Japan's Lost Decade and the Complexity Externality (Revised)

The Japanese economy has suffered from three anomalies since the beginning of the 1990s: persistently low economic growth, continuously declining asset prices, and prevalence of procrastination over the serious problems of nonperforming loans (NPLs).

We present the notion of a complexity externality a coordination failure by which inefficiency in one firm affects other firms' productivity through the network of the division of labor. A simple model illustrates that the spreading of the complexity externality, which was triggered by NPL problems, may lead the economy into a bad equilibrium where these anomalies become conspicuous.

Our empirical results suggest that the Japanese economy shifted to a bad equilibrium at the beginning of the 1990s.