Why Japan Is Stuck

Free money can't budge the economy

Decades from now, people may still be arguing over one of the most intriguing economic mysteries of the 1990s: How did a country as rich and sophisticated as Japan fall into a liquidity trap, a bizarre state of affairs in which even near-zero interest rates fail to get banks lending, businesses investing, consumers spending, and the real economy moving?

By any measure, Japan's economic crisis this decade has been a nightmare. A vortex of falling asset prices, banking crises, declining corporate profits, and rising government debt has sucked the economy down. After bumping along with a meager average growth rate of 1.5% between 1990 and 1997, Japan is now mired in an awful recession. On Mar. 30, the government announced February's jobless rate had jumped to a record 4.6%, while household spending fell 5.7% in January, a 13-year low.

Now, the best minds in economics are brooding. Why haven't the standard postwar policies to kick-start an economy worked for Japan? The U.S., for instance, bailed out its banking sector in the early 1990s with monetary tools. The Federal Reserve engineered a 300 basis-point spread between short- and long-term rates that allowed banks fat profit margins on lending. Nordic countries such as Sweden used government handouts to fix their banks.

Japan has tried and failed. Nearly $1 trillion worth of public works, tax cuts, bank bailouts, and even shopping vouchers have been pumped into the economy. All Japan has to show for it is a world-class budget deficit that's about 10% of gross domestic product. The Bank of Japan slashed its discount rate from 6% in 1991 to 0.5% in late 1995. In March, it even pushed short-term rates to zero. Yet few see the economy pulling out of recession until late next year.

Until recently it was barely credible that an advanced economy could face Japan's dilemma. True, academics once thought a lot about liquidity traps, which Depression-era economist John Maynard Keynes raised as a possibility in the 1930s. But interest in the issue waned in the inflationary postwar decades. And periodic recessions responded to the usual measures.

BLUNT TOOLS. Then came the great Japanese recession. Today, the BOJ is virtually giving money away, and nobody wants it. Japan has vast savings but no credit creation. Japan may have waited far too long to apply classic remedies. Fiscal and monetary tools become blunted once a depression psychology, such as Japan now suffers, sets in. And when Tokyo did move, the measures were ill-matched to the economy's needs. In 1997, for instance, the government raised taxes to shrink budget deficits, assuming--wrongly--that the economy was on the mend.

Even today, Japan may not be expanding the money supply fast enough. In February, it grew 3.5% year on year. So while the BOJ has cut rates, it has not pumped money into the system by, for instance, buying government bonds from the public to put more cash in their pockets. "There's a confusion that low interest rates indicate an easy monetary policy," says Michael R. Rosenberg, managing director of international fixed-income research at Merrill Lynch & Co. in New York. "The BOJ has not done a major quantitative easing. The money supply has failed to grow."

The failure of Japanese policies is leading to calls for radical solutions. For example, Richard Jerram, ING Baring Securities' Tokyo-based economist, says the BOJ should expand money supply by 25% and edge inflation up. The logic: Consumers will spend if they fear prices will rise later. Government and private debt burdens would melt away in nominal terms. It's an idea that has support. "If deflation sets in, they've got a major problem on their hands," says Rosenberg. "They've got to avoid deflation by inflating."

But neither BOJ Governor Masaru Hayami nor the bank's policy board likes the idea. That's because they don't think execs and consumers are likely to cheer up and spend just because a dose of inflation makes them feel richer. Japan's loss-making companies don't have much incentive to borrow. Meanwhile, ordinary Japanese are so anxious about their jobs, incomes, and retirement that they would rather save than spend. So half of Japan's $10 trillion in household financial assets languish in bank deposits yielding less than 1%.

And whatever liquidity the central bank may have created is not sticking in Japan. Where did the money go? Some fled overseas as Japanese investors snapped up higher-yielding foreign bonds, mostly U.S. Treasuries. More became a sort of Japanese gift to world bond and equity markets as foreign hedge funds made a killing borrowing yen cheap and flipping them into U.S. and European assets.

LEERY LENDERS. But precious little liquidity actually flowed around Japan's own economy. Last year, bank lending fell some 4%, while the economy shrank 2.5%. That's largely due to the dicey state of banks. Because they're carrying a humongous $600 billion of bad loans on their books, they are leery of lending to companies--even if they could find sound ones that wanted to borrow. That's a big stumbling block, as banks have always been a far bigger conduit for capital in Japan than in other rich countries. "The tried and true method of making loans in Japan has broken down, and nothing has emerged to replace it," says HSBC Securities economist Peter Morgan.

That explains, in large part, why the BOJ's cheap-money policy hasn't worked. Commercial banks are basically lending surplus cash on their books right back to the government by buying government bonds. That tactic created a bond market bubble that collapsed in February. The Finance Ministry had to spend $3.6 billion to refloat the market.

One senior BOJ economist admits that the central bank is now in "uncharted territory." Cheap money hasn't had any significant impact. So the BOJ is hoping that Japan's bank bailout and fiscal push will do the trick. But such gradualism may be crumbling. BOJ minutes show that on Feb. 12 its policy board discussed, but voted down, a plan to increase base money supply by 10%.

If Japan's economy doesn't recover soon, the central bank may turn on the printing presses, pushing the yen into a free fall. That could trip up a recovering Asia, home to 40% of Japan's exports, and widen the country's huge trade surplus with the U.S. But it might be the price of a lasting recovery in Japan. It won't be fun. But little about the dreaded liquidity trap is.

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