The Foreign Exchange Origins of Japan's Economic Slump and Low Interest Liquidity Trap

• Published date: 01 March 2001
• Author: Kenichi Ohno,Ronald McKinnon
• Date: 01 March 2001
• DOI: http://doi.org/10.1111/1467-9701.00357

The Foreign Exchange Origins of

Japan’s Economic Slump and Low

Interest Liquidity Trap

Ronald McKinnon and Kenichi Ohno

1. JAPAN’S DOMESTIC ECONOMY IN THE 1990s

BEFORE considering the strong international influences on Japan’s

economy, let us sketch the evolution of Japan’s slump in the 1990s from

a purely domestic perspective.

When Japan’s bubble economy burst in 1991–92, the sharp fall in the stock

market and land values made a significant economic downturn – or at least a

period of sluggish growth (by Japanese standards) – inevitable. Bad loans in the

banking system, associated with the collapsing value of real estate and equity

collateral, proliferated and impaired bank capital. The sharp decline in household

wealth caused consumer expenditures to fall. Excess capacity induced business

firms to curtail investment. Such economic travail is hardly surprising when asset

bubbles burst.

More surprising is that, almost a decade later, Japan’s economy has yet to

recover. Figure 1 shows how sluggish Japanese GDP growth has become in the

1990s. Except for 1996 when annualised growth touched 5 per cent (more on this

below), GDP growth since 1991 has averaged less than 1 per cent per year – and

was sharply negative in 1998 with negligible growth in 1999. Yet, among

industrial countries, Japan had been the premier growth economy for the previous

four decades. With the world’s highest saving rates and seemingly endless

capacity to adapt to, and dramatically augment, the latest industrial technologies,

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RONALD McKINNON is Professor of Economics at Stanford University, California. KENICHI

OHNO is Professor at the National Graduate Institute for Policy Studies, Tokyo. The argument here

updates and extends their recent book, Dollar and Yen: Resolving Economic Conflict between the

United States and Japan (MIT Press, 1997; Japanese translation, Nihon Keizai Shimbunsha, 1998).

But the book provides necessary supporting empirical and analytical detail. The authors would like

to thank Rishi Goyal of Stanford University for his research assistance. Akiyoshi Horiuchi of the

University of Tokyo, and Kunio Okina and Hiroshi Fujuki of the Bank of Japan, made helpful

comments – although they may not agree with the authors’ main argument.

Japan’s GDP grew at 6 to 12 per cent in the 1950s and 60s – and at a robust 3 to 5

per cent in the 1970s and 80s, when the rest of the industrial world was

comparatively stagnant. Moreover, these basic virtues of private industry and

thrift, and a highly skilled labour force with unmatched engineering capability in

hi-tech manufacturing, remain intact. However, throughout the 1990s into 2000,

domestic aggregate demand – both private investment and consumption – failed

to recover.

a. The Fiscal Response

On the fiscal side, the Japanese government responded with massive public

expenditure programmes designed to prime the pump of aggregate demand.

Consequently, Japan’s fiscal deficit in 1999 exceeded 10 per cent of GNP. Table

1 shows that Japanese government gross debt rose from 58.2 per cent of GDP in

1991 and the OECD projected it to increase to more than 114 per cent of GDP in

2000,

1

and 120 per cent in 2001. This upward trend is completely out of step with

other G-7 countries. Even Italy has succeeded in putting its similarly large debt

ratio on a downward trajectory (Table 1).

Offsetting this fiscal ‘expansion’, the yen appreciated sharply in 1994–95 –

peaking out at a highly overvalued 80 to the dollar in April 1995 – and depressed

both exports and private domestic investment. (More on the causes of this

FIGURE 1

Japan GDP Growth Rates

1

OECD Economic Outlook (December 1999, p. 226).

280 RONALD McKINNON AND KENICHI OHNO

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appreciation below.) However, in 1996 when the yen fell and became less

overvalued, output growth spurted to 5 per cent. Recovery seemed at hand.

In April 1997, believing that this fiscal pump priming had worked but

concerned with the out-of-control debt buildup, the government of the then Prime

Minister Ryutaro Hashimoto seized the opportunity to increase the general sales

tax from 3 to 5 per cent – and to close other tax loopholes. This tax increase sent

TABLE 1

General Government Gross Financial Liabilities

(As a percentage of nominal GDP)

Estimates and

Projections

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

US 65.5 68.1 69.7 68.9 68.3 67.7 65.4 62.4 59.3 57.1 55.2

Japan* 58.2 59.8 63.0 69.4 76.0 80.6 84.7 97.3 105.4 114.1 122.1

Germany** 40.1 43.4 49.0 49.2 59.1 61.9 62.8 63.3 62.6 61.7 60.2

France 40.3 44.7 51.6 55.3 59.4 62.3 64.5 64.9 65.2 64.6 63.4

Italy 107.4 116.1 117.9 124.0 123.1 122.2 120.4 118.2 117.7 115.2 112.3

UK 40.1 46.9 56.2 53.7 58.9 58.5 58.9 56.4 54.0 51.2 48.6

Canada 80.9 88.2 96.8 98.0 99.2 98.9 94.1 91.7 86.9 82.5 78.5

Notes:

* Includes the debt of the Japan Railway Settlement Corporation and the National Forest Special Account from

1998 onwards.

** Includes the debt of the German Railways Fund from 1994 onwards and the Inherited Debt Fund from 1995

onwards.

Source: OECD Economic Outlook (December 1999, p. 226).

FIGURE 2

Japan: Consumption Expenditure

(Change from the same month of the previous year)

Sources: Management and Coordination Agency (overall real consumption expenditure); Department Stores

Association (department sales); Japan Automobile Dealers Association (new car sales).

FOREIGN EXCHANGE ORIGINS OF JAPAN’S SLUMP 281

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