The "how" and "why" of the bubble economy can be traced back to the unique economic relationship between Japan and America. In the mid-1980's, before the European Union
became what it is today, Japan and the United States were the G-2
, the two most powerful economic entities on the planet.
Around 1985, the dollar was grossly overvalued vis a vis the yen, trading at about ¥240=$1. The administrations of Ronald Reagan and Nakasone Yasuhiro began secret negotiations to significantly weaken the dollar, in hopes of also improving the trade balance between Japan and the US. While this was technically a G-5 initiative, the other three countries didn't have any say in it: Japan and America pretty much said "This is what we're going to do." The "Plaza Accord," as it was called, was approved in 1985, and the Bank of Japan followed up by raising short-term interest rates.
Essentially, the problem after that was that Japan was saving too much of its money, and America was spending too much of its money. By early 1988, following the largest stock market crash in American history, the dollar's value had halved relative to the yen, to about ¥120. With the yen riding strong, the BoJ decided to lower interest rates again, bringing their lowest lending rates down to 2.5 percent. This is what sparked The Bubble.
By early 1989, the first section of the Tokyo Stock Exchange was valued at ¥530 trillion... over 130% of Japan's GDP. And that was just the large-cap stocks! By mid-year, land prices in Tokyo were up sixty to seventy percent from the year before. The BoJ began to get nervous about this spending spree, and tentatively brought their lowest lending rates up to 3.75 percent.
It wasn't until Christmas Day, 1989, that the bomb hit. The new governor of the BoJ announced that rates would be raised again, to 4.25 percent. Four days later, the Nikkei 225 hit its record high of 39,000.
Between January and August 1990, the bubble collapsed on itself. BoJ rates climbed from 4.25 percent to six percent, citing fears over the Gulf War. By the end of August, the Nikkei was at 26,000 and falling; by the end of September, it was down to 20,000. Investors lost billions in the stock market slump, and land prices began to fall again. Everyone in Japan lost money in 1990.
By the end of 1991, rates were back down to 4.5 percent, but a $13 billion tax hike to fund Japanese support for the Gulf War offset that. The following year, the Nikkei hit bottom at 15,000. Most people were so furious at the mismanagement of the ruling Liberal Democratic Party that in 1993, they were voted out of power for the first time in nearly forty years. However, the change in power didn't bring back Japan's economic happy days, even after the BoJ pulled interest rates down to 1 percent in 1995. Japan is still in the doldrums, and despite the promises of current premier Junichiro Koizumi, may not get out for some time. (2005 addendum: Koizumi is still in office and Japan is getting out. Yay!)
Tidbits of idealism from the bubble economy:
Architect Kisho Kurakawa planned to create 30,000 hectares of landfill in the middle of Tokyo Bay over thirty years at a cost of ¥2.38 trillion. (This would be enough to fill half of the bay.)
The Tokyo Metropolitan Government was planning to give JR the money to build an underground level for the Yamanote Line, effectively doubling its capacity. (This eventually sort of happened with the completion of the Tokyo subway's 12th line in 2001. Sort of. Maybe. Not really.)
Mitsubishi was planning to build a Mach 5 jetliner called the "Orient Express." Narita to LA in three hours?!
People would put gold shavings in their coffee, and drink them. (This is still done with sake, albeit rarely.)