FRBSF Economic Letter
2000-19; June 16, 2000
Japan's Recession: Is the Liquidity Trap Back?
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
Since the early 1990s, rising unemployment, price deflation, sluggish
growth, and even recession have beleaguered Japan. The country's central
bank, the Bank of Japan (BOJ), has responded by lowering interest rates
to stimulate demand. Short-term rates, shown in Figure
1, were gradually lowered from 8.3% in early 1991 to virtually
zero by early 1999 and have stood at that level for more than a year.
By mid-1999, the two-year government bond rate was only 0.48% and the
corporate bond rate was 0.80%.
With interest rates at historic lows, why is the Japanese economy still
in a slump? One explanation, put forward by Paul Krugman (1998a, b), is
that traditional monetary policy instruments are powerless to provide
effective stimulus to the economy because Japan is in a "liquidity trap."
This Economic Letter evaluates the liquidity trap argument against
a leading alternative explanation: a credit crunch associated with Japan's
Japan is the first major industrial economy to face serious deflation
since the 1930s, and, not surprisingly, that also was the time that the
liquidity trap explanation for the ineffectiveness of monetary policy
was popularized. A liquidity trap is characterized by a situation--similar
to Japan today--where interest rates are at or near zero. Monetary policy
is seemingly impotent to stimulate demand and raise spending since interest
rates are already at the lowest point possible--no one would normally
be willing to hold bonds with negative yields over (zero interest-bearing)
Is Japan in a liquidity trap? Krugman (1998a) forcefully argues this
case and suggests a specific and unorthodox policy recommendation--that
the BOJ bring inflation and inflationary expectations up to 4% and keep
them there for 15 years (see Spiegel 2000). The key element of Krugman's
analysis is that the equilibrium real interest rate--that is, the real
rate that would match saving and investment--is negative in a liquidity
trap. How could the equilibrium real interest rate be negative? Because
poor long-run growth prospects, which, in Japan's case, presumably are
linked to unfavorable demographic trends, make investment demand so low
that a negative short-term real interest rate would be needed to match
saving with investment. Given a nominal interest rate floor of zero, Krugman
argues that a positive expected rate of inflation is necessary to generate
negative real interest rates, which will stimulate aggregate demand and
restore full employment.
Krugman draws on two bits of empirical evidence to support the liquidity
trap argument. First, he points to the fact that short-term interest rates
have reached a minimum point, virtually zero. Moreover, the yield curve
has been virtually flat, as the 10-year government bond yield declined
to less than 1% for a brief period in late 1998. The low interest rates
seen in Japan at the end of the 1990s are unprecedented for any major
industrial country since the 1930s.
Second, Krugman points out that injections of liquidity by the central
bank have not been very effective in raising the growth rate of the broader
money aggregates. He shows that the monetary base grew 25% from 1994 to
1997, but that the broader monetary aggregate (M2 + CDs) grew only 11%,
and bank credit grew not at all. And more recent statistics indicated
that "money hoarding" continued to be evident in 1998-1999, as an expansion
of the monetary base in the range of 8% to 10% resulted in only about
a 3% growth in M2 + CDs. Bank lending has collapsed since early 1998,
as shown in Figure
2. Moreover, low interest rates and expansion in the monetary base
had not helped increase aggregate demand--the economy continued in recession.
Alternative explanation: the credit crunch
The main alternative explanation for the ineffectiveness of monetary
policy to stimulate the economy is the "credit crunch" view. This explanation
focuses on the contraction of the supply of bank credit (credit crunch)
caused by massive nonperforming loans accumulating in the financial system.
This argument has two parts. The first focuses on the decline in bank
capital due to the accumulation of bad loans held by Japanese banks. The
capital asset ratio of the 20 largest financial institutions in Japan
fell significantly between 1994 and the end of 1998. Less than candid
reporting initially both by banks and by the Ministry of Finance about
the magnitude of the nonperforming loan problem made it difficult for
banks to raise capital in domestic and international financial markets.
They therefore responded by reducing the amount of loans. Japanese financial
institutions have attempted to raise capital-asset ratios, in part in
response to recently tightened international capital standards, as well
as in response to pressure from the markets and the government. But building
capital-asset ratios by restraining lending takes a long time. And it
induces a credit squeeze in the process--the origins of the credit crunch
The second part of the credit crunch explanation focuses on the cautious
lending attitude of Japanese banks following their recent experience with
bankruptcies, nonperforming loans, and recession. Liabilities associated
with bankruptcies hit an all-time high of 2.7 trillion yen in October
1997, and a trend line shows a sustained rise to the highest point in
the postwar period towards the end of the decade. These circumstances
make firms less desirable potential borrowers than they used to be, from
the banks' point of view. And they also have the self-reinforcing effect
of tightening credit conditions and worsening the recession.
Evidence of a credit crunch also is suggested by the BOJ survey known
as Tankan. This survey asks firms their views of the "lending
attitude of financial institutions." Despite the low interest rate environment,
the survey indicates a sharp tightening of credit conditions in Japan
since mid-1997 facing both large and small enterprises. The "lending attitudes"
of financial institutions, at least from the borrower's perspective, have
become much more stringent.
A credit crunch implies that injections of liquidity (base and narrow
money expansion) do not increase credit and aggregate lending. This is
exactly what has occurred in Japan. Base and narrow money have increased
at a robust pace in 1997-1999, but the broader money aggregates most directly
related to spending in the economy grew modestly. Most disturbing is that
aggregate lending by banks has decreased sharply, the flip side of which
is the tightening of credit conditions faced by enterprises in Japan.
Which is right?
Krugman (1998a) dismisses the credit crunch argument, arguing that banks
with a large portfolio of nonperforming loans should take on excessive
risk and stand ready to lend even to questionable borrowers. Excessive
lending, rather than a credit contraction, would be predicted, as banks
gamble on high-risk projects, hoping to restore solvency before they are
forced into bankruptcy by the financial authorities.
This type of excessive lending occurred in Japan at the early stages
of the banking crisis. Lending by real estate lending institutions, known
as jusen, actually grew rapidly in 1991-1992, as they faced growing
problems with nonperforming loans (Cargill, Hutchison, and Ito 1997).
But at the current stage of the banking problem--with the creation of
a new Financial Supervisory Authority, greater transparency, and more
disclosure on loan positions--the supervisory authorities are not sitting
by idly and allowing excessive risk-taking on the part of banks. Greater
stringency in banking oversight is the new modus operandi in Japan since
1998 (Cargill, Hutchison, and Ito, forthcoming).
The balance of evidence seems to support the credit crunch explanation
of why monetary policy--and zero interest rates--have not been effective
up to this point in stimulating the Japanese economy. Low interest rates,
slow broad money growth, and falling commercial loans are consistent with
either a liquidity trap or the credit crunch explanation. But the Tankan
survey results and some other facts tilt the balance of evidence towards
the credit crunch view. In particular, the banking sector was hurt by
the temporary emergence of the so-called "Japan premium" (extra expense
Japanese banks must pay for raising funds in overseas markets) and by
the downgrading of the investment ratings (by agencies such as Moody's)
on debt issued by Japanese financial institutions. More generally, the
overall negative publicity about the Japanese financial system and economy
clearly contributed to a very pessimistic atmosphere in Japan in the late
To address the banking and credit crunch problems, public funds totaling
60 trillion yen (12% of GDP) finally were set aside in 1998-1999 to recapitalize
banks. A number of institutions have used these funds (via the issuance
of special equity shares to the government) to increase capital-asset
ratios significantly. In principle, this should ease the credit squeeze
and induce banks--particularly with further injections of liquidity into
the banking system--to increase lending. Long-delayed capital injections
and restructuring of the banking system should finally help push Japan's
economy into an expansion. The analysis here suggests that bank recapitalization
should ease the credit crunch, and, if the BOJ keeps interest rates low,
economic growth will soon follow.
Professor, UC Santa Cruz, and Visiting Scholar, FRBSF
Cargill, T., M. Hutchison, and T. Ito. 1997. The Political Economy
of Japanese Monetary Policy. Cambridge, MA: MIT Press.
Cargill, T., M. Hutchison, and T. Ito. Forthcoming. Financial Policy
and Central Banking in Japan. Cambridge, MA: MIT Press (November
Krugman, Paul. 1998a. "It's Baaack: Japan's Slump and the Return of the
Liquidity Trap." Brookings Papers on Economic Activity 2, pp.
Krugman, Paul. 1998b. "Japan:
Still Trapped?" <http://web.mit.edu/krugman/www/japtrap2.html>
(accessed June 6).
Spiegel, Mark. 2000. "Inflation Targeting for the Bank of Japan?"
FRBSF Economic Letter 2000-11 (April 7).
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