What Happened
Japan’s bubble was the product of the Plaza Accord (1985), which forced yen appreciation and required loose monetary policy to cushion the export sector. Easy money flowed into stocks and property. Tokyo Imperial Palace grounds were said to be worth more than all of California. The Nikkei rose 300% from 1985 to 1989.
The BOJ began hiking rates in 1989 to cool the bubble. By 1992 the Nikkei had fallen 60%. Property prices began their 15-year decline. Banks held property as collateral — as collateral values fell, their capital evaporated. Rather than writing off bad loans, banks engaged in “evergreening” — rolling over zombie loans to avoid recognizing losses.
Richard Koo of Nomura identified what was happening: a balance sheet recession. Private sector companies were paying down debt regardless of interest rates, meaning monetary policy had almost no effect. Fiscal stimulus was necessary but delivered in insufficient doses repeatedly rather than one decisive shock. Japan tried 10 fiscal packages over 10 years and achieved L-shaped recovery rather than V-shaped.
The Mechanism
Balance sheet recession — when borrowers become saversIn a normal recession, lower interest rates cause businesses to borrow and invest. In a balance sheet recession, businesses are focused on paying down debt from the bubble era, not on new investment. Interest rates can go to zero and it does not stimulate borrowing — the private sector is repairing balance sheets. Only fiscal policy (government spending) can substitute for absent private demand. Japan learned this slowly and applied the medicine in insufficient doses.
What the Consensus Believed
The prevailing view before the reckoning
Japanese land cannot fall in price — Japan is an island with scarce land. The keiretsu corporate structure and management practices gave Japan permanent competitive advantages. The BOJ would engineer a soft landing. Bank problems were temporary and would resolve with modest assistance.
What the Record Shows
Zombie banks extend crises
Banks that do not write off bad loans cannot lend to healthy borrowers. Capital tied up in zombie loans cannot support new growth. Japan's experience is the definitive case.
Deflation is harder to cure than inflation
Japan could not escape deflation for 30 years despite zero rates, QE, and fiscal stimulus. Deflationary expectations become self-fulfilling — consumers defer purchases waiting for lower prices.
Fiscal stimulus must be decisive
Small repeated doses of fiscal medicine without structural reform create debt without recovery. A single large shock with structural reforms (labor market, banking) might have worked. Ten small packages did not.
Demographics make everything worse
Japan's aging population compounded the balance sheet recession. Fewer workers, more retirees, falling domestic consumption. The structural headwinds from demographics persist today and are relevant to China's situation.
↑ Cognitive pattern: Exceptionalism — Japan Inc as permanently different
Key Voices
Called It Right
Richard Koo
Nomura Research
“Japan is in a balance sheet recession. Private sector is paying down debt regardless of interest rates. Fiscal policy is the only tool.”
1995 Correct diagnosis
Various skeptics
Various
“The Imperial Palace grounds are worth more than all of California. This is what a bubble looks like.”
1989 Correct on bubble
Wrong
Japanese consensus
Banks, government, analysts
“Japanese real estate can only go up. Land in Japan is scarce and demand is permanent.”
1988 Wrong
BOJ and government
Japanese authorities
“The BOJ rate hikes will cause a soft landing. The economy is strong enough to absorb higher rates.”
January 1990 Triggered 34-year bear market