Japan's Economic Miscues Offer Lessons on Policy

Japan's economists and politicians are trying to cut government debt, bolster the economic recovery and conquer deflation—a tall order complicated by recent and past policy missteps that offer red lessons for other nations.

After squelching emerging growth with untimely tightening moves in the late 1990s, policy makers in Tokyo stayed away from consumption-tax increases even as government debt soared. But spooked by the Greek debt crisis, Prime Minister Naoto Kan in June broke the taboo and proposed doubling the tax rate to 10%. Voters rejected the idea, by delivering a major defeat to Mr. Kan's ruling party in elections this month.

For nations looking to leave their stimulus programs behind and tighten monetary policy, Japan offers a cautionary tale of moving too fast on the fraught path to economic recovery.

In 1997, Japan looked to be on such a path, thanks to thriving exports, business investment and consumer spending—even though the job market hadn't fully recovered.

Tokyo policy makers, sensing a turnaround, raised the national sales tax and cut spending to reduce government debts piled up by aggressive fiscal stimulus in the previous few years.

It turned out they misread the economy and implemented the wrong policies, which saw Japan fall back into recession several months later. The Asian financial crisis erupted, draining juice out of an already vulnerable economy. Consumers—without prospects for better jobs and pay increases—shifted into perpetual thrift, pushing the economy into deflation. Price declines started in 1998 and still haunt the nation today.

That protracted pain offers lessons today, as policy makers across the globe discuss withdrawing stimulus programs. Soaring government debts and fears of adverse bond-market reaction can prompt policy makers to red tighten on flickers of economic good news. But actions that are too hasty or drastic can endanger a recovery.