1998 Reports

The causes of Japan's financial crisis

Patrick, Hugh T.

Japan's financial system, and especially its banking system, today are in substantial trouble, epitomized by the bad loan problems. This paper provides an overview of the major causes of the current banking mess. Fundamental forces include the transformation of the Japanese economy in the mid-1970s from one of excess investment demand to excess savings surplus, and with successful growth the development of a number of strong, increasingly companies. The paper briefly discusses four major causes that were particularly important: failure to create a prudential regulatory system as deregulation proceeded; the creation and then bursting of the stock and real estate market bubbles; globalization; and the high rate of financial innovation. A series of five major macroeconomic policy mistakes are identified as retarding the recovery of the economy, and indeed the late 1996 policy errors led to the 1987-98 recession. Japan's 1990s poor economic performance has made the banking problems more severe and costly, as hopes were dashed that the economic recovery would reduce the bad loan adjustment process.