Debate on Deflation in Japan #2

Comment on Katz' Deflation Argument

Koichi MERA (University of Southern California, USA)

Richard Katz has made a clear-cut argument on the current deflation in Japan. In essence he argues that (1) Japan is not in a deflation spiral, and (2) deflation is not significantly worsening the NPL problem. I would like to give my view on these issues.

1. Deflationary Spiral
   He demonstrates through a graph that weak demand is causing deflation. But, he states that deflation is not causing weak demand. Deflationary spiral requires causation in both ways, but he says that the other causation is missing. Therefore, the current deflation is Japan is not a spiral. He simply says "There is no significant statistical correlation between deflation today and demand tomorrow."
   
   I have not tested any statistical correlation between deflation and demand. But, I suspect that the relationship is not a simple one-year lag as in the case of the other causation. Weakened demand started in the early 1990s, and the slowing of inflation/mild deflation started at the same time. He says that the deflation in Japan is mild. As long as we observe the prices of regular goods and services it is true. But, if you look at asset prices, the deflation is phenomenal. The commercial property prices went down to a tenth to a quarter from the highs in the 1980s in many downtown areas. The stock index is also a quarter of the previous high. The asset price deflation is profound and should have impacted the economic behavior of producers and consumers. Mr. Katz did not pay any attention to this important segment of the deflationary process. When he does, he would have different conclusions.
   
   
2. Deflation and the NPL Problem
   He argues that when the revenue goes down due to deflation, the operating costs should also go down at the SAME rate, leaving profits at about the same level. Therefore, he says, deflation should not worsen the Non-Performing Loans problem in any significant way. In this argument, he admits that there is some negative impact on the NPL problem, but he maintains it is not a major problem. In this argument, he assumes producers are able to change the composition of inputs flexibly and rapidly. This is one significant point that he did not address.
   
   For good or bad, Japanese companies have not been able to adjust their inputs quickly and drastically. Companies have been having "permanent employees" and they are even raising salaries when the economic conditions are worsening. When the companies have reformed their management style drastically, his argument could be accepted. But, in the current situation in Japan, deflation is causing a detrimental impact on the NPL problem.
   
   Mr. Katz maintains that a slight decline in profits while the amount of the loan unchanged is not a significant problem. This may be so when the economy is doing well. But, at this time in Japan, every penny is important for the survival of corporations. A 10 percent decline in profits is a serious problem to most corporations.
   
   Again I must remind him of the deflation of the asset sector. The property prices are going down at the rate of about 5 percent during the past nearly 10 years. The properties have been used as collateral for most business loans. A result is obvious: the creditworthiness of many borrowers has deteriorated beyond any reasonable risk forecast. Thus, the asset deflation is definitely and significantly worsening the NPL problem in Japan.

Despite some differences in detail, I support his overall position that a definite increase in demand is a necessary condition for the revival of the Japanese economy. One way for turning the demand to increase is to break the deflationary spiral. But, the economy needs strong measures in several spheres of the economy to achieve this objective. Anti-deflation measures alone will not be enough.