Back in the 1980s, Japan’s economy was the envy of the rest of the world, growing at an average annual rate (as measured by GDP) of 3.89 percent. The US, by comparison, was growing at a rate of 3.07 per cent.

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According to the book Devil Take the Hindmost by Edward Chancellor, which gives a historical account of major financial speculations and bubbles, share prices in Japan in the 1980s rose over three times faster than corporate profits. Around 1990, the property market in Japan was on fire, being valued at over 2,000 trillion yen, about four times the value of real estate in the US.

The price-earnings (P/E) ratio -- a company's share price to its earnings per share -- was over 60 at the peak of the market in 1989. A high P/E ratio could either mean that a company’s stock is overpriced or that investors expect high growth in future.

However, all this was too good to last. The bubble was bound to burst. The country was soon sucked into one of its longest-running economic crises -- a slowdown which stretched across 10 years, and came to be known as the Lost Decade.

The Beginning of Doom

According to several economists, the bubble began sometime around September 1985 when Japan and four other countries -- France, Germany, United Kingdom and the United States -- inked the Plaza Accord to manipulate exchange rates through depreciation of the US dollar relative to the Japanese yen and German Deutsche mark. In other words, the intention was to minimise the current account deficit of the US, which was hovering around 3 percent of GDP, while overcoming the negative growth rate in Japan and the European countries.

What happened instead was that the value of yen and Deutsche rose dramatically in comparison to the dollar. The yen soared as speculators bought the Japanese currency and sold US dollars.

As the yen appreciated, Japanese companies faced big losses in exports as they had to sell their products in the US at higher prices than earlier to make a profit.

This affected the economy, the key driver of its economic growth being its export surplus. The GDP dipped from 6.3 percent in 1985 to 2.8 percent the next year, leading to recession.

The Accelerator

Given the losses in exports, the Japanese government decided to stoke demand for domestic products and services within the country.

To curb further appreciation, the Bank of Japan reduced the discount rates (repo rates) to increase money flow and market activity. The discount dropped from 5 percent in January 1986 to 2.5 percent till 1987. During this phase, the bank lent more money, so more people could afford loans at low rates. Regulation was poor, leading to bad loans.

In May 1989, the discount rate was increased to 3.25 percent, with the bank calling it a preventive measure against inflation. However, the economy continued to expand. The discount rate was once again raised by 0.5 percent each in October and December that year, and twice more in 1990 in the months of March (1 percent) and August (0.75 per cent).

Money supply grew despite the rise in discount rate and peaked around the second quarter of 1990. The last hurrah for the asset-inflated bubble economy was recorded on December 29, 1989, when the Nikkei stock market index touched a record high of 38,916.

Soon after, it all went downhill, with the stock market losing close to $2 trillion by the end of 1990. All that was left were ridiculously high property and share prices.

The Aftermath

Following the stock market crash, land prices tumbled in 1991. This asset price bust seemed to have far-reaching consequences for the Japanese economy. Urban land prices fell 1.7 percent from the peak by 1992, with six major cities being the worst hit. Commercial, industrial and residential land prices nosedived by 15.2 percent, 13 percent and 17.9 percent, respectively.

As the decline in asset prices lingered on, there was a sharp fall in household real income and consumption. Financial institutions suffered heavy losses due to accumulation of non-performing loans. Most banks had sanctioned big loans backed by property, but with land prices plummeting, the value of assets kept by banks as collateral dipped.

The painful phase of low GDP growth rate and stagnant economy, dubbed as the Lost Decade, continued till the 2000s. No matter what revival strategy or policy the government offered, the economy remained cold. People had lost faith in banks, saw them as unstable, and therefore chose to keep money locked at home.

The policies were finally revised in the 2000s with the government deciding to bail out the banks with taxpayer money to clear the piling debts and increase supply of money.

The Causes

While there is unanimity among economists and historians about the catalysts that caused the Lost Decade, the causes are still a subject of debate. Most of them agree one these factors – record low interest rates fuelling the stock market, speculation in real estate sending valuations through the roof and general overconfidence. Japan was held guilty of considering itself invincible due to its solid position in the international financial markets and also due to takeovers of foreign companies by Japanese firms.

According to Nobel Prize winner Paul Krugman, Japan got caught up in a liquidity trap where consumers held on to their savings, fearing the economy would go from bad to worse. Such sentiment led to an overall decline in the economy's productive capacity.

Other researchers have focused on how a collapse in land and equity prices slashed overall household wealth and disposable income, that could otherwise have driven up demand.

A research paper published in 2017 attributes Japan’s economic woes to “vertical investment-saving,” blaming it on an ageing population coupled with a slowdown of the country's innovation ecosystem.

The Lessons Learnt

The Bank of Japan did not act in time to nip the crisis in the bud. It should have keenly monitored the currency’s standing vis-à-vis other major currencies during the process of appreciation and also while lowering the discount rate.

Don’t underestimate or forget how far people can stretch the markets. Also, there is almost always a price to pay for overconfidence.

Spending may not hold the key to boost public confidence. Japan invested a lot in developmental projects, but that hardly convinced people to put their money in the bank.

Valuations matter, but may not necessarily work as a timing tool. The market is defined by volatility and so, don’t depend entirely on math. Back it with your common sense and intuition.

Don’t make decisions based on ‘certainty.’ Many were certain about Japan overtaking the US as the largest economy, but as the yen kept appreciating, the entire game turned on its head.

Try not to invest your entire corpus in a single asset class. Japanese government bonds gave annual returns of over 6.1 percent from 1990-2015, moving faster than the stock market.

(Edited by : Shoma Bhattacharjee)