Deflation and Economic Stagnation in Japan

Soaring prices is a common phenomenon in Nepal, with an average of 8% inflation. We are tired of increasing prices. So, when we hear of deflation (opposite of inflation), we might think it as a positive phenomenon, but actually it is not! which we will discuss later in this article. Inflation refers to general increase in price level and Deflation indicates a persistent decrease in the price level. Disinflation might be confusing with deflation. However, disinflation is the decrease in the inflation rate, and when the inflation rate reaches zero and even falls below zero, it is referred to as deflation. Deflation has been a common phenomenon in most of the European countries and Japan. Japan has been facing deflation since 1990s and Japanese government has experimented all kind of policies to recover its economy out of deflation since then. However, the recovery seems to be difficult for Japan. The decade of deflation is also known as "Lost Decade" in Japan. Lost Decade in the sense that the economy has remained stagnant since then. So, why the decrease in prices matter for the economy. We will look at the case study of Japan. 

How the deflation started at all?

Deflation was created since 1990s, when the real estate bubble crashed. The soaring prices came down and it has not been able to catch up the race since then(except in 2006, when the signs of recovery was seen but couldn’t last long). Japan had experienced an economic miracle during the period of 1950s to 1970s. The growth rate was around 10% per year. The globalization had allowed the Japanese trade to bloom and its human resources were complimented for their hard work and dedication towards the expansion of the Japanese economy. It was boosted by the stable political leadership during the period.

The Plaza Accord of 1984, decided to undervalue dollar against yen as yen was highly undervalued hurting the export of other countries. The appreciating yen led to expensive exports of Japanese goods and thus, pushed the country to mild recession. To counter it, the Japanese government adopted an expansionary monetary policy, cutting the interest rates to encourage investments. The appreciating yen coupled with expansionary monetary policy led to surge in the prices. The cross-share holdings of oligarchic Japanese business community, corrupt bureaucrats inclined to bankers and businesspeople, manipulative financial data and reckless lending practices were among the reasons of soaring prices.The stock price index and the land price index quadrupled from 1983 to 1989. The stock price index (Nikkei 225) rose from 10,000 yen at the end of 1983 to near 40,000 at the end of 1989. It was rumoured that the land underneath the Tokyo Imperial Palace to have been worth as much as the entire state of California in the same year.

Bank of Japan is often criticized for its expansionary policy during the bubble creation phase. When the Central Bank finally tightened the monetary policy in 1989, stock prices declined by 50% in 1990 and by 60% by 1992. The real estate price also saw the similar decline. Nikkei Index is being traded below 20,000 even till date. The worst state policy after 1990s was zombie lending, whereby state failed to recognize the unhealthy firms and protected them with bail-outs, thus distorting the health of the economy.

Japanese economy since then has been into a deep recession, with falling prices, wage, employment and appreciating yen.

How deflation affects the economy?

An economic growth is possible with an increased labour force, increased employment, increased production, increased sales and increased wages. However, when deflation enters the economy,  the reverse happens. Hoarding money will be beneficial to people, rather than any kind of investments. Moreover, the borrower will be at loss, as the real principle payment will be increased. People will thus delay their purchases with the expectation of further decrease in the value. The decline in consumption, then will affect the sales, corporate profits and employment situation. The following figure explicitly explains, why deflation is bad for economy. And this is happening in Japan right now. Japan has been caught in a deflationary spiral.

 Factors fueling deflation in Japan

After the burst of the bubble, Japanese economy needs some strong stimulus to recover its economic growth. However, there are some structural phenomenons to fuel the deflation mentioned as below:

Demographics: Japan has an ageing demographics. The working labor force is decreasing annually. In 2015, the people above 65 years of age occupied 26.7% of the total population. The population beween the age of 15-64 accounts for 60.8% of the total population and is rapidly declining. With an aging population, the productive workforce has to work much harder just to maintain status quo. The government expenditure increases on the pension funds and retirement benefits. And the aging population tend to spend less. The deflation of the Japanese economy caused by the slow spending will aggravate in this case. The Japanese government needs to welcome more immigrants into the country to boost the economy. However, the Japanese government seems very reluctant towards immigrants till date.

Appreciating Japanese currency and slow exports: Japanese currency has been appreciating in spite of slowing economy. With Plaza Accord, the currency was devalued against US $. Hoarding of yen has resulted to its appreciation creating high demand. Yen is basically considered to be a safe haven currency. Thus, with Brexit, European currency and even with the Trump's victory in US election led to the appreciation of yen. So, how appreciation of yen slows the economic growth.

 

 Government Policies: The government and the Bank of Japan is often criticized for its policies to regulate its market. The government deliberately protected the zombie firms after 1990s. When the economy was showing signs of recovery in mid 1990s, the government raised consumption tax, pushing the economy back into the recession. Moreover, the government was reluctant to adopt Zero Interest Rate Policy, and the raising of interest rate in 2000 is also considered to be a policy mistake. The economy thus has very low credibility towards the Central Bank of Japan.

What Central Bank of Japan and government has been doing to tackle deflation?

Central Bank of Japan has adopted numerous policy to tackle deflation as "inflation/deflation is considered to be a pure monetary phenomenon". Japan was the first economy to start the quantitative easing program by buying  the government bonds. Through quantitative easing, it had tried to inject money in the market, when the zero interest policy could not recover the economy. In 2016, also Bank of Japan has declared that it would buy government bonds worth of 80 trillion yen per annum. The Bank of Japan has interestingly also adopted the Negative Interest Rate, whereby the banks have to pay the Central Banks for its deposits. This unconventional policy was also adopted to encourage banks for lending. The bank has targeted an inflation rate of 2%, which seems difficult to achieve as it hovers around negative to near zero. Bank of Japan buys the Exchange trade funds to facilitate the depreciation of yen and to stimulate the economy. With Shinzo Abe elected as Prime Minister in Japan, the Abenomics has been a new economic term. Abenomics has three arrows: Arrow 1: Monetary Easing, Arrow 2: Fiscal Spending Arrow 3: Economic growth (Structural Reforms).

All these experimental programs of Bank of Japan has yielded results for the short term, but has failed to sustain for the longer period. The recovery was considerably hampered by the US Financial crisis of 2008. And again the economy is slowing down in 2016. Moreover, the Japanese public debt is also soaring, with its expansionary policy.

Lessons Learnt from the Japanese Economy:

The government should act promptly in the time of crisis as markets may not resurrect by itself. The reactions of Central Bank is often criticized as "too little; too late".  There were some clear policy mistakes as well. The accounting system of Japanese Banks were also faulty to create the bubble. This clearly indicates the close supervision of banks and need of efficient accounting system. Moreover, the corruption in the politics also fueled the bubble. Thus, the government and the Central Bank always needs to be an independent analyst rather than a puppet of businessmen and bankers. Central Bank of Japan has been applying unconventional monetary policies and every possible means to revive the economy lately. In fact, there is no experiment left for the Central Bank of Japan to adopt for the economic stimulus.  In continuation with the expansionary monetary policy, the structural problem of the Japanese economy: Demographics needs to be addressed, through revised immigration policies.