Background on the Japanese Economy Review


On January 29th, 2016, the Japanese government instituted a negative interest rate for the first time in history. The stated objective of this policy is to “encourage banks to lend, business to invest and savers to spend,” but the policy has come under heavy criticism. It is, ultimately, a high-risk policy that essentially takes Japan into uncharted waters (Reuters, 2016). To suggest that this policy is unorthodox is an understatement, but it highlights the rather unique position that Japan is in with respect to its economy. Economists in particular will be observing what happens with this policy closely, because it is a new situation, and the impacts can only be theorized at this point. This paper will outline the context for this decision, and analyze whether it not this is a good move by the Bank of Japan.

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Background on the Japanese Economy, 1940s to 1980s

Understanding how this move came about requires an understanding of the Japanese economic context. After World War Two, Japan began a program of industrialization in order to modernize its economy. In part, this was the result of losing in the war, where America’s technological superiority was clear to Japanese leadership as the cause for the outcome in the Pacific theater. The nature of industrialization in Japan was highly-centralized. It was, for many years, the only industrialized nation not to follow the Western model of industrial development. The Japanese model relied on the keiretsu concept. In this concept, companies are grouped in mutually-beneficial alliances. At the heart of each group is a major bank, and this bank enables the other members of the group to obtain financing, often on favorable terms. Multiple industrial concerns will out the keiretsu, encompassing different major industries. Many of these companies would grow to become conglomerates. The central government, through the Bank of Japan, exercised control over the keiretsu via the major banks at the heart of these groups. In a given keiretsu, directors would sit on the boards of the other companies, so that corporate governance was designed that each company within the keiretsu would hold the other companies accountable (Twomey, 2016).

The keiretsu allowed companies to flourish with new businesses, investing in capacity because they could all but guarantee a certain amount of demand. As such, this system was ideal for growing industrial capacity rapidly. It served Japan well through the 1980s, when some of the faults in the system began to show through. The relative lack of competition was starting to hurt the ability of keiretsu to compete on the global markets, with the emergence of South Korea and other Asian nations. The Japanese economy, which had been growing rapidly for a few decades to that point, began to slow down. The keiretsu model, which included some other facets that constrained the ability of its companies to compete, was no longer an engine for growth, but was too strong to be undone easily.

At the heart of the Japanese growth story was technological development. The major industrial companies were well-run, and enjoyed successes because they were able to capitalize on the Japanese education system and on their preferential access to capital. However, some other facets of the system were of questionable value. Major companies in Japan provided, for example, lifetime employment, and promotions were based on tenure, moving up through the hierarchy. Ultimately, this would prove to be a problem, because managers were not incentivized to excel, knowing that not only would they not be fired, but that they probably would be promoted anyway, to some extent regardless of performance. Inefficiencies like this would eventually pose a challenge, at such point in time as Japanese companies could no longer compete strictly on technological superiority. As global markets began to open up, many Japanese products were no longer competitive.

The Japanese economy grew rapidly in the 1960s, but then slowed in the 70s, only to roar back to life in the 1980s, in particular as Japan began exporting automobiles around the world, as well as with growth in personal electronics. The problem for Japan is that this was not sustainable. The country relied on high tariffs to protect its own markets, but as the major trading nations moved to start lowering trade barriers, this policy would eventually hurt Japan two ways. First, its domestic companies, because they did not have to be competitive, were not. Second, some Japanese markets had to be opened, and this allowed for foreign products to enter Japan.

Another issue with the Japanese economy is that unlike most other industrialized nations, Japan does not have a growing population. Most industrialized nations have birth rates that are below replenishment levels, and rely on immigration for most of their population growth. Economic growth, basically since the dawn of industrialization, relies on two things. One is growing population, as the world’s population has increased rapidly since industrialization. The other is resource exploitation. Japan lacks much in the way of natural resources, so was never going to grow that way. The domestic market, even when it is protected, is a no-growth market. So Japanese companies were always going to rely on exporting in order to achieve growth. If their products became less competitive globally, the country would experience economic stagnation. In the early 90s, that is exactly what happened.

Background on the Japanese Economy, The 1990s

In the early 1990s, the Japanese economy faced a no growth scenario. Coming on the heels of the 1980s boom, this was a shock and resulted in significant restructuring of the Japanese economy. This period was known as the “lost decade.” The Japanese economy had at that point caught up to the other industrialized nations. With little incremental natural resources to exploit, and a flatlined population, Japan would only have been able to increase its GDP with another technological boom cycle, or increases in productivity (Smith, 2012). The keiretsu system, as noted, was an impediment to productivity increases. As it turned out, Japan was not at the fore of the next major technological cycle, which instead was driven by the U.S. with the Internet.

The country has come under considerable criticism for its macroeconomic policies during the lost decade. Appendix A shows the real GDP growth for Japan, the U.S. and the Eurozone, as a means of highlighting the country’s output gap. In addition to Japan losing its edge in technology, and its stagnant population, the country also suffered from a high savings rate. At the end of the 80s, the country faced a financial crisis. For the first time, Japanese people felt apprehension about their future, as mass layoffs took their toll on the national psyche. The savings rate increased, to the point where by the late 2000s Japan had by far the highest savings rate in the G7. Massive amounts of wealth were held by the country’s elderly. Again, though, this is attributable to macroeconomic policy. Savings passed down to children were taxed as regular income, which discouraged the elderly from passing that wealth down at all, and if they did they would wait until the child was retired, to minimize the negative impact of that taxation (The Economist, 2009).

Another policy response in the 1990s was massive fiscal stimulus. After the stock market and real estate bubbles burst at the end of the 1980s, Japan faced massive financial shock. The government’s response was as series of stimulus initiatives, both in terms of public works spending and loan programs. These efforts did not do much for the Japanese economy, in part because the works projects often added little real value to the country (Yang, 2009). Interest rates were dropped to rock bottom as well.

This policy put Japan into the realm of the liquidity trap. Essentially, the Japanese central bank lowered its rates rapidly in response to the bursting of the 80s bubble. . Then it added the various stimulus programs, but those were ill-conceived. Moreover, it quickly became apparent that Japan was no longer technologically superior and would need to restructure its economy. This process would take years. As the 90s dragged on, there were elements of this restructuring. By the mid-90s there was a slight uptick in the economy, and the government promptly raised its consumption tax (Yang, 2009). This of course crushed consumer spending. The economy now lapsed back to recession, the government had already kept its interest rates at the zero bound, so it had no power to stimulate the economy by lowering rates further — they could not be lowered past zero (Krugman, 1998).

The restructuring of the economy was required, however. Fiscal policy would be insufficient to prop up Japan during this period, and with monetary policy already used up, more or less, Japan’s recession dragged into the lost decade. Critical time had been lost before the government adopted the needed measures to address the bad debt that was holding Japan back, bad debt that was a hangover from the real estate and stock market bubbles (Kobayashi, 2009).

Others have argued that the reason that the fiscal stimulus did not work was because the packages were not large enough. This line of reasoning is rooted in the Keynesian rationale that increased government spending will spur economic growth, extrapolated to mean that if the spending did not work, then more spending was required (Nanto, 2009). The problem with this is that spending always has a multiplier. Good projects have better multipliers than bad ones, and most observers feel that the projects in which the Japanese government indulged in the early 1990s were bad ones.

The Modern Context

Appendix B shows the recent trend in Japan’s interest rates. After the lost decade, Japan began to enjoy some economic growth. This appears to be related to an increase in exports to China, such as automobiles. The country was experiencing deep cuts in public expenditure at the time. However, there was also an increase in domestic spending, partially the result of the millennial generation coming of age and beginning to spend. But the exports to China, which began in earnest in mid-2003, appear to be the major cause for Japan’s economic recovery of the mid-2000s (Jones, 2005). This was reflected in the country’s interest rates. It is not surprising at all that this growth collapsed in late 2008, because growth in the rest of the world did as well.

Japan never recovered, however. Even during the mid-1990s, Japan suffered deflation, the CPI having declined for six consecutive years to 2004. This points to Japan’s growth being largely driven by its exports to China and other countries in Asia. The problem is that this turnover did not really stick. Both net exports and private spending, which were strong in 2004, slowed down in the subsequent years (IndexMundi, 2016).

The Japanese economic recovery, therefore, was short-lived and largely illusory. The country saw a collapse in 2008-2009, an increases in 2010 but then in 2011 the economy fell again. It was this fall that saw the central bank drop interest rates to zero. This might have been premature, but there was a need for that, given that the U.S. interest rates have been near zero for much longer. This drop in the rate, however, put Japan in the interesting position of being back at the zero bound. If other structural aspects of its economy did not change, it would not see strong economic growth, but would once again find itself in a liquidity trap.

The lack of Japanese recovery from the 2008 crisis has contributed to the current situation. While the U.S. Fed has kept its rates at rock bottom, it has faced criticism in some circles for doing so, because many believe that it should have raised rates at least a little bit, to give it some flexibility in the event of another slowdown, or just to moderate the risk of the U.S. economy overheating. Japan’s situation has some interesting parallels. It faced a real estate crisis to precipitate the lost decade, then struggled to find its way out of the wilderness, despite some aggressive fiscal and monetary policy. Structural issues are clearly contributing to the Japanese experience, and continue to do so.

But there are differences in the banking system. The keiretsu system meant that a handful of major banks have always been the key drivers of the Japanese economy, but it also meant that Japan’s companies were mainly the big conglomerates in the keiretsu. This is different than, say, the U.S. economy, where there is still strong influence for SMEs, and where there is more competition in banking. In essence, the U.S. economy is better equipped to adapt to changes in economic policy. Japan’s economy is still overly reliant on its banks and on the adaptive capabilities of the large conglomerates. This has significant implications for the potential effectiveness of the sub-zero interest rate policy.

Below Zero

The current move to drop the interest rate below zero is intended to have the following effects. The general idea is to get money back into the economy. The below zero rate means that people holding yen will see the value of their holdings decline. This, the way the Japanese central bank sees it, should mean that people and businesses have motivation to invest, as otherwise they will experience a negative real return. Getting more money into the economy by forcing people to invest was an idea so unprecedented that the banking system had not prepared for it, and was surprised by the announcement (Reuters, 2016).

The current Japanese economy has been growing slowly, at around 2% for a few years now. This is the sort of modest growth rate that maintains a status quo; it does not growth an economy substantially but nor does it put the economy at risk. Japan is still on average a competitive nation, but it has not been able to find a meaningful source of growth since the 1980s. The major issues of high savings rates, a flatlined domestic market still exist but the country has improved the structure of its economy to make it more competitive globally. At issue, however, is that Japan cannot be a low cost producer of anything, so it must have superior quality, and there are still only certain sectors of the economy where Japan can say that.

In 2012, in response to the weakening economy, Japan undertook policies that were intended to devalue the yen, and make exporters more competitive. This set of policies, colloquially known as Abenomics, allowed some exports to pop — notable beneficiaries were Panasonic and Toyota (Einhorn, 2016). The problem for Japan is that there was no clear driver of the economy, and as such no sector has emerged to drive Japan for more than a few quarters at a time. This has challenged policymakers, who remain unsure of where to put their energies in order to build economic growth.

Just prior to the announcement of the zero rate, the yen underwent strong gains, 5.6% at the beginning of 2016. As a result, the exporters who were benefitting from Abenomics saw their success threatened as their products promised to become less competitive. There are still lingering structural issues as well. Cited have been needed reforms on labor laws and easing of the regulatory environment. There is still talk of increasing the consumption tax, which would have a further cooling effect on the Japanese economy. Part of the move to the zero rate was to force investment.

This investment would theoretically allow the private corporations to make effective choices about how to invest their money. The result should be, in the long –run anyway, an increase in productivity through investment in technology or through acquisition of overseas entities that are already more productive than Japanese enterprises. The devaluation of the yen is another objective of this policy, which should help exporters to regain their competitiveness in the global marketplace. Theoretically, the move was supposed to send a signal to the market that Japan was trying everything that it could be get its economy going again, though in reality this move did nothing to restore confidence in Abenomics (Einhorn, 2016).

Discussion and Analysis

There are several intended outcomes of the sub-zero interest rate policy. For the most part, these outcomes are intended to work in the long run, because most of them rely heavily in increasing investment. To want to increase investment is one thing, but to actually have things in which to invest is another. The multiplier on bad investments is not particularly high. It is better than losing money, which is the thinking behind the sub-zero policy, but ultimately not much better. This section of the report will analyze the different intended outcomes of the policy, and look at them through the lens of economic orthodoxy to try to predict whether or not the strategy will be effective.

The first intended outcome is that the banks will start to lend. The principle behind this is simple. The major banks are critical to the Japanese economy. They lend to the big corporations, first, but they also lend to smaller companies. If they are sitting on excess capital, then the policy is intended to encourage them to move that capital out into the economy, on the threat of it losing money. This situation echoes the situation that the U.S. faced in 2009 after TARP. The big U.S. banks were flushed with capital as the result of various fiscal and monetary policy stimulus, but they were hesitant to lend.. There were no projects deemed worthwhile — just because they had the money did not mean that they were going to invest it. The banks were willing to be cautious. In a sense, this is what the Japanese banks have been doing the past several years, sitting on capital waiting for good projects.

If there are issues, structurally, culturally or otherwise, that are preventing Japanese banks from getting their money into other countries — into Asia’s many growth economies — then these issues are going to be a problem. There is no meaningful growth in Japan. Why would there be ? The population is not growing and there are not many resources to exploit. Japanese companies can only turn to productivity improvements to grow, or new markets. If the best markets are saturated or otherwise unavailable, and there are no major innovations that need to be financed, then there is a fairly good explanation as to why the existing capital is not being put to good use.

This, in essence, is why the sub-zero rate was introduced, to spur higher levels of business investment. Should Japanese companies be hesitant to invest, for whatever reason, the policy will not work. It is not hard to imagine an investment with a net present value above losing money. But the reality is that the rate has dropped only a tiny bit from where it was before, so how many new projects are realistically going to open up. The banks might have an incentive to invest, but projects fail, and when companies are forced to invest, there is a default risk there. Banks know that, and are unlikely to open up their lending criteria just to move money. They might lose some money, gradually, with a sub-zero rate, but investing in bad projects can cost them all the money, if the project goes into default. This is a rather pragmatic take on the issue, but the threat of losing 0.1% has to be worse than the threat of loss on an investment in order for the sub-zero rate to work. Banks were already incentivized to invest in just about any project that paid back an IRR over 0, plus whatever risk premiums are applied. If that was not enough, lowering that IRR by 0.1% is not exactly a solution to the problem.

So what happens when banks are incentivized to lend, but have no good projects to pursue? Companies are also incentivized to borrow, because their rates will be next to nothing. But again, in an economy that has limited growth prospects, what incentive is there for banks or companies to make investments — arguably not much. More likely, banks are going to take the hit on their cash holdings rather than take on increasingly risky projects. They will take the known loss over the unknown loss., and good projects were always going to be approved, so the incremental gain in lending and business investment does not appear to be much.

Of course, banks and companies with large cash holdings will now no longer just settle for a negative real return but a negative nominal one as well. All things being equal, it seems unlikely that this policy will spur investment. It will reduce earnings, though. Unsurprisingly, the Nikkei tanked as soon as the policy was announced (Reuters, 2016). Where lowering positive rates can spur growth, cutting rates into the negative does is unlikely to have the same effect.

The other objective was to get consumers to spend more. This is, of course, a double-edged sword. First, if two-thirds of the country’s savings is held by the elderly, and with a median age of 46.5 and life expectancy of 84.74 that sounds about right, these are not people who are likely to alter their purchasing habits. It thus falls on a relatively small segment of the population to respond to the threat of devaluation. Realistically, though, there are a lot of reasons why they will not respond by spending. One, most Japanese live in cities, in small flats. They can only spend so much on consumer goods, because they have nowhere to put them. That includes cars — you don’t buy a car in Japan unless you have somewhere to put it. The threat of minor devaluation is not likely to spur spending for rather pragmatic reasons.

Consumers can spend more on things like travel, but of course they need time off from work for that. When your savings are literally being devalued, that makes the case for working harder to make more money, not to take time off, and certainly not to go out and spend that money on things you do not need. It would not surprise if savings rates increased as a result of this policy. The only difference is that more money might make its way into higher risk investments. This is not to say that a real estate or stock market boom will occur, but those are the sorts of investments that people will want to put their money into in order to preserve its real value. If the objective of the policy was to increase the risk profile of the Japanese investor, this policy might be effective. But many people are risk averse. Senior citizens, who hold two-thirds of these savings that the government is trying to mobilize, are not only naturally risk averse but are typically advised by their financial planners to invest in low risk securities because of the short time horizons with which they work.

Thus, it is not hard to see that the policy stands a reasonable good risk that it will not achieve its intended results. The policy will make the risk averse increase savings, maybe take on a little bit more risk, and work harder. It is not likely to get them to spend more. The young people who might be inclined to spend more are the ones with nowhere to put things. They might be encouraged to eat their savings, but that is about it — purchases of consumer durables and automobiles are unlikely to see a bump from this policy. Real estate might, which would be good for the economy. There are practical issues, there, too. If banks are more willing to lend for younger people to buy, they still need young people willing to buy. If people are looking at miserable commutes to buy a house in the suburbs, that could give them pause for thought. Young Japanese have tended to reject the sort of lifestyles that their parents lived, with the two hour commutes and that sort of lifestyle. There is a case to be made that even real estate might not see much gain from the policy.

What probably will gain from the policy is capital flight. If having money in Japan means that your net worth will decline, that is a recipe for capital flight. Japan does not have the sort of tight capital controls to prevent this. If the capital flight comes in the form of corporations making investments overseas, that would be beneficial. Whether this will happen or not is unknown. Japanese companies have historically not made too many massive overseas investments. Automakers own a few factories in other countries, but a lot of Japanese companies have, perhaps for cultural reasons, shied away from overseas investments. The idea that the threat of devaluation of wealth might spur foreign direct investment is reasonable, but whether this occurs is another matter. Even if it does occur, this comes back to the issue about good projects. The projects undertaken will have to have value in order for this concept to work.

As for consumers, there is the risk that there will be capital flight there as well. This would more likely come in the form of selling yen to buy foreign currency. The yen has increased, however, since the announcement. That is perhaps counterintuitive. The policy devalues yen holdings, which should have created a selloff in the yen, but the USD has been weakening of late, so the movement of the yen might have more to do with that. The USD’s movements have been partially related to oil prices. It is not known if the changes in the value of the yen are particularly related to the sub-zero interest rate policy.


Japan has, of course, flirted with deflation before. During the lost decade, it faced it, and again in the early part of the 2000s the country suffered a multiple-quarter swoon in CPI. Deflation is the risk here, too. While the policy is intended to spur an increase in demand, negative interest rates lower the value of the currency that people hold. Prices would have to decrease just to maintain a stable real value. So this policy creates deflationary pressure. If prices begin to fall, the economic could completely stall out. This is especially the case if Japan does not experience any surge in demand or business investment as the result of the negative rate. Given that increased spending and investment are not givens, there is real risk of deflation inherent in this policy.

Another aspect of deflation is that investors fail to earn on their investments, especially fixed income investments. Consumers do not earn on their savings, either. While the government feels that this will spur spending, it could just as easily convince people to hoard their money, or better yet to hoard foreign currency. Such hoarding is a natural response to fear — especially if one feels that the sub-zero rate is only temporary. If the impression is that the sub-zero rate is temporary, savings should increase in the short-run because people will consider savings to be a form of discretionary spending, in that you pay to do it. This could curtail other discretionary spending, to the extent that consumers substitute saving money for spending it on discretionary items. Either way, that type of response would be a means of trying grow one’s savings, if access to foreign currency is not an option and equity investments are not within one’s risk tolerance. Even holding paper yen is more plausible that putting money into the bank and seeing its nominal value reduced — and Japan is a safe enough country that one could put their entire life’s savings in their flat and not worry too much about having it stolen. So this actually could happen.

Deflation would bring about an economic crisis. This potential outcome is one of the reasons why there is widespread concern about the sub-zero policy. If deflation causes a confidence crisis, that will affect outside investment. Even the risk of deflation could hurt inbound foreign direct investment. There is considerable risk here, because many outsiders and many within Japan do not feel confident regarding Shinzo Abe’s track record on economics. A desperation move by somebody who has not enjoyed much success is not going to fill the markets with confidence. If investment in Japan falters, the entire project could go off the rails. Japan should be taking steps to instil confidence.

It can be argued that with the core CPI near zero, Japan was already on the cusp of a deflationary crisis. Given this, the risk here is not new. Rather, it is an existing risk and the Bank of Japan is attempting an unorthodox solution. This may simply be a desperate attempt to solve a desperate situation. It has been speculated that the Bank of Japan has institute the negative rate as a means of balancing out future demand shocks, such as from a China slowdown, and their impact on Japanese taxes. The risk of deflation, then, is nothing more than a calculated one, and one within the bounds of reason because the country was already at flat CPI (Jones, 2016).


One of the questions, then, is what alternatives did Japan have? The country was up against the zero bound, so basically in a liquidity trap. If it is in a liquidity trap, then lowering rates to the negative is not much of a solution. Part of the problem is that Japanese fiscal policy has largely been working against the monetary policy (Krugman, 2016). Monetary policy from the Bank of Japan has been expansionary for years, since 2011, but the fiscal policy has seen not only tax increases but talk of further tax increases. These are in place to help Japan address its debt, but of course they do not help to grow the economy. Further, government layoffs have lowered government spending, again to deal with debt, but again at the expense of kneecapping monetary policy initiatives.

As such, the desperation here is not necessarily needed. The reality is that Japan seems to lack a concerted effort in one direction or another. It is trying to reduce its debt — admirable — but at the same time those initiatives are hurting the economy. They are taking a greater share of the country’s GDP and putting it towards debt relief. Unfortunately, this comes at the cost of growing the economy. The negative interest rate may not have been needed if there was better coordination between monetary and fiscal policy. Japan needs to determine if it is going to prioritize debt reduction as a path to growth, or growth as a path to debt reduction.

There is a reasonable case to be made that debt reduction as a path to growth will not work, at least not when it comes with tax increases and other measures that create short-term economic issues. The end goal of debt reduction is that a country can start to put more of its money into growth if it spends less on debt service. In that respect, Japan is actually in a good position because the rate on its debt is quite low. With low borrowing costs, Japan does not need to worry as much about debt right now, and should focus on finding a pathway to growth.

The counterargument is that the country has not been able to sustain any sort of growth in recent years anyway. It has not had much growth since the 1980s. Japan has an aging, shrinking population and few natural resources. If it cannot mobilize more younger workers, if it cannot increase productivity through technological leadership, and if it cannot encourage higher growth rates through foreign investment, then there is no meaningful pathway to growth. Krugman argued “we are all Japan,” and there is some logic to this. Western Europe is facing similar population flatline, and limited remaining natural resources to exploit.. Its companies are more active internationally, but the situation is roughly analogous — the global economy is in some ways a zero sum game. There are only so many resources in the world, and even when the human population increases there are limits to what it can consume. We might not be anywhere near the theoretical limits on the size of the global economy, but there are reasons to think that it might be in for a prolonged slowdown. Japan, with its aging population, is just the first country to truly experience this, but Europe looks poised to join Japan. Other industrialized nations like the U.S., Canada and Australia are in better positions, as immigrant countries with tremendous natural resources.

So if Japan is more or less condemned to no meaningful growth, then what is the potential value of a negative rate? The only way the negative rate works is if it spurs investment in innovation, or outbound FDI. For Japanese companies, innovation was once a strength. There are reasons to think that it can be a strength again, but it is not clear if the current structure is conducive to this. With a negative rate, companies will be compelled to invest, and they might take more risks in order to find a way to earn a return. This can be beneficial for innovation, but Japan’s innovation historically relied on the keiretsu system. It is unclear whether Japan’s corporate system has evolved enough to deliver higher innovation.

It is possible that the banks will be more willing to lend, and in doing so may help to foster more of an entrepreneurial culture. The problem with this of course is that such an impact only occurs in the long-run. The negative rate policy would need to be promoted for the long-run, and communicated as such so that everybody can plan their investments properly. It might be difficult to sustain this in the long run, however. If the negative rates bring Japan into a deflationary situation that threatens to get out of control, the government may be forced to backtrack on this well before the desired impacts have taken hold. The negative interest rate appears as though it will need a long time to work, if it ever does.

This holds true for spurring Japanese investment in foreign markets. If the government initiative works, the companies still need to find the right investments. This is not necessarily easy, and the payoff with international M&A activity can take years to manifest. Again, if this negative rate strategy is to work, it will take years, and Japan might not have years.

This is why many observers question the wisdom of the policy. The negative rate is not something that will be that effective in the short run. It creates significant short run risks, but the reward is highly hypothetical, and primarily in the long run. Japan will take time to restructure its economy, to mobilize whatever capital is coaxed out of hiding, and to deliver on the innovation and investment needed for the negative rate policy to spur growth. It was never going to work in the short-run, and instead the short-run risks are relatively high. Observers are right to be wary. A lot has to go right for this policy to work, and there will need to be a lot of patience involved. The international financial community is more likely to be patient if Japan is following orthodox policy, but one whiff of failure from a risky, unprecedented policy could spur a panic strong enough to undermine the entire effort.


The move to institute a negative interest rate is a risky one on Japan’s part. It appears to be born of desperation. With fiscal policy that is inhibiting the country’s attempts to grow its way out of trouble, Japan is working against itself. Monetary policy alone is responsible for Japan’s growth, and the country has been up against the zero bound for years without gaining any traction. It is not surprising that the Bank of Japan went off-script in trying to avoid yet another lost decade scenario. The issue with the plan is that a lot of things have to go right for it to work. Japanese banks need to be motivated to lend, and businesses need to be motivated to find projects that are worthy of their investment. On that front, knowing that the current rate plus company risk premium is only going to lower discount rates by a tiny bit, it is not necessarily likely that anybody in Japan is going to increase investment in response to this policy. There is risk that the attempt to mobilize capital that is presently on the sidelines will go nowhere. If it fails, then Japan is left in an interesting situation.

The country has increased its risk of deflation, and may experience negative externalities, such as people selling off yen to buy dollars, or holding all their money in cash. These are not the intended effects of the policy, but capital in Japan would still need to be put to good use, if mobilized, and there are not necessarily a lot of good uses. This is a country with an aging, shrinking population and limited natural resources. It only makes sense that Japan has faced long-run economic stagnation. It still has economic and commercial structures that are the remnants of the keiretsu system, and these are constraints on growth as well. Overall, Japan is taking a lot of risks, still needs structural reforms, and ultimately might not even be successful with this experiment.

Given the risks that Japan is taking, and the slim likelihood that this policy will actually spur growth, the negative interest rate is not likely to be a success. Even everything goes right and the rate is a success, it will take months or more likely years in order for that success to manifest. Japan might not have that long, especially if it faces deflationary pressures, continues to have contractionary fiscal policy or economic growth slows any further. Japan would indeed be challenged at that point to maintain this policy long enough to give it a chance to actually work.

Of course, traditional policy measures are not effective. There were no further interest rate cuts to be made, so only unconventional monetary policy remained as a means of spurring investment. The country was looking for a way to take money off of the sidelines and get it back into the economy. But there are very real, practical issues here. This move is unlikely to unlock consumer savings, because most of the money is in the hands of elderly who are not likely to change their consumption habits based on this change. Moreover, urban Japanese have no space for more stuff — trying to get them to buy more stuff is not a great economic plan. Ultimately, the best opportunities lie in business investment in innovation and foreign investment that can increase profits for Japanese firms, as that would at least have a positive effect on the stock market.

Thus, there is good reason to believe that the positive outcomes from this plan will not materialize. IF they do not, then the country has taken on deflationary risk, and the risk of economic contraction, for nothing. Most economists seem to agree that this strategy of the negative rate is not going to work, will spook the markets and will have adverse outcomes, unplanned ones. If the success occur, it will take months or years, and Japan might not have that long with this policy. But all told, the major issues that are inhibiting Japan’s growth are still unresolved. Even if some temporary relief was granted by this policy — something that is unlikely — then the Japanese economy will still need to continue its structural overhaul in order for it to lead to long-run, sustained success. That is why the policy is high risk, and should not have been undertaken. Negative interest rates are unorthodox for a reason — they will only deliver a small win, in a long time frame, and will require a high rate of risk in the meantime. The negative interest rate is not recommended.

Appendix A: Japanese real GDP comparison

Source: The Economist (2009)

Appendix B: Japan’s Interest Rate trend

Source: Trading Economics


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Krugman, P. (2016). Paul Krugman, meeting with Japanese officials, 22/8/16. City University of New York. Retrieved April 22, 2016 from

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