Is Deflation’s Loss the Cause of Japan Returns?

Thu Feb 29 2024
Rachel Long (667 articles)
Is Deflation’s Loss the Cause of Japan Returns?

In recognition of Japan’s remarkable economic revival, the Nikkei stock index hit a fresh all-time high last week, marking the first such occurrence in 34 years.

This news comes at a time when there is growing proof that Japan has managed to escape deflation. As at the end of the first month of 2019, inflation has risen to 2.2%. Wage growth has also been on the rise.

That deflation was a key factor in Japan’s decades-long slump seems to have been supported by this. However, it could be too soon to draw that conclusion. The negative effects of deflation have been hard to prove, and the favorable effects of low, positive inflation may be just as nebulous.

A lot of people are startled to hear that deflation is considered detrimental for consumers. Even analysts and regular people in the US wouldn’t bat an eye if prices dropped little after climbing so dramatically since 2021.

When prices continue to decline year after year, it becomes problematic since salaries, incomes, and the values of assets like property often follow suit. The financial system is in jeopardy because debtors are having trouble repaying their loans and may cut expenditures or even fail. When prices in the United States dropped 27% between 1929 and 1933, that is exactly what occurred.

Mild deflation can theoretically impede growth. In order to encourage spending, central banks bring down nominal interest rates to levels below inflation, resulting in a negative real cost of borrowing. When inflation is negative, that becomes nearly impossible.

The causes of deficit spending

When the bubbles in Japan’s real estate and stock markets broke in the early 1990s, deflation set in. Banks were unable to lend as a result of the losses that followed. A negative inflation rate was recorded in 1999.

Restoring Japan’s economic health, according to Western economists like Ben Bernanke, who would later chair the Federal Reserve, hinged on resolving deflation. After initially agreeing only partially, the Bank of Japan eventually gave its enthusiastic approval.

For the near term, it employed zero and negative interest rates. Afterwards, long-term government securities were bought, followed by short-term ones. Lastly, in an effort to increase expenditure and inflation, the BOJ even purchased stock in companies using newly printed money.

The Bank of Japan was only able to achieve a level of inflation close to zero. Underlying inflation was finally pushed to the bank’s target of 2% by the worldwide supply chain shocks caused by the pandemic.

Along with one of the poorest growth rates in the developed world, Japan experienced 25 years of zero or negative inflation. Deflation in Japan served as a lesson for other nations, most notably China, where prices are also declining.

There is no easy way to prove that deflation caused Japan’s troubles. Possibly more of a symptom than a cause, one could argue.

Negative growth in the working-age population began in the early 1990s. At the same time as this was happening, Japan was finishing its post-war period of catching up to other industrialized nations. At the same time, businesses started outsourcing to nations with lower wages.

Prices, wages, and growth were all structurally pushed lower by all of this and the banking crisis.

Foundational efficiency

Nonetheless, Japan’s results have been commendable when taking into account the country’s declining population. Its production per hour worked increased at a rate of 1.3% between 1991 and 2019. According to economists Jesús Fernández-Villaverde, Gustavo Ventura, and Wen Yao, this was quicker than in Italy or Spain, but slower than in the United States, comparable with France, Germany, and Britain, and slower than in Canada.

According to my calculations, the United States saw a 7% increase in output per working-age person since 2019, Japan a 5% increase, the Eurozone a 2% increase, and Britain a 0% increase. (Many of Japan’s retirees continue to maintain their jobs, so this might be an exaggeration of the country’s success.) Any traveler to Japan can witness to the fact that the country is still very much alive and well.

In an interview, Fernández-Villaverde claimed, “I don’t think I would have been able to do better” if given 25 years of absolute power as governor of the Bank of Japan.

Deflation was not benign, and this disproves that. If it weren’t for the monumental monetary efforts of the BOJ, growth (and deflation) may have been far worse. And growth could have been more robust if inflation had been positive.

However, this begs the uncomfortable question: what proof is there that zero to negative inflation is indeed harmful?

How prices are determined

Slight shifts in attitude or action on the part of investors, businesses, or the general public might be harmful. One example is how a market economy relies on signals such as shifting relative pricing and wages to move resources from sectors that aren’t growing to others that are.

Japanese economist Tsutomu Watanabe of the University of Tokyo claims that changes in relative prices occur very seldom. He discovered that almost half of the products had no change in pricing between 1995 and 2021. This was due to factors other than relatively low inflation rates, such as relatively small price fluctuations relative to global averages.

Governor Kazuo Ueda of the Bank of Japan stated in a December speech that the “status quo in wage- and price-setting behavior” resulted from years of low to negative inflation, meaning that many wages and prices remained unchanged. “The ability to increase prices was subsequently eradicated,” he remarked.

Productivity and dynamism were drained, according to Ueda, due to the lack of this price-discovery function.

Prices have been less stable and more volatile since January 2022, according to Watanabe’s analysis. The most recent upswing in the Nikkei index happened to start a full year after that.

This is due, in large part, to the support from influential outside investors like Warren Buffett, advances in corporate governance that benefit shareholders, and Japan’s growing role as a viable alternative to China in the global supply of advanced manufacturing and technology.

Paul Sheard, a longtime expert on the Japanese economy and a former vice chairman at S&P Global, speculated that inflation could play a role as well. Stock prices, profits, dividends, and cash flow are all things that investors worry about, but they are not real.

All those indicators are made flatter by higher inflation. Interest rate hikes would wipe out that advantage, but bond yields in Japan have lagged behind inflation expectations, bringing real yields to a negative 0.6%.

Inflation may be reawakening the primal instincts of business owners and investors. Nonetheless, growth in 2017 was about equal to pre-pandemic levels and even turned slightly negative in Q3 and Q4, leading to a technical recession. Wages have also not kept pace with inflation, and support for Prime Minister Fumio Kishida has been steadily declining.

The fight against deflation may have been won by Japan. Japanese citizens, however, have not yet reaped the benefits of peace.

Rachel Long

Rachel Long

Rachel Long is our Desk Correspondent covering Stock Markets across the globe. She is based in New York