Japan’s Lost Decade: Lessons for Other Economies

Abstract

Japan has suffered from sluggish economic growth and recession since the 1990s, a phenomenon dubbed “Japan’s Lost Decade.” The People’s Republic of China, many countries in the eurozone, and the United States may face similar problems in future and they have been concerned by Japan’s long-term recession. This paper will address why Japan’s economy has stagnated since the bursting of its economic bubble. Our empirical analysis challenges the beliefs of some western economists, such as Paul Krugman, that the Japanese economy is in a liquidity trap. We argue that Japan’s economic stagnation stems from a vertical IS curve rather than a liquidity trap. The impact of fiscal policy has declined drastically, and the Japanese economy faces structural problems rather than a temporary downturn. These structural problems have many causes: an aging demographic (a problem that is frequently overlooked), an over-reliance by local governments on transfers from the central government, and Basel capital requirements that have made Japanese banks reluctant to lend money to startup businesses and small and medium-sized enterprises. This latter issue has discouraged Japanese innovation and technological progress. The paper will address all these issues empirically and theoretically and will provide some remedies for Japan’s long-lasting recession.