Japan's Great Stagnation: Financial and Monetary Policy Lessons for Advanced Economies (review)

The "Great Stagnation" of this book's title is the economic slowdown in Japan from 1991 until at least 2005, when the book was written. It is a collection of nine essays by 17 authors, including prominent economists from Japan, the United States, and Europe. The recent U.S. financial crisis, which occurred only after this volume went to press, will surely deepen interest in whatever lessons can be gleaned from Japan's experience.

The immediate cause of Japan's great stagnation was the sharp drop in asset prices in 1990–91 that precipitated a banking crisis. The Japanese government's slow response to the crisis prolonged and deepened the stagnation. This is the conventional view and these authors embrace it. Toward the end of their overview in the first essay, "The Great Japanese Stagnation: Lessons for Industrial Countries," Takatoshi Ito and the book's editors, Michael M. Hutchison and Frank Westermann, draw parallels between the banking crisis in Japan and episodes in Finland (1991–94), Sweden (1990–93), and Norway (1987–93), also precipitated by collapses in asset prices. They note that the European crises were fairly quickly resolved. In the case of Sweden, this was accomplished with the help of prompt government action to nationalize failed banks, induce management changes, and inject public funds into banks. In contrast, the Japanese government was slow to respond to the banking crisis, slow to force revelation of banks' true balance sheets, slow to close insolvent banks, and slow to inject public funds into banking. These authors further suggest that a collapse in asset prices need not imperil banks in the first place, if proper government regulation and oversight of banks is in place. In Japan in the 1990s proper government oversight was not in place. The conclusion is that flawed banking regulation left Japanese banks unnecessarily vulnerable to falling asset prices, and slow or mistaken policy responses to the banking crisis prolonged it.

At the nub of banking regulation is deposit insurance. This is a conventional view and a premise of the book. To prevent bank runs, the government of Japan and of the United States and most other developed countries maintain deposit insurance. If a bank becomes insolvent, the depositors are reimbursed by the insurer. This makes it less likely that a banking crisis will arise from the self-fulfilling belief of bank depositors that bank reserves are insufficient. But insurance invites moral hazard. If deposits are insured, a bank is more inclined to make imprudent investments than if it were itself obliged to meet obligations to depositors in every contingency. It behooves the insurer, in this case the government, to insist that bank shareholders place their own wealth at risk or that they are bound not to undertake investments that in general could be regarded as inherently risky. Failure to do this may have been an underlying cause of Japan's banking crisis. In the algebraic model developed here by Robert Dekle and Ken Kletzer, in "Deposit Insurance, Regulatory Forbearance, and Economic Growth," the government insures bank deposits but does not constrain banks' investments. Banks take on more and more risk until eventually some of them fail and taxpayers must bear the cost of reimbursing depositors, which adds to the public debt. The higher taxes needed to service the large government debt distort the economy and lower the standard of living. One curious aspect of all of this is that the failure of banks causes asset prices to collapse, not the reverse as is so often claimed about Japan and the United States. In the Dekle-Kletzer way of thinking, flawed regulations led to Japan's crisis. It was not just the random consequence of a speculative bubble.

All of this presumes that undercapitalized banks whose deposits are insured are prone to risky investments. This is the moral hazard argument. The debt overhang problem, which is...