Nathan Lewis

Everyone’s a Japan expert these days. It is a morality tale, supposedly, of banks and government “refusing to deal with the problem” – the problem is usually “bad debt” – resulting in endless stagnation.

It is a total fantasy.

“Inflation is always and everywhere a monetary phenomenon,” we are told. Almost everybody understands that when a currency loses value, it eventually takes more and more currency to buy things.

It works the other way as well. When a currency rises in value, it takes less and less currency to buy things. Let’s call this process “monetary deflation.”

This hardly ever happens. Inflation has natural temptations, but there is normally little political support for sustained deflation. Beginning in 1985 – with a bit of international arm-twisting known as the Plaza Accord – Japan experienced probably the longest and most dramatic monetary deflation (rising currency) in the last 500 years, if not all of human history.

This is obvious in foreign exchange rates. Beginning in late 1985, the yen soared above 250/dollar level that it traded in the early 1980s, eventually peaking at 80/dollar – a threefold increase – in 1995. Ouch. The yen’s rise is more definitively described by the ratio of the yen to the eternal measure of value, which is gold.

This may puzzle some people. Wasn’t the Japanese economy roaring into a bubble in the late 1980s? Indeed it was – driven in part by the 300 basis point decline in interest rates that resulted from the soaring yen. You can imagine the effects on the already-overheated property sector. Also, the government was engaging in a series of dramatic tax cuts, in line with the similar Reagan tax cuts in the U.S.

This, plus a healthy dose of irrational exuberance, was enough to keep the economy humming even though the CPI hovered around a negative 2.0% in 1987, 1988 and 1989 (when adjusted for an increase in the consumption tax).

However, once the asset bubble popped, the full effects of the monetary deflation were felt. The yen kept rising, eventually hitting a peak near 28,000/oz. of gold in 2000. This was about a seven-fold rise in the yen’s value from its 1980 nadir near 200,000/oz., and a threefold rise from the mid-1985 value of about 90,000/oz.

I think it is fair to characterize the property market of the late 1980s as a “bubble” similar to the one we’ve experienced in the U.S., but it did not die naturally. No, the Japanese property market was pushed.


The government, aware of unsustainable asset valuations, embarked in a draconian series of steps to depress property prices throughout the 1990s. This not only blew away the froth of unsustainable valuations, it also demolished the real, fundamental value of property. They began with a series of tax measures on January 1, 1990 – the first day of the bear market – which eliminated certain preferential capital gains tax treatments for property. To take a few of a great many such steps which followed: In 1992, the tax rate on short-term capital gains (under 2 years) on property was raised to 90%. Long-term gains were taxed at 60%. A 0.3% National property tax was introduced (this was several multiples greater than existing property taxes). A City Planning Tax of 0.3%. A Registration and License Tax of 5% of the sale value of a property. A Real Estate Acquisition Tax of 4%. An Office Tax of 0.25%. A Land Ownership Tax of 1.4%. Even the regular property tax, the Fixed Assets Tax, was effectively raised by several multiples. From 1990 to 1996, Japanese property values imploded by as much as 70%. However, the revenues from this tax rose by 46%. You can do the math.

All of this resulted in epic levels of bad debts at banks. For some reason, the banks managed to get the blame for this, as if they were responsible for the unprecedented monetary deflation during the decade, or the tax assault on property owners.

Banks wrote off and liquidated loans continuously during the decade. However, the economy was unable to improve due primarily to the hideous monetary deflation, so more bad debts kept piling up as one borrower after another reached the end of their resources. This gave the appearance that the banks “weren’t doing anything about their bad debts.” As fast as they bailed out their boat, new water was coming in.

In 2000, the government, still convinced that banks “weren’t doing anything about their bad debts,” undertook an extensive audit of bank assets on a loan-by-loan basis. They wanted to determine if there were any “hidden bad debts,” borrowers that had effectively gone bust but were being carried as performing loans. Then, having dug all the skeletons out of the closet to their satisfaction, they mandated that the banks resolve all these bad debts over the course of the next few years. Banks were required to state their progress under this plan in their financial statements.

Thus, we can see with great precision what banks were up to. As of September 30, 2000, Sumitomo Mitsui Financial Group had “bankrupt and quasi-bankrupt assets” of 653 billion yen. These were the real bad loans – those that had defaulted. There were another 2,594 billion of “doubtful assets” – these were loans that were paid in full, but where the borrower was in some difficulty (a large cohort after 10 years of recession).

By March 31, 2003, SMFG had reduced this original group of “bankrupt and quasi-bankrupt assets” to 144.5 billion, a decline of 78%. Problem solved? As of March 31, 2003, the bank had 524.9 billion of “bankrupt and quasi-bankrupt assets,” with the difference made up not by leftovers from a decade earlier, but the brand new bad debts caused by the recession of 2001-2002.

Banks were doing more-or-less what they should have been doing. The government, far from “doing nothing” about the problem, was actually carpet-bombing the economy with the most destructive sorts of new taxes, on top of the horrible monetary deflation that persisted until about 2003.

The Bank of Japan eventually figured out the problem and implemented its “ryoteki kanwa” plan, which was translated into English as “quantitative easing.” With the decline of the yen beyond its 10- and 20- year moving averages, monetary deflation was not a problem in Japan after 2003. Finally free of the crushing monetary deflation, the economy managed a modest rebound. Yet, the economy has been strangely moribund, even taking into account the difficulties happening worldwide since 2007.

Is the government still “doing nothing?” Hardly. The Japanese government’s tax barrage continues to this day. Already there is an annual rise in payroll taxes, scheduled for every year between 2004 and 2017, which will eventually take the payroll tax rate from 13.6% to 18.3%. (Employers match this, and there is no maximum income to which it applies.) And what about the increase in taxes on dividends from 10% to 20%? Or the introduction of a brand-new capital gains tax on equities of 20%, which had effectively been tax-free before? Or the effective 25% increase in personal income taxes, the result of the elimination of a 20% tax cut introduced in 1998? On top of all that, politicians are talking about increasing the consumption tax (similar to a sales tax) from 5% presently to 10% or higher. Until a 3% consumption tax was introduced in 1989, there was no consumption tax at all in Japan, not even at the prefectural or municipal level.

This performance is spookily similar to the policies of both Herbert Hoover and Franklin Roosevelt, both of whom raised taxes throughout the 1930s and squandered boatloads of money on public works and other such spending “stimulus,” with little long-term effect.

There is certainly a lesson to be learned from Japan, but it is not the one that most people think. The lesson is: keep your money stable, and taxes low. When Japan was on the gold standard in the 1950s and 1960s, and reduced taxes steadily, it was the growth wonder of the world.


Nathan Lewis
for The Daily Reckoning

Nathan Lewis

Nathan Lewis was formerly the chief international economist of a leading economic forecasting firm. He now works for an asset management company based in New York. Lewis has written for the Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and authored Gold: The Once and Future Money.

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