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Will the U.S. and Europe Avoid a Lost Decade? Lessons from Japan’s Postcrisis Experience


This paper reexamines Japanese policy choices during its banking crisis in the 1990s and draws some lessons relevant for the United States and Europe in the aftermath of the global financial crisis of 2007–09. The paper focuses on two aspects of postcrisis economic policy of Japan: the delay in bank recapitalization and the lack of structural reforms. These two policy shortcomings retarded Japan’s recovery from the crisis and were responsible for its stagnant postcrisis growth. The paper also suggests some political economy factors that contributed to the Japanese policies. In France, Italy, and Spain bank recapitalization has been delayed and the structural reforms have been slow. Without drastic changes, they are likely to follow Japan’s path to long economic stagnation. The situation in Germany looks somewhat better mainly because the structural reform was undertaken before the crisis. Although the recovery has been slow in the United States as well, the problems are at least different from those faced by Japan then and many European countries now.

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  1. 1.

    Schaltegger and Weber (2013) also compare the current Europe to Japan in the 1990s and find many similarities.

  2. 2.

    We thank an anonymous referee for making this point.

  3. 3.

    The English version of the document can be found at (accessed on September 22, 2013).

  4. 4.

    This is obviously subjective. To do this each of us independently ranked the policies and in the vast majority of cases our assessments agreed. In cases where we did not agree we added a third rating by our research assistant and used her judgment to break the tie.

  5. 5.

    For example, see his interview with Jon Hilsenrath and Megumi Fujikawa, “Japan’s Bernanke Hits Out at His Critics in the West,” Wall Street Journal, March 1, 2011.

  6. 6.

    Nishimura (1999, p. 119) also claims that another concern on asking banks to clean up their balance sheets was the possibility of massive credit crunch.

  7. 7.

    The subsidy, which is (ironically) called Subsidy for Employment Adjustment, is given to firms that avoid redundancies by implementing other measures such as furloughs, dispatching workers to related companies (shukko), or offering internal job training. The policy was originally introduced in 1975 and continues to today.

  8. 8.

    See for example, “Fed Chief Gets Set to Apply Lessons of Japan’s History,” Wall Street Journal, October 12, 2010. Available via the Internet, (last accessed July 27, 2014).

  9. 9.

    One critical consideration is that the largest U.K. banks during the same period raised more than 100 billion pounds. So Table 1 figures on capital raised in Europe are heavily influenced by the mandated recapitalization that was taking place in the United Kingdom.

  10. 10.

    See the sources that are listed at the bottom of the table for a full description of where the different data were obtained.

  11. 11.

    “Health Check,” The Economist, October 5, 2013.

  12. 12.

    See for example, and

  13. 13.

    van der Veer and Hoeberichts (2013) use the underlying bank-level responses from this survey for Dutch banks to assess how lending standards translate into lending. They find that when a bank reports that it has tightened standards by one notch in the survey, the bank’s quarterly growth rate of business lending falls by about 0.5 percentage points. Moreover, that one time drop is not reversed until standards are eased.

  14. 14.

    The 2014 IMF Article IV consultation for the euro area argues that “successful execution of the AQR and a common fiscal backstop are needed to facilitate balance sheet repair and sever bank-sovereign feedback links.”

  15. 15.

    These data are available at and the figures referenced above were accessed on July 27, 2014.

  16. 16.

    “A Quick Guide To ‘Agenda 2010’,” Deutsche Welle, October 17, 2003.

  17. 17.

    See Weidner and Williams (2014) for recently updated estimates of the U.S. output gap.

  18. 18.

    Retrieved from on June 24, 2013.

  19. 19.

    Retrieved from on July 25, 2014.

  20. 20.

    House of Councillors, the National Diet of Japan, “Dai 136 Kai Kokkai Gaikan (Overview of the 136th Diet Session” (

  21. 21.

    See retrieved June 26, 2013.

  22. 22.

    Hoshi (2002) discusses how the convoy rescues worked and how it changed over time.

  23. 23.

    As Tett (2003) describes, extravagant entertainment of bureaucrats and politicians by Japanese businesses had existed before the 1990s, but the public became much more aware of these practices (especially regarding MOF staff participation) during these “scandals.” See Tett (2003, Chapter 4) and Mikuni and Murphy (2002, pp. 199–201).

  24. 24.

    “Japan Vote Unconstitutional as Abe’s Win Valid: Kyodo,”, November 20, 2013.


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Additional information

*Takeo Hoshi is Henri and Tomoye Takahashi Senior Fellow at the Freeman Spogli Institute for International Studies (FSI) and Professor of Finance (by courtesy) at the Graduate School of Business, both at Stanford University. His main research interest includes corporate finance, banking, monetary policy and the Japanese economy. Anil K. Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago Booth School of Business. His research focuses on banking, business cycles, corporate finance, and monetary policy. His research has won him numerous awards, including a Sloan Research Fellowship, the Nikkei Prize for Excellent Books in Economic Sciences, and a Senior Houblon-Norman Fellowship from the Bank of England. Originally prepared for the IMF Annual Research Conference, November 2013. The views expressed are those of the authors only and should not be attributed to any of the institutions with which they are affiliated. Kashyap thanks the Initiative on Global Markets at the University of Chicago and National Science Foundation through a grant administered through the National Bureau of Economic Research for financial support. The authors’ information on outside compensated activities can be found on their websites. The authors thank Giovanni Dell’Ariccia, Jeff Frieden, Pierre-Olivier Gourinchas (Editor), Ayhan Kose (Editor), Sebastien Lechevalier, Benoit Mojon, David Romer (Discussant), Ken Sheve, seminar participants at École des Hautes Études en Sciences Sociales (EHESS) and four anonymous reviewers for the comments. The authors also thank Giuseppe Bertola, Paola Sabbione, Matt O’Connor, and Matt Spick for helpful advice about U.S. and European Banking data, Phillip Lipscy and Megumi Naoi for data on the political systems, and Charles Starnaud and Nomura research for sharing data on equity issuance. Huiyu Li and Yingcong Tang provided outstanding research assistance, though all mistakes are of the authors.



This appendix provides more details that support the general summary of events in Japan that are presented in Sections II and III of the paper.

More Background on the Japanese Banking Problems

As of 1999, it was already clear then that Japanese banks were seriously undercapitalized even after two rounds of capital injections into large banks using public funds. The review of the various estimates as of mid-1999 that are given in Hoshi and Kashyap (1999) pointed to optimistic official estimates of 3.5 percent of GDP of unrecognized losses, and contrasted these to estimates from various private sector analysts suggesting impending loan losses of twice that size. We pointed out at that time the government was reluctant to address the problem and cited various contemporaneous news accounts documenting that hesitation.

By the end of 2001, the market also started to worry about the health of large Japanese banks once again. Ito and Harada (2006) show that the CDS spreads for major Japanese banks fell right after the public capital injection of 1999 but started to rise again and settled at between 150 and 200 basis points toward the end of 2001. The CDS rates remained elevated until September 2002 (the end of the sample period for this study).

Kashyap (2002) reviews a number of estimates of undercapitalization of Japanese banks. He also conducted a survey of leading Japanese bank analysts and private sector economists asked them to estimate the difference between the market value of assets and liabilities of the Japanese banks. These responses clustered around 4 percent of GDP (20 trillion yen). Hence to move the banks from having negative net worth to being adequately capitalized would have taken about twice that amount. Paul Sheard in his response to the survey emphasized that the Deposit Insurance Fund had resources that were equal to about 10 percent of GDP, meaning that the funding was available. So it was an open secret that even five years after the acute part of Japan’s banking crisis the banks remained seriously undercapitalized.

There is also a very large literature analyzing the misallocation of bank credit in Japan (see Sekine, Kobayashi, and Saita (2003) for a survey). One very convincing demonstration comes from Peek and Rosengren (2005) who show that poor performing firms were more likely than better performing firms to receive additional bank credit. They attribute this tendency to banks’ desire to avoid loss recognition. They find that this behavior is most pronounced for banks that are close to the regulatory minimum level of capital. They note that for existing equity holders rolling over a loan rather than foreclosing is rational because foreclosing on a bad loan locks in a loss and requires the bank to find additional equity financing to comply with minimum capital requirements. As we discuss in the next section, the government may also have reason to allow underperforming firms to survive.

Caballero, Hoshi, and Kashyap (2008) offer a model and some evidence showing how this perverse behavior can create slow aggregate growth. They start by showing a rise in lending to the corporations that appear to be subsidized. This is difficult to prove since there is not standard data showing all aspects of bilateral loan contracts. So they rely on reported total interest payment made by firms. Their approach is to assume all firms are able to get funding at the most favorable possible rates on each type of borrowing that is undertaken; For example, if the highest rated firms are able to borrow at a 0.25 percent interest rate in the corporate bond market, then Caballero, Hoshi, and Kashyap (2008) assume that this rate would be available to all corporate bond issuers. By making similar assumptions for each category of borrowing, they construct the lowest possible amount of interest payments that a firm could reasonably be expected to pay. Firms that paid less than that amount of interest are assumed to be receiving subsidies. The subsidy is almost certainly coming from banks, since there is no reason to expect arm’s length investors to offer unusually low credit terms.

They next present a model to analyze macroeconomic outcomes in an environment where unprofitable firms receive subsidies. In this situation, profitable firms will gain less market share than in a normal situation where struggling firms fail and release their workers and customers to the successful firms. More importantly, the better performing firms have less incentive to invest and raise employment because any attempt to expand can trigger a higher subsidy to the weak firms. Over time the ongoing subsidies and the weak incentives for strong firms to grow create a persistent misallocation of resources that will harm overall productivity growth.

Caballero, Hoshi, and Kashyap (2008) confirm these predictions by looking at the behavior of normal firms that do not appear to be receiving subsidized credit. They find that these firms invest less and add fewer workers when there are relatively more firms receiving subsidized credit in their industry. They also find that the regular firms have to have a higher productivity advantage relative to the subsidized firms to stay in business.

Japanese Government Assessments of Outlook for the Economy

Prior to the election of Prime Minister Koizumi in 2001, the Japanese government argued and acted as if the main problems facing the economy were short-term ones that would soon abate. For example, in February 1999, then Vice Minister of International Finance, Eisuke Sakakibara, was quoted as saying that the Japanese banking problems “would be over within a matter of weeks.” Perhaps the most notorious example was the decision by the Bank of Japan in August 2000 to raise short-term interest rates. At the time of that decision, which was roundly criticized by many observers including the representatives from the Ministry of Finance and the Economic Planning Agency, the Bank of Japan issued a statement stating:

Over the past one year and a half, Japan’s economy has substantially improved, due to such factors as support from macroeconomic policy, recovery of the world economy, diminishing concerns over the financial system, and technological innovation in the broad information and communications area. At present, Japan’s economy is showing clearer signs of recovery, and this gradual upturn, led mainly by business fixed investment, is likely to continue. Under such circumstances, the downward pressure on prices stemming from weak demand has markedly receded.

Considering these developments, the Bank of Japan feels confident that Japan’s economy has reached the stage where deflationary concern has been dispelled, the condition for lifting the zero interest rate policy.

In October 2000, the government announced its plan called “A Policy Package for New Economic Development toward the Rebirth of Japan.” In the preface of the document, the government wroteFootnote 18: “As a result of the swift and large-scale economic stimulus measures implemented by the Japanese government since 1998, the Japanese economy has averted the peril of falling into a deflationary spiral and is now gradually improving, after bottoming-out around the spring of 1999.”

By January 2001, the Ministry of Finance had taken the optimistic view on board. The January monthly review statesFootnote 19: “Although the Japanese economy is still in a severe situation with meager improvements in the household sector, activities on the whole continue to rise modestly. The strength is seen mainly in the corporate sector, where autonomous nature of the recovery has become increasingly evident.” Hence, until the arrival of the Koizumi government in April 2001, there was limited recognition of the structural challenges facing the Japanese economy.

The Jusen Bailout Controversy

In the late 1980s, seven specialty housing finance lenders called jusen had run into trouble (see Milhaupt and Miller (2000) for details). The Ministry of Finance (MOF) assured the public (on multiple occasions) that no public funds would be used to rehabilitate them. But repeated reorganizations, using mostly private money from the banks which had founded them, failed to rehabilitate them.

So eventually in 1995 it was apparent that they had to be completely restructured—as of March 75 percent of the loans were nonperforming and by September all seven were estimated to be insolvent. Over the course of the year the government convened negotiations to allocate losses. Ultimately, the government determined that a ¥6.41 trillion write-off would be needed. The negotiations that followed resulted in the founding banks taking a loss of ¥3.50 trillion, agricultural coops that had invested with them writing off ¥0.53 trillion, and other lenders losing ¥1.70 trillion. Milhaupt and Miller (2000) report that the government had intended the coops to bear a larger share of the losses, but they refused to contribute more than ¥0.53 trillion. Hence, to finalize the deal the government agreed to contribute ¥0.68 trillion (which would come from taxpayers).

The cabinet approved this plan on December 19 and the public and press condemnation was immediate and strident. The main Japanese financial newspaper, the Nihon Keizai Shimbun, penned a stinging editorial criticizing the nontransparent process that led to the deal and accusing the government of caving into the Liberal Democratic Party (LDP) politicians known as the “agricultural policy tribe.”

The deliberations in the Diet over the bill were especially contentious. The bill eventually passed in June 1996, 137 days after its introduction. In the interim there was three-week sit-in by opposition parties led by the New Frontier Party (NFP) that blocked the entrance to the Budget Committee room in the Diet and halted progress on the bill.Footnote 20 According to a poll in the Asahi Shimbun in March at the time of the sit-in, approval for the Prime Minster and cabinet had dropped by one-third from January and only 12 percent of the public backed the rescue.Footnote 21 Although the Jusen Bill eventually passed the Diet, the government felt compelled to ask the banks to contribute more to establish a fund that would be used to cover future additional losses from closing down the jusen. Given this background it is hardly surprising that there was little political appetite for telling the public that a much, much bigger bailout was needed.

The Conflicting Incentives of the Ministry of Finance in Addressing Banking Problems

As Kamikawa (2005) argues, as the primary regulator of all the banks, the MOF stood to be blamed if they admitted that there had been supervisory failures. In addition, the MOF had traditionally been able to deal with failing banks without spending public funds by asking bigger and healthier banks to absorb them. It would have been a dramatic shift to eschew this so-called convoy rescue approach in favor of using public funds.Footnote 22

The protracted nature of the problems also put the MOF in a difficult position. In the early 1990s, the successful convoy rescues in the past likely led the MOF to simply assume that the nonperforming loan issue could be handled without direct taxpayer assistance. But as the decade progressed there were a series of scandals involving bank examiners at MOF. In the most notorious one, lower-level bank examiners were prosecuted for leaking the dates of on-site examinations to a bank in return for the bank’s entertaining them with panty-less waitresses at a shabu shabu restaurant.Footnote 23 In addition, many former MOF officials had leadership positions at the jusen. As the jusen scandal gained attention, the MOF was criticized for tolerating reckless lending.

Hence, by the peak of the banking crisis, the MOF was on the defensive as calls were being made to break up the ministry. Ultimately, in July 1998 the examination function of the MOF was removed from the ministry and assigned to a new agency (Financial Supervisory Agency). The MOF’s influence over the Bank of Japan was also trimmed. Up until April 1998, the Bank of Japan had been tightly controlled by the MOF and by convention every other governor appointed to the bank was an ex-MOF official. In April 1998, the BOJ was granted legal independence. Although the scandals and the decline of political power of the MOF were not the only factors that led to the creation of the FSA and independence of the BOJ, they certainly played a role.

Even after the supervisory function was moved to the FSA, the MOF initially retained the power to formulate banking policy, which included decisions over whether and how to recapitalize banks. Eventually this power was also stripped. The first step was in July 2000, when the policy formulation function was also moved to the FSA and the Financial Supervisory Agency was renamed the Financial Services Agency (conveniently still referred to as the FSA). Then in January 2001, the FSA was merged with Financial Reconstruction Commission (which had been created to implement the injection of public capital into banks starting in March 1999), and the FSA gained the full power to force banks to write off nonperforming loans and recapitalize. In the fall of 2002, Mr. Takenaka utilized this power to start serious recapitalization of major banks that was described above.

Political Economy on the Slow Structural Reforms in Japan

Recent research in political economy focuses on political institutions that shape the incentives of individual politicians and influence policy outcomes. Estévez-Abe (2008) studies how Japan came to have the system of social protection that is fragmented (with different mechanisms applying to different groups delivering different levels of protection) and relies less on direct government protection and more on “functional equivalents” that disguise direct government spending. An important outcome of this approach is that entire industries or occupational groups are often shielded from market forces. The most important factor in her model, which she calls a “structural logic model,” is the electoral system and the nature of political competition that the system creates. In her words,

To put it briefly, the structural logic model claims that the Japanese electoral system (multimember districts and single nontransferable vote) produced strong incentives in favor of highly targeted forms of social protection at specific constituent groups or areas. Japan thus spent less on comprehensive social welfare programs, because such programs made it difficult to steer distributive benefits to specific areas and groups. Instead, Japan developed social insurance schemes and functional equivalents to social security programs that allowed occupational and geographical targeting. (Estévez-Abe, 2008, Introduction)

In a multimember district, more than one candidate wins a seat in the parliament. Thus, a candidate does not have to appeal to a large number of unorganized voters to secure victory. Relying on the support from a small but well-organized group is often sufficient. This makes the strategy to support a fragmented system of social protection attractive. Moreover, the Liberal Democratic Party (LDP) in Japan was politically dominant for most of the postwar era and the LDP almost always placed multiple candidates in a single district to capture more than one seat. This meant LDP politicians needed to compete among themselves, which gave rise to more personal-based voting rather than policy-based voting, amplifying the importance of having support from well-organized groups.

Lynch (2006) also examines social protection provided by government though with a different focus and different countries in a series of case studies. She focuses on “age orientation” of social policies, which is measured by how much the government spends to protect the elderly relative to the government spending for working-age adults and children. Lynch (2006) finds that the countries with elderly oriented social policies have an “occupationalist” structure of welfare programs, where different programs cover different occupations and the coverage for people outside the occupational groups is scant. The countries with citizenship-based welfare programs, which provide social protection for citizens at large, are more youth-oriented. She traces the differences to different experiences during the two historical periods: when these countries introduced the social welfare programs in the late nineteenth to early twentieth centuries, and when some countries shifted from the occupationalist systems to the citizenship-based systems right after World War II. The countries that started out with the citizenship-based systems stayed citizenship-based and tended to have an orientation that favors the young.

More interestingly, she argues that the different choices observed among the occupationalist systems depended on the nature of political competition. The countries where political competition focuses on providing benefits to favored constituencies (often called clientelism or particularism) stuck with the occupationalist systems, which provides more convenient ways for politicians to allocate more resources to their core supporters.

Thus, Lynch’s discussion also features the nature of political competition as the most important determinant of the social protection policy. In terms of age-orientation, Japan is classified as one of the most elderly oriented ones among the countries she studies. Consistent with Lynch’s hypothesis, the nature of political competition in Japan is described as particularistic: politicians catered to their core support groups in order to win under MMD (multimember districts) and SNTV (single nontransferable vote) system.

Though MMD/SNTV system characterized Japan’s electoral system for a long time, the electoral reform of 1993 changed the system. Japan’s electoral system since the reform is characterized as a mixed system of SMD (single-member districts) and PR (proportional representation). Thus, the explanations based on political institutions would imply that policy decisions in Japan must have started to change after the electoral reform. Indeed Rosenbluth and Thies (2001) claim that they find such an expected change in the resolution of jusen:

We credit, at least in part, the new electoral rules for a policy shift away from the bank-coddling practices of the past. After trying to stick taxpayers with the tax for cleaning up the jusen mess, the LDP did not get away with it. (Rosenbluth and Thies, 2001, p. 35)

Our assessment of the jusen resolution is different from theirs. The final resolution of the jusen, which relied mostly on (reasonable) contributions from the banks with minimum burden on agricultural coops and taxpayers, was in line with the traditional logic of convoy rescues. The new electoral system did not change the policy of the MOF drastically and the government continued to delay bank restructuring and significant recapitalization until late 2002.

But Rosenbluth and Thies (2001) are correct in pointing out the new electoral system made it difficult for the government to impose unpopular policies on voters. Estévez-Abe (2008, Chapter 2) explains that SMD means that even a government with parliamentary majority will be reluctant to impose unpopular policies because the “identifiability” and “accountability” of the ruling party is high. In this case, the voters can easily see the ruling party is clearly responsible for legislating the unpopular policies (high identifiability) and the voters can easily express the displeasure by voting for the most promising opposition candidate in an SMD (high accountability). Thus, the introduction of the SMD system in Japan may have ironically made it difficult to implement the economic reforms that require (at least temporary) increases in tax burdens, such as bank recapitalization using public funds and introducing a universal safety net for unemployed workers instead of subsidizing inefficient firms to maintain employment.

There are two groups that are especially protected under the current system in Japan and hence have much to lose from many economic reforms: farmers and the elderly. As Lynch (2006) shows, Japanese social policies are very elderly oriented. As Hoshi and Kashyap (2012) point out, Japan’s agricultural sector is heavily subsidized: in recent years, a widely used measure of the total amount of subsidies that farmers receive (Producer Subsidy Equivalent; PSE) have been roughly equal to the value added of the agricultural sector.

Both groups have been important supporters of the LDP. Although the number of farmers shrunk over time as Japan industrialized, they continued to have disproportionate political power because the allocation of seats to electoral districts did not adjust automatically as people moved from rural to urban areas. This caused the over-representation in rural electoral constituencies that have relatively more farm votes. The malapportionment in Japanese elections also favored the elderly because the proportion of the elderly is also high in rural areas.

Occasional redistricting reduced the malapportionment over time. For example, in the 1985 lower house election, the number of voters per seat in the most densely populated constituency was 5.12 times of that in the least densely populated constituency. The redistricting that added eight seats to most populous districts and subtracted seven from least populous districts lowering the ratio to 2.92 in the 1986 lower election. After another redistricting in 1993, the ratio declined to 2.14 in the 1994 election. (George Mulgan, 2000, pp. 330–331, Table 5.6).

Malapportionment still remains and is being contested in the courts. For the most recent lower house election in December 2012, the number of voters per seat was less than 50 percent of that in the most densely populated constituency in 72 out of 300 single member districts. Sixteen cases were litigated as being in violation of the constitution, and the High Courts ruled that the election was unconstitutional in all of the 16 cases. On November 20, 2013, the Supreme Court agreed with High courts and ruled that the election was unconstitutional, although they did not nullify the election results.Footnote 24

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Hoshi, T., Kashyap, A. Will the U.S. and Europe Avoid a Lost Decade? Lessons from Japan’s Postcrisis Experience. IMF Econ Rev 63, 110–163 (2015).

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JEL Classifications

  • E65
  • G01
  • G28