Deflation is back in Japan. Prices are falling again. Surely, we should rejoice, everything is getting cheaper. But not if your salary is falling too, and certainly not if falling prices mean real interest rates are automatically too high.
In fact, for most of the past 15 years, the overall level of prices has been falling in Japan. Not by much, around one per cent or so a year. But this all adds up. Since the Bank of Japan became independent in 1998, consumer prices have undershot price stability by 16 per cent, real estate prices have fallen by one-third and equity prices by one-quarter.
Although this seems tiny, it does matter. Government policy through central banks seeks to manage the economy through raising interest rates when the economy is too hot and lowering interest rates when the economy is too cool. But interest rates cannot be reduced below zero. This means that when prices are falling and interest rates are positive, real interest rates (inflation minus “nominal” interest rates) are positive and usually too high. This is one of the reasons why the IMF has recently argued for central banks targeting a higher rate of inflation, like 4 per cent.
In short, Japan now has one of the world’s weakest economies, and it also has one of the tightest monetary policies. Macquarie Bank estimates that Japanese interest rates are 4 per cent too high! Indeed, deflation has been one of the reasons why the Japanese economy has been so weak for so long. True, there have been some periods of growth, like the few years of growth under Prime Minister Koizumi. But, overall, growth has been too weak for too long.
Deflation also has other costs. When prices are falling, consumers defer consumption into the future to benefit from lower prices. This weakens demand. Also, when overall prices are falling some are more flexible than others resulting in distortions in relative price movements.
What is the cause? Some say it is globalization and the rise of China. Japan has outsourced lots of its production to China and elsewhere. This means that Japanese workers are now competing head-to-head with Chinese workers. This pushes down their wages and thus prices. Wages are flexible because bonuses are a big component, and non-regular workers wages can be easily cut. The entrance into the Japanese retail market of cheap suppliers like the clothing chain “Uniqlo” also has an impact.
But how can this really be significant when imports represent such a small share of the Japanese economy. Japan is still very much a closed economy, with the services sector protected from international competition.
So deflation could also be caused by the shortage of domestic demand. Japan’s population is now shrinking. It is worried about the security of its retirement income and health care system. Also, unbalanced liberalization of the labour market has resulted in one-third of workers having irregular, short-term contracts. This means lower wages.
Also, Japanese companies are happy to invest in Japanese Government Bonds, rather than investing in the economy. Over the last year or so, capital expenditure fell below depreciation. This means that Japan’s capital stock is declining. In fact, given that so much infrastructure spending is a waste of money, the real effective capital stock has probably been declining for many years.
Be all that as it may, traditional economists believe that inflation and deflation are essentially monetary phenomena. And this is true to the extent that if the Bank of Japan were really serious about solving deflation, it could pump money into the system (by buying up Japanese Government Bonds) until prices started to increase. As reckless governments like that of Zimbabwe have demonstrated, printing money will ultimately push up prices, even when demand is weak.
If it is as simple as all that, why doesn’t the Bank of Japan just stoke up the economy, as I suggest? A dose of inflation could adversely affect pensioners and workers who have fixed incomes. Adopting an aggressive anti-deflation policy would mean an abrupt about face for the government. Who is brave enough to contemplate that? Especially not Japanese bureaucrats who change jobs every two years, and are only too happy to leave today’s problems to the next guy. And especially not Prime Minister Hatoyama and Finance Minister Kan who have many other problems to worry about, and who would need to invest some of their disappearing political capital.
As usual, caution will likely prevail at the Bank of Japan, with timid, ineffective measures to tackle deflation. And with the economy now picking up, any sense of urgency is dissipating. But once deflation sets in, it is had to extinguish. It gets built into expectations and wage negotiations.
Is this ultimately an important problem? With its massively rising public debt and the looming health and pension costs of its ageing population, Japan is quite simply on a “highway to hell”. If the government could cure deflation, it could provide an important boost to growth. That would help ease of the pressures of debt and the ageing population.
Macquarie Economics Research, "Fighting Deflation: Expect a skirmish not a war", 11 March 2010.
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