Support for Prof. Miyao's Argument about Asset Deflation

Peter Tasker (Arcus Investment)

This commentary originally appeared in the "Japan-U.S. Discussion Fourm" (http://lists.nbr.org/japanforum) on May 7, 2003: posted here with the author's permission.

May I offer support to Professor Miyao, who has been warning of the devastating effects of asset deflation since the early nineties. I wonder how many other observers of the Japanese economy can look back to their opinions of ten years ago with equal satisfaction.

Sadly his analysis is still not widely accepted. Instead it is suggested that a collapse in share and real estate prices of 80% and a decline in 20 year bond yields to below 1% has little economic significance. Worse, this truly parlous state of affairs continues to be obscured by posturing about reform.

Professor Miyao's conclusions are indeed radical, but they follow logically from the following propositions –

1) collapsing asset markets are the cause, not the result of many of Japan's problems.

2) asset markets are not driven by rational estimates of future returns, but by crowd psychology. They have a strong propensity to overshoot.

3) due to complacency and stubbornness, Japanese policy-makers have missed the opportunity to use conventional methods of alleviating the damage. Only unconventional methods are left.

Regarding the first point, the collapse of the Nasdaq bubble has led to something of a reappraisal of the effects of asset prices. The quarterly reports of the Bank of England, for example, go into lengthy detail about the relationship between house prices, consumer borrowing, and final demand. Many observers believe that the world economy would have suffered a much more serious downturn without the benign effect of house price inflation (see "The Houses that Saved the World" in the Economist of March 2002.) In Japan's case real estate and equity values are even more significant, acting as capital for the financial system and collateral for all corporate lending. Asset deflation forces a deleveraging of the entire economy, which in turn feeds back through weakness in demand to further declines in asset markets. As the process continues, credit quality deteriorates across-the-board, bank capital erodes, and ultimately the financial system becomes insolvent.

Regarding the second point, there may be some people who believe that changes in the prices of internet stocks or London houses are driven by fundamentals. But not many, I would guess. It's at least plausible that Japanese asset prices are overshooting on the downside, given that the Nikkei Index is currently at a forty year low relative to GDP.

Regarding the third point, it is instructive to see how the US is dealing with its much milder post-bubble adjustment. The Bush-Greenspan agenda includes huge tax cuts targeted at the stock market, negative real interest rates, currency depreciation, `the stoking of a housing boom, and clear statements that deflation is dangerous and will not be tolerated. If Japan had followed a similar approach in the 1990s, there might be no need for drastic measures of the sort now suggested by Professor Miyao.