After Japan’s defeat in World War II, the nation rose out of its ashes to become one of the world’s fastest growing, and biggest, economies, in an era known as the “economic miracle”. That topic is beyond the scope of this paper, but can briefly be described as greatly helped by foreign (especially American) investment and efficient market regulation. A trend seen in the mid to late 1980’s was that, due to various factors caused by the expanding economy, credit became increasingly easy to obtain by the general public, with many people taking risky loans to invest in properties, driving prices to unsustainably high levels. The bubble burst around 1990, when property values plummeted and did not recover until the late 2000’s. In this paper I will be investigating the immediate aftermath of the crisis, including the measures taken by the government to alleviate the problem, and the impact on major world economies. To set the context, I will also briefly present the background and causes of the crisis.
Having avoided the economic crisis seen in the rest of the Western world by the Arab oil crisis in the 1970’s,  Japan emerged in the early 1980’s as one of the world’s strongest and most stable economic powers. In the 1980’s, the Japanese government sought to liberalize the currency to world trade, including appreciating the yen against the US dollar to alleviate a trade imbalance.  However, the continued expansion of the economy and stability of the financial sector may have masked some inherent flaws in the government’s policy of financial liberalization. Thomas F. Cargill, an American economist at the University of Nevada, Reno, points out several fundamental problems in the policies. One flaw he noted was that the policies that the Japanese government implemented, which were modeled after similar programs in the rest of the Western world, did not suit a government-regulated economy. 
Another problem that directly contributed to the asset bubble was that because of the close ties between corporations and the banking system in Japan, loans directly went into real estate, the returns of which went back into the bank’s assets, which allowed for more loans.  This circular trend contributed to the inflation of the real estate bubble. These, coupled with the fact that it simply became easier to obtain credit from banks due to government deregulation policies,  meant that property values were being driven artificially high. According to figure 1 (see appendix), urban property values in Japan peaked at around March 1991, then declined drastically and continued to drop until 2007. This trend reflects the general condition of the economic and financial market (figures 2-3, appendix), supporting the idea of banks directly influencing asset prices. Also, in his research, Daniel I. Okimoto of Stanford University finds that the appreciation of the yen against the US dollar after 1985 was a factor leading to economic stagnation, and impeded in efforts to relieve the problem. 
One trend that directly contributed to the inflation of the bubble was excessive speculation. Even as experts believed that asset prices were growing to an unsustainable level, a sense of crowd mentality continued to attract investors.  Okimoto also argues  that excessive savings by the Japanese people, stemming from long-standing government regulatory policy, was a cause of the influx of purchases, both directly and indirectly, the indirect reason being that the high levels of savings made it easier for banks to grant large and risky loans.
Characteristics of the loans and real estate development
Japanese economist Yoshiyuki Iwamoto described the banking system’s process of lending money directly to real estate investment as a “magic wand”,  in that banks fed money to real estate firms as an easy way to make money from the increasing values. However, like the aforementioned authors, he notes a cycling trend of banks making money from real estate, and real estate firms making money from investing bank loans. Around that time, a third major financial institution emerged: the non-banking institution (NB).  They were funded by banks, and could lend money in the same manner as a normal bank. NB’s were often turned to when normal banks rejected a loan application as too risky; as a result they were called “roundabout loans”.  This scheme of lending became so large-scale that Iwamoto described the atmosphere as customers flocking to NB’s in droves to apply for loans in an attempt to snatch whatever available land there was:
In many cases, the prospective customer showed a map to the bank staff and pointed out the area where the property was located. It could be anywhere- deep in the mountains, in a river bed that was dry at this season but would soon be covered with water, a hilly place full of rocks that would require days of bulldozing, or in very damp or windy locations. 
Another interesting characteristic of the loaning game was the ratio of collateral (the amount of the loan over the value of collateral, i.e. the asset that the loan is being used to purchase). The norm in the mid 1980’s was around 50-60 percent.  However, as the bubble expanded and land values grew at an increasing rate, the collateral ratio soon rose to 100 percent, with some NB’s offering up to 120 percent.
The bursting of the bubble, and its immediate effects
The first sign of a bursting of the asset bubble was the Japanese government’s decision to increase interest rates in May 1989, apparently to curb inflation,  however Australian economist S. Javed Maswood pointed out that aside from artificially high land prices, there were few signs of inflation in the Japanese economy. He notes another economist’s suggestion that the government intentionally wanted to lower asset prices as owning property was becoming unaffordable to many workers in the service sector.  In 1990, in response to the Iraqi invasion of Kuwait and the resulting uncertainty in world oil supplies (which impacted Japan more than most nations due to its heavy reliance on imported oil), the government raised interest rates again to curb risky loaning practices to brace for potentially unstable economic conditions as a result of the oil situation.  During the height of the bubble, interest rates were as low as 2.5 percent. In 1991, that had increased to 6 percent.  Unlike the Great Depression, in which the economy crashed suddenly and rapidly, the crisis in Japan in the early 1990’s caused a more gradual decline of the economy that lasted over a decade. Cargill notes a series of “business cycles”- periods in which the economy went through recession but appeared to recover soon after.  He identifies three cycles, the first being from the economic peak in 1991 to that of May 1997, with the low point being in October 1993. 
Effect on financial institutions
Perhaps not surprisingly, one of the first measures taken by the major financial institutions of Japan was to change their lending behavior, which was a major cause of the asset price bubble from the onset. In 1990, after the stock market index was visibly in great decline, banks took on a more conservative approach to loans, instead of aggressively pursuing them without regard to risk or profitability, as seen in the years leading up to the crash.  The Bank for International Settlements published an article written by Hiroshi Nakaso in 2001 highlighting the financial effects of the market crash. In that article, Nakaso lists four stages of difficulties encountered by the major banks, by focusing on three major banks that failed in the 1990’s: 
1. Risk-sensitive market participants and large depositors became more selective and reluctant to do business with the troubled banks. As a result, higher risk premiums were charged to these banks [ — ]
2. As information about the troubled banks spread to the market, providers of funds in the market also started to avoid placing long-term deposits with these banks. Thus, the average maturities of deposits with the troubled banks grew shorter over time [ — ]
3. As their problems became more widely known, even retail depositors began losing confidence in the banks and started withdrawing their deposits [ — ]
4. When the liquid assets for sale were exhausted and funding in the interbank market became unsustainable, the banks gave up their attempt to continue business on their own [ — ]
As a result, out of the 21 major financial institutions in Japan in 1990, only 14 still existed in 2000- the rest being merged, consolidated into larger entities, or simply dissolved.  The stock market never regained the peak levels from the 1980’s, and continued to decline until well into the 2000’s.
Response of the government
Even as the situation worsened through the decade, the Japanese government was initially slow to react. The crisis was initially viewed as a temporary setback to long-term financial and economic prosperity.  Finally, in 1991, the Minister of Finance was forced to recognize the failures of ten small banks, and sought for a major bank to assume the assets and liabilities of the failed institutions.  However, Cargill noted that this measure was simply to mask the inherent problems within the Japanese financial system, and for the majority of financial workers, life went on as normal.  The poor performances of loans issued by banks were only reported as a compilation of all banks, as opposed to by individual banks, and even that was only started in 1992. 
Meanwhile, the Japanese government continued to manage the economy in a similar way to the post-war era (which brought about the economic miracle). In contrast to many other Western powers, which focused on deregulating their industries as a response to economic stagnation in the 1970’s, Japan’s economy was still going by its interventionist policies.  Maswood responds by noting the inefficiencies of such government-regulated policies. By shielding certain industries from the basic fundamentals of supply and demand, it was ensured that those industries would not remain competitive in the world market. This he credits as being the inhibitor to economic recovery in the 1990’s.  He does acknowledge several arguments against deregulation, mostly involving it being a long-term policy that distracts from the short-term goal of economic recovery; however, he maintains that the effect of regulation on Japan’s role in the world market outweighs the potential short-term drawbacks. 
In 1995, a Deregulatory Committee was set up, which was renamed the Regulatory Reform Committee in 1999.  Maswood notes that the name change was significant in that it implied that the government was willing to relax its controls over the economy, as opposed to simply and completely removing them.  This is reflected in the policies of the committee: they were simply modifications of the old regulatory system and were still quite different from the deregulated economies of many other Western nations.  Still, the reforms met opposition from bureaucratic parties, who were threatened with having their spheres of influence reduced. This opposition further limited the effectiveness of regulatory reforms. 
The Japanese asset bubble of the late 1980’s was caused by various parties. Financial institutions are to blame for being overly liberal with their lending policies, which, coupled with their close involvement in the real estate market, caused a spiraling effect in which loans and asset prices pushed each other to unsustainably high levels. Investors were too quick to take high-risk loans and put them into real estate, driven by the crowd mentality, even though some may have been aware of the dangers of the inflation of the bubble. The government did not help the situation by lowering interest rates, and its policy of encouraging savings only added to the amount of capital being invested into the bubble. The government should also be held responsible for being slow to react to the crisis, and not implementing major deregulatory reforms as seen in the rest of the Western world, which lifted them out of economic stagnation in the 1970’s. As a result, the Japanese economy was slow to recover from the crisis of the early 1990’s, and GDP growth has yet to return to pre-crisis levels.
Appendix- Statistics and Figures
Okimoto, Daniel. “Causes of Japan’s Economic Stagnation”. Stanford, 1999. (accessed March 15, 2011).
Cargill, Thomas F., and Takayuki Sakamoto. Japan Since 1980. New York: Cambridge University Press, 2008.
Iwamoto, Yoshiyuki. Japan on the Upswing: Why the Bubble Burst and Japan’s Economic Renewal. New York: Algora Publishing, 2006.
Maswood, S. Javed. Japan in Crisis. New York: Palgrave Macmillan, 2002.
Nakaso, Hiroshi. “The Financial Crisis in Japan During the 1990s: How the Bank of Japan Responded and the Lessons Learnt.” Bank for International Settlements Papers (October 2001): 36. http://www.bis.org/publ/bppdf/bispap06.pdf (accessed March 12, 2011).
Friedman, Benjamin. “Japan Now and the United States Then: Lessons from the Parallels.” Japan’s Financial Crisis and Its Parallels to U.S. Experience (2000): 37.
 Thomas F. Cargill and Takayuki Sakamoto, Japan Since 1980 (New York: Cambridge University Press, 2008), 11.
 Ibid, 14
 Ibid, 84
 Ibid, 87
 Ibid, 90
 Daniel Okimoto, “Causes of Japan’s Economic Stagnation” (Stanford, 1999) (accessed March 15, 2011).
 Cargill, 98
 Yoshiyuki Iwamoto, Japan on the Upswing: Why the Bubble Burst and Japan’s Economic Renewal (New York: Algora Publishing, 2006), 12.
 Ibid, 9
 Ibid, 16
 Ibid, 17
 S. Javed Maswood, Japan in Crisis (New York: Palgrave Macmillan, 2002), 20.
 Ibid, 21
 Cargill, 101
 Ibid, 102
 Hiroshi Nakaso, “The Financial Crisis in Japan During the 1990s: How the Bank of Japan Responded and the Lessons Learnt,” Bank for International Settlements Papers (October 2001): 36, http://www.bis.org/publ/bppdf/bispap06.pdf (accessed March 5, 2011).
 Ibid, 37
 Benjamin Friedman, “Japan Now and the United States Then: Lessons from the Parallels,” Japan’s Financial Crisis and Its Parallels to U.S. Experience (2000): 37.
 Cargill, 105
 Ibid, 106
 Maswood, 88
 Ibid, 89-90
 Ibid, 91
 Ibid, 93-94
 Ibid, 96