´´ The Showa Recession and Financial Crisis - Japan's Other Lost Decade

Saturday, December 13, 2014

The Showa Recession and Financial Crisis - Japan's Other Lost Decade

A lot has been researched, written and commented about Japan's Heisei recession between 1992 and 2003. To the broader public the Heisei recession is better known as Japan's so called „first lost decade" and often described as unprecedented in Japan's modern economic history with regard to scope and extent. But unduly so!

The Showa recession, which gripped Japan between 1920 and 1927, was characterized by slow growth, mild deflation and chronic financial crises. The prolonged weakness of the Japanese economy and the persistent financial instability finally culminated into the Showa Financial Crisis of 1927. (Shizume) Surprisingly, in spite of many striking similarities between the Showa recession and the Heisei recession, the former never sparked real interest by academia. Little research is to be found about the Showa recession, although it resembled the Heisei one in three important ways. Firstly, the trend was deflationary on the whole. Secondly, the Yen fluctuated significantly on the forex market. And, last but not least, the grand final was, just like after the “Lehman Shoku”, a full blown synchronized global financial crisis and economic slump: The Showa Depression of 1930/ 1931. (Shizume)

The Showa recession and depression was the only (other) major deflationary downturn and collapse in Japan in recorded market history. When the Japanese stock market peaked in the final trading days of December 1919 it entered into a spectacular and prolonged secular bear market. This bear market lasted roughly 12 years. Finally, in November 1931 the Nikkei equivalent bottomed some 74 percent lower than its peak in 1919. The damage to stock prices was so great from the Showa bear market that it took roughly 10 years after the initial bottom, and a "violent" 2-year bounce of roughly 2.5 times trough-to-peak in between, for the market eventually to fully recover.

The Showa Recession


The First World War bestowed Japan an extraordinary demand for its products on the global market. (Kuronuma) But after the war the economy of the UK eventually recovered significantly (Moussa et al.) and, after the UK industry had concentrated on fulfilling its war demand during the war period, it now started to compete with Japan in the product markets of Asia and within Japan's colonies. Subsequently, Japanese companies experienced a heavy inventory buildup.

Not only did the U.K more and more penetrated Japanese markets, but the British government also started to prepare for the return to the gold standard at prewar parity. The U.S already did so in 1919 and the rest of the industrialized world seriously explored ways to rebuild the international gold standard. This issue was the main agenda both for the Brussels Conference in 1920 and the Genoa Conference in 1922. Eventually, most of the countries decided to return to the gold standard at the prewar parities by the mid 1920's. (Hamada) Japan, on the other hand, hesitated to return to the gold standard at pre- war parity during the 1920's.

U.K vs. Japan: Flirting with Deflation


By reinitializing the gold standard the U.K, with the pound by than being the reserve currency, deflated its economy and shifted the relative price relations of the Yen and the Pound in favor of the latter. This created additional problems for Japanese exports, the Japanese industry and economy as a whole. The competition with the U.K was fierce and Japan was gradually loosing competitiveness. Since the Meji restauration, and the subsequent industrial revolution in Japan, the Japanese industry had been operating in a relatively inflationary environment. But in order to maintain the relative parities between the Japanese Yen and the British Pound the Japanese government and BOJ had to engage in deflationary policies too.

Furthermore, did Japan not only try to reduce Japanese prices in order to maintain competitiveness, but also in preparation for an eventual return to the gold standard (Moussa et al.). Although Japan hesitated to return to the gold standard at pre- war parity throughout the 1920's, Kinkaikin (literally, lifting the restriction on gold exports) had always been an important national economic agenda. Due to the fact that the actual Yen was significantly more depreciated than at the prewar parity, each time the Japanese government announced such a policy intention, expectations drove up the Yen. But the Yen always fell back when the policy shift was not realized. Hence, the Yen volatility was significant and ever increasing during that period, which resulted in an increased uncertainty among the Japanese business community. (Ohno)

The Looming Banking Crisis in Japan


But uncertainty among the Japanese business elite did not stem solely from the Yen's volatility on the forex market. Additionally, the Japanese financial system was pestered with numerous and dubious small to medium sized institution banks, so called Kikan Ginko.

Kikan Ginko is a term describing a bank set up to serve only one or a few firms. It is captured and subordinated by the parent firm and has no management independence. Naturally, it had several weaknesses, such as: no separation of ownership and management (the same family often owned and managed the firm and the bank), no information disclosure, no portfolio diversification, no capability of risk assessment or project evaluation, etc.

Why were such banks created? Well, one should consider a situation in which a famous family in a certain local district wants to start a business. The family establishes a company but wants to keep it under total control, thus not going public or borrowing from other financial institutions. To finance its activities a bank is set up by the same family. Since the family has a good name locally, many people happily deposit their savings with this bank. They are believing that the bank is safe, but actually without knowing its real financial situation.

In this fashion, many Kikan Ginko were established throughout the country. There were over 2,000 banks in Japan in the 1900s and 1910s, many of whom Kikan Ginko. This was a bit too many. When the economy boomed, even dubious banks prospered. But when it finally slowed down after WW1, Kikan Ginko started to have a mounting bad debt problem. Since their balance sheets was extremely opaque, outsiders could not judge the size of the problem, increasing significantly the uncertainty about the state of the Japanese financial system. (Ohno)

Japanese officials and the business community blamed domestic banks and foreign exchange traders, especially those in Shanghai, for excessive speculation that resulted in an ever increasing financial instability. (Ohno) But the truth was that it had been the inconclusive monetary policy and an extremely opaque banking system, which led to the high uncertainty and vulnerability of the Japanese financial system. Those factors further damaged the Japanese economy already faced with slow growth. (Ohno) It exacerbated the deflationary pressure and uncertainty in Japan’s financial markets and finally induced severe consequences for the Japanese financial system and the economy as a whole. (Moussa et al.)


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