"Japan's lost decade" is one of those terms that gets tossed around in the media quite a lot nowadays, often as a scenario which we are told Europe and the United States of America face. It seems to have escaped these commentators that Europe and America have already "lost" half a decade since the credit crunch initially hit in 2008, and that the more likely scenarios facing the global economy now make Japan's experience look like a picnic. But more on this later. First, what was Japan's "lost decade"?
It has actually already been two decades. The phrase refers to the aftermath of the economic bubble that Japan experienced in the late 1980s and into 1991, in which the Japanese economy experienced extremely low growth and persistently high, although not catastrophic, unemployment. Both of these things have characterized the Japanese economy since 1991, and don't look likely to change soon. This was a particularly ironic outcome given widespread paranoia in Europe and America that Japan was going to "overtake" the rest of the developed world and out-compete it in manufacturing; and it's an outcome which ought to give pause to those who predict now that China will do the same.
What went wrong in Japan, although it has been exacerbated by other factors, was quite simply a huge boom and a huge bust. The details of why the boom and bust happened are less simple. Japan experienced a credit bubble very similar to the one which happened in the West prior to 2008. There was so much money swirling around the Japanese economy that it ended up getting invested in ever-riskier places because, to the banks and the investors, this money was cheap. There was plenty of it around. So housing prices and the stock market skyrocketed, and the banks lent plenty of money to companies who didn't have business models to turn a profit and eventually pay them back. The stage was set for an almighty crash when all the chickens came home to roost - or, more literally, when house prices finally dropped, stocks went down, and all those bad loans weren't repaid. The banks, and in turn the taxpayer, was left holding the can.
The reasons for the bubble were peculiar to Japan. Japan had an enormous trade surplus with the rest of the world, meaning that it sold much more overseas than it purchased. This was one reason cash flowed into the Japanese economy. It was also the reason that Americans got so worried about the Japanese, because there manufacturing companies were finding it difficult to compete with Japanese rivals. This led the U.S. to harangue Japan about the value of its currency, the yen - the Americans argued, just as they do with China now, that the yen was too cheap and made it artificially easy for Americans to buy Japanese goods, undercutting U.S. companies.
And so in 1985, America, some European countries, and Japan signed the Plaza Accord. The accord called for a managed appreciation of the yen against the dollar to make it easier for European and Japanese consumers to buy American goods. But the managed appreciation of a currency is like catnip to currency speculators, who rushed to buy even more yen and hence pour more cash into the Japanese economy. That's because if you know the yen will be worth more tomorrow than it is today, you buy yen. Once you've brought your yen, you put it in a Japanese bank and contribute to the credit bubble already underway. But given the possible impact of the Plaza Accord on Japanese manufacturers, it became even harder to try to control the crazy credit bubble, because doing so might lead to a recession.
Eventually the whole thing had to come to an end, and the Japanese authorities pricked the credit bubble in 1989 by increasing interest rates. The result was terrible, but had they waited longer it would have been even worse. The stock market crashed, companies started going bust, banks had to be bailed out, and homeowners went underwater (sound familiar?) Economic expansion in the entire decade of the 1990s was negligible as the whole edifice struggled under the debts which had been accumulated during the boom and which now couldn't be paid off; profits, such as they were, had to go to paying down debt, not expansion or hiring new workers. Deflation, the opposition of inflation, set in. The economy was arguably in a liquidity trap, which means that however low interest rates were set or however much money was used to bail out the banks, no-one invested it anyway because they were so scared about the overall economic environment.
What was actually happening was that the Japanese authorities were unwinding the folly of the boom years very, very slowly, allowing the stock market and house prices to gradually trend downwards without ever dropping suddenly and causing absolute disaster, as during the Great Depression. And in this they were largely successful. While Japan experienced little to no economic growth, it remained one of the richest countries in the world without experiencing major social instability. While hardly a happy outcome, it's certainly better than the one which faces the world now if the eurozone debt crisis doesn't get tackled, and if China's similar debt-driven credit boom leads to an uncontrolled crash: a Great Depression style calamity.
Happy new year.