Beware the lair of the seiya

So, Japan’s Nikkei stock index followed its real estate market up, and peaked at almost 39,000 in December 1989. What happened after that?

The bubble started to burst. By April 1990 the Nikkei fell to 29,585, or about 24%. By June 1995 the index had lost 63% of its value.

The Bank of Japan, the rough equivalent of the Federal Reserve, lowered interest rates from the high of 8% all the way down to effectively zero. Under normal conditions this would stimulate lending and lift an economy out of recession. Instead, Japan continued to slide.

As assets (real estate) declined in price, businesses cut back on expansion, expectations fell, and confidence collapsed. Inventories grew, and producers cut prices (deflation) to get rid of excesses. Economic activity shrank, as deflation set in.

What happened here?

First, Japan’s banks were eyebrow-deep in land development deals that became essentially worthless. Writing off these bad loans would leave the banks technically insolvent; even as they continued operations they had neither the will nor the capability (capital) to lend.

Second, the government feared social upheaval if they let the banks fail, so instead they propped them up with bailouts. This avoided an uprising, but left Japan with a shell of a banking system — often referred to as “zombie banks”.

Third, Japan has historically been a nation of savers, not so much consumers. This aided Japan’s recovery and export-fueled growth during the good times. But deflation and thrift feed on each other.

When you expect an item to be the same price or cheaper next year, you will probably hold off on buying it until you must have it. That’s rational behavior, but it’s also something economists call a deflationary spiral. Because price drops are required to spur spending, prices will drop, which leads to overall lower economic output. Lather, rinse, repeat.

What were Japan’s responses to this crisis? I’ll cover that in the next post.