Debate on Deflation in Japan #8
Moderator's Summary and Comments
Takahiro MIYAO (GLOCOM)
This debate on "deflation in Japan" was conducted by using e-mail on March 4 through 6. As the debate organizer, I first wish to summarize the main points that each participant has made, and then give some overall comments on our discussion in order to open up this debate for our general audience.
1) Richard Katz maintains in his keynote article that Japan is in deflation but NOT in a deflationary "spiral," and that deflation is NOT a cause BUT a symptom of Japan's problems and a result of weak demand relative to supply. Katz also argues that deflation is NOT significantly worsening the NPL (non-performing loan) problem, as widely believed, and expresses his doubt about the effectiveness of such monetary policy as inflation targeting. Instead, he argues for "consumer tax cuts" and the cleanup of bad loans.
2) Koichi Mera comments on Katz' argument by pointing out that Japan may be in a mild deflationary "spiral" if you take a longer viewpoint than Katz' one-year-lag approach, but more importantly, "ASSET PRICE" deflation is phenomenal and must have impacted producers as well as consumers. Mera also warns that deflation, especially ASSET deflation, is definitely worsening the NPL problem, as Japanese companies are stuck with fixed costs such as employees' salaries while losing their creditworthiness as a result of declines in the value of their properties as collateral for business loans. However, he agrees with Katz that just anti-deflation measures alone are not enough to increase demand and revive the economy.
3) Craig Freedman, while agreeing with Katz that focusing on deflation alone is misleading and monetary policy alone cannot solve Japan's economic woes, clearly points out that it is important to distinguish between flows (general price deflation) and stocks (ASSET price deflation) and criticizes Katz' argument because it does not discuss the WEATH effect connected to housing values, for example. Freedman goes on to say that even in the case of general price deflation, Japanese companies could be seriously impacted by a time lag between inputs and outputs, leading to the accumulation of outstanding debt. Regarding policy options, he emphasizes not only demand-side measures but also "the right monetary policy."
4) Tsutomu Watanabe basically supports Katz' argument, and even goes further by saying that there may NOT exist such a thing as a "deflationary spiral" in the first place, and that some forces such as WEATH effects should work to prevent the Japanese economy from falling into any kind of spiral, contrary to the argument by Mera and Freedman. Then Watanabe turns to his Phillips curve analysis to maintain that weak demand is NOT a dominant cause of deflation, seemingly in contrast to Katz' conclusion. Watanabe also argues that the Bank of Japan may have been responsible to push the Japanese economy into a "liquidity trap" by aiming at a too low level of inflation in the 1990s, although he does not advocate the use of monetary policy to escape from such a trap.
5) In his rejoinder, Katz responds to Mera and Freedman regarding asset deflation by saying that while "asset deflation has had a significant effect on demand," there is NOTHING we can (or should) do about it directly, since it was a result of the overvaluation of stocks and real estate in the past. Katz also denies any significant damage caused by general deflation as suggested by Mera and Freedman, since deflation is so mild and marginal in Japan. Then, Katz discusses the POLITICS of anti-deflation by pointing out that "anti-deflation is the name that anti-reformers give themselves," (although he seems to recognize that many reformers are also concerned about deflation). However, Katz agrees with Freedman that monetary stimulus may be important and effective IF it is combined with structural reform. He also responds to Watanabe's comment about the Phillips curve by saying that he argues for demand stimulation NOT to fight deflation, BUT to offset the initial contractionary effect of structural reform.
6) Mera, while agreeing with Katz on his political analysis that LDP is using anti-deflation for its political survival, disagrees with him on the issue of ASSET deflation. Mera insists that the government CAN and SHOULD exert influence on asset prices, since asset deflation is a significant CAUSE of the decline in demand, although the best medicine for asset markets is overall revitalization of the economy, as Katz suggests.
7) Freedman goes along with Katz in calling for the need to deal with Japan's economic problems including deflation as a part of the whole picture and concludes that attacking deflation alone is NOT a sufficient first step. However, Freedman clarifies his points that the housing market is so important that targeted tax relief for homeowners should be considered, that the time lag problem with deflation is significant even if cost structures are flexible, and that aggregate figures on excess capacity can be misleading since not all of such "excess capacity" is actually obsolete. Finally, he points out Japan's political structure which is not conducive to the solution of the economic problems.
Finally, my comments are as follows:
Having summarized the deflation discussion, I would like to point out that, while the discussants have agreed on their basic approach to the deflation problem, there seem to be a number of important differences remaining in their analyses of specific aspects of deflation in Japan.
For one thing, there is a difference in their evaluation of the effect of general deflation on public and private debts. Katz downplays its significance compared to other factors, while Mera and Freedman emphasize possibly serious damages to corporate and government balance sheets due to prolonged deflation, although no statistical analysis or evidence is provided by either discussant. In this connection, I wish to mention an article entitled, "Non-performing loans as a result of deflation," by Yutaka Harada (Finance Policy Research Institute), that appeared in Nikkei Shinbun on February 19, 2002, where Harada empirically shows that the NPL problem is likely to be a result of whole-sale price deflation and not vice versa.
In my view, however, the most significant difference among the discussants lies in their analyses and policy implications regarding ASSET deflation. While Katz and, probably, Watanabe seem to regard asset deflation as rather a marginal issue in the whole picture (actually, deflation itself is a marginal issue relative to Japan's economic woes, according to Katz), Mera and, to some extent, Freedman take asset deflation more seriously, as they say that asset deflation (housing price deflation in the case of Freedman) may be a significant cause of demand stagnation in Japan.
I think this is quite an important difference, since it could lead to very different policy prescriptions to deal with economic problems including general price deflation. Even if our discussants all agree on a certain policy such as tax cuts, for example, they could mean very different kinds of tax policy: Mera and Freedman might well argue for permanent tax reduction on stocks and housing in particular, while Katz and, possibly, Watanabe would talk about general tax cuts on income or consumption. We all know that those two kinds of taxes are very different in nature and in magnitude.
Even more significantly, one's understanding of asset deflation will affect one's conclusion as to whether the deflation problem can be solved independently of other structural problems such as restructuring of public and private corporations including financial institutions. Katz says "definitely no," because he seems to believe that deflation is a result of those structural problems, while Mera and Freedman would say "maybe not," as there might be a way to mitigate, if not completely solve, the deflation problem by targeting asset markets for stimulation through tax cuts together with monetary stimulus. Personally I would go even further to say that attacking asset deflation by stimulating the stock and real estate markets is the key to the solution of such seemingly structural problems as increasing public and private debts, low consumption, low productivity growth and general economic stagnation in Japan.
In any case, our discussion on deflation has just begun. So far it has led to more questions than answers. I urge you, our audience, to participate in this discussion in order for us to contribute to the policy debate that is actually taking place in and around the government right now.