Debate on Deflation in Japan #5

Rejoinder to Mera, Freedman and Watanabe

Richard Katz (The Oriental Economist Report)

I'm glad to see that Profs. Mera, Freedman, Watanabe and I all agree on the main policy point. Anti-deflation policies are no magic bullet for Japan's problems. Prof. Freedman also agrees that such "such obsession can be counterproductive when used by politicians to promote 'business as usual' policies."

Both Profs. Freedman and Mera, however, think I've gone too far, or ignored certain important factors, in my argument. Let me address those criticisms. Then, I'll respond to Prof. Watanabe.

1. Asset Deflation Versus Goods And Services Deflation

Both Prof. Mera and Prof. Freedman focus on asset deflation, while agreeing that goods and services deflation is "mild" (Mera) and "moderate" (Freedman).

I focused on goods and services deflation because that is the focus of most policy discussion. Few call upon the BOJ to conduct Price-Keeping Operations (PKOs) for stocks and real estate.

Surely, as they say, asset deflation (stocks, real estate) has had a significant effect on demand. Just as the overvaluation of stocks and real estate led to an excessive and unsustainable boom in private business investment (factories, equipment, stores, office buildings), so the collapse of asset prices has contributed to slack investment.

But what is the policy implication? What can, or should, be done about asset prices?

Land underneath the Imperial Palace, once said to be worth as much as all of California, is now down to, perhaps, just Los Angeles. The government has repeatedly tried and failed to launch PKOs for stocks and real estate. They've failed because sky-high prices don't make economic sense. As the U.S. found out in the Saving & Loan crisis, it was not until they let prices for land hit bottom, that buyers would finally come in, feeling that the only direction was up. The longer Tokyo uses PKOs, the longer they draw out the malaise.

Moreover, a nation loaded with excess capacity does not need another artificial stimulation of investment, but a shift to a consumer-led economy.

2. The Damage Caused by Mild Deflation

Prof. Freedman comments, "I have seen no studies which try to estimate the damage caused by low level deflation."

I find it absolutely remarkable that some of the most fervent and prominent advocates of inflation-targeting have not presented statistical studies backing up their case. In a long academic paper for the Brookings Institutions, Paul Krugman presents not a single regression even trying to test his arguments for Japan. So, what we have are assertions and assumptions, not tested facts.

Both Prof. Mera and Freedman insist that deflation must make the NPL problem worse, because operating costs have not gone down as much as sales prices.

Prof. Mera refers to permanent employees, saying "they are even raising salaries when conditions are getting worse." In fact, real wages have been falling since 1997, with an interruption in 2002.

Both Profs. Mera and Freedman refer to lags. Of course, I don't deny that some costs are fixed and therefore, total input costs may not go down as fast as sales prices. I said that in my initial piece, but their comments make it clear to me that I need to make that recognition more clear in future writings. My point is: how important is deflation in the overall scheme of things? Quantities matter a lot. Taking two aspirin will cure a fever; taking a bottle-full will kill you. Prof. Mera says, "A 10 percent decline in profits is a serious problem to most corporations." I agree. But, given the mild deflation Japan is now experiencing, the most important cause of those falling profits is declining sales volume. Deflation is marginal.

3. The Politics of Anti-Deflation

Suppose, for a minute, that I'm right, and that deflation is a mild symptom, but not a major cause, of Japan's problems. Why, then, are some people in Japan pushing so strongly on this issue? While many are sincerely motivated, Morgan Stanley is right when it wrote in a recent memo to clients that "anti-deflation" is the name that anti-reformers give themselves. The primary political push on deflation comes from those who want to use BOJ-created money to prop up deadbeat borrowers at near-zero interest rates and those who want the BOJ to monetize the government debt so the LDP can go on building bridges to nowhere. We have to look at these issues in their political context, not just in abstract.

Consider this. As Morgan Stanley also points out, to the degree that ZIRP is used to prop up zombie borrowers, it sustains excess capacity in various industries, which worsens deflationary pressure.

4. Monetary Stimulus Absolutely Necessary But Not Sufficient.

Prof. Freedman wrote: "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."

Absolutely, I agree. My point is that, saying Japan needs monetary stimulus is like saying a car needs gasoline to run. Absolute true, but it could also use an engine. By itself, monetary stimulus is pretty weak. In combination with other measures, it can be quite powerful.

For example, Heizo Takenaka, in a recent speech in Aichi, said, "Unless banks make progress on bad-debt disposal, the monetary easing by the Bank of Japan will not produce results, making it impossible to beat deflation."

The IMF has said: "Banks play a crucial role in transmitting monetary shocks to economic actors…We conclude that policy measures to strengthen banks are a prerequisite to restoring the effectiveness of the monetary transmission mechanism."

Similarly, a recent Brookings paper by Adam Posen and Kenneth Kuttner stated, based on some regression analysis: "The monetary shock ... initially increases prices, but the effect is reversed after a few quarters.... In addition, given the weak link between M0 [i.e. the monetary base] and M2 (and thus between M0 and prices), an increase in high-powered money [another name for the monetary base] will have only a limited effect if banks are unable or unwilling to lend the additional reserves....If fiscal stimulus is effective, then ultimately the role of monetary policy should be to accommodate expansionary fiscal policy." This finding was particularly noteworthy given Posen's prominent role as an advocate of inflation-targeting.

Macroeconomic stimulus and structural reform have been treated as if they were alternatives. They should be regarded as partners. Neither works without the other.

5. The Phillips Curve in Japan

Prof. Watanabe writes: " The Phillips curve is still alive in Japan!" Yes. I've attached a different form of my original chart showing this.

He also writes that the Phillips curve flattens making it more costly to raise inflation. "Given this fact, I am against his idea of stimulating aggregate demand to stop deflation." Prof. Watanabe misunderstands me. I am not arguing to stimulate demand for the purpose of fighting deflation. I want to stimulate demand to close the output gap, help get the economy moving, and provide some offset to structural reform, whose initial effects will be contractionary. Do the right thing on these other fronts and deflation will take care of itself.

6. Supply Shocks, Good Deflation

Prof. Watanabe writes: "In fact, our research mentioned above finds that supply shocks played an important role in lowering the inflation rate in the 1990s." I'd be interested in hearing more about your results. Certainly, the crash of oil prices in 1986 had a big effect in Japan. Certainly, the lowering of apparel prices, long-distance phone calls, and, more recently, food, have been significant factors in the Consumer Price Index. And, yet, it seems to me that, if supply shocks were the primary factor in deflation, then lowered prices (a lower supply curve) should lead to higher output down the road (all other things being equal). I don't find that in the data. I'd like to hear more evidence on the relative role of demand and supply shocks in Japan's disinflation/deflation.