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November 1, 2004

Reflation Necessary for Sustained Economic Recovery

Kikuo IWATA (Professor, Gakushuin University)

There have been fierce debates among economists on the cause of Japan's stagnation that continued for more than ten years since 1992. The arguments could be broadly classified into two categories: One that finds the cause in Japan's structural problems, and the other that blames the financial policies that induced deflation. In the course of assessing the validities of the arguments, it might be worthwhile to reflect on these theories in light of the recovery since 2003.

There are variations within the arguments of those who view structural problems as the cause of the stagnation. The most typical is to accuse banks' reluctance to advance new loans while extending forbearance lending. Indeed, if the reluctance of banks to lend were the cause of the stagnation, the volume of bank loans must increase in order for the economy to recover. But the recent recovery has been achieved without increased bank lending.

According to the proponents of the forbearance-lending hypothesis, economy remains suppressed as funds are absorbed by forbearance lending and would not become available for new businesses. But during the current recovery so far, sound firms have utilized their own funds, and in fact, firms in general have been repaying their loans to banks.

Some supporters of the structural-problem hypothesis claim that the recovery is a result of Koizumi reforms. But what Koizumi reforms have achieved so far is limited to laying the groundwork for privatization of the Housing Loan Corporation and Highway Corporation. It is difficult to relate those decisions to the recovery of the economy. Also, some say that the cuts of public spending by the Koizumi government have urged local regions' self-reliance, which formed the basis for the recovery, but this is hardly a convincing argument.

Before looking into the theory that deflation caused the prolonged stagnation, the misconception often seen in counter-arguments to the theory that the economy cannot be considered recovered so long as deflation persists must be corrected. There are countless cases in history when relatively high growth was achieved in deflationary environments. In Japan, the mini-growth during 1995-96 was realized during a period of deflation, according to GDP deflator figures, and the recovery of 2000, dubbed afterwards the "IT bubble recovery," was attained when the consumer price index as well as the GDP deflator was registering deflation.

Those who assert that deflation is the villain argue that it is necessary for public sentiment to change from anticipation for deflation to expectation for inflation. They point to the necessity of expected real interest rates to decline to levels necessary to realize full employment, which in turn sets the basis for sustained and stabilized growth. This means that if people's anticipation for deflation ceases, or expectation for inflation develops, it would lower expected real interest rates, which should bring about real economic recovery.

Analyses of the behaviors of recent inflation-indexed government bonds in the market indicate changes in people's sentiment toward the future in that they seem to sense the end to the deflationary trend. The reasons for the calming sentiment are the heavy intervention in the foreign exchange market by the Ministry of Finance in 2003, and the clear indications of the Bank of Japan's commitment to breaking away from deflation. Recent remarks by BOJ Governor Fukui have been filled with expressions of strong commitment to fight against deflation, which, incidentally, is unimaginable from his words and actions before assuming the governorship.

That said, the expected real interest rate has not yet reached levels required to realize full employment. In order for the expected real interest rate to drop to necessary levels, the general expectation among people of 2 to 3 percent inflation should be formed. Therefore, the policy for the Bank of Japan to pursue now is to set an inflation target and show strong commitment to attaining 2 to 3 percent inflation.

(The original Japanese article appeared in the October 30, 2004 issue of Weekly Toyo Keizai)

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