Causes and Remedies of the Japan's Long‐lasting Recession: Lessons for China

• Date: 01 March 2016
• Published date: 01 March 2016
• Author: Naoyuki Yoshino,Farhad Taghizadeh‐Hesary
• DOI: http://doi.org/10.1111/cwe.12149

23

China & World Economy / 23–47, Vol. 24, No. 2, 2016

©2016 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Causes and Remedies of the Japan’s Long-lasting

Recession: Lessons for China

Naoyuki Yoshino, Farhad Taghizadeh-Hesary*

Abstract

Japan has suffered from sluggish economic growth and recession since the early 1990s. In

this paper, we analyze the causes of the prolonged slowdown of the Japanese economy (the

lost decade). Economics Nobel laureate Paul Krugman has argued that Japan ’s lost decade

is an example of a liquidity trap. However, our empirical analysis shows that stagnation of

the Japanese economy comes from its vertical IS curve rather than a horizontal LM curve,

so the Japanese economy has been facing structural problems rather than a temporary

downturn. The vertical IS curve is caused by an insensitivity of investment to a lower interest

rate partly because of the decline of sales due to the aging population and firms not wanting

to invest. The structural problems come from the aging demographic, which is often neglected

by scholars and policy-makers, and also from the allocation of transfers from the central

government to local governments, and the unwillingness of Japanese banks to lend money

to startup businesses and small and medium enterprises (SMEs), mainly because of Basel

capital requirements. Many countries, like China, are expected to face similar issues,

particularly given the aging population. The present paper will address why the Japanese

economy has been trapped in a prolonged slowdown and provide some remedies for

revitalizing the economy.

Key words: aging population, Japanese economy, Japan’s lost decade, vertical IS curve

JEL codes: E12, E62

I. Introduction

In the early 1990s, Japan’s real estate and stock market bubble burst and the economy went

into a tailspin. Since then, Japan has suffered from sluggish economic growth and recession

(with this period referred to as Japan’s “lost decade”), and the country’s growth rate

*Naoyuki Yoshino, Dean, Asian Development Bank Institute, and Professor Emeritus, Keio University,

Tokyo, Japan. Email: nyoshino@adbi.org; Farhad Taghizadeh-Hesary (corresponding author), Assistant

Professor, Keio University, and Visiting Professor, University of Tokyo, Tokyo, Japan. Email:

farhadth@gmail.com.

24 Naoyuki Yoshino, Farhad Taghizadeh-Hesary / 23 –47, Vol. 24, No. 2, 2016

©2016 Institute of World Economics and Politics, Chinese Academy of Social Sciences

during this period has been the lowest among the world’s major developed countries.

During the 1995–2002 period, for example, Japan ’s annual average growth rate of real GDP

was only 1.2 percent, lower than that of all the other G7 countries (i.e. Canada at 3.4 percent,

the USA at 3.2 percent, the UK at 2.7 percent, France at 2.3 percent, Italy at 1.8 percent and

Germany at 1.4 percent), lower than the eurozone average (2.2 percent), less than half that

of all of the other larger OECD countries (Korea at 5.3 percent, Australia at 3.8 percent,

Spain at 3.3 percent, the Netherlands at 2.9 percent and Mexico at 2.6 percent), and lower

than the OECD-wide average (2.7 percent) (Horioka, 2006).

Figure 1 shows the trend of Japan’s real GDP and the real GDP growth rate during

1990–2015. As can be seen from this figure, after Japan’s real estate and stock market

bubble burst in the early 1990s (the so-called post-bubble period), Japan ’s real GDP started

to decline sharply. This long recession lasted almost 25 years.

Studying the causes of and remedies for Japan’s long-lasting recessions and low

growth is crucial for other countries, including China, to prevent similar situations from

occurring. Nobel laureate Paul Krugman has argued that the reason for Japan ’s recession

is that the country is currently in a liquidity trap, a situation in which monetary policy is

ineffective in lowering interest rates. However, our empirical analysis in this paper indicates

that the problems in the Japanese economy stem from other sources. Theoretical and

empirical results in this paper will show that stagnation of the Japanese economy comes

Sources: World Economic Outlook Database (October 2015), IMF.

Notes: Data for 2015 is the estimate of IMF staff. GDP, gross domestic product.

Figure 1. Japanese GDP Trends, 1990–2015

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Year

GDP (constant prices) GDP (current prices) GDP (constant prices, percent change)

Japanese Yen Billion

400 000

420 000

440 000

460 000

480 000

500 000

520 000

540 000

Percentage

-8

-6

-4

-2

0

2

4

6

8