Deflation

From Wikipedia, the free encyclopedia

For other uses, see Deflation (disambiguation).

In economics, deflation is a decrease in the general price level of goods and services.[1] Deflation occurs when the annual inflationrate
falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods
with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation
declines to lower levels).[2] As inflation reduces the real value of money over time, conversely, deflation increases the real value of
money – the functional currency (and monetary unit of account) in a national or regional economy.

Currently, mainstream economists generally believe that deflation is a problem in a modern economy because of the danger of
adeflationary spiral (explained below).[3] Deflation is correlated withrecessions including the Great Depression, as banks defaulted on
depositors. Additionally, deflation may cause the economy to enter the liquidity trap. However, historically not all episodes of deflation
correspond with periods of poor economic growth.[4]

[edit]Effects of deflation

In the IS/LM model (that is, the Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model),
deflation is caused by a shift in the supply and demand curve for goods and services, particularly a fall in the aggregate level
of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of
goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces
overall economic activity.

Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An
answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority
to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk:  where the risk-adjusted return on assets drops to negative, investors and
buyers will hoard currency rather than invest it, even in the most solid of securities. [citation needed] This can produce a liquidity trap. A central
bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than
slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on
government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the
currency producing higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or
an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic
contraction of the money supply, or to adhere to a gold standard or other external monetary base requirement.

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit
of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation, which is similar to taxing currency
holders and lenders (savers) and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In
modern economies, deflation is usually caused by a drop in aggregate demand, and is associated withrecession and (more rarely) long
term economic depressions.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments,
the costs of deflation to borrowers have grown larger. Deflation discourages investment and spending, because there is no reason to
risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower. Consequently
deflation generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become
more prudent just to hold on to money, and not to spend or invest it.

Deflation is, however, the natural condition of hard currency economies when the rate of increase in the supply of money is not
maintained at a rate commensurate to positive population (and general economic) growth. When this happens, the available amount of
hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency
increases. The late 19th century provides an example of sustained deflation combined with economic development under these
conditions.

Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production
efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit
margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to
apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay
less for those goods; and consequently deflation has occurred, since purchasing power has increased.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt, since—after some period of
significant deflation—the payments one is making in the service of a debt represent a larger amount of purchasing power than they did
when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate. If, as
during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid
with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a
target for a short-term interest rate — the overnight federal funds rate in the United States — and enforcing that target by buying and
selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by
lowering its usual interest-rate target.

During severe deflation, targeting an interest rate (the usual method of determining how much money to create) may be ineffective, as
even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers.
Thus the central bank must directly set a target for the quantity of money (called "quantitative easing") and may use extraordinary
methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves
(such as mortgage backed securities). As the current Chairman of the United States Federal Reserve, Ben Bernanke, said in 2002,
"...sufficient injections of money will ultimately always reverse a deflation." [5]

Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the
lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of
the economy.

Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist
sentiment, as in the late 19th century, when populists in the United States wanted to move off the gold standard and onto a silver or
bimetal standard because the supply of silver was increasing relatively faster than the supply of gold (making silver inflationary (or less
deflationary) compared to gold).

Effects of deflation

1. Decreasing nominal prices for goods and services.

2. Cash money and all monetary items increase in real value over time.

3. Discourages bank savings and decreases investment.

4. Enriches creditors at the expenses of debtors.

 5. Benefits fixed income earners.
6. Associated with recessions and unemployment.

[edit]Deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand,
which leads to further decreases in price.[6] Since reductions in general price level are called deflation, a deflationary spiral is when
reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded by
some[who?] as a deflationary spiral. Whether deflationary spirals can actually occur is controversial. [citation needed]

A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea
is Irving Fisher's theory that excess debt can cause a continuing deflation.

[edit]Causes of deflation

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand
for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often
been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as
with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the
money supply. Studies of the Great Depression by Ben Bernankehave indicated that, in response to decreased demand, the Federal
Reserve of the time decreased the money supply, hence contributing to deflation.

[edit]Basic types of deflation

Some types of deflation can be distinguished.
On the demand side:

 Growth deflation. (Increase in the supply of goods. Decrease in CPI).[citation needed]

 Cash building (hoarding) deflation (More savings of cash. Decrease in velocity of money. Increase in the demand for money)
[citation needed]

On the supply side:

 Bank credit deflation. (Decrease in the bank credit supply by bankruptcy or contraction of the money supply by the central
bank)[citation needed]
[edit]Money supply side type deflation
From a monetarist perspective deflation is caused primarily by a reduction in the velocity of money and/or the amount of money
supply per person.[citation needed]

[edit]Credit deflation
In modern credit-based economies, a deflationary spiral may be caused by the central bank initiatinghigher interest rates (i.e., to
'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less
lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. Demand falls, and with the
falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs
of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get
assets which have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut
supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-
performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit,
since they do not have money to lend, which further reduces demand, and so on.

[edit]Effects of scarcity of 'official' money

In unstable currency economies, barter and other alternate currency arrangements such asdollarization are common, and therefore
when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Russia and
Argentina).[citation needed]Since in such economies the central government is often unable, even if it were willing, to adequately control the
internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect,
barter acts as protective tariff in such economies, encouraging local consumption of local production. [citation needed] It also acts as a spur to
mining and exploration, since one easy way to make money in such an economy is to dig it out of the ground.

[edit]Special arrangements (?)

When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering
interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero
nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially)
increase the money supply.

[edit]Examples of credit deflation

This cycle has been traced out on the broad scale during the Great Depression. International trade contracted sharply, severely
reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan,
beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the
collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense
debate.

[edit]Risk of severe deflation during post-2000 recession

There are economists[who?] who argue that the post-2000 recession had a period where the US was at risk of severe deflation, and that
therefore the Federal Reserve central bank was right in holding interest rates at an "accommodative" stance from 2001 on. [citation needed]

[edit]Counteracting deflation

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally
increase and the economic system would correct itself without outside intervention.

This view was challenged in the 1930s during the Great Depression. Keynesian economists argued that the economic system was not
self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through
tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So
were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased
money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash)
to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing
the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to
spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. Economists [who?] now worry about the
(inflationary) impact of monetary policies on asset prices. Sustained low real rates can be the direct cause of higher asset prices and
excessive debt accumulation. Therefore lowering rates may prove only a temporary palliative, leading to the aggravation of an eventual
future debt deflation crisis.

[edit]Examples of deflation
[edit]Deflation in Hong Kong
Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th
quarter of 2004 [2]. Many East Asian currencies devalued following the crisis. The Hong Kong dollar however, was pegged to the US
Dollar, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap
exports from Mainland China, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump
that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian
financial crisis.[7][8]

Deflation in Ireland
In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with
prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall
consumer prices decreased by 1.7% in the month. [9]

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account,
"Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector
pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living
this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The
Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm
caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern
era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be. [10]

Deflation in Japan
Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates (part of their
'quantitative easing' policy), but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

 Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in
late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

 Insolvent companies:  Banks lent to companies and individuals that invested in real estate. When real estate values dropped,
these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks
delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks
made even more loans to these companies that are used to service the debt they already had. This continuing process is known
as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will
continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested
(byThe Economist) as methods to speed this process and thus end the deflation.
 Insolvent banks:  Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not
receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to
cover the bad loans.

 Fear of insolvent banks:  Japanese people are afraid that banks will collapse so they prefer to buy (United States or
Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for
lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the
economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it
inflates land prices.

 Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower
wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match
these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

 Japanese style deflation: Deflation has been persistent in Japan for two decades due to very low unemployment rate in Japan
for the very low GDP growth rate. If the GDP growth rate decreases, the unemployment rate should be increased since average
annual household income can be maintained in that way. But Japan did not do that. Instead Japan maintained a low
unemployment rate compared with other developed countries. Therefore, an annual Japanese household income has been
decreasing for two decades. The solution to Japanese persistent deflation is to give much more flexibility in the labor market.

In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices
fell in October 2009 by a near record 2.2%. [11]

Deflation in the United States

Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004.

Major deflations

There have been three significant periods of deflation in the United States.

The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about
30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in
prices and a decrease in the available quantity of money.
The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring
paper money printed during the Civil War.

"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing
technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it.
It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls.
Between 1875 and 1896, according to Milton Friedman,[citation needed] prices fell in the United States by 1.7% a year, and in Britain by 0.8%
a year.[12]

The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into
the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because
there was an enormous contraction of credit (money), bankruptciescreating an environment where cash was in frantic demand, and
the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet
the sudden demand for cash— see Fractional-reserve banking). From the standpoint of theFisher equation (see above), there was a
concomitant drop both in money supply (credit) and thevelocity of money which was so profound that price deflation took hold despite
the increases in money supply spurred by the Federal Reserve.

Minor deflations

Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative
inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.

Some economists believe the United States may be currently experiencing deflation as part of theFinancial crisis of 2007–2010;
compare the theory of debt-deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due
to a steep decline in energy prices.[citation needed] Consumer prices dropped 1 percent in October, 2008. This was the largest one-month fall
in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline. In response, the Federal
Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008. [13] In late 2008 and early 2009,
some economists feared the US could enter a deflationary spiral.[citation needed] Economist Nouriel Roubini predicted that the United States
would enter a deflationary recession, and coined the term "stag-deflation" to describe it. [14] It is the opposite of stagflation, which was
the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily
decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009
the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first
time a state has cut its minimum wage since 1938.[15]

United Kingdom
During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to
finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international
exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war
gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the
pound.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s. [16]

See also
  Agflation

 Biflation

 De-growth

 Inflation

 Hyperinflation

 Stagflation

Deflation in Japan

The curse of defeatism

Anybody who thinks deflation is no longer a threat should look at Japan and its flailing
authorities
Nov 26th 2009

JUDGING by the shrill comments from Wall Street, Japan’s biggest problem is its huge public-sector debt, which
has grown to nearly twice the size of the country’s GDP. But it isn’t (see article). Far more pressing is deflation.
On November 20th the new government of Yukio Hatoyama acknowledged what has been obvious for months:
that prices are falling again after a three-year hiatus. This is worrying not just for Japan; countries such as
America and Britain have more similarities with Japan than is commonly acknowledged (see article). Sadly
neither the Hatoyama administration nor the central bank has shown any intention of tackling the latest
incarnation of the deflationary curse.
That is a grave miscalculation. Prices in Japan may not yet be in a downward spiral, but deflation is entrenched:
even the Bank of Japan (BoJ) acknowledges that prices may fall for at least another two years. The more they
do so, the bigger the burden of Japan’s debt becomes, and the more households and firms are likely to
retrench. As it is, high real interest rates act as a powerful brake on Japan’s incipient recovery.

Related items
 Tackling Japan's debt: A load to bearNov 26th 2009
 Parallels between Japan and the West: Same chords, different tune Nov 26th 2009
 Japan’s ailing economy: The other D-wordNov 20th 2009

Japan may have muddled through such scares before, most recently after a five-year splurge of liquidity
unleashed by the BoJ between 2001-06. There may be some complacency that because deflation did not spiral
downwards then, it will not do so this time. But a few years ago the world economy was strong and Japan could
export its way back to health. This time around, global conditions are weaker and the yen is one of the world’s
strongest currencies. It is a credit to Japan’s exporters that they are doing well despite such conditions. Largely
thanks to them, Japan’s economy jumped forward in the third quarter, though there are already signs that the
pace of recovery may be slowing. But to nail deflation once and for all, bolder steps by monetary and fiscal
authorities are needed.

The BoJ can start by being more assertive. It is almost as if it is so exasperated by the flaky achievements of its
previous anti-deflationary efforts that it would rather sit back and wait for a recovery. But that is a defeatist
attitude. If nothing else, it should publicly revive discussion of alternative plans to reflate the economy. That
could include increasing government-bond purchases, or setting itself a monetary target not just based on a
positive inflation rate, but on robust growth of nominal GDP. If the recovery falters, the BoJ could go further,
exploring the use of negative interest rates on bank balances, which would encourage banks to lend money
rather than hoarding it at the central bank. Such extraordinary measures would almost inevitably lead to a
weaker yen, which would irritate Japan’s trading partners. But Japan cannot get out of the deflationary mess if
the yen keeps strengthening.

Mr Hatoyama’s administration, meanwhile, should stop pestering the BoJ about deflation and face up to its own
responsibilities. In the short run that includes keeping fiscal-easing measures in place, at least until there is less
deflationary slack in the economy. (So far the government has prevaricated about the need for continued fiscal
stimulus.) In the longer term, it should strive to raise Japan’s trend rate of growth, which many reckon has
fallen to about 1% a year from 1.5-2% previously, as the population shrinks.

That means boosting productivity through labour-market reform, immigration policies and free trade, none of
which the ruling Democratic Party of Japan has been keen on so far. Its goal of prompting growth in the
underachieving domestic side of Japan’s economy is a fine one, and certainly there is room for huge
productivity improvements in some areas, particularly agriculture. But that should not come at the cost of
harming exporters, which the DPJ has myopically threatened to constrain through union-friendly wage controls.

Big bang-bang
In short, Japan needs a double-barrelled big bang to jolt its economy back to life. If that threatens to spook
investors, the authorities should have up their sleeve a credible long-term plan to restore order to public
finances—but one which should be put in place only when growth is on a firmer footing and deflation has been
truly licked. If the consequence of all this additional stimulus is a weaker yen, so be it. It will be a small price to
pay if the eventual result is more openness and buoyancy in one of the world’s largest economies.

Japan pledges to beat deflation and cut corporation ta

New premier Naoto Kan wants to cut Japan's debt levels

Japan's new government has pledged to slash corporation tax and beat deflation to achieve stable
economic growth of 2% a year.

It said it aims to defeat deflation by April 2011, but revealed few details on how it would achieve this.

The government also said it would cut corporate tax from 40% to nearer 25%.

Earlier this week, Japan's central bank announced plans for up to 3 trillion yen (£22bn; $33bn) in loans to spur
economic growth.

The plans mark the first time Japan has set a time frame for tackling deflation, which has plagued the economy for
much of the last two decades.
 JAPAN IN FIGURES

Continue reading the main story

 Government debt: 200% of GDP
 Government deficit: 8% of GDP
 External surplus: 2.5-3.5% of GDP
 GDP growth: 3%
 Inflation: -1.5%
 30-year bond yield: 2%
Source: Daiwa

Persistent deflation has hampered economic growth, with consumers opting to hold off on making major purchases,
expecting prices to fall even further.

However, the ambition of the new government was met with scepticism by some analysts.

"The growth targets don't sound like anything new to me, just wishful thinking," said Junko Nishioka at RBS
Securities.

Japan's growth averaged just 1.3% a year before the recession brought on by the financial crisis.

Like many other developed economies, Japan is also suffering from high levels of sovereign debt.

Its plans for cutting borrowing levels are due to be announced next week.

New Prime Minister Naoto Kan has made cutting the country's deficit his priority.

What Japan needs to do to end deflation

June 30th, 2010
Author: Ulrich Volz, German Development Institute

Japan is again haunted by deflation. While the nation is following the beef bowl price wars between fast food restaurants on
television, the prices of consumer goods are falling and households are tightening their purse strings. Concurrently,
companies are holding back investment and trying to cut costs to remain competitive.

Last November the Japanese government acknowledged the resurgence of the country’s deflation problem and passed on
the buck to the Bank of Japan and pressured it to do something about it. After slight resistance the BOJ did as told, calling a
surprise policy board meeting in early December, and announcing it would inject up to 10 trillion yen in three-months loans
to commercial banks at a rate of 0.1 per cent. BOJ governor Masaaki Shirakawa described the move as ‘quantitative easing
in a broad sense’ and declared that the BOJ would not tolerate falling consumer prices. In March, the BOJ responded to
further government pressure by increasing the programme to 20 trillion yen.

While these were moves in the right direction, they will not suffice to battle deflation. According to BOJ predictions, prices
may fall for at least another two years. It is not clear from where the BOJ takes the confidence that deflation may end after
two years. The BOJ appears to be hoping for the best, instead of developing new ideas to get the country out of the
deflation trap. Yet hope might not suffice; the last round of deflation lasted much longer than two years, from March 2001
to June 2006. Overcoming it was helped by strong growth of the world economy that generated demand for Japanese
exports, rising commodity prices and a modest yen. It would be foolish to count on a benevolent world economy to do the
trick again. Rather, the BOJ, with the political support of the Japanese government, should develop a clear strategy that will
prove its determination to reflate the economy and convince the Japanese public that it will succeed in overcoming
deflation.

What needs to be done? First, the BOJ should develop and communicate to the public a comprehensive and credible anti-
deflationary monetary policy strategy. This should not only include quantitative easing measures such as those implemented
recently or the intensified purchase of government bonds, it should also set out a clear inflation target.

Second, the BOJ should underline its determination to pull out all the stops to meet this target by emphasising its
willingness to employ even as unconventional measures as negative interest rates on banks’ balances if quantitative easing
doesn’t do the job. Negative interest rates would not only push banks to lend out money rather than hoard it at the BOJ,
they would also cause capital outflows and thus put downward pressure on the yen. A lower yen would help Japanese
exports and thus economic recovery, and increase the cost of imports, which would bring about much-welcome inflationary
pressure.

Third, if deflation persists, the BOJ could employ a further exceptional policy tool and do like most of its East Asian
neighbours and intervene in the foreign exchange market to reduce the yen’s value. Whereas continued forex intervention
to keep the yuan pegged to the dollar has caused unwanted monetary expansion and inflationary pressure in China, this
would exactly be the desired effect of the Japanese intervention. Given the ministry of finance is in charge of the yen’s
exchange rate policy, the intervention would need to be approved by the government. Of course, exchange intervention
Chinese style would be a radical measure that would almost certainly trigger complaints from abroad. The ministry of
finance should thus seek to find a cooperative solution with the Chinese, American and European partners to reduce the
yen’s value – a move that might also deflect attention from the bilateral Sino-American currency dispute.

These three policy steps towards overcoming deflation would need to be supported by further fiscal expansion and broader
economic reform measures by the Japanese government. While gross Japanese public-sector debt is already twice the size
of the economy, the fact that 93 per cent of Japanese government bonds are held domestically (and partly through the BOJ
and state-owned entities like the Japan Post Bank) means that auxiliary fiscal stimulus is unlikely to trigger a debt crisis.

While fiscal and monetary policies have important roles to play in overcoming deflation, the government must also embark
on reforms of the notoriously rigid labour market and an education system that straightjackets talent and suppresses
creativity. But maybe more than any of the aforementioned, the country needs to regain its dynamism and optimism: to
help overcome the pessimism that has befallen the Japanese society and which is at the roots of the deflation problem,
Japan needs to transform itself into a more child-friendly society.