Stanford economist Takeo Hoshi examines Japan’s halting recovery from economic stagnation and concludes that America and Europe can learn from that nation’s experience.

The United States and European countries can take steps to avoid making the same economic mistakes that Japan committed during the latter’s “lost decade,” a Stanford economist wrote in a new paper.

The study, published in the IMF Economic Review, describes the reasons Japan was not able to pull out of its long recession in the 1990s, offering some lessons for U.S. and European leaders in the wake of the 2007-09 meltdown.

In particular, the delay in bank recapitalization and the lack of structural reforms in the economic sphere kept Japan from realizing a full recovery, wrote Takeo Hoshi, the Henri and Tomoye Takahashi senior fellow at Stanford’s Freeman Spogli Institute for International Studies.

“Bank recapitalization” refers to a governmental reorganization of failing banks, often involving the use of public money to keep them solvent. “Structural reforms” describes how a government might overhaul its economic structures to increase business competition – such as deregulation to cut costs for firms.

The shortcomings in these two policy areas “retarded Japan’s recovery from the crisis and were responsible for its stagnant post-crisis growth,” said Hoshi, whose co-author was Anil K. Kashyap, an economics professor at the University of Chicago Booth School of Business.

Risky bank lending

Japan’s “lost decade” originally referred to the 1990s, though the country has still not regained the economic power it enjoyed in the 1970s and 1980s. Some say Japan has actually experienced two lost decades if the 2000s are counted as well.

Faced with a huge financial crisis at the dawn of its lost decade, Japan had to navigate challenges that other advanced economies had not confronted since the Great Depression, Hoshi and Kashyap wrote.

However, government leaders made mistakes, Hoshi said. One was failure to rehabilitate the banks and another was to misunderstand the nature of the problems afflicting the Japanese economy. For example, much like the United States in 2007-09, the Japanese banks had made many dubious loans to risky customers.

“Instead of recognizing that major structural adjustments were needed, much of the policy response was calibrated under the assumption that Japan faced a simple cyclical problem that could be addressed with indiscriminate fiscal stimulus,” wrote Hoshi, the director of the Japan Program at the Shorenstein Asia-Pacific Research Center.

For example, on the demand side, monetary policy was not as expansionary as it could have been, he said. Deflation persisted for a long time. And fiscal stimulus packages – such as tax cuts – were inconsistent. Meanwhile, much of Japan’s fiscal spending took the form of public works projects that had low productivity.

As for structural reforms, the Japanese government lacked a sense of urgency. For example, even in the reform-minded administration of former Prime Minister Junichiro Koizumi, only eight of the proposed 35 reform initiatives would have directly boosted growth. Of the others, 16 might have indirectly supported growth and 11 would have had no effect on growth, Hoshi said.

Drastic change needed

Unfortunately, some European nations seem to be following Japan’s lead, Hoshi said.

“In France, Italy and Spain, bank recapitalization has been delayed and the structural reforms have been slow. Without drastic changes, they are likely to follow Japan’s path to long economic stagnation,” Hoshi and Kashyap wrote.

The problems that held back Japan seem to be less serious in the U.S., Hoshi said: “Employment protection is low in the United States and the labor market shows high mobility. The regulatory advantage for incumbent firms is smaller than in Europe or Japan and starting new business is relatively easy.”

As the researchers noted, the United States and Germany are in a bit better economic shape, partly due to the fact that they did undertake structural reforms sooner rather than later. The U.S. was able to recapitalize its banks more quickly, for example.

Still, five years after the failure of the Lehman Brothers investment bank left the world’s financial markets in chaos, the U.S. and Europe are not yet back to what had looked normal before the crisis, according to the research. For instance, employment levels have not reached the levels seen before the 2007-09 crash.

“The U.S. recovery has been tepid despite a number of extraordinary macroeconomic policies (at least in the traditional sense). This suggests that the U.S. economy also has problems, but they are just different from those in Japan and in Europe,” Hoshi said.

In the years leading up to the financial crisis, the researchers wrote, U.S. growth was fueled by a consumption boom from rapid housing price increases and rising debt levels.

“In a broad sense, the U.S. economy before the crisis was similar to the Japanese or Spanish economies,” noted Hoshi, adding that in Japan, the speculative investment boom in the late 1980s masked structural problems.