Japan's Economic Lessons: A Cautionary Tale for Global Policymakers
Explore the lessons from Japan's economic trajectory, from the 1980s asset bubble to the lost decades, and how these insights can inform current global economic policies.
Economic PolicyJapanInflationDebtBalancesheet RecessionReal EstateMay 27, 2025
Japanese post-war success was based on low costs, manufacturing competence, and an undervalued currency. When the 1985 Plaza Accord forced a revaluation of the yen and adversely affected exports and growth, the authorities cut interest rates, fuelling a debt-funded real estate and stock price boom. The bubble economy collapsed in 1990 and triggered a balance-sheet recession, as heavily indebted households and businesses cut back on consumption and investment to reduce debt.
Over two decades, Japanese policymakers repeatedly lowered interest rates, injected liquidity, and unleashed waves of government spending to resuscitate the economy. The policies alleviated the slowdown, but did not restore the growth levels or create the inflation needed to boost nominal asset prices and reduce real debt levels. Japan’s potential growth rates fell, reflecting misallocation of capital that reduced returns on investment. Excessive manufacturing capacity and low domestic demand increased reliance on exports and balance of payments surpluses to align production and demand. Government-financed infrastructure investment only provided a short-term boost in economic activity.
Low interest rates and abundant liquidity allowed excessively high debt levels. Weak businesses survived in a zombie-like state, operating only to pay loan interest. Banks avoided writing off loan assets, tying up capital and reducing credit availability for productive enterprises, especially small and medium enterprises. Low returns reduced income for savers, decreasing consumption and encouraging additional savings for retirement.
The increasing reliance on government spending led to a steady deterioration in public finances as the government ran large deficits. Government debt increased to 220 percent of GDP. The policies acted as a palliative, allowing essential reforms to be deferred. Policymakers borrowing from Japan’s playbook misunderstand the country’s circumstances. When its bubble economy collapsed, Japan was relatively rich and technologically advanced. The country entered the crisis with modest government debt. It had high domestic savings and a high home investment bias, which allowed the government to finance its spending domestically, assisted by the central bank’s quantitative easing programmes.
In the 1990s, Japan benefitted from favourable external conditions. Strong global growth allowed exports to partially offset the lack of domestic demand. A weaker yen was helpful in creating economic activity. Contrary to commonly-held views, Japan’s demographics were helpful. Its aging population was an advantage, because it meant fewer new entrants into the workforce, keeping unemployment low. A falling population supported per capita income, and disinflation or deflation ameliorated the erosion of living standards. There were problems of a shrinking workforce and lower tax base, but Japan’s welfare system is less generous than those in many countries.
The social and political background were favourable. Shaped by the hardships of the Second World War and the immediate post-war period, Japanese culture is characterised by strong national consciousness, stoicism, and selflessness, particularly among older citizens. There was acceptance of the need for economic sacrifices. Japan is also, de facto, a one-party state, where the ruling LDP is able to pursue its policies with little political opposition. This allowed the country to pursue consistent policies to manage its problems with limited opposition. Most of these conditions do not exist in other countries, should they seek to copy Japan’s approach. The problems are now global in scope. The world now faces unsustainable debt levels. There are trade and currency wars that are likely to escalate. There is a deteriorating geopolitical security environment, an expensive and slow energy transition, and a resource scarcity. In essence, one lesson from Japan’s experience is that it is better to enter a crisis first as there are greater options.
Despite its advantages, Japan has never fully recovered its economic and financial standing. The period since the collapse is known as the ‘lost decades’. There are social costs—elderly poverty encouraging some to commit crimes for the security of jails and a cohort of dispirited young who have opted out of society. Now, Japan may be illustrating the terminal phase of this process where the side effects of the initially effective policies become toxic. The endgame begins with inflation. Beginning in 2020, the supply shocks from the pandemic and geopolitical events combined with the longstanding loose monetary policies has created price pressures. Japan’s inflation rate, while comparatively lower, rose to around 3 percent. Despite tentative steps, Japanese authorities are reluctant to normalise policy settings. They fear the impact of higher interest costs, especially for the government and highly indebted businesses. There is the risk of falls in asset values which support high debt levels. This creates currency weakness. The differential between Japan’s low rates and those in most advanced economies caused the yen to fall from around 100 to the dollar to over 160 (with a modest recent recovery). The devaluation feeds inflationary pressures through higher import prices, especially for raw materials, food, and energy. It feeds capital flight, limits policy options, and flexibility to respond to new crises.
In August 2024, a modest 0.25 percent rise in rates was partially responsible for large falls in stock prices and volatility as the infamous yen carry trade (yen borrowings funding higher-yielding assets) was unwound. It points to how difficult and painful reversal of the policies in place for decades may be. The real lesson is that expansionary monetary and fiscal policy purchases time for reducing debt levels and structural reforms of industrial structure, productivity, corporate governance, labour markets, and public finance. You cannot cover up underlying economic weaknesses with increasing borrowing, government spending, and low rates forever. Policymakers elsewhere might benefit from reviewing Japan’s experience to understand how crushing debt, inability to adjust interest rates, dysfunctional financial markets, and currency pressures work to lock nations into stagnation and decline. It might help them avoid a similar fate. But no one learns anything from history or from the experience of others, as we choose to believe that we know better.
Frequently Asked Questions
What was the main cause of Japan's economic bubble in the 1980s?
The main cause of Japan's economic bubble in the 1980s was the revaluation of the yen following the 1985 Plaza Accord, which led to lower interest rates and a debt-funded boom in real estate and stock prices.
How did Japan's balance-sheet recession affect households and businesses?
Japan's balance-sheet recession, which began in 1990, forced heavily indebted households and businesses to cut back on consumption and investment to reduce their debt levels.
What were the long-term effects of Japan's low interest rate policies?
Long-term low interest rate policies in Japan led to high debt levels, weakened businesses, and reduced credit availability for productive enterprises, particularly small and medium enterprises.
How did Japan's demographics play a role in its economic challenges?
Japan's aging population was both an advantage and a challenge. Fewer new entrants into the workforce kept unemployment low, but it also led to a shrinking workforce and lower tax base.
What are the key lessons from Japan's economic experience for other countries?
Key lessons from Japan's economic experience include the importance of addressing underlying economic weaknesses through structural reforms rather than relying on expansionary monetary and fiscal policies, and the risks of high debt levels and currency pressures.
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