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durable consumer goods became commonplacethroughout the country contributed to the nation’srapid growth.Japan’s trend growth was shifting lower in theearly 1970sLooking back, we know that Japan’s trend growthrate started falling in the early 1970s after internalmigration started tapering off a decade earlier. Hadan omniscient authority overseen macro policy, itmight have been possible to maintain price stabilitywhile gradually steering growth down to a newcruising speed of around 4%, but most Japanese atthat time still believed trend growth was in the 9%range. So when GDP growth slipped below 8%, theJapanese authorities thought the economy wasfalling into recession and they resorted toexpansionary fiscal policies and monetary easing topush growth back to 9% to prevent the output gapfrom deteriorating.Misunderstanding of drop in trend growth led tothe Great InflationWhat happens when the trend growth declines butpolicymakers misunderstand this and repeatedly tryto shore the economy up? While it might be possibleto elevate growth above trend for a period of time,continually trying to do so will result in variousimbalances. Excessive liquidity can cause rampantspeculation in real estate and can ultimately triggersoaring inflation. When the return of capital (naturalrate of interest) is down sharply, continued monetaryeasing can facility a property bubble. And ifbottlenecks develop in the labour supply after robustaggregate demand, rising wages can trigger homemadeinflation. When Japan’s growth abruptly fellfrom the 9% range to the 4% range in the early1970s, there was a nationwide boom in speculativereal estate dealings and consumer prices surged to25% y/y, resulting in what came to be called the‘Great Inflation’.Impact of 1973 oil shock and Tanaka’s ‘balanceddevelopment’ policyThe direct cause of this ‘Great Inflation’ was the firstoil shock in 1973. At the same time, soaring realestate prices were fuelled by speculation triggered bya plan by the 1972-74 Kakue Tanaka government to‘remodel’ the Japanese archipelago, by curbing anurban concentration in favour of ‘balanceddevelopment’. Even so, these were just theimmediate catalysts and the underlying cause wasthe maintenance of expansionary fiscal andmonetary policies because it was not understood thatthe economy’s slowdown was due to a drop in trendgrowth. Meanwhile, US inflation at this time peakedin the 12% range, surging to double-digit proportionson the mistaken anti-inflation policies (such as pricecontrols) of the Nixon Administration as well as the353025201510Chart 5: Japan’s Manufacturing Sector Wages(Firms with over 30 employees, % y/y, quarterly)5060 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85Source: MHLW, BNP Paribas302520151050-5-10Chart 6: Japan’s Land Prices(Land for commercial use, % y/y)-1571 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11Source: Cabinet Office, MIC, BNP ParibasFed’s mistaken continuation of monetary easing.(The Fed thought rising US unemployment was dueto weak aggregate demand but the real cause wasan increase in NAIRU from the influx of babyboomers into the labour force.) That Japan’s inflationrate was more than twice was as bad as America’sreflects the policy mistakes Japan made.Successful forbearance policiesIncidentally, when this speculative real estate boomcollapsed in the mid 1970s Japan did not experiencesevere balance-sheet troubles (non-performing loansin the banking sector and excessive debt in othersectors). Trend growth was still in the relativelystrong range of 4% so Japan could grow out of itsproblems without resorting to drastic measures. Inother words, a forbearance policy approachsucceeded at that time. Unfortunately, that successprobably contributed to the adoption of forbearancepolicies after Japan’s 1980s credit bubble burst. Buteconomic growth in the 1990s was too weak toresolve the resulting balance-sheet problems, whichfestered until the authorities imposed stricter assetassessments, adequate loan-loss reserves, andpublic fund bailouts.Ryutaro Kono 27 October 2011Market Mover23www.GlobalMarkets.bnpparibas.com