Deflationary Virus Spreading Worldwide

Toshihiko FUKUI (Chairman, Fujitsu Research Institute)

The world economy has been tracking a mild recovery path for more than a year, delivering unexpectedly favorable results. The heartening performance defies the pessimistic expectations that prevailed in the aftermath of the Sept.11, 2001, terrorist attacks on the U.S.

Among other factors, the U.S. economy's resiliency to the dreadful emotional impact of the World Trade Center atrocity left a breathing spot for the global economy.

The U.S. drew support from three factors - swift progress in inventory cuts, the firm tone of individual consumption and housing investment, and the bold measures taken by the government and the Federal Reserve Board to cushion the impact of the terrorist attacks.

However, prospects for the world economy this year are not so rosy, for several reasons - the possibility of a U.S. war with Iraq, the slowing of fresh investment as Japan's corporate sector suffers under the burden of excessive spending and a global trend toward increasing deflationary pressure.

Deflation - falling prices of products and services - is no longer a problem peculiar to Japan. The whole world is starting to see the phenomenon as it spreads across an increasingly integrated global economy.

So what aspects of deflation are likely to be the most prominent?

Accelerating trends toward economic globalization and the information technology revolution are sure to affect price-setting mechanisms. With more countries shifting to the market economy, people, goods, capital and information are moving more freely across national borders. Such changes are bringing the prices of goods and services as close as possible to the supply/demand equilibrium delineated in classical economics.

In the past, on markets segregated from each other big-name companies displayed their power to control prices and boosted profits by lifting prices higher and absorbing some of consumers' surplus purchasing power.

But such an earnings strategy is no longer valid. Returning to basics, companies are concentrating their efforts on earning profits through creation of value-added products and services.

Price movements are generally somewhat neutral to macroeconomic trends.

Let us assume that economic realities validate the theory of price neutrality, provided there exist no restraints on management resources, including technologies, management expertise and employee creativity; that downward support for wages is not too rigid; and that corporate borrowers are not too heavily indebted.

China's real-term economy has expanded by more than 7% annually for the past several years. But the country has recently seen consumer prices declining at about the same rate as in Japan.

China is blessed with an abundant labor supply and has actively solicited foreign direct investment. The inflow of foreign capital has been accompanied by technology and management know-how, which has largely freed the country from the constraints of resources.

As Chinese wage levels remain extremely low, the issue of pay resisting downward pressure never arises there, in contrast to countries like Japan, which is currently gripped by the issue. Because state-run corporations and banks in China carry a huge mass of excess debt and nonperforming loans, their activities have largely been suffocated; smaller businesses in the private sector and foreign firms are serving as the engines of China's high growth. It would be interesting to examine whether the example of China is applicable to the hypothesis about the neutrality of price movements.

On the contrary, limitations of resources bring about distortions in economies. Japan is afflicted with a myriad of problems, making it impossible to hold that deflation is neutral to macroeconomic trends. First, although at a glance the country would seem to have limitless resources, in fact in the public sector the structure of fiscal spending is inflexible and tax reform has made little progress. This shows that tax and fiscal policies are unable to properly perform the essential role of redistributing resources.

In the private sector, meanwhile, many areas are still tightly bound by regulations, hampering the mobility of resources.

Moreover, at a time when Japan needs to shift to the next phase of development as its economy matures, it is marking time in establishing management expertise and fostering capable people who are well-suited for such a transition. In addition, the country has failed to build a framework for providing risk money, a necessary mechanism to meet fund demand in the new era.

Second, although Japan's wage system is relatively flexible, it has not yet evolved into a structure that lets pay levels be determined by productivity.

Third, Japan is still struggling to clean up excess debt at companies and mountain of nonperforming loans at banks.

Thus, deflation should be taken seriously here. At the same time, however, deflation is not merely a monetary phenomenon. The government needs to work harder to formulate economic policies with fresh ideas, even if the role of monetary policy is of great importance. I also think private companies should take the initiative to help cure some of the economy's ills.

With deflation dragging on, the excessive indebtedness of the central and local governments has produced a huge and enduring effect.

The huge outstanding balance of low-interest government bonds not only adds to the moral hazard of bond-issuing entities, but could sow the seed of a new systemic risk to the economy once interest rates resume rising again. The government would be well advised to begin issuing bonds linked to the prices of goods and services as early as possible.

(This article originally appeared in the February 24, 2003 issue of The Nikkei Weekly. Do not quote without the permission from the original publisher)