Accounting for the 'Lost Decade' in Japan

There is no debate amongst economists that Japan performed poorly during the1990s. This can be seen in falling growth rates of GDP per capita, investment per capita and mounting problems of non performing loans and ballooning Government deficit. A lot of models have tried to come up with an explanation for the Lost Decade. However, none of them have yet been able to clearly account for the growth slump. At this point, it is necessary to revisit all possible distortions that might have caused the dismal performance during the 1990s. This would help us to correctly identify the possible problem areas and search for more specific causes of downturn of the economy in a considerably narrowed field. In this paper, I have tried to bring together the different proposed theories in a consolidated way to help isolate promising theories from not so promising ones. To do so, I applied the Business Cycle Accounting procedure developed by V V Chari, Ellen R McGrattan and Patrick Kehoe to the Japanese case. I find that efficiency wedge is important in explaining the dismal performance of the Japanese economy during the 1990s but labor wedge is not very important except for a brief span of time during 1996 to 1997. My most important result is that investment wedge played a major role in the performance of the Japanese economy during the 1990s. So, any model that tries to focus on what went wrong in Japan in 1990s would do well to focus on frictions on productivity and investment financing that might be at the root of the dismal performance of the Japanese economy.