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For two decades deflation has dogged Japan. This curse arrived after the country’s real estate and stock markets collapsed in the early 1990s. Heavily indebted companies delevered. A “balance sheet” recession ensued. Post-bubble forces, however, cannot explain the persistence of Japanese deflation to the current day. Some commentators say deflation is a consequence of Japan’s shrinking population. Others blame the monetary authorities for excessive conservativism. Whatever the causes, the Bank of Japan has at last caught the Bernanke religion. Deflation will be dispelled by its printing press.
The American economist Irving Fisher famously explained the origin of deflation in his 1933 paper entitled the “Debt-Deflation Theory of Great Depressions”. His theory was simple: during the boom period, too much debt was accumulated. During the bust, loans were repaid. As a result, the money supply shrunk and prices fell. Japan’s experience post-1990 pretty much followed Fisher’s playbook. Although the Bank of Japan cut interest rates to zero in 1999 and later experimented with large-scale asset purchases, companies continued to delever. Deflation lingered.
In a recent speech at the London School of Economics, the Bank of Japan governor Masaaki Shirakawa said monetary policy was ineffective in the face of continuous deleveraging. The good news for Japan is that after two decades of debt reduction, corporate balance sheets are in rude health. Between 1990 and 2005, Japanese non-financial corporations reduced indebtedness from 130 per cent to about 80 per cent of GDP. Japanese companies today sit on piles of cash. Their balance sheet recession is over.
So why has deflation persisted in Japan? Economist Kosuke Motani of the Development Bank of Japan blames the aging population. Since the mid-1990s, Japan’s workforce has contracted. Fewer workers have less money to spend. But supply has not shrunk at the same pace. This has put downward pressure on prices. “What is happening in Japan,” says Mr Motani, “is not deflation of all, but a collapse in the price of products consumed by the working age population.”
There is something to this story. Foreign investors are often exasperated at the excessive resources Japanese companies devote to a shrinking domestic market. Since hostile takeovers are rare, businesses are largely insulated from the pressure to cut supply in the face of falling demand. Monetary policy is no panacea. Governor Shirakawa has stressed the need for Japan’s economy to adapt and for zombie companies to be allowed to fail.
Yet even in slow-moving Japan, it is unlikely that a shrinking population could be a persistent source of deflation. After all, Say’s Law suggests that when fewer people are employed both supply and demand contract in tandem. A decline in the working population results in a lower trend rate of economic growth but not a continuous fall in the price level. On the contrary, as workers become more scarce as a factor of production demand for their services should rise, along with incomes. But in Japan labour incomes have been stagnant and there are large numbers of semi-employed temporary workers.
Another source of deflation in recent years has been the mighty yen. As the currency has appreciated, exporters have been forced to cut costs. The pressure to shift operations offshore has been relentless. Yet the strength of the yen has largely reflected the Bank of Japan’s failure to keep pace with the monetary debauching of the Federal Reserve and other western central banks. Governor Shirakawa has been sceptical about whether unconventional monetary policies can boost economic growth.
On February 14, however, the Bank of Japan put out a surprise statement clarifying its “determination to overcome deflation”. The bank announced a new “goal” of price stability, with the intention of delivering 1 per cent inflation in the near term. The central bank said it would increase the size of this year’s asset purchases by Y10tn ($123bn). Jaded Japan-watchers mocked this announcement. It was suggested the central bank had eschewed the adoption of a target because a goal was less binding. Others claimed asset purchases would be insufficient to dispel deflation.
Yet this move should not be dismissed lightly. The Bank of Japan has committed itself to further easing until its inflation goal is “in sight”. Now that deleveraging has abated, the central bank should have the power to change inflation expectations. For the first time in years Japan’s bond markets are no longer forecasting a fall in the price level. Among the swirling oceans of quantitative easing, Japan no longer remains an island of deflation.
Edward Chancellor is a member of the asset allocation team at investment manager GMO
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