So What Made the Theory Stick?

In the 1990s following the collapse of Japan’s asset bubble, the country was in the grip of a recession. Growth as measured by GDP was less than a modest 2%, reinvestment by Japanese corporates was effectively nil, and there was strong competition emerging from neighbouring nations such as Malaysia and Thailand. The Bank of Japan needed to take action so it lowered the nominal interest rate and embarked on quantitative easing increasing the money supply, yet there was no sign of growth on the horizon.

Japan had found itself in a liquidity trap; an idea that is was previously regarded only as a theoretical boundary condition. Money is added to the economy and with a low or nearly zero nominal interest rate there is no increase in borrowing or investment, instead money is saved despite lower prospect of returns. The government’s fiscal policy is impotent and growth remains stagnant. So where has this mentality of such tentativeness towards investment and preference to save come from?

If we first consider the supply side to the monetary base; there is nothing unique in the way Japan implements its monetary policy. Thus it is expected that even in a recession, when additional funds are supplied to the monetary base through the central bank (Bank of Japan) via open market operations that inflation rates should increase. One potential sticking point may have been Japan’s financial sector that was widely viewed as highly inefficient and over regulated, resulting in lack of credit. This argument unfortunately doesn’t carry much weight, as the regulatory restrictions were similar to the time during the boom when credit was easily accessible.

So we must consider the demand side; if it is the case that in a recession peoples’ expected future income may be lower than compared with amounts needed to satisfy current consumption patterns, people will prefer to save resulting in little or no change in inflation rates. Some fairly unique characteristics of the Japan’s demography could explain such low expectations of growth and expected future wealth; Japan’s ageing population combined with low immigration has resulted in a declining labour force, which may be a factor in the negative expectation of future economic capacity.

While it is accepted that Japan’s demography does figure highly in the argument as to problem faced by Japan in the 1990s it is not a fool-proof explanation, and other arguments do exist. Many of which are based on inefficient microeconomic systems, but perhaps a wavy macroeconomic problem requires a wavy macroeconomic explanation.