Japan's &#34;Lost 30 Years&#34;: What Experience and Lessons Can It Bring to the Present?
As the Chief Economist of Nomura Securities, Chao-Ming Gu has previously proposed the theory of &#34;balance sheet recession&#34; through studying Japan's economic decline at the beginning of the millennium. Now, the global economy is facing a series of challenges such as inflation, interest rate hikes, and recession, and this theory is being mentioned again.
Therefore, in the report published this month, Chao-Ming Gu once again reviewed Japan's economic situation over 30 years ago and summarized the experience and lessons from it.
Chao-Ming Gu pointed out that over 30 years ago, Japan had a huge asset bubble, and excessive liquidity led to the overexpansion of corporate balance sheets. However, the crash in asset prices in the 1990s directly pushed Japan into a balance sheet recession.
Although fiscal stimulus supported Japan's economy during the balance sheet recession, it still took nearly 20 years for Japan to truly emerge from the balance sheet recession.
He proposed that during the balance sheet recession, fiscal stimulus must meet the &#34;Three S's&#34;: speedy, sufficient, and sustained. He also warned that the balance sheet recession does not start when asset prices fall, but rather when people's perception of asset prices changes.
<h2>Japan 30 Years Ago: Massive Asset Bubble and Overexpansion of Balance Sheets</h2>
Chao-Ming Gu pointed out that over 30 years ago, the significant characteristic of Japan's asset bubble was its enormous scale, mainly derived from commercial real estate:
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Japanese commercial property prices quadrupled within a five-year period starting around 1985. At one point, it was estimated that the value of land under the Tokyo Central Palace alone was roughly equivalent to the total value of the entire state of California.
Companies and individuals who accumulated wealth during the prosperous period began to spend lavishly, and both Japan's nominal and real GDP grew at astonishing rates. The profits generated during this process allowed Japanese companies to acquire office buildings and golf courses across Europe and the United States.
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Chao-Ming Gu believes that the main causes of Japan's asset bubble were excessive self-confidence and an aggressive monetary easing policy:
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There were two main causes of the bubble. One was the excessive praise from the United States and Europe, which was reflected in the saying &#34;Japan is number one.&#34;
Another reason was Japan's aggressive monetary easing policy, which was implemented under the Plaza Accord in September 1985. The Plaza Accord aimed to correct the excessive strength of the US dollar, making Japanese companies increasingly unwilling to invest domestically.
However, since companies were unwilling to borrow for fixed capital expenditure (capex) investments, the excess funds could only flow into existing asset markets, further fueling the formation of the bubble economy.
During the bubble period, banks became extremely willing to lend. It was once said that calling the bank for loan approval was faster than ordering buckwheat noodles from a nearby noodle shop.
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As mentioned earlier, loose monetary policy caused excess funds to flow into existing asset markets, such as stocks or real estate. Gu Chaoming pointed out that this meant Japanese companies increased both financial assets and financial liabilities during the bubble period.
As shown in the figure below, the white bars represent the increase in financial assets of the non-financial corporate sector, while the shaded bars represent the increase in financial liabilities. The line represents financial assets minus financial liabilities, that is, financial surplus or deficit. When the line is above 0, the non-financial corporate sector has a financial surplus, and when it is below 0, it has a financial deficit.
Before 1999, the non-financial corporate sector in Japan was in a financial deficit state, and the decline in the balance sheet began around 1990.
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<h2>Sharp Decline in Asset Prices</h2>
In 1990, the Japanese asset bubble burst, and commercial real estate prices plummeted.
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By 2005, the average property prices in Japan's six major cities had fallen by 87%. In the process, the country lost a total wealth of 150 trillion yen, about three times the domestic gross domestic product in 1989.
The sharp decline in asset prices led to many Japanese companies being technically insolvent because their assets shrank on the balance sheet while liabilities remained unchanged.
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Faced with this situation, the collective response of these companies was to use cash flow to repair their balance sheets and repay debt.
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The entire non-financial corporate sector began to have a financial surplus in the 1999 fiscal year. In other words, despite interest rates falling to zero, the sector was making every effort to minimize debt (i.e., deleveraging).
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Gu Chaoming pointed out that while it is correct and responsible for individuals to try to repair damaged balance sheets and restore financial health, if everyone does so at the same time, it will lead to a severe deflationary spiral known as balance sheet recession.
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In a national economy, when someone saves or repays debt, others must increase borrowing and consumption of those savings, otherwise the economy will collapse.
Under normal circumstances, central banks and financial securities firms act as intermediaries. When there is a shortage of borrowers, interest rates fall; when there are too many borrowers, interest rates rise. This is how the income cycle from lenders to borrowers is maintained.
However, after the burst of the asset bubble, even at zero interest rates, borrowers were extremely scarce, and the resulting excess savings in the private sector overflowed from the income cycle, causing the economy to fall into a balance sheet recession.
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<h2>Fiscal Stimulus Supporting the Economy</h2>
Gu Chaoming stated that while the private and household sectors deleveraged, the responsibility of digesting excess savings fell on the government:
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During the balance sheet recession, despite interest rates being at zero, the private sector was still forced to deleverage, rendering monetary policy essentially ineffective. In this situation, the only way to support the economy was for the government to represent the private sector and borrow and spend the excess savings through fiscal stimulus.
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It is precisely because the government borrowed and spent the excess savings of the private sector through fiscal stimulus that Japan's GDP never fell below the level of the bubble period.
He refuted the view that fiscal stimulus is ineffective and believed that in the case of monetary policy failure, fiscal stimulus is the &#34;only way&#34; to address balance sheet recessions:
However, this approach was considered ineffective. Economists in 1990 were unaware of the existence of balance sheet recessions, and they did not know that fiscal stimulus was the only treatment method and that the treatment had to continue until the private sector's balance sheet recovered.
Policymakers and academic economists at the time believed that the economic downturn was a short-term phenomenon caused by the business cycle. Therefore, they attempted to stimulate the economy through standard monetary easing and temporary Keynesian fiscal stimulus in order to &#34;revive the economy.&#34;
However, in a world without borrowers, monetary easing is largely ineffective.
<h2>The &#34;Three S's&#34; of Fiscal Stimulus</h2>
Gu Chaoming stated that one of the main reasons why some economists believe that fiscal stimulus is ineffective is that &#34;when the stimulus stops, the economy will weaken again.&#34;
He proposed that during a balance sheet recession, fiscal stimulus must meet the &#34;Three S's&#34;: speedy, sufficient, and sustained:
Economists expected that short-term fiscal stimulus could &#34;revive the economy,&#34; which is incorrect because the private sector needs at least five to ten years to repair its balance sheet. Fiscal stimulus during such times must be speedy, sufficient, and sustained - the &#34;Three S's.&#34;
In other words, fiscal stimulus must be implemented quickly to prevent a deflationary spiral; it must be of sufficient scale to absorb all the excess savings of the private sector; and it must continue until the private sector completes the repair of its balance sheet.
However, he believed that Japan in the 1990s did not realize this. Although fiscal stimulus supported the economy, it was always temporary and always lagged behind the situation, resulting in a much longer economic recession:
Some public works projects, such as roads and bridges, were built under fiscal stimulus during this period without fully considering economic efficiency. This drew severe criticism from domestic and foreign media, making it increasingly difficult for the government to implement necessary fiscal stimulus during the balance sheet recession. As a result, the recession lasted much longer than necessary.
If the decision-makers in Japan at that time knew that they were dealing with a balance sheet recession and that even under the best circumstances, it would take five to ten years to repair, they might have taken a longer-term perspective when choosing public works projects. In that case, public criticism of fiscal stimulus might not have been so severe.
Gu Chaoming stated that due to the failure of monetary policy, the effectiveness of fiscal stimulus was limited. Some people began to argue that Japan's recession was caused by structural problems in the economy, but he believed that these structural reforms actually prolonged the recession.
Since 2008, the same argument has been made in the Eurozone, claiming that structural reforms are the solution to economic weakness.
However, it is clear that the sudden and severe slowdown in the economy after the bursting of the bubble cannot be explained by structural factors that have existed for decades. Structural reforms have no stimulating effect on economies that are already struggling with balance sheet problems.
On the contrary, the shift towards structural reforms has actually prolonged the recession, both in Japan after 1990 and in Europe after 2008.
Even if the Japanese government's initial response to the recession was perfect in every way, the economy, due to the massive scale of the previous bubble, may have taken at least a decade to recover from the resulting balance sheet recession.
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Due to Japan's less-than-optimal response to the balance sheet recession, it took over 20 years for Japan to escape the balance sheet recession.
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It wasn't until around 2013 that companies finally stopped deleveraging and made their debt consistently positive.
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<h2>The starting point of the balance sheet recession: A change in asset price consensus</h2>
Gu Chaoming astutely points out that the balance sheet recession does not begin when asset prices start to fall, but rather when people &#34;realize that the asset prices they were chasing were wrong.&#34;
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When asset prices in Japan first began to decline in 1990, many people were not overly concerned because they believed it was just a temporary correction. It took the Japanese people a long time to realize the risk of falling real estate prices, as housing prices had never experienced a single downturn since the post-war period. As long as people expected asset prices to eventually rise again, there would be no balance sheet recession.
In fact, there was no significant downturn in the economy in the first two years.
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He states that this highlights the characteristic of a balance sheet recession—it only occurs when there is a change in people's mindset:
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In other words, as long as there is a perceived risk, even if the announced asset prices have not yet fallen, people's mindset may change, and the economy may fall into a balance sheet recession, especially when the published numbers are doubted.
When people start to doubt asset prices, the balance sheet recession has already begun.
When people believe that asset prices are already too high and unlikely to rise significantly from current levels, and are more likely to fall, they naturally want to reduce leverage (borrowing, etc.). If they collectively take such action, the economy will fall into a balance sheet recession.
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Gu Chaoming reiterated that fiscal stimulus is the only way to rescue the balance sheet recession due to the ineffectiveness of monetary policy, and it must meet three conditions: fast, sufficient, and sustained.

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