This paper claims that a scarcity of profitable private investment opportunities starting in the early 1990s or even earlier is a fundamental cause of Japan's prolonged economic stagnation during the 1990s and early 2000s. It presents evidence that the economy has been largely at a private equilibrium (i.e., at its optimum for the physical and human capital Japan has inherited from the past), rather than in a disequilibrium constrained by the binding zero bound of nominal interest rates and/or widespread liquidity constraints. Consequently, aggressive aggregate demand policies, particularly zero nominal interest rates coupled with aggressive quantity easing, are ineffective means for escaping from Japan's current economic stagnation and deflation. Reflation policies based on money financing alone are unlikely to solve the problem because of their strong distributional side effects and limited effects on employment and output. The paper concludes that although exchange rate policies are more promising than other aggregate demand policies, their political feasibility is questionable, and aggregate demand policies are unlikely to be effective without new structural initiatives to increase investment. Although the Japanese economy is at a private equilibrium, it is far from its social optimum. Socially desirable investment opportunities have not been exploited fully in Japan, mainly because most of them are unprofitable for the private sector. Socially oriented investment trusts are proposed as one way to encourage such investment.

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