Debate on Deflation in Japan #3

Comment on Katz and Mera

Craig Freedman (Macquarie University, Australia)

Richard Katz is absolutely correct in what I believe to be the essence of his analysis. Focusing on the question of deflation alone is misleading. Deflation doesn't occur in an economic vacuum. Moreover, such an obsession can be counterproductive when used by politicians to promote "business as usual" policies. He is also correct to focus on the obvious link between deflation and demand. For instance, the successful attempts to curb inflation seem mostly to have come about by deliberately choking off demand, though everyone may not accept this. Certainly attacking deflation without at the same time dealing with sluggish and faltering demand would seem to be a mistake. The US attempt in the thirties to inflate prices by going off the gold standard proved to be no magic bullet in and of itself. I doubt that there is a simple way, through monetary policy alone, to resolve Japan's economic woes by inflating prices.

Economic damage associated with deflation

However, in his desire to focus attention on what Mr. Katz sees as the more fundamental aspects of Japan's problems, I believe he tends to go a bit overboard. As Koichi Mera points out, when we talk about deflation, there are two distinct aspects to the problem, that of flows and stocks. Price inflation has so far been quite moderate, but not so asset inflation. In the US in the thirties, asset values dropped sharply, but in real terms staged a reasonably prompt recovery. In Japan, asset prices have slumped continuously throughout the nineties. These prices have seen little or no improvement as of today. In some of his other writings, Mr. Katz has seemed to dismiss the wealth effect connected to asset values. Let me touch on just one important aspect, namely housing. Home ownership in Japan is reasonably widespread. As is the case in a number of other industrialized countries, home ownership often represents a large portion of household wealth. Recent studies have shown that housing values have a greater impact on consumption than has been previously suspected. In fact, there is good reason to believe that the US recession has been greatly buffered by the fact that housing prices have generally maintained their level. The drastic drop in Japanese home prices would affect not only those who bought housing while prices were rising, but those who purchased housing in the nineties after the initial drop in value, say when prices had dropped 25% off their peak. At least some of these people now own an asset with a negative net value. All of them have seen their wealth drop drastically. In this sense, asset inflation has been a serious issue.

But let's turn to the type of price deflation that is the issue more often under discussion. I have seen no studies which try to estimate the damage caused by low level deflation. This contrasts with a number of studies which try to measure the damage or benefits of low level inflation. However, the potential for damage surely exists in an economy where firms are heavily indebted. Here I think Mr. Katz makes an error in the example he presents. Production is not accomplished simultaneously. Inputs are purchased prior to producing output. Relatively more expensive inputs produce output, which is subsequently sold at lower prices. Wages and the price of other inputs do adjust eventually but only with a lag. In other words, if goods today sell at a price 5% lower than last year, the inputs, which produced those goods, did not similarly drop 5% in cost. Given the indebtedness of many Japanese firms, even a mild deflation may seriously inhibit servicing outstanding debt. Certainly, in real terms, their debt will continue to accumulate. Is Mr. Katz willing to make the symmetrical claim that inflation doesn't help borrowers just as deflation, according to his analysis, doesn't hurt borrowers?

Mr. Katz is also ignoring the fact that deflation, even mild deflation, worsens government indebtedness and may potentially hinder the ability of the Japanese government to respond to a worsening economic crisis.

Deflationary Spirals

Mr. Katz is correct in saying that there has been no deflationary spiral in the sense of an accelerated decrease in prices. Does that prove that there has been no feedback between falling prices and falling demand? I simply don't have any empirical basis for coming to a conclusion on this question. As Mr. Mera indicates, such a link may only appear with a lag. Or perhaps, fiscal and monetary policy has inhibited any such spiral from appearing. Without any other evidence, I could only say that because such a deflationary spiral has not yet developed, I have no reason to believe that it cannot or will not, if the Japanese government continues to delay taking any decisive action as it has for the last decade. I need more convincing on this issue.

I would strongly support the main thrust of Mr. Katz's argument. However, I think he would agree that even if the correct policy focus should be on demand, having the right monetary policy in place is not without importance as well.