Japan has suffered from sluggish economic growth and recession since the early 1990s. In this paper, we analyze the causes of the prolonged slowdown of the Japanese economy (the lost decade). Economics Nobel laureate Paul Krugman has argued that Japan’s lost decade is an example of a liquidity trap. However, our empirical analysis shows that stagnation of the Japanese economy comes from its vertical IS curve rather than a horizontal LM curve, so the Japanese economy faces structural problems rather than a temporary downturn. The structural problems mainly come from the aging demographic, which is often neglected in other studies, and also from the allocation of transfers from the central government to local governments, and the unwillingness of Japanese banks to lend money to startup businesses and SMEs, mainly because of Basel capital requirements.