This is measured by the so-called ‘output gap,’ or the gap between actual GDP and what GDP would be at if every work-eligible citizen were employed and all factories and office buildings and other factors of production were in use. Today, the gap is about 7 per cent of GDP. Due to the law of supply and demand, when demand weakens, prices turn soft. Over the past 25 years, there has been a very high correlation between the output gap and price movements, with a slight lag.
A decade ago, some monetarists claimed Japan could cure deflation by ‘quantitative easing,’ a process that involves printing tonnes of money. The BOJ tried it and it failed. In normal times, nominal GDP and the money supply grow in tandem. But deflation has broken that link. Since 1995, the BOJ has hiked the monetary base 115 per cent, but nominal GDP has fallen 8 per cent.
When quantitative easing failed, some proponents then claimed that, if quantitative easing were coupled with ‘inflation targeting,’ that would surely work. The BOJ should announce a target, say 2 per cent inflation, and then promise to print enough money and buy enough financial assets until it reached its goal. Targeting has stabilised inflation in countries where it already exists, but there is no evidence it can cure deflation. The theory is as follows: Consumers in Japan expect prices to fall, so they postpone purchases, which, by the law of supply and demand, reinforces deflation. If the BOJ led people to expect inflation, they’d buy more now, creating a self-fulfilling prophecy.
Every factual assumption behind this theory is wrong:
Assertion 1: People in Japan expect intractable deflation. On the contrary, a survey begun by the Cabinet Office in 2004 shows that the Japanese people have consistently and wrongly expected inflation to return in the 12 months following every survey.
Assertion 2: People buy less due to deflation. If that were true, the savings rate would have risen. In reality, since 1995 when deflation took hold, the household savings rate has steadily decreased from 13 per cent to 2 per cent.
Assertion 3: The central bank can get people to expect inflation. This assumes ordinary people know about and care about BOJ policy. A 2005 study showed that only half the people even knew about major BOJ actions such as zero overnight interest rates and quantitative easing, and only 10 per cent said it affected their inflation expectations. The biggest influence on expectations for the coming 12 months was what had happened in the preceding 12 months.
Assertion 4: People will buy more if they expect prices to go up. Wrong again. When people expected more inflation, they bought less. During 2004-09, there was a negative 84 per cent correlation between inflation expectations in one quarter and consumption growth two quarters later. The reason is simple. If people expect prices to go up, but they don’t expect wages and other income to rise as much, that means a cut in their real (price-adjusted) income. People who expect a cut in real income buy less.
Policy-makers should base their measures on what people actually do, rather than insist that people change their behaviour to accord with unfounded theories. Fortunately, there is a solution harmonious with people’s behaviour: a fiscal-monetary one-two punch.
Japan should use fiscal policy to boost demand by putting money directly into consumers’ hands, which will narrow the output gap. For example, in the recent period, Tokyo successfully boosted household purchases of big-ticket items such as cars through its cash-for-clunkers program and appliances via its eco-points program.
Meanwhile, to prevent markets from raising long-term rates in response to bigger deficits, the BOJ should announce that it is both willing and able to keep long-term rates down, by purchasing government bonds if necessary. Ben Bernanke, now chairman of the US Federal Reserve, made a sound proposal along these lines during a May 2003 speech in Tokyo. He pointed out that, because the Finance Ministry would be selling bonds to the central bank rather than the private market, this would not add to the problem of excess government debt. Unfortunately, his advice was spurned at the time—and still is.
Partly due to pressure from the Finance Ministry, the Hatoyama administration has equivocated on funding the boosts in household income on which it campaigned. The ministry would like to believe that the BOJ can solve the problem of deflation and weak demand all by itself. The central bank properly rejects inflation targeting, but unfortunately joins the finance ministry in railing against fiscal stimulus and resists greater purchases of government bonds. That leaves Japan simply waiting for the rest of the world to rescue it via purchases of Japanese exports. That’s the passive mindset that has created two decades of stagnation—so far.
This article is reprinted from The Wall Street Journal Asia © 2010 Dow Jones & Company, Inc. All rights reserved.
Richard Katz is Editor-in-Chief of The Oriental Economist Report (TOE).
It seems that the Japanese case has some uniqueness and consequently any policy for dealing with the Japanese economy will have to address the causes underlying that uniqueness.
In my view, the economic experience Japan has had since the late 1980s or early 1990s has been different from any financial and economic problems the world leading economies have had, including the great depression of the 1930s.
There are two main differences. One is that Japan has been experiencing population aging, and in danger of declining. This has implications for social burden or the so called dependent ratio. Clearly the dependent ratio has been expected to rise and people will live longer, including more years after retirement.
The second is that Japan has had relatively high productivity. The implication of this is that it is difficult to expect that significant advances in productivity from Japan if it is on the world production frontier.
Thirdly, Japan, as similar to other East Asian countries, has had high saving rates.
While there can be other uniqueness, but the combination of these three factors can be very serious and indeed deadly, especially following the serious balance sheet recession that occurred in the early 1990s.
People’s expectations have been formed under these factors. They had realised that the past rapid economic growth was over; that their assets values have permanently decreased and cannot increase much; their income from work was also limited by being already high and on the world productivity frontier; that they will need more savings for their retirement.
Conventional fiscal policies, whether they are in the form of government investment in infrastructure or giving people spending power may be ineffective, because it can be regarded as purely wasteful rather than productive. Conventional monetary policies when they came to liquidity trap, that is zero or near zero interest rates.
It is likely that any policies will have to be credible to change the underlying behaviours out of those concerns. They need to shape people’s “rational expectations”, so people can see a credible way to increase their current consumptions and still be able to live in retirement comfortably, due to the implementation of those policies.