Japan's "Bubble" Economy
The Japanese economy in the l980s was driven by excessive monetary growth, asset inflation, and investment in production capacity. After the burst of its "bubble" economy in 1989, Japan experienced an astonishingly long economic recession whose gravity surpassed any seen in the industrialized world since the 1930s. The disastrous sustained deflation and economic stagnation included the loss of literally tens of trillions of dollars in vanished land and stock wealth.
Following the 1985 Plaza Accord, the yen’s value rose sharply, reaching 120 yen to the U.S. dollar in 1988—three times its value in 1971 under the fixed exchange rate system. A consequent increase in the price of Japanese export goods reduced their competitiveness in overseas markets, but government financial measures contributed to growth in domestic demand.
During the second half of the 1980s, Japan enjoyed both rapid economic growthand low inflation (as recorded in price indices for goods and services). The Japanese yen appreciated from ¥260/US$ in February 1985 to a then all-time high of ¥150/US$ during the summer of 1986. Fearing a loss of price competitiveness for Japanese manufactured exports in the United States, the Japanese government changed the thrust of its economic policy from non-inflationary real GDP growth in Japan to containing the appreciation of the yen relative to the US dollar. Despite a booming economy, the Bank of Japan loosened its monetary policy to stem the appreciation of the yen by reducing its policy interest rate in steps from 5.0 percent in January 1986, to 2.5 percent in February 1987. This overly accommodative monetary policy fueled unsustainable price bubbles in the Japanese stock and commercial real estate markets.
Corporate investment rose sharply in 1988 and 1989. With higher stock prices, new equity issues swiftly rose in value, making them an important source of financing for corporations, while banks sought an outlet for funds in real estate development. Corporations, in turn, used their real estate holdings as collateral for stock market speculation, which during this period resulted in a doubling in the value of land prices and a 180% rise in the Tokyo Nikkei stock market index.
Japan is widely thought to have experienced an asset price bubble in the late 1980s, with a primary affected asset class being real estate. Japanese real house prices rose almost 40 percent between 1986 and 1990. After the 1990 peak, by 2005 real house prices had fallen around 34 percent, nominal house prices had fallen even further. Demographics, if not the only driver, appears to have played a significant role in the run-up in house prices in Japan in the 1980s and appears linked to the decline in house prices over the 1990s. Between 1970 and 2005, Japanese real house prices exhibited peaks in 1974 and 1990. A simple model, using Japanese demographic data, successfully predicts the 1974 and the 1990 house price peaks. Strikingly, the model also predicts a 30 percent decline in real house prices over the fifteen years following the 1990 peak.
To prick the stock and commercial real estate market bubbles, the Bank of Japan began to tighten its monetary policy, raising its policy interest rate from 2.5 percent in May 1989 in steps to a peak of 6.0 percent in August 1990. This tightening caused these bubbles to pop. The Nikkei 225 index, which was 13,000 at the end of 1985, peaked at 38,916 on the last trading day of 1989 and then fell by one-half in 1990. By 1993, all of the gains in share prices since 1985 had been eliminated. The Nikkei 225 index declined to a post-bubble low of 11,820 on March 13, 2001. The urban land price index rose by 199 percent from 35.1 in September 1985 to a peak of 105.1 in September 1990. The index then gradually declined over the next ten years to 34.6 percent in September 2000, eliminating all of the gains in real estate prices since 1985.
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