Free markets economies are subject to cycles. Economic cycles consist of fluctuating periods of economic expansion and contraction as measured by a nation's gross domestic product (GDP). The length of economic cycles (periods of expansion vs. contraction) can vary greatly. The traditional measure of an economic recession is two or more consecutive quarters of falling gross domestic product. There are also economic depressions, which are extended periods of economic contraction such as the Great Depression of the 1930s.

From 1991 through 2001, Japan experienced a period of economic stagnation and price deflation known as "Japan's Lost Decade." While the Japanese economy outgrew this period, it did so at a pace that was much slower than other industrialized nations. During this period, the Japanese economy suffered from both a credit crunch and a liquidity trap. In this article we'll define and discuss the meanings of these terms, and draw upon "Japan's Lost Decade" for examples.

Japan's Lost Decade
Japan's economy was the envy of the world in the 1980s - it grew at an average annual rate (as measured by GDP) of 3.89% in the 1980s, compared to 3.07% in the United States (according to the Bureau of Economic Analysis). But Japan's economy ran into troubles in the 1990s. From 1991 to 2003, the Japanese economy, as measured by GDP, grew only 1.14% annually, well below that of other industrialized nations ("The Causes of Japan's Lost Decade" by Charles Yuji Horioka. Japan & The World Economy, June 2006). We'll look at the causes of Japan's slow growth in the following sections, but it's worth mentioning here that the slow growth started in 1989 with the bursting of a couple bubbles.

Japan's equity and real estate bubbles burst starting in the fall of 1989. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990s, falling an incredible 70% by 2001. (To read more about bubbles, see Economic Meltdowns: Let Them Burn Or Stamp Them Out? and Why Housing Market Bubbles Pop.)

The Bank of Japan's Interest Rate Mistakes
It is generally acknowledged that the Bank of Japan (BoJ), Japan's central bank, made several mistakes that may have added to and prolonged the negative effects of the bursting of the equity and real estate bubbles. For example, monetary policy was stop and go; concerned about inflation and asset prices, the Bank of Japan put the brakes on the money supply in the late 1980s, which may have contributed to the bursting of the equity bubble. Then, as equity values fell, the BoJ continued to raise interest rates because it remained concerned with real estate values, which were still appreciating. Higher interest rates contributed to the end of rising land prices, but they also helped the overall economy slide into a downward spiral. In 1991, as equity and land prices fell, the Bank of Japan dramatically reversed course and began to cut interest rates, according to "Japan's Lost Decade: Lessons for the United States in 2008", by John Makin (AEI Online, March 2008). But it was too late, a liquidity trap had already been set, and a credit crunch was setting in.

A Liquidity Trap
A liquidity trap is an economic scenario in which households and investors sit on cash; either in short-term accounts or literally as cash on hand.

They might do this for a few reasons: they have no confidence that they can earn a higher rate of return by investing, they believe deflation is on the horizon (cash will increase in value relative to fixed assets) or deflation already exists. All three reasons are highly correlated, and under such circumstances, household and investor beliefs become reality. In a liquidity trap, low interest rates, as a matter of monetary policy, become ineffective. People and investors simply don't spend or invest. They believe goods and services will be cheaper tomorrow, so they wait to consume, and they believe they can earn a better return by simply sitting on their money than by investing it. The Bank of Japan's discount rate was 0.5% for much of the '90s, but it failed to stimulate the Japanese economy, and deflation persisted. (For more insight, see What does deflation mean to investors?)

Breaking Out of a Liquidity Trap
To break out of a liquidity trap, households and business have to be willing to spend and invest. One way of getting them to do so is through fiscal policy. Governments can give money directly to consumers through reductions in tax rates, issuances of tax rebates and public spending. Japan tried several fiscal policy measures to break out of its liquidity trap, but it is generally believed that these measures were not well executed - money was wasted on inefficient public works projects and given to failing businesses. Most economists agree that for fiscal stimulus policy to be effective, money must be allocated efficiently. In other words, let the market decided where to spend and invest by placing money directly in the hands of consumers. (For related reading, check out What Is Fiscal Policy?)

Another way to break out of the liquidity trap is to "re-inflate" the economy by increasing the actual supply of money as opposed to targeting nominal interest rates. A central bank can inject money into an economy without regard for an established target interest rate (such as the fed funds rate in the U.S.) through the purchase of government bonds in open-market operations. This is when a central bank purchases a bond, in which case it effectively exchanges it for cash, which increases the money supply. This is known as the monetization of debt. (It should be noted that open-market operations are also used to attain and maintain target interest rates, but when a central bank monetizes the debt, it does so without regard for a target interest rate.) (To learn more, read How do central banks inject money into the economy?)

In 2001, the Bank of Japan began to target the money supply instead of interest rates, which helped to moderate deflation and stimulate economic growth. However, when a central bank injects money into the financial system, banks are left with more money on hand, but also must be willing to lend that money out. This brings us to the next problem Japan faced: a credit crunch.

Credit Crunch
A credit crunch is an economic scenario in which banks have tightened lending requirements and for the most part, do not lend. They may not lend for several reasons, including: 1) the need to hold onto reserves in order repair their balance sheets after suffering loses, which happened to Japanese banks that had invested heavily in real estate, and 2) there might be a general pullback in risk taking, which has happened in the United States in 2007 and 2008 as financial institutions that initially suffered loses related to subprime mortgage lending pulled back in all types of lending, deleveraged their balance sheets and generally sought to reduce their levels of risk in all areas. (Keep reading about the mortgage meltdown in our Subprime Mortgages special feature.)

Calculated risk-taking and lending is the life-blood of a free market economy. When capital is put to work, jobs are created, spending increases, efficiencies are discovered (productivity increases) and the economy grows. On the other hand, when banks are reluctant to lend, it is difficult for the economy to grow. In the same manner that a liquidity trap leads to deflation, a credit crunch is also conducive to deflation as banks are unwilling to lend and, therefore, consumers and businesses are unable to spend, causing prices to fall.

Solutions to a Credit Crunch
As mentioned, Japan also suffered from a credit crunch in the 1990s and Japanese banks were slow to take losses. Even though public funds were made available to banks to restructure their balance sheets, they failed to do so because of the fear of stigma associated with revealing long-concealed losses and the fear of losing control to foreign investors ("Japan's Lost Decade: Lessons for the United States in 2008", by John Makin, AEI Online, March 2008) To break out of a credit crunch, bank losses must be recognized, the banking system must be transparent, and banks must gain confidence in their ability to assess and manage risk.

Clearly, deflation causes a lot of problems. When asset prices are falling, households and investors hoard cash because cash will be worth more tomorrow than it is today. This creates a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn leads to bank losses. When banks suffer losses, they stop lending, creating a credit crunch. Most of the time, we think of inflation as a very bad economic problem, which it can be, but re-inflating an economy might be precisely what is needed to avoid prolonged periods of slow growth such as what Japan experienced in the 1990s. (To learn more about inflation, see Inflation: What Is Inflation?)

The problem is that re-inflating an economy isn't easy, especially when banks are unwilling to lend. The great American economist, Milton Friedman, suggested that the way to avoid a liquidity trap is by bypassing financial intermediaries and giving money directly to individuals to spend. This is known as "helicopter money", because the theory is that a central bank could literally drop money from a helicopter. This also suggests that regardless of which country you live in, life is all about being in the right place at the right time!

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