The Beginnings of Japan's Economic Crisis
An Explanation of the Factors that Created Japan's "Lost Decade"
Feb 25, 2009
Japan's Real Estate Bubble
In the late 1980s, financial markets of Japan experienced a real estate bubble similar to the one recently experienced by the United States. This bubble, however, was largely based in the commercial sectors of urban areas. Many financial firms, noticing the high returns on real estate investment, were convinced that the risk of a missed opportunity outweighed the risk of a collapse. Because of this, many banks expanded the role of speculation in the commercial real estate market. At the height of this bubble, in fact, it was estimated that the real estate value of the Imperial Palace in Tokyo exceeded that of the entirety of the state of California.
Overconfidence in the Banking System
Japan’s Banking sector was also highly regarded for its supposed institutional stability. After World War II, the Japanese banking system had been set up in a heavily regulated manner, and during this time, had formed many business ties to the point that their institutions were seen as an integral bedrock of the economy. Moreover, Japan's banks had never experienced a major bank failure, and were in fact expanding volumes in the wake of large-scale deregulation.
Japanese financial institutions were not a major concern of groups such as the Deposit Insurance Corporation, which played a supervisory role in the economy. Hiroshi Nakaso, the Executive Director of the Bank of Japan later explained the ideology behind Deposit Insuranc Corporation (DIC) policies at the time, when he writes, "the DIC had an insurance fund of ¥300 billion, far smaller than what would be required in the event of a failure of a major bank."
This lack of financial support reflected the optimism in the stability of Japan's banks at the time, and would come to be a liability. With little oversight, an overconfidence in the solvency of the banking system as a whole, and a rapidly escalating trend of speculation, Japan’s financial sector had opened itself up to new vulnerabilities, which became all too clear when the real estate market crashed. In the early 1990s, real-estate property values began to fall.
Loan Collateral Aggrivates the Crisis
The way Japanese banks utilized real estate as collateral aggravated the real estate crisis. As soon as land prices began to drop in 1990, loans which had once been seen as soluble became near-worthless – without value in the real estate, companies did not have enough assets to pay back loans even after they defaulted. With each default that occurred, more real estate became open, which drove prices further, a spiral which pulled the Japanese market into recession. Since even its largest banks began to see a loss in capital, few were able to utilize enough resources to build the economy back up to pre-recession standards.
