If you follow the business news, you might have noticed that the economic world has turned into a Hello Kitty crazed tweenager over Japan. Shinzo Abe, the new Prime Minister, has become famous for the portmanteau* of his new policies (Abenomics). And Paul Krugman likes to name-drop Japan’s liquidity trap as a lesson to anyone that is even vaguely empathetic to the austerity cause…

My point: Japan seems strangely important at this point in time.

Why is Japan so important?

Some facts:

• Japan is the third-largest economy in the world.
• From the 1950s through the 1980s, Japan experienced three decades of rapid economic growth and general prosperity.
• It began with heavy government investment in infrastructure, which got everyone a bit euphoric, which made things improve a bit quicker, which caused even more euphoria, and so on…
• …into manic hysteria in the late 1980s/early 1990s, when everyone took advantage of financial deregulation and general excitement to buy anything and everything. Houses, shares, everything.
• And it was happening on lots of borrowed money (sounding familiar yet?).
• Then
• Then the Japanese Finance Ministry panicked in the face of all this liquidity and exuberance.
• The fools.
• And they hiked interest rates.

What Happens When You Hike Interest Rates in Japan

This may require a bit of further background. You see – in the 1950s, to get this whole economic growth thing rolling, the Japanese Central Bank started the practice of “over-loaning”. Translation: the commercial banks allowed the big industrial corporations to borrow beyond their capacity to repay. This, in turn, led to the commercial banks over-borrowing from the Central Bank.

Admittedly, there is a fairly okay-ish reason for allowing that to happen. A company’s “capacity” to repay is measured by looking at their past performance. But let’s say that they’re going to invest in something that will generate enough money to allow them to repay the loan in the future… Would you lend to them? Possibly yes. It’s much the same principle as giving out a student loan – because sure, the kid couldn’t repay it now; but if he’s going to study something useful (debatable), he can repay the money out of his future salary.

And it was very successful – it did lead to three decades of Japanese awesomeness.

However, it also meant that everyone got high off borrowed money. And the low interest rates being created by the Central Bank made sure that everyone lived well past the edge of their borrowing capacities.

Again – sound familiar?

So when the Finance Ministry upped their interest rates in the early 90s, most people did a collective “Oh”. Or, rather:

ああ!

To put this into perspective: if you’ve borrowed 100 million yen at 2.5% interest, and interest rates suddenly spike to 6%, your annual interest cost just more than doubled. Here’s a picture of Japanese interest rates at the time:

In fact, some might say that it sounds a lot like a teaser rate mortgage situation – where your home loan interest repayment suddenly leaps up after the first three years of really low interest rates…

And what happens? Some people start to sell-off their assets in order to cope with the higher interest rates; and the sell-off causes asset prices to fall. Those asset prices were standing as collateral for all these loans, so more borrowers start to panic that they might not be able to make their payments, so they too start to sell-off; causing asset prices to fall even further. Foreign investors start leaving, taking their capital with them. And the sell-off reaches critical mass, and suddenly, you tip over into a market crash.

So the market collapsed; money went elsewhere; and Japan fell into her Lost Decade of no growth and general discontent. And you’ll notice (if you look at the blue in the above graph) that interest rates haven’t really moved off zero since? All those desperate attempts at monetary stimulation having next-to-no impact?

Paul Krugman has declared himself famous for talking about Japan getting stuck in a liquidity trap – which is the focus of tomorrow’s post (Abenomics 102).

But the real answer to my original question is: Japan is important because it was the bustling all-important predicted-to-be-the-largest-economy-in-the-world-by-2010 poster-child of capitalistic success. And after its credit crisis in the 1990s, it became the little third-largest-engine-in-the-world that couldn’t.

Therefore, given Japan’s experience: should America really be so reliant on a Federal Reserve that’s trying to keep interest rates near zero?

It’s a powerful question.

*Apparently, that’s the official name for a new combination of words where you’re also combining their meanings. Other famous portmanteaus: “brunch” (breakfast and lunch), “Tanzania” (Tanganyika and Zanzibar), “Wikipedia” (wiki and encyclopedia) and “stagflation” (stagnant economy and inflation). Fascinating linguistic aside.