Deleveraging and Monetary Policy: Japan since the 1990s and the United States since 2007

Both Japan in the late 1980s and the U.S. in the mid-2000s experienced an unsustainable boom in real estate prices along with high stock market valuations, and when the bubble burst, many households and financial institutions found themselves in dire straits. One major lesson from this experience is that deleveraging attempts by individual economic agents in the aftermath of large financial imbalances can generate significant negative macroeconomic externalities. In Japan's case, a negative feedback loop developed among falling asset prices, financial instability, and stagnant economic activity. This negative feedback loop has sometimes been called "Japanization." Japan's deleveraging became serious because the negative feedback loop was not contained in its early stage of development. The Japanese government did not act promptly to recapitalize banks that were suffering from the erosion of their capital buffer due to their large holdings of stocks. As a result, Japan's banks only slowly recognized bad loans, while stopping lending to promising new projects. Slow, but protracted asset sales resulted in a long period of asse t price declines. Nonfinancial companies perceived the deterioration of their balance sheets as permanent and cut spending drastically. As Japan's economy stagnated, the total amount of bad loans turned out to be much larger than initially estimated. In contrast to Japan, U.S. policy authorities responded to the financial crisis since 2007 more quickly. Surely, they learned from Japan's experience. It is also important to recognize, however, that the market-based nature of the U.S. financial system, as compared to a Japanese financial sector. This paper also shows that a rapid response by a central bank in a situation of financial crisis and economic stagnation can be a better choice than allowing a process of Japanization to drag on for years. In a weak economy, interest rates are already very low and the zero lower bound on interest rates limits a central bank's ability to stimulate the economy further. Moreover , nonconventional monetary policy measures work by reducing risk premiums and spreads between long-term and short-term interest rates. However, when a long period of economic stagnation occurs, these spreads have a tendency to decline to low levels, which then limits the effectiveness of such measures.