Japan's Forgotten "Lost Decade": The Showa Depression
Shedding Light on Japan's First Financial Crisis in Modern Economic History Nobody Knows About
Japan’s Showa recession and financial crisis of the 1920s resembled the Heisei recession on many important counts. Nevertheless, academics and investors in stock markets never really paid attention to it. It culminated in the Showa depression of 1930/31, a devastating and traumatizing event for the Japanese economy and society as a whole
The Showa depression was a fundamentally different economic crisis than the Showa recession and financial crisis of the 1920’s, a macroeconomic event mainly induced by external factors and policy mistakes. It will mark the trough of a relentless bear market in Japanese stocks, losing roughly three quarters of its nominal value over a 12-year period. However, the extent of the damage to investors and business sentiment brought forth by the Showa depression was so great that the stock market would not fully recover for another ten years.
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This is the last post in a two-part series (link to first part) about economic policy blunders, financial follies, and the mismanagement of money and credit, a story about Japan’s forgotten “Lost Decade”.
The Long Road to Restoring the Gold Standard in Japan
Following WWI, leaders all over the world attempted to quickly restore the suspended international gold standard to its pre-war parity and rebuild the European economy.
The U.S. had already returned in 1919. It took a little longer in the U.K. The planned adoption was met with a heated debate between economists who opposed the return to the gold standard—at least not at pre-war parity—and politicians, business leaders, and other supporters of the gold standard.
John Maynard Keynes was the most outspoken British opponent of restoring the gold standard at pre-war parity. In 1925, he stated that the equilibrium exchange rate had significantly shifted due to international price divergence. If an exchange rate was chosen that was too high, a recession would follow. Nevertheless, the U.K. joined the gold standard in April 1925, and by the latter part of the 1920s most industrialized nations had returned
Although, restoring the gold standard had always been an important political agenda in Japan throughout the 1920s, it decided not to join the other major nations in 1925. Japan had legitimate reasons to be wary.
Recurring bank runs during the Showa recession and financial crisis revealed the fragility of Japan’s financial system. Furthermore, persistent trade deficit signaled the country's declining competitiveness. And last, the nation's foreign reserves, which had been accumulated through large trade surpluses during WWI, were declining.
However, the advocates of the gold standard at prewar parity were in the majority. Dissident voices, like those of the economic journalist Tanzan Ishibashi, advocating for a return to the gold standard at a new, more depreciated parity, were in the minority camp and mostly ignored.
The government’s aim was twofold: First, to join the group of respectable nations that were all already on the gold standard. Second, to reduce “conspicuous” consumption, increase saving and frugality, restructure industry, and increase efficiency.
Many leaders in Japan believed that the great boom of WWI caused businesses to lose qualities essential for a country's rapid development. They were convinced they could be restored by a "shock treatment" in the form of a recession. For them, returning to the gold standard at prewar parity was a suitable means to that purpose.
Shrink First in Order to Extend
It was the Minsei Party government (July 1929-April 1931), with Prime Minister Osachi Hamaguchi, Finance Minister Junnosuke Inoue, and Foreign Minister Kijuro Shidehara that finally initiated economic policy measures to return to the gold standard at prewar parity.
Finance Minister Inoue deliberately deflated the economy, which eventually led to a sustained real appreciation of the Yen, and implemented a macroeconomic austerity program arguing that:
„ (...) Our economy remains very unstable because of the export ban on gold, the yen’s non-convertibility to gold and the resulting exchange rate fluctuation. We must liberalize gold exports as soon as possible. But we cannot liberalize gold exports without preparation. What is required in preparation? The government must tighten the budget. The people must accept this fiscal austerity and they themselves must reduce consumption. If that happens, prices will start to fall, and imports will begin to contract. That will create an upward pressure on the Yen in the foreign exchange (...) we face a recession without an end in sight. If nothing is done, we will sink deeper into the recession.” (Essays of Junnosuke Inoue, Vol. 1, 1935)
The preparation occurred precisely at the worst possible time. Wall Street had just been severely shaken by the October 1929 stock market crash, the prelude to a depressionary economic crisis that would quickly engulf all capitalist nations.
Finally, in the 1930’s, with the overwhelming support of the public, Japan restored a fixed exchange rate of 2 yen per dollar, returning to the gold standard at prewar parity. The outcome was an absolute disaster.
The Showa Depression
Although, the Showa depression was shorter and milder than in other parts of the industrialized world, it was nevertheless a traumatic experience for the country.
After reintroducing the gold standard, the Japanese economy immediately experienced an economic double whammy. The consequences of the global depression unfolding in combination with a rapid Yen appreciation.
The result was an abrupt and severe deflation and contraction in economic activity. When compared to the Showa recession and financial crisis of the 1920s, basically a banking crisis with manageable adverse negative effects for the overall economy, the Showa depression was a completely different beast.
Nominal GDP growth plummeted -9.7% in 1930 and -9.5% in 1931. As prices fell, the initial response by manufacturers was to produce even more to support earnings and production utilization. Although, individually a rational calculus, collectively it accelerated the oversupply and the deflationary forces in the economy.
The wholesale price index contracted by approximately 30% between 1929 and 1931, while agricultural prices slumped by 40% and textile prices plummeted by nearly 50%. Thus, the macroeconomic downturn was felt primarily in falling prices, and not so much in output contraction as in the ROW (estimated real growth was slightly positive between 1930/1931).
The impact of the Showa depression on the Japanese society was devastating, especially in rural areas. Around 1931, rural poverty became unbearable. Many undernourished children were born, and farmers even forced to sell their daughters. The disaster sparked widespread outrage and criticism of the government and large corporations. Still, the government pushed through cartelization and rationalization.
Later, with the free-market system discredited, output restriction agreements were adopted. This practice spread to almost every material industry (cotton yarn, rayon, carbide, paper, cement, sugar, steel, beer, and coal, etc.). It only aggravated an already desperate situation.
When the United Kingdom abandoned the gold standard in September 1931, speculators around the world where betting that Japan would soon follow suit. In a frenzy they sold Yen for Dollar, drawing massive amount of capital out of Japan.
Although, the crisis got worse by the hour, the Japanese government would stubbornly stick to the gold standard, with the BOJ primed and ready raising the discount rate twice. A fruitless attempt that only exacerbated the economic catastrophe.
Economic turmoil was followed by political. In the end, on December 13, 1931, the Wakatsuki Cabinet failed and was replaced by the Inukai Cabinet. As soon as the new government was sworn in, finance minister Korekiyo Takahashi completely reversed Inoue's policies. It immediately took the country off the gold standard and began efforts to reflate the economy
The Showa depression was a very different kind of economic and financial crisis than the Showa recession and crisis in the 1920s, which was primarily a banking crisis with limited adverse effects on aggregate demand and supply. Some experts even assert that it contributed to the improvement of the Japanese financial system.
No such claims are made regarding the Showa depression. The only individual who stubbornly defended the idea that Japan required deflation was ex-Finance Minister Junnosuke, arguing that, with the assistance of the government and the Bank of Japan, unprofitable banks and businesses had been able to survive the Showa Recession and financial crisis of the 1920s. For him the deflationary shock around the adoption of the gold standard was painful, but inevitable to get rid of the last inefficient businesses.
Barely 60 years after the Showa depression, policy makers in Japan would once again fall prey to questionable beliefs like those of Mr. Junnosuke. In the 1990 and 2000’s they held the same kind of debates and made the same kind of policy errors like during the Showa recession, financial crisis and depression. Paving the way to the Heisei recession after the Japanese stock market and housing bubble popped in 1990. A crisis that is still reverberating at the time of writing, over 30 Years later,.
Koichi Hamada; Asahi Noguchi; The Role of Preconceived Ideas in Macroeconomic Policy: Japan’s Experiences in the Two Deflationary Periods; CENTER DISCUSSION PAPER NO. 908; March 2005
Yuji Kuronuma; Showa Depression: A Prescription for "Once in a Century Crisis"; Japan Center for Economic Research; April 2009
Kenichi Ohno; The Economic Development of Japan: The Path Traveled by Japan as a Developing Country; GRIPS Development Forum; March 2006
Masato Shizume; The Japanese Economy during the Interwar Period: Instability of the Financial System and the Impact of the World Depression; Institute for Monetary and Economic Studies; May 2009
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Given that the actual Yen was much more depreciated than at prewar parity, each time speculation about a return to the gold standard intensified the Yen soared. This was followed by a slump when the policy shift was postponed. Thus, the Yen was extremely volatile during that time.