Japanese Deflation

Between 1999 and 2005, Japan experienced deflation (International Monetaray Fund, 2003, 2008). That is, on average, prices fell. Between 1985 and 1994, Japan experienced an average inflation rate of 1.4 percent, a relatively low inflation rate by world standards. A slowing economy brought the inflation rate down to negative territory in 1995. It rebounded and climbed to the 2 percent range in 1997, before falling again, sinking into negative territory by 1999. The inflation rate of consumer prices stood at zero in 2007. The inflation rate of consumer prices edged into positive territory in 2008.

The economic deceleration that marked the beginnings of deflation began when an asset bubble burst. In 1986, the Nikkei Index of the Tokyo stock market stood in the 12,000 range (www.finance.yahoo.com). The market took off, reaching the dizzy height of roughly 39,000 in 1989. Then the market began unwinding, sinking to the 15,000 range in 1992. The market never recovered its previous high. In October 2008, the Tokyo stock market sank to 6994.9.

In monetary systems managed by modern central banks, unwanted and uncontrolled deflation poses a puzzle in the eyes of many observers. In the past, central banks were limited in the amount of paper money they could issue by a gold standard. Today, central banks can issue as much money as is consistent with stable prices. If a country is caught in a deflationary spiral, the central bank is free to augment domestic circulating money stocks until prices stop falling. The concept that printing more money leads to inflation is standard economic doctrine.

The trend toward deflation marked the end of a spectacular phase of economic development in Japan. Between 1960 and 1973, economic growth in Japan averaged 9.8 percent annually, over twice the rate of most developed countries. Between 1973 and 1980, economic growth in Japan slipped to 3.9 percent, still a relatively high growth rate for that period. The United States averaged 2.1 percent growth for the same period. Nearly all countries experienced a substantial deceleration of growth for that time frame. Between 1980 and 1988, growth converged closer to the average of other developed countries, averaging annual growth of 3.6 percent. The United States averaged growth of 3.3 percent for this same period. These comparisons are based on data in Summers and Heston (1991). In the 1990s, Japan went from above average growth to below average growth, averaging less than 1 percent between 1992 and 2002 (Bank for International Settlements, 2005).

In Japan, the overnight interest rate is the main index of monetary policy, comparable to the federal funds interest rate in the United States. Monetary laxness shows up as lower interest rates. To arrest the deflation and stimulate economic growth, the Bank of Japan dropped the overnight interest rate. In 1995, the Bank of Japan changed the rate from over 8 percent to less than 0.5 percent (International Monetary Fund, 2003). The easy money policy failed to stem the tide of deflation. As inflation slipped into the negative column, the Bank of Japan pushed the overnight interest rate to ranges measured in one thousandths of a percentage point. For 1999, the International Monetary Fund reports an average overnight interest rate of zero. The average rose to 0.2 percent for 2000, and then sank back to zero for the years 2001 through 2005. The International Monetary Fund reports an average rate of 0.2 percent for 2006. In February 2007, the average rate stood at 0.5 percent.

The development of deflationary expectations became a major complicating factor. Expectations of inflation persuade consumers and businesses to borrow money and buy goods before prices go up. Inflation encourages buying goods and capital equipment sooner rather than later. Expected deflation has the opposite effect. Consumers and businesses are hesitant to buy goods and equipment with borrowed money if the goods and equipment are selling for prices higher than what they will sell for in the future. With expected deflation, businesses require a higher expected rate of return before borrowing funds to purchase capital equipment.

Many economists believe Japan in the 1990s entered into a liquidity trap. In a liquidity trap, money is in high demand because of the expectation that all other assets can be purchased on more favorable terms in the future. The strong demand for money as a financial asset frustrates efforts to increase spending by increasing the money supply.