Deleveraging and Monetary Policy: Japan since the 1990s and the United States since 2007

Abstract

The U.S. economy in the aftermath of the Great Recession that started in 2007 has a number of similarities with Japan’s experience since the early 1990s, at least on the surface. Both economies experienced an unsustainable boom in real estate prices along with high stock market valuations, and when the bubble burst, many households and financial institutions found themselves in dire straits. One major lesson from this experience is that deleveraging attempts by individual economic agents in the aftermath of large financial imbalances can generate significant negative macroeconomic externalities. In Japan’s case, a negative feedback loop developed among falling asset prices, financial instability, and stagnant economic activity. This negative feedback loop has sometimes been called “Japanization.” As the U.S. economy works through a sluggish recovery several years after the Great Recession technically came to an end in June 2009, it can only look with horror toward Japan’s experience of two decades of stagnant growth since the early 1990s.Japan’s deleveraging became serious because the negative feedback loop was not contained in its early stage of development. The Japanese government did not act promptly to recapitalize banks that were suffering from the erosion of their capital buffer due to their large holdings of stocks. As a result, Japan’s banks only slowly recognized bad loans, while stopping lending to promising new projects. Slow, but protracted asset sales resulted in a long period of asset price declines. Nonfinancial companies perceived the deterioration of their balance sheets as permanent and cut spending drastically. As Japan’s economy stagnated, the total amount of bad loans turned out to be much larger than initially estimated.In contrast to Japan, U.S. policy authorities responded to the financial crisis since 2007 more quickly. Surely, they learned from Japan’s experience. It is also important to recognize, however, that the market-based nature of the U.S. financial system, as compared to a Japanese financial sector, which is more intertwined with government and less subject to market pressures, meant that the need for government action was more apparent in the U.S. context.When a national economy is confronted with Japanization, the central bank finds itself on the front line of policy making. As with Japan’s other policymakers, the Bank of Japan’s response in the 1990s was slow. As a result, the process of deleveraging became overly severe and protracted. This criticism of the Bank of Japan is not a new one: for example, Ben Bernanke (2000, see also 2003), then still a professor at Princeton University, criticized the Bank of Japan for not being more aggressive in its fight against deflation. Krugman (2012), Ball (2012), and others have argued that, in a provocative turnabout, Federal Reserve Chairman Ben Bernake has not been willing to push for the same aggressive monetary remedies for the United States that he earlier prescribed for Japan. Bernanke has responded by making two points: 1) the U.S. economic situation is objectively different, in the sense that Japan faced actual deflation in the late 1990s; and 2) the Fed has indeed pursued aggressively expansive monetary policy in a number of nonstandard ways (Federal Reserve, 2012b, p. 9).This paper does not seek to resolve the debate over the degree of consistency between what Bernanke wrote in the early 2000s and the policies that the Federal Reserve has undertaken since 2007. However, the paper does show that a rapid response by a central bank in a situation of financial crisis and economic stagnation can be a better choice than allowing a process of Japanization to drag on for years. In a weak economy, interest rates are already very low and the zero lower bound on interest rates limits a central bank’s ability to stimulate the economy further. Moreover, as I will explain below, nonconventional monetary policy measures work by reducing risk premiums and interest rate spreads between long-term and short-term financial instruments. However, when a long period of economic stagnation occurs, these spreads have a tendency to decline to low levels, which then limits the effectiveness of such measures.I will begin by describing how Japan’s economic situation unfolded in the early 1990s and offering some comparisons with how the Great Recession unfolded in the U.S. economy. I then turn to the Bank of Japan’s policy responses to the crisis and again offer some comparisons to the Federal Reserve. I will discuss the use of both the conventional interest rate tool–the federal funds rate in the United States, and the “call rate” in Japan–and nonconventional measures of monetary policy and consider their effectiveness in the context of the rest of the financial system.