Deflation in Japan

The Japanese asset price bubble of the eighties started in 1985 with the establishment of the Plaza Accord. Quickly, the Yen doubled in value. With it, the property values skyrocketed. Stock market valuations also became stretched. The bubble burst in early 1990 when interest rate was raised. Since then, asset prices have been falling.

Starting 1999, the price of general goods has been falling too. This phenomenon is termed as deflation. The government, in trying to reflate the economy, pumped $1 trillion-plus into the economy by way of public-works spending, tax cuts and rebates in the last decade. It is now saddled with a public debt of about US$10 trillion – twice the GDP. Luckily, 90% of this debt is sourced domestically. (Japan has a household saving of some $15 trillions.) Otherwise, Japan could well be bankrupt. As such, the same formula of fiscal stimulus cannot be used further.

On the monetary side, its interest rate is at near zero (0.1 %) for years now. The only option left for the BoJ is on quantitative easing – making ample funds available for business and the public. Even this does not seem to work as businesses are reluctant to invest in a deflationary scenario. This is because the return under such an environment is uncertain and the debts are harder to pay off. The consumers, on the other hand are not spending as they feel that any purchase is likely to be cheaper in the future.

Deflation is causing wages to turn downwards. Coupled with a shrinking workforce, there is ample spare capacity in the country. The strong currency is also working against the manufacturing sector. However, a good work ethic is beating all these odds. The high productivity of the workers is helping the country to still achieve a trade surplus.

It is this good value, fiscal reforms and a strong monetary stimulus which will probably pull Japan out of deflation. The measures could range from an overhaul of the tax code, deregulation of farming, opening up of protected areas of the economy like transport and energy to foreign competition, boosting the birthrate and allowing more immigration. There is also the flip side to the strong currency. A strong Yen will enable a stronger consumer which in turn will stimulate domestic demand and spur growth.