TCS Daily

Land of the Falling Sun

By Christopher Lingle - July 6, 2005 12:00 AM

Japan's economic growth since 2002 has been 5.5 trillion yen, or 1.1 percent of GDP.

While this marks a sharp turnaround from a nominal decline of 23 trillion yen from 1997 to 2002, this tepid performance is a far cry from the glory years when Japan's economy was expected to overtake the U.S.economy. Unemployment rates remain not far from record highs while industrial production has been all over the map.

Although the underperformance of Japan's economy is worrying, too many analysts mistakenly focus upon deflation as the principal problem.

Japan has been hit by seven consecutive years of falling prices. As of the end of March 2005, the core consumer price index fell by only 0.2 percent, versus 0.8 percent the previous two years. There's also been a massive decline in the value of assets held as collateral by banks, with the average index for land prices in the largest cities well down from the second half of 1990.

Many thus see aggressive expansion of fiscal and monetary policies as the best response to get prices going up again. These economists and observers fret that declining prices are inducing people to spend less as they await lower prices tomorrow. This along with a drop in business investment is interpreted to cause an economic slowdown.

To jumpstart Japan's economy, they would encourage inflationary expectations hoping it will boost household spending as people try to get ahead of rising prices.

But falling prices are not all bad nor should they be confused with deflation. Indeed, falling prices are an enduring and redemptive element of free market economies. Throughout history, industrialized market economies have experienced persistent declines in general prices.

Like inflation, deflation is a monetary phenomenon.

Price declines can occur due to a combination of competition, increased capital accumulation and improved technology that lead to expansions in the amounts of goods. Declining prices lead to increased purchasing power of money, and since more goods can be produced for sale at prices that more people can afford, people are wealthier. A vivid recent example is the dramatic fall in prices of computers, mobile phones and other electronic goods. Similarly, real prices of most important raw materials have been declining since the beginning of the Industrial Revolution.

It is peculiar for analysts to depict an expansion in real wealth from falling prices as the cause for consumers to delay purchases that keeps Japan's economy depressed, especially as many of the same commentators suggested that increased purchasing power, a so-called wealth effect, was sparked by the defunct dot-com bubble in the United States.

Besides, the decline in prices in Japan is a consequence and not the cause of its current economic malaise.

Japan's problem of sluggish growth was caused by the government following monetary and fiscal policies in earlier decades that created an illusion of boom. In short, the cause was its following the kinds of policies being pushed to solve the solve the current malaise. Most historical cases of booms and busts begin with loose monetary policies.

Booms inevitably end for at least two reasons.

First, as businesses try to acquire more funds to maintain their production, higher interest rates put a squeeze on profitability, especially for producers of capital goods. This tends to be accompanied by rising inventories and followed by reduced manufacturing production.

Secondly, loose monetary policies eventually lead to price instability that induces central bankers to tighten monetary policy. This eliminates funds for various activities that were started during the previous round of loose monetary policy.

Either way, it eventually becomes clear that the investment boom caused by increased availability of cheap credit can't be supported by economic reality. With spending based upon more bits of paper money in the system instead of fundamental changes in real purchasing power, industries find themselves burdened with excess productive capacity.

This is exactly what Japan experienced in the late 1980s when sharp declines in the demand for goods and services depressed prices.

Japan then tried the Keynesian nostrum of an expansive monetary and fiscal policies promoted to improve it's overall economic condition. Inter-bank call interest rate dropped from 8.22% in March 1991 to nearly zero with the average pace of monetary expansion over the past 10 years of 18.5%. Meanwhile, immense amounts of deficit spending have raised the ratio of public-sector debt to GDP to rise from 56% of GDP at the beginning of the 1990s to more than 140% without inducing a sustained increase in economic activity.

Ultimately, investment spending depends less on the general direction of prices than on whether profits can be earned. Entrepreneurs pursue prices that allow them to earn profits, even if that involves pushing them down relentlessly.

Japan's economy cannot escape from its malaise until all the inappropriate investments induced by loose monetary and fiscal policies are wrung out of it. There must be substantial gains in business activity supported by real fundamentals instead of a flurry of paper money and government IOUs for Japan's economic prospects to improve. But with many policy makers confused about the causes of declining prices, it is likely Japan will remain feeble or end up trying to cope with even more devastating effects of stagflation -- inflation without growth.

Christopher Lingle is Research Scholar at the Centre for Civil Society in New Delhi and Professor of Economics at Universidad Francisco Marroquin in Guatemala.


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