Abstract

Is the recovery from the global financial crisis now secured? The crisis that stalled Japan’s growth miracle in 1990s may provide some clues. This chapter explores the parallels between the two crises and draws potential implications for the current global recovery. On two occasions during Japan’s crisis, “green shoots” withered as the economy was buffeted by severe external shocks aggravated by a still-fragile financial system, forcing policymakers to intervene with more aggressive support. A sustainable recovery took hold only when spillovers from a favorable external environment reinvigorated private demand and the financial and corporate sector problems at the heart of the crisis were adequately addressed. Japan’s experiences suggest three possible lessons for policymakers today. First, green shoots do not guarantee a recovery, implying a need to be cautious about the outlook. Second, financial fragilities can leave an economy vulnerable to adverse shocks and should be resolved for a durable recovery. And third, while judging the best time to withdraw policy support is difficult, clear medium-term plans may help.

Is the recovery from the global financial crisis now secured? The crisis that stalled Japan’s growth miracle in 1990s may provide some clues. This chapter explores the parallels between the two crises and draws potential implications for the current global recovery. On two occasions during Japan’s crisis, “green shoots” withered as the economy was buffeted by severe external shocks aggravated by a still-fragile financial system, forcing policymakers to intervene with more aggressive support. A sustainable recovery took hold only when spillovers from a favorable external environment reinvigorated private demand and the financial and corporate sector problems at the heart of the crisis were adequately addressed. Japan’s experiences suggest three possible lessons for policymakers today. First, green shoots do not guarantee a recovery, implying a need to be cautious about the outlook. Second, financial fragilities can leave an economy vulnerable to adverse shocks and should be resolved for a durable recovery. And third, while judging the best time to withdraw policy support is difficult, clear medium-term plans may help.

Following two quarters of free fall, the latest economic news from across the world provides grounds for cautious optimism. Buoyed by a sharp rebound in Asia together with stabilization or modest recoveries in other regions, the world economy seems to slowly be returning to life. The panic that gripped global financial markets last fall has also receded significantly, although stresses remain. In differing patterns and intensity, green shoots are sprouting across the world, fueling hopes that the Great Recession may be ending and that an enduring recovery could be around the corner.

But has the global economy reached a true turning point, and should policy support be reversed anytime soon? Aggressive macroeconomic stimulus, unprecedented financial sector interventions, and restocking associated with global inventory cycles are providing an important boost to activity. Beyond these transient forces, however, the durability and shape of the recovery are likely to vary across economies, based, among other things, on the health of their financial systems, the soundness of private sector balance sheets, and their relative dependence on external demand and financing. Looking ahead, policymakers in individual economies will need to judge the extent to which any recovery that may be underway is on a firm footing, based primarily on whether private demand is sufficiently well placed to replace generous government support.

To help assess current economic prospects, this chapter recalls Japan’s experiences with incipient recoveries during its banking crisis of the 1990s. Many commentators have noted the striking similarities between Japan’s “lost decade” and the ongoing crisis, notably with respect to their genesis and the policy challenges they posed. During the spring, when the crisis was turning global, the May 2009 Asia and Pacific Regional Economic Outlook looked back at the lost decade in search of lessons for combating the outbreak and containing its fallout. With conditions now having stabilized, this chapter revisits Japan’s history for insights on the process of economic recovery, highlighting two episodes in which green shoots emerged but could not be sustained. Based on Japan’s experience, the chapter asks:

  • Are current green shoots harbingers of a true turning point or “false dawns” propped up by stimulus and other temporary factors?

  • What are the key signs of a sustainable economic recovery, and how important are efforts to restore the soundness of creditor and debtor balance sheets?

  • How should policymakers design and articulate exit strategies, even if they are implemented only after a durable recovery takes hold?

For Asia, these questions have an added significance. First, they could be informative about the likely endurance of the rebound that is underway within the region. Second, given the region’s high exposure to demand from the United States and Europe, the outlook for these key trading partners has important implications for Asia’s ability to sustain high rates of growth in the short run, as well as the urgency of rebalancing over the medium term.

Japan’s Lost Decade: From Crisis to Recovery

Contrary to popular perception, Japan’s lost decade was not an uninterrupted period of economic decline, but involved three distinct phases (Figure 2.1). On two occasions, green shoots of recovery emerged, allowing stimulus to be withdrawn. However, on both occasions, the external environment subsequently deteriorated dramatically, and the shock to the economy was magnified by a still-fragile financial system. A more severe downturn ensued, necessitating even more aggressive stimulus to support real activity and magnifying the longer-term challenges associated with unwinding policy support. An enduring recovery was ultimately possible only when financial and corporate sector problems at the heart of the crisis were addressed, allowing a resumption of policy stimulus and a favorable external environment to reinvigorate private demand.

Figure 2.1.
Figure 2.1.

Phases in Japan’s Banking Crisis

(Real GDP growth; year-on-year, in percent)

Source: Haver Analytics.

By the time it was over, Japan’s crisis featured three dips in activity and spanned almost a dozen years. As the crisis unfolded, the Japanese authorities faced a set of challenges unprecedented in the postwar era and responded with innovative measures that ultimately proved successful. Japan’s crisis also highlights the tremendous uncertainty involved in judging the strength of recovery from a postbubble recession and the difficulty in timing the exit from policy support. In particular, while fragilities in the financial system and debtor balance sheets remain, a recovery can be derailed by unforeseen adverse shocks. This section summarizes Japan’s experiences with fledgling recoveries that did not endure and the keys to its eventual sustained turnaround.

Phase 1: 1990–97—Crisis Outbreak and Fragile Recovery

Much like the Great Recession, Japan’s crisis was sparked by the collapse of bubbles in its stock and real estate markets in the early 1990s. After tripling during the latter half of the 1980s, these markets collapsed in 1989–90. Whereas real estate prices declined continuously over the next decade, the stock market staged intermittent bull runs (1995–96) and (1999–2000), only to subsequently slide to new lows. As in the present situation, private debt also escalated in the lead-up to Japan’s crisis, although it reflected borrowing by firms, not households.

The fallout was relatively muted during the first phase of the crisis, as the bursting of the twin bubbles stalled Japan’s long postwar expansion for a few years. For two decades, Japan had enjoyed the strongest growth among advanced economies, expanding by almost 4 percent annually after the oil shock of 1973, compared with an average among countries of the Organization for Economic Cooperation and Development (OECD) of about 2¾ percent. Over the same period, unemployment was less than half the OECD average and inflation almost 3 percentage points lower. After the bubbles burst, the economy stagnated, with growth falling to an average of 1½ percent between 1991 and 1994. Unemployment ticked up, and inflation fell gradually from highs of about 3½ percent, although credit growth remained relatively resilient and official nonperforming loans (NPLs) were low.

By the middle of the decade, green shoots were sprouting in the face of policy stimulus. With the Bank of Japan (BoJ) cutting policy rates to near zero by 1995, together with successive fiscal stimulus packages, the economy was expected to emerge relatively quickly from what was seen as a cyclical downturn. Indeed, a recovery appeared to be taking hold from 1994, with growth and inflation picking up, unemployment leveling off, and the stock market rallying. Industrial production also recovered, supported by a technical correction related to the inventory cycle (Figure 2.2). Signs of recovery allowed policy stimulus to be withdrawn—with a fiscal consolidation effort launched in April 1997 in response to concerns about escalating public debt (Figure 2.3).1

Figure 2.2.
Figure 2.2.

Japan: Industrial Production and Unemployment

Source: Haver Analytics.
Figure 2.3.
Figure 2.3.

Japan: Fiscal Stimulus and Growth

Sources: Ministry of Finance; Cabinet Office; and IMF staff estimates.1 Defined as the change in structural balance.

Phase 2: 1997–2000—Renewed Systemic Stress and Second Recovery Attempt

The Asian crisis then struck in 1997, pushing the economy into a second and more virulent phase of crisis and bringing Japan close to a financial meltdown. The bursting of the asset bubbles had left Japan’s financial system saddled with large NPLs, but these were masked by regulatory forbearance and their full scale not properly diagnosed. The increasing mistrust of financial institutions came to a head when the external environment deteriorated unexpectedly as a result of the Asian crisis—mounting losses on failed real estate loans and falling share prices led to a seizing up of the interbank markets and a wave of large-scale failures in the financial sector. The real impact was severe, as a credit crunch ensued and the economy contracted for two years in a row (in both 1998 and 1999).

The economy then seemed to mend between 1999 and 2000. In the aftermath of the 1997 crisis, capital was injected into the banking system—albeit with few conditions and without tackling the NPL problem—and policy stimulus was reintroduced, in the form of larger fiscal packages and a shift to a zero-interest rate policy. These actions helped to calm markets and supported a pickup in activity. With the worst seemingly behind, the policy rate was raised modestly by 25 basis points in August 2000 (Figure 2.4).

Figure 2.4.
Figure 2.4.

Japan: Policy Rate and Stock Market Index

Source: Haver Analytics.

Phase 3: 2001–03—Renewed Systemic Stress Followed by Sustained Recovery

The collapse of the global information technology bubble from March 2000 onward triggered a third phase of financial and economic stress as deteriorating corporate profits strained the still-fragile banking system, and policy stimulus was reintroduced. With the economy barely growing in 2001 and 2002, a large output gap opened up. As credit contracted in the face of long-delayed but much-needed deleveraging, unemployment rose to a postwar high of 5½ percent in 2002, and NPL ratios peaked at almost 9 percent. Against this weak economic backdrop, public debt rose to nearly 75 percent of GDP in net terms, easily the highest among advanced economies.

A comprehensive strategy for addressing underlying problems in the financial and corporate sectors was finally put in place in 2002–03. A more aggressive approach to dealing with problem loans and capital shortages in the banking system was adopted, helping to restore confidence in the banking system (Figures 2.5 and 2.6). In addition, corporates—helped by a push to restructure distressed assets—made significant progress in shedding the “triple excesses” of debt, capacity, and labor from the bubble period (Figure 2.7). As a result, corporate debt, which had continued to rise even after the bubbles burst—from 80 percent of GDP in the early 1980s to 120 percent in 1995—returned to prebubble levels by 2004.

Figure 2.5.
Figure 2.5.

Japan: Nonperforming Loans

(In billions of yen)

Source: Financial Services Agency of Japan.
Figure 2.6.
Figure 2.6.

Japan: Bank Capital and Lending

(In percent)

Sources: Haver Analytics; and Bank of Japan.
Figure 2.7.
Figure 2.7.

Japan: “Triple Excesses” of the Corporate Sector

(In percent)

Source: Ministry of Finance, Corporate Survey.

What was different about the third episode? A more aggressive approach to restoring financial health combined with positive growth stimulus from China enabled a more durable expansion to finally take hold. In contrast to the earlier recovery attempts, private domestic demand was on a stronger footing (Figure 2.8), supported by a revitalized banking system and a healthier corporate sector. As a result, sustained growth finally resumed—averaging a healthy 2 percent between 2003 and 2007—on the back of a virtuous circle, with bank and corporate profits rebounding, credit flowing again, employment rising, the stock market surging, and investment picking up (Figure 2.9). Favorable global conditions, together with a real effective depreciation associated with deflation and a weak yen, also benefited the recovery, with net exports accounting for about a third of Japan’s growth during this period.

Figure 2.8.
Figure 2.8.

Japan: Contributions to GDP Growth

(In percent)

Sources: Haver Analytics; and IMF staff calculations
Figure 2.9.
Figure 2.9.

Japan: Corporate Leverage and Investment

(In percent)

Source: CEIC Data Company Ltd.

From Stimulus to Exit: Japan’s Disengagement Strategies

The exceptional actions described above eventually needed to be unwound to avoid undermining longer-term growth and macroeconomic stability. Policymakers faced the difficult dilemma of maintaining stimulus long enough to support growth and prevent deflation, while considering the appropriate timing of exit to prevent new imbalances and a rise in public debt. The costs of unconventional monetary and financial policies also increased over time, notably by reducing market activity, compressing credit spreads, and dampening incentives for restructuring.2 Twice the authorities withdrew stimulus under what appeared to be favorable conditions before having to ease policies again as underlying financial and balance sheet fragilities left the economy extremely vulnerable to adverse shocks. Against this backdrop, the next section will discuss possible ways to judge the appropriate timing of exit on the basis of trends in high-frequency indicators. In addition to the timing, the choice of instruments to achieve the unwinding is another key policy challenge, and Japan’s exit experiences are also likely to be informative in this regard.

Japan found unwinding its fiscal policies to be particularly challenging. Although a law aiming to reduce deficits over the medium term was formulated in 1997, it was quickly scrapped in light of the sharp economic contraction at the beginning of the second phase of Japan’s crisis. Only in mid-2001 was a target for achieving a primary balance (excluding the social security fund) announced, by which time net debt had quintupled on weak growth, stagnant tax revenues, and increased spending (Figure 2.10). The protracted downturn and the delay in framing a medium-term strategy saw the income tax cut introduced in the late 1990s only fully lifted 10 years later (in 2007), contributing to persistently large deficits and a continued rise in public debt. While long-term yields have remained low given the large available pool of domestic savings, the elevated public debt—now approaching 200 percent of GDP in gross terms—continues to limit policy flexibility.

Figure 2.10.
Figure 2.10.

Japan: Public Debt

(In percent of GDP)

Sources: Cabinet Office; and IMF staff calculations.

Exit was more successful in the monetary arena, as the BoJ was able to end quantitative easing and smoothly unwind its balance sheet. In October 2003, the BoJ clarified the timing of its exit by announcing two necessary conditions: that core CPI be nonnegative for a few months and that it be forecasted to remain positive by a majority of Policy Board members. This also helped the BoJ to better manage market expectations about the future path of interest rates (the so-called policy duration effect). With these conditions met, the BoJ announced in March 2006 that it would gradually drain liquidity while keeping overnight interest rates effectively at zero. By July of that year, the BoJ had smoothly transitioned to a more normal monetary framework, with current account balances normalizing and the policy rate raised.

Since quantitative easing in Japan had relied mainly on extended liquidity operations and the purchase of government securities, the BoJ was able to exit through normal open market operations. Given its large holdings of short-dated government paper, the BoJ managed to withdraw liquidity without selling Japanese government bonds (JGBs) or issuing its own bills (Figure 2.11). With the recovery drawn out and inflationary pressures subdued, the BoJ was also able to avoid losses and yield spikes by holding JGBs to maturity. In the end, the money market, which had withered during the late 1990s, was revived, as institutions gradually reduced their reliance on the BoJ for funding. In addition, outright purchases of asset-backed securities and asset-backed commercial paper carried sunset clauses and were of short maturity, facilitating the eventual unwinding.

Figure 2.11.
Figure 2.11.

Bank of Japan Assets

(In trillions of yen)

Sources: Haver Analytics; and Bank of Japan.

Fully unwinding financial sector interventions, however, has proved more difficult. An exit strategy for divesting public shares in the banking system and other interventions took longer to be designed. To restore market discipline and minimize moral hazard, blanket guarantees were replaced with partial deposit insurance, and public funds were gradually repaid. Impressively, nearly three-fourths of the 10 percent of GDP in public funds needed to dispose of NPLs and recapitalize banks has been recouped (Table 2.1). However, the BoJ has been unable to fully unwind its purchases of equities held by banks, and some banks have been unable to fully repay their public funds. Similarly, the withdrawal of public support of SMEs (primarily in the form of generous credit guarantees) has been relatively gradual and may have held back needed restructuring of the sector.

Table 2.1.

Japan: Public Funds Allocated to the Financial Sector (1999–2008)

article image
Sources: Bank of Japan; Financial Services Agency of Japan; and Deposit Insurance Corporation of Japan.

10.4 trillion yen is covered by the taxpayers, with the remaining amount scheduled to be covered by deposit insurance fees paid by financial institutions.

Notwithstanding these partial successes with exit policies, the crisis has left some long-term scars, manifested in persistently lower investment, weak price pressures, and a significant rise in public debt. Compared with rates reached in the 1980s, gross fixed capital formation has on average been more than 5 percent of GDP lower, and average growth has fallen by half. Asset prices also have never fully rebounded, with the stock market and house prices remaining some 40 and 70 percent below their precrisis highs, respectively. Meanwhile, deflationary pressures have persisted, with headline inflation only edging into positive territory from 2006 and policy rate peaking at a mere 50 basis points.

How Does the Current Great Recession Compare with Japan’s Lost Decade?

What can Japan’s experiences tell us about the outlook for the global recovery? This section recreates recovery “heat maps” for various time periods during Japan’s lost decade and compares them with those for the United States, the United Kingdom, the euro area and Asia since the beginning of the year. The heat maps track a set of high-frequency indicators—for trade, financial conditions, and private domestic demand—classifying them as being in modes of recovery (dark green), green shoots (light green), stabilization (orange), or deterioration (red) based on their underlying momentum. The time intervals considered for Japan are 12-month windows centered on: (1) March 1997, (2) June 2000, and (3) June 2003. Recall from the previous section that the first two episodes represented fledgling recovery attempts stifled by negative external shocks after the withdrawal of stimulus (the consumption tax increase in April 1997 and policy rate increase in August 2000), whereas the third episode marked the onset of a more durable recovery.

Although comparing the Japanese heat maps highlights the difficulty of differentiating green shoots from genuine turning points, it also reveals some interesting patterns (Figure 2.12):

Figure 2.12.
Figure 2.12.

Recovery Heat Maps in Japan: Three Phases of the Banking Crisis

Sources: CEIC Data Company Ltd.; Thompson Datastream; Haver Analytics; and IMF staff calculations.1 Three-month (or short-term) money market rate minus equivalent T-bill rate.2 See Balakrishnan and others (2009). The index comprises seven variables capturing developments in the banking sector, the securities markets, and the foreign exchange markets.3 House price index not available for Japan, proxied by stock market instead.
  • A sustained upturn was possible only when indicators across all the components—trade, financial conditions, and private domestic demand—were displaying signs of tangible recovery by flashing green. This suggests that a broad-based pickup may have been a key ingredient for a lasting recovery.

  • In all three episodes, exports and industrial production seemed to be recovering strongly, but there was little spillover to private demand during the first two recovery attempts. Underlying momentum was weak, with significant fragilities remaining in the financial system and corporate balance sheets. As a result, when external shocks hit, the economy foundered again.

  • In the final episode, private demand was stronger—in particular, corporate investment—as firms had made progress in cleaning up their balance sheets and deleveraging, and the financial system had been recapitalized and was in a position to lend again.

  • Although it is difficult to tease out a precise sequence, it appears that certain financial market indicators, in particular the stock market, were typically the first to show signs of recovery, together with a cyclical correction in inventories that supported production. In the middle stages, there was a tendency for consumer and business sentiment to improve, bolstering domestic demand. In the final stage, only reached at the third attempt in Japan, private credit, house prices, and the labor market turned, sealing the recovery.

Qualitatively, the patterns in leading indicators over the last year in advanced economies outside Asia resemble somewhat those in the lead-up to Japan’s incipient recovery attempts (Figure 2.13). Much as in those two episodes, indicators related to trade and financial markets are showing signs of recovery in places, but private domestic demand—which was a key ingredient for Japan’s lasting recovery—still appears weak:

Figure 2.13.
Figure 2.13.

Recovery Heat Maps in Advanced Economies in 20091

Sources: CEIC Data Company Ltd.; Thompson Datastream; Haver Analytics; and IMF staff calculations.1 See footnotes to figure 2.12.
  • Trade related: Global stimulus efforts are bolstering exports, and inventory adjustment is progressing. However, the recovery in production has yet to take hold.

  • Financial markets: Reflecting aggressive credit easing and financial sector support measures, recovery is most strongly apparent in some financial market segments, led by the United States. Money markets in the United Kingdom have also recovered strongly. Overall, however, financial markets are still under strain, and credit conditions remain exceptionally tight for many households and firms.

  • Private domestic demand: Improvements seem to be lagging in the real economy. Although fiscal stimulus appears to be providing some support to confidence in the euro area, consumer and business sentiment generally remain depressed. Moreover, spending is uniformly subdued and labor market conditions extremely weak.

By contrast, emerging Asia, in particular China and India, are rebounding much more quickly. As discussed in Chapter 1, sizable monetary and fiscal stimulus and the rebound in global risk appetite have underpinned the striking recovery in emerging Asia. At the same time, industrial production and exports are benefiting from an unwinding of earlier global inventory adjustments. Sound macroeconomic management in the lead-up to the crisis has also allowed more aggressive policy responses in many parts of the region. In turn, their effectiveness has been magnified by the generally much better condition of private sector balance sheets, as banks have been more willing to lend and borrowers less constrained by debt in their decisions to borrow and spend out of tax cuts. In marked contrast to most other regions, credit has continued to expand across most of Asia, and in China it has accelerated rapidly, providing further support to consumption and investment. That said, private domestic demand still looks vulnerable in the export-oriented Asian economies, with business confidence and private consumption still not in full recovery mode.

Potential Implications for the Global Outlook and Policies

A global repeat of the lost decade is by no means inevitable or even likely. Through forceful interventions, policymakers appear to have precluded the worst possible outcomes, and the world economy is on the cusp of a recovery. The beginning of the end of the Great Recession could well be in sight, but based on Japan’s experiences, where could the global economy go from here?

An important lesson from Japan is that green shoots do not guarantee a recovery, implying a need to be cautious on the outlook today. In fact, if Japanese history is any guide, the global recovery could still be in the initial stages. Systemic risks of collapse have been sharply reduced, and the macroeconomic response has generally been forceful and faster than was the case with Japan’s more drawn-out crisis. These would seem to lower the risk of a double-dip or a very protracted recession. However, financial conditions remain far from normal, credit growth remains subdued, and weak labor markets and sizable excess capacity are weighing on global output. Moreover, as was the case in Japan in the early stages of the lost decade, the problems that lay behind the crisis in advanced economies linger: delinquencies on mortgage loans are still rising, households remain highly indebted, and the financial system remains encumbered by an uncertain amount of distressed assets and doubts about firms’ capital positions. Even in emerging Asia, a vigorous and sustained turnaround cannot yet be taken for granted, and the significant fragility of external demand outside the region may slow the momentum of exports, dampening what has historically been a key channel for Asia’s recoveries.

Indeed, Japan’s experiences caution that lingering financial fragilities can magnify the impact of adverse shocks on the economy. On two occasions in Japan, adverse external shocks were amplified by a weak banking system, pushing the economy back into stagnation. Today, given downside risks and the still strained nature of financial systems and household balance sheets in advanced economies, the possibility of a double-dip cannot be discounted altogether. Moreover, a double-dip recession would necessitate further rounds of aggressive and costly macroeconomic and financial interventions, which could worsen longer-run outcomes.

So what does this imply about the appropriate setting of policies? First, a lasting recovery is likely to depend on concerted efforts to resolve financial sector and debtor imbalances. In Japan, it was only when corporate debt had returned to prebubble levels and banks had disposed of their distressed loans and been adequately recapitalized that the benefits from policy stimulus and a favorable external environment could spill over and reinvigorate private domestic demand. In advanced economies that find themselves at the center of the Great Recession, this would suggest that a robust private-led recovery may not take hold until household debt levels fall back toward more normal levels and banks are sufficiently strengthened (Figure 2.14).

Figure 2.14.
Figure 2.14.

Household Debt

(In percent of GDP)

Sources: U.S. Federal Reserve Bank; and Thompson Datastream.

Second, while restructuring is underway and until the recovery becomes better established, policy stimulus may need to be maintained. As in Japan, stimulus could facilitate needed restructuring by giving banks and households in advanced economies time to rebuild their balance sheets. It could also lay down firmer foundations for renewed growth.

Third, while policy support is maintained for as long as needed, clear plans for exit are likely to be beneficial. As illustrated in Japan, calibrating the timing of actual exit will be challenging under extreme uncertainty about the underlying strength of the economy and financial vulnerabilities. In particular, policymakers will need to navigate skillfully between avoiding a withdrawal of stimulus before underlying imbalances are redressed, and maintaining support for too long at the expense of longer-run outcomes. In Japan, stimulus was necessary but not a panacea, and over time its effectiveness waned on concerns over rising public debt and banking sector problems. To address these risks and guide expectations, the underlying exit strategies need to be communicated carefully and at an early stage, as in the case of Japan’s exit from quantitative easing. This time around, the global scale of the crisis also makes it important that exit strategies be well coordinated across economies.

Japan’s experiences suggest that clear and credible exit strategies can help anchor expectations and reinforce confidence:

  • Outlining a concrete medium-term fiscal consolidation strategy could help manage the difficult balancing act between supporting the economy and maintaining confidence in longer-term debt sustainability. Aggressive fiscal stimulus being implemented across the world is projected to result in a rapid rise in levels of public debt and markets may require convincing that this trend will eventually reverse.3 In the current setting, laying out policy options for achieving the desired fiscal adjustment could also help address longer-run spending needs associated with aging populations and expanding social safety nets.

  • An exit strategy from exceptional monetary policies needs to be convincingly articulated to help guide market expectations. The most desirable exit scenario would be for investors’ risk appetite to recover and credit markets to normalize smoothly, as happened in Japan. Communicating to the markets on how and under what conditions monetary stimulus would be withdrawn could help ensure a smooth transition to more normal conditions. At the same time, making available a diverse set of tools for managing liquidity—including for instance, granting central banks authority to issue their own debt—would enhance policy flexibility and credibility.

  • A strategy for eventually unwinding financial and corporate sector policies is needed to minimize distortions and fiscal risks. As was the case for Japan, this will likely imply tightening terms on facilities extending support to financial institutions and corporations, as well as gradually reducing guarantees and subsidies.

Once the dust settles, global economic conditions could look markedly different from the benign precrisis environment. Unlike cyclical downturns, postbubble recessions can undermine long-term output as risk repricing, deleveraging, and financial restructuring dampen investment and curtail credit. Such forces were at play in Japan, where growth rates have never returned anywhere close to precrisis levels, falling to only half the 4 percent rate achieved during the 1980s (Figure 2.15). Broader international experience also suggests that financial crises result in permanent losses of output (see, for example, Cerra and Saxena, 2008, and Reinhart and Rogoff, 2009), although there is less evidence of an impact on potential growth rates. Moreover, the global dimension of the current crisis may introduce additional complications. Whereas the emergence of a durable expansion in Japan was supported by strong external conditions, the weak global environment today may limit prospects for an export-led recovery. In the face of these potentially long-lived effects on advanced economies, it will be critical to rebalance the global economy to ensure robust growth over the longer term.

Figure 2.15.
Figure 2.15.

Japan: Real GDP

(In trillions of yen)

Source: Haver Analytics.

Note: The main authors of this chapter are Kenneth Kang, Murtaza Syed, and Kiichi Tokuoka, with assistance from Souvik Gupta, Ioana Hussiada, and Adil Mohommad.

1

As announced two years earlier, the consumption tax rate was raised to 5 percent from 3 percent in 1997, and a temporary income tax cut was lifted. At the same time, social security premiums were raised.

2

For example, ample liquidity and low interest rates may have delayed the recognition of problem loans and undermined market discipline by making it easier for essentially insolvent borrowers to remain current on their interest payments.

3

Here Japan’s experience may not be typical since government bond yields have shown little sensitivity to changes in the debt stock or fiscal deficits over time. This can be explained by Japan’s large pool of household savings, stable institutional investors, and a strong home bias (see Tokuoka, 2009).