“Price stability is an indispensable prerequisite to ensure sustainable development of the economy” (Masaru Hayami, Governor Bank of Japan). 77 year-old Mr. Hayami however has failed so far to deliver such a position. This political paralysis, where political resistance to reform is demonstrated, is hindering Japan’s recovery.
Again, the current Japanese Prime Minister, Junichiro Koizumi (elected April 2001), who unveiled a series of economic reforms has met with little success against this rigid political system, resistant to reform. Furthermore his termination of Makiko Tanaka (his Foreign Minister) in January 2002, along with his lack of co-operation with Economics Minister, Heizo Takenaka, has left Japan still in search of a cure.
Is there Evidence of Inflation or Deflation in Japan at the moment? What problems might be associated with very low inflation or deflation?
Deflation is defined as the persistent decline in the general price level of goods and services. The most common measure of inflation statistics is the Consumer Price Index (CPI). In Japan, this has fallen at a rate of about 1% since 1999. If the GDP Deflator is used this deflationary trend can be traced back to 1995. The difference between potential and actual GDP is called the output gap. This is another indicator of price stability (or instability).
Price stability is defined as the sustained absence of deflation (falling prices) and inflation (rising prices). It is fundamental to the second pillar of the new consensus, macroeconomic stability. Therefore policy makers welcome disinflation and low inflation. Owing to the bias in constructing CPI indices, an inflation rate of 0-2% has become acceptable.
There are certain costs of changing prices regardless of whether these are due to high inflation or deflation. There is a loss in efficiency as "menu costs" and "shoe leather costs" are incurred. Additionally, the necessary fiscal and monetary policies required to attain stability are costly. More specifically, why is deflation problematic? Initially, falling prices seem like a good thing and people feel as if they have more money in their pockets to spend. Even those on a fixed income, (state pensions, social welfare) benefit from an increase in real income. In spite of all this, the far-reaching contagion effects of deflation mean it is a phenomenon to be avoided.
Rather than spending more on the goods, which they can now afford, a continuous fall in prices means that consumer and investor spending actually slows down. Consumers and businesses are reluctant to buy goods, which they expect to drop in value in the near future. Such speculation curbs investment and saving increases. In an effort to encourage borrowing for investment, nominal interest rates fall and approach zero. Since the nominal interest rate is the opportunity cost of holding money, savings further increase. This fall in investment demand and activity retards economic growth. Furthermore, since the nominal interest rate cannot fall below zero, the real interest rate will always be positive. In times of deflation, the burden of debt therefore increases. It would seem that lenders gain and borrowers lose. The problem for lenders occurs when debt rises too high and borrowers cannot afford repayments. Banks - who earn profits through loan repayments - cannot attract big borrowers. This type of debt deflation is the main problem in the Japanese economy today but is also reminiscent of the Great Depression in the 1930's.
In times of low economic growth, it is typical to lower the currency value thereby making exports more attractive to foreign investors. However, the low nominal interest rates induced by deflation have caused foreign demand for the Yen to rise. The Yen remains strong and exports remain relatively expensive.
On the whole, wages are accepted to be ratchet. This means that even if prices are falling, the nominal wage rate will not fall. Higher debt repayments and squeezed profits mean that the pressure on companies to cut costs is twofold. This leads to a "Darwinian shake-out" as companies see job cuts as the only option to save on costs.
Deflation is clearly at the root of Japan's failing economy. Policy makers must now look to the formulation and implementation of an effective plan to fight deflation if there is any hope of a recovery.
Evaluate Japanese policy effects on inflation and economic growth over the past ten years.
Inflation:
Over the past ten years, Japan’s economic policies have had a definite and crucial impact on levels of inflation. As discussed previously, Japan is now in a period of deflation, which the policies of the Japanese government in the early 1990’s are by and large accountable for. The policies of the Japanese Government are discussed below. As can be seen from the table below, levels of inflation, (taking into account consumer prices, food prices and the GDP deflator), have fallen sharply from 1990, to deflationary levels. GDP deflator annual % levels have fallen from approximately 3% in 1991 to approximately
-1% in 2001. Both the levels of inflation for consumer and food prices have also fallen dramatically during this period.
The collapse of the Japanese stock market in the early 1990’s also was of major impact to levels of inflation. From 1990 to 1992 Japanese stock prices decreased by half. Following this, prices of land and real estate also declined. By 1997 commercial land prices were at only 55% of their 1990 value. (Blanchard: p.143, 1999). This collapse in stock and land prices also had a major effect on Japanese banks. Many of the banks had loaned money to buyers of stocks or real estate. And so, when these prices collapsed, borrowers could not repay their loans. Bad loans on the balance sheets of twenty of the largest banks in Japan added up to 4% of Japan’s GDP for 1997. (Blanchard: p.143, 1999).
Economic Growth:
Economists use many different methods to measure economic growth. The most common way to measure the economy is real gross domestic product, or real GDP. Essentially, Gross Domestic Product includes production within national borders regardless of whether the labour and property inputs are domestically or foreign owned. In contrast, gross national product is the output of labour and property of a country regardless of the location of the labour and property. Gross National Product includes income earned by the factors of production (assets and labour) owned by a country's residents but excludes income produced within the country's borders by factors of production owned by non-residents. It is summed up by the equation:
GDP = C + I + G + X - M.
Gross domestic product or GDP is the broadest measure of the health of an economy. Real GDP is defined as the output of goods and services produced by labour and property located in said economy. There are at least three different ways to measure growth of real GDP. It is important to know which is being used, and to understand the differences among them. The three most common ways to measure real GDP are:
- Quarterly growth at an annual rate
- The four-quarter or "year-over-year" growth rate
- The annual average growth rate
Quarterly growth at an annual rate shows the change in real GDP from one quarter to the next, compounded into an annual rate
The four-quarter, or "year-over-year" growth rate, compares the level of GDP in one quarter to the level of GDP in the same quarter of the previous year.
Finally, the annual average growth rate is the average of year-over-year percentage changes reported during a year.
For the benefit of this project and considering the time spans to be considered, we shall only deal with the annual average growth rate.
As can be seen from the graphs below, Japan’s GDP annual growth fell sharply during the period 1991-1993. It rose sharply till 1997, but then with the Asian crisis of 1997, fell steadily from 3.46% to –1.099% in 1999. The slump in economic growth in Japan will be discussed fully in relation to the economic policies of Japan below.
Economic Policies:
Japan, the worlds second largest economy and largest creditor nation, has been relatively stagnant since the early 1990’s following the bursting of the real estate and stock market bubbles of the 1980’s, which can be seen from the above graph. Things turned particularly bleak in 1998, with a full-fledged recession (defined as two consecutive quarters of negative growth). Grave fears remain about “Japan being sucked into a deflationary spiral” (The Economist, 1998, June 20)
The majority of these problems stemmed from the multifarious number of bad loans, which arose from the dramatic crash into depression the economy suffered in 1998. Yet through the diversification of Japans economic policies it has threatened to shrug off the cloud of doubt, which hangs around it.
The bulk of these strategies were concerned with re-inflating the economy through aggregate demand management policies i.e. monetary and/or fiscal. The hope was to re-stimulate consumption which was said to be “at a standstill” (ICR, 19998, p.106) and also to increase FDI through the relaxing of the Large Scale Retail store Law which protects local merchants from retail competition while at the same time lowering taxes with long term economic and GDP growth in mind. However, the effectiveness of reducing tax burdens as a means of augmenting private expenditure may be limited due to so-called ‘Ricardian Equivalence’.
Other examples of these strategies include monetary measures such as The Fiscal Structural Reform Law of 1996, which was introduced by the then Prime Minister Hashimoto. The aim of this law is to ensure that the budget deficit is cut to just 3% by 2004.
Again in April of 1998, the Japanese authorities announced a ¥16.7 trillion fiscal stimulus package (or about 3% of GDP). The package was the fifth such measure since October of 1997 in that year. The Ricardian Equivalence proposition may have caused this to falter also. Such a problem lead to the dilution of these measures. GDP fell from 1.8% to a disastrous -1.019%
In an effort to increase demand, the Japanese central bank decreased interest rates to very low levels. Interest rates in Japan have remained under 1% since 1996. The government also used its fiscal policy to increase demand. As stated previously, the government cut taxes in order to stimulate spending by consumers and firms. However, these measures have not had much effect on output.
Some conclude because of this evidence, that the problem is a lot more serious, that the economy will not grow fast again before a number of structural problems have been recognised and fixed. With the collapse of land and stock prices in the 1990’s, Japanese banks have been left with substantial amounts of bad debt. Some banks have now had to close; more are likely to follow. Some Economists argue that until the financial sector and the banking system have been restored to full health, it will be difficult for Japan to return to steady growth.
Errors in fiscal policy over the past years has proven costly, particularly since monetary policy has been rendered relatively ineffective by the “Liquidity trap”, i.e. interest rates are now so low they cannot be cut further, and by the accumulated problems of the banking system which, as mentioned above, has been saddled with bad loans.
Essentially Japan is suffering from a confidence deficit. People are refusing to take the policies of its government as credible steps towards solving the economies fiscal woes. Japan suffers from a chronic structural complaint and a critical demand condition. To focus on the chronic complaint is to risk aggravating the critical condition. The priority is to boost demand, to cushion the economy during the needed reform. As we can clearly see the current efforts at such reform are either inadequate or ineffective. The economy is shrinking again after some promising GDP growth in 1998 with the cash injection but the pessimism around the yen continues to harbor any real progress.
Proposed Solutions:
In a deflationary spiral such as the one Japan faces, the standard remedies are expansionary monetary and fiscal policies. Government spending boosts aggregate demand while an expansionary monetary policy reduces interest rate, (thus stimulating investment), generates expectations of future price increases and contributes to exchange rate depreciation. The preferred mix of policies in Japan is an ongoing debate.
Voices from financial markets, government and LDP calling on the Bank of Japan to “counter deflation through inflation targeting” are growing stronger. Bank of Japan leadership has repeatedly rejected these proposals for inflation targeting, but this leadership will be replaced in March 2003. Senior Politicians including the Prime Minister, have expressed a preference for a stronger anti-deflationary monetary policy. (Citibank – Japan: Issues and Prospects pgs.1-3). Up to now, the policy of inflation targeting has actually been a policy of maintaining a low real inflation rate to ensure stability in the economy. Whether an opposite type of inflation targeting; trying to jump start inflation to stop deflation in Japan’s economy, will be effective is the question. In the long term it may in fact be possible, but in the short and medium term it will be almost impossible to accomplish. The reason is that using monetary policy to stop deflation at this point in Japan is very difficult. The business sector is still in the process of improving their balance sheets and this remains their top priority. Households are still uncertain about the future and continue to be prudent toward buying. Given this exceptionally chilly demand climate, the Bank of Japan has not been able to stimulate economic activity even after buying government bonds and greatly expanding the amount of base money in the economy. Obviously, it will take a lot longer period of time to raise inflation given the current situation.
In the long run, there is no other solution to Japan's structural problems, of which deflation is one large factor, than to speedily carry out structural reforms. The role of the Bank of Japan is to minimize the side effects of financial deregulation in the reform process and act as a break on deflation where possible.
Incidentally, the Economist has advocated a large depreciation of the yen as a way to escape deflation, however, the fact is the historically high dollar is in a downward adjustment phase, and countries in Asia are falling into recession as a result of decreased exports. This is the current reality, so inducing a lower yen could prove difficult.
In the long-term, the potential for inflation in Japan is high anyway, given its massive public debt and fiscal deficit. If the results of structural reform are positive, there is a good chance the economy will recover and deflation will be reversed. In the case structural reform doesn't advance, government debt will rise further and fiscal discipline in the market will come apart. In either scenario, inflationary pressures will rise. So, at this stage the effectiveness of infusing and inflation targeting should be studied further.
Germany has been experiencing a fall in the general price level of goods but a healthy services sector has meant that they have thus far avoided deflation.
There are three main bias in constructing this index, namely composition bias, quality bias and substitution bias
