Ever since the asset bubble of the second half of the 1980s burst in 1990, the Japanese economy has undergone a phase of slow growth during which it has experienced four recessions. A slight reversal of this trend is visible in the provisional GDP figures released in June 2002, which suggest that the Japanese economy grew by 2 per cent during the first three months of this year. Coming as it does after three consecutive quarters of contraction the previous year, this evidence has rekindled hope among some observers. They see the country as being on the verge of a recovery from the fourth recession that has afflicted it over the last twelve years. Others are still pessimistic, however, for recent experience has shown that similar cause for hope has been quickly sunk by real developments.
 
If the trend rate of growth of GDP in Japan during the period 1970-90 had been maintained, the country's GDP would have been close to 50 per cent higher by the turn of the century(Chart 1). This is significant to note, for Japan's expansion at a breakneck pace since the Second World War had in fact slowed after the oil shock of 1973. As Chart 2 shows, as compared with annual rates of growth of 9.4 and 8.3 per cent recorded during 1946-60 and 1960-75, the growth rate during 1970-90 was much slower, at 4.1 per cent. It was from this slower rate, which was creditable in itself when compared with that in the US for example, that Japanese growth slumped to 1.6 per cent during 1990-2001 and 1.2 per cent during 1995-2001.
Chart 1 >> Chart 2 >>
 
For a population that had almost forgotten  the suffering brought about by war,,  thanks to the country's rapid and prolonged post-war growth, the more than decade-long collapse of the economy has indeed been painful. Long accustomed to guaranteed and lifelong employment, the Japanese have had to contend with a rising unemployment rate which has nearly tripled during this period, from just above 2 per cent in 1990 to close to 6 per cent at present(Chart 3). Anecdotes about increasingly insecure Japanese households cutting back on consumption are now legion. Combined with a reduction in investment, which triggered the downturn in the first place, this has meant chronic deflation. Inflation rates that fell from 3 to 0 per cent over the first half of the 1990s, have been negative in most years since 1996(Chart 4).
Chart 3 >> Chart 4 >>
 
The principal puzzle that emerges from the prolonged period of near-stagnation coupled with periodic recessions is the failure of conventional counter-cyclical policies to deliver a recovery. Over these twelve years, the Japanese government has launched almost as many reflationary initiatives, by increasing deficit spending and prodding the central bank to cut interest rates and maintain an easy money policy. The general government fiscal balance, which showed a surplus of close to 2 per cent of GDP in the early 1990s, has been in deficit since 1993. And the level of that fiscal deficit has risen from just 2.5 per cent of GDP in 1993 to 5 per cent in 1996 and 8.5 per cent in 2001(Chart 5). Yet the Japanese economy has not been able to extricate itself from the recessionary bias that has characterized it through the 1990s.
Chart 5 >>
 
Mainstream explanations for this predicament, now internalized by sections of Japan's government as well, revolve around the country's failure to reform what is considered to be a badly designed and unviable financial system propped up by the state. However, as has been noted by some observers, there are two problems with such explanations. First, they leave unanswered the question as to why, during the years of rapid post-war growth, the same Japanese financial system was considered to have been the engine that triggered and sustained that growth, and therefore a 'model' that was worth emulating. Second, they do not take into account the fact that the asset price bubble and its collapse, which preceded the period of deflationary bias, followed and in all probability was triggered, inter alia, by a process of financial liberalization.
 
The financial system that underlay Japan's post-war growth was one in which government regulation and control were the key. Interest rates on deposits and loans were controlled, with the government using differential interest rates as a mechanism to target the growth of specific industries. Similarly, the design and pricing of insurance products were state-guided, keeping larger objectives in mind. The net result of such control was: either (i) the government had to guarantee financial agents a portfolio of activity that ensured that they earned returns adequate for self-sufficiency and growth, or (ii) the government had to channelize resources garnered through taxation or other means to the financial system to ensure the viability of individual financial agents. The government's implicit or explicit guarantee of such viability implied that it guaranteed depositors' savings as well, making bank deposits and insurance products rather than stock market investments the preferred form in which household savings were held.