When a Big Enough Bubble Bursts, it’s Gonna Make a Splash.

Commonly known as the “Lost Decade” the period from 1991 to 2000 following Japan’s Asset Price Bubble, Japan experienced a prolonged period of economic stagnation. It is during this time period that great Keynesian advocate Paul Krugman (1998), claims Japan fell into its liquidity trap. While it is historically well known that cyclic nature of any economy predicts a low after every high, one wonders what type of boom doesn’t just go bust?

Japan’s Bubble was the accumulation of a number of factors including; domestic policy encouraging widespread saving of income, Japan's historical large trade surpluses, financial deregulation and a strengthening Yen. Which was compounded by the Plaza Agreement of 1985 by the world’s leading economies to weaken the U.S dollar relative to the Yen and German Deutsche Mark.

The full effects of the above factors came to fruition in the period 1986 to 1991, when real estate and stock prices in Japan were greatly inflated, fuelled by easy access to credit and aggressive speculation. At the peak of the boom select properties in Tokyo were worth up to $93,000/FtSquared and in December of the same year the Nikkei stock index closed as high as 38915.87. These benchmarks represented a three-fold increase in property prices in less than a decade and similar magnitude of increase in stock prices.

The inevitable happened in 1990, boom went to bust helped along by the Bank of Japan raising interest rates. A customary banking crisis enveloped prompting Japanese government to announce a taxpayer backed guarantee on bank deposits, which effectively amounted to a bailout on firms that were considered “too big to fail”. There were also a number of economic stimulus projects leading to budget deficit in less than four years. In 1991 property values were only 40% of the peak value attained less than two years previous.

The reaction of population was to stem consumption and increase savings. Firms used earnings in an attempt to reduce capital structure and reinvestment fell. A recession gripped the economy and the Japanese government lowered interest rates close to zero and engaged in an expansive policy of quantitative easing with the goal of creating growth.

In spite of the Japanese government extensive efforts through monetary changes in supply, the economic stagnation continued throughout the whole of the 1990s. In essence Japan’s economy had fallen prey to the Keynesian prediction outlined for the zero bound condition on interest rates.