts, while the Bank of Japan acted as lender of last resort. The firm was declared bankrupt in 1999, with the Bank of Japan as the single largest creditor. At the end of 1997, Tokuyo City Bank failed and bank runs began. The notion of “too big to fail” became a thing of the past, and confidence weakened even more as the Asian financial crisis hit in Southeast Asia.
Major steps were taken in 1997 and 1998 to curb the crisis, as part of a “Big Bang” financial system liberalization and reform. These included expanding methods of asset investment by liberalizing securities derivatives and expanding the use of stock options; facilitating corporate fundraising by revising listing and initial public offering (IPO) standards and introducing new corporate bond products; providing a wider variety of services by reforming market-entry regulations and reducing restrictions on the range of business open to securities companies; creating efficient markets by deregulating unlisted companies and strengthening the over- the-counter securities market; assuring fair trading by enhancing fair trading and the dispute settlements system; and ensuring soundness of intermediaries by enhancing financial disclosure and creating investor and policyholder protection rules (Okubo 2003).
The Financial Crisis Management Committee was created in 1998 to direct newly legislated public funds to handle the crisis. All major bank received capital injections in two rounds (Kanaya and Woo 2000). This improved confidence in the market for two months, until the failure of Long Term Credit Bank of Japan. The Long Term Credit Bank was subsequently nationalized months later. After the crisis of the Long Term Credit Bank, legislation was passed under the Financial Reconstruction Law to deal with failed financial institutions. Economic measures were implemented in April 2001 to resolve corporate debt and deal with nonperforming loans (Okubo 2003).2
There are several reasons for Japan’s financial meltdown. Due to deep economic structural problems stressed by Gao (2001) and touched on by Bernanke (2000), Japan’s economy had become relatively unproductive, and a lack of profitability led to an increasing interest by firms and individuals in speculation. Loans were extended to unprofitable businesses and ventures, and finance was liberalized in several directions. To make things worse, Japan had insufficient provisions against loan losses and an antiquated financial system (Hoshi and Kashyap 2004). Banks were grossly under-reserved, even against recognized bad loans. Banks disguised large loan losses during the 1990s by realizing capital gains. But banking accounted for most of the financial sector, and banks lacked measures sufficient to deal with risk. The final burden was to be borne by the taxpayer, estimated at 4 percent of GDP.
There was also an optimistic expectation that the financial problems that began in the early 1990s would diminish on their own, that asset prices would once again increase (Sato 2003). Reflecting this hope, extensive policy measures were not implemented until the late 1990s. The policy changed from preventing failure in the early 1990s, to accepting inevitable failures while limiting their repercussions. Risk management became critical.
Monetary policy strained to find a fix for the crisis, to combat the “three excesses” of debt, capacity, and employment, and later to eliminate deflation (Takahashi 2013). The discount rate was lowered nine times between 1991 and 1995, going from 6.0 percent to 0.5 percent. This proved ineffective. At the same time, fiscal policy was carried out with little impact. Tax cuts and government spending were unable to stimulate the economy, because they fell short of what was needed either qualitatively or quantitatively. Recovery after the crisis was quite slow, and economic troubles, including deflation, continued into the 2000s, even to the extent that both the 1990s and 2000s are sometimes included in the “lost decade.”