The Japanese economy is again shrinking while prices are continuing to fall. A slowdown in global economic activity is reducing the volume and value of Japanese exports so that manufacturers are reducing output to avoid large increases in their inventories. Private-sector machinery orders, considered a leading indicator of corporate spending in the subsequent six to nine months, are also down. This negative stance has contributed to the jobless rate remaining at a record level and has forced a halt in job growth. Perhaps the most troubling news is that deflation in Japan, as measured by a declining consumer price index, was 0.3 percent in 1999 and 0.4 percent in 2000. Japan is the only major industrialized country where the domestic price level has fallen for two consecutive years. Meanwhile, asset prices have also been in retreat with the Nikkei 225 average trading at its lowest levels since 1984 before recovering slightly.
Price declines have meant that businesses have experienced falling revenues and profits so that they have encountered increased difficulty with repaying their outstanding loans. Consequently, consumer prices have undergone a long-term decline relative to wholesale prices.
Some elements of the price declines are "virtuous" and reflect structural improvements in distribution or increased productivity. However, most of the problems with downward pressure on prices are arising from weak demand due to slow growth in investment spending by businesses because of industrial overcapacity. Meanwhile, households are suffering from insecurity over job losses and sharp declines in stock and land prices.
In response to these conditions, many economists have encouraged the Bank of Japan to undertake a more expansionary monetary policy. One of the goals of this sort of quantitative easing of the money supply is to establish a target inflation rate and then pursue monetary policy based on that goal.
In response, the Bank of Japan has announced its intention to increase the rate of growth of the money supply. This will be done by raising the level of excess reserves in the banking system to ?6 trillion from ?5 trillion and increasing monthly bond purchases.
It is misguided to think that printing more money will resolve Japan's economic problems. At the same time, all the talk about inflation targeting misses the point.
Part of the support for the insistence upon inflation targeting is the inappropriate fixation on household expenditures as one of the key elements for eventual economic recovery. Although lower consumer spending contributes to deflation, it is not the principal cause. Indeed, low household expenditures are a result of the earnings power of members of households that is principally determined by productivity.
Yet the principal transmission mechanism of expansionary monetary policies is to provoke changes in business decisions. The idea is that when BoJ purchases securities from banks, companies and institutional investors will provide them with additional funds to spend on additional investments or new hiring. Expanding growth in the money supply may not stimulate the economy since most of Japan's corporations are undergoing restructuring. Consequently, they may be unwilling or unable to expand their investments even in the face of cheaper access to credit.
This is because borrowing decisions by corporations are guided more by the availability of viable investment opportunities instead of current interest rates. As it is, central bank action can only affect the supply of funds. The demand for funds by companies arises out of their view on the future economic conditions in that the expected return on investment must exceed market rates of interest. As it is, the earlier operation of a "zero interest" policy by the BoJ did not attract sufficient demand for new credit from viable borrowers.
And even if short-term interest rates do fall, long-term rates could actually rise since inflationary expectations influence long-term expectations on returns on capital spending. If companies begin to liquidate holdings of government bonds to avoid losses from declining bond prices, the bonds will attract lower prices. As yields on bonds move in an opposite direction to their selling prices, a drop in bond prices will push up interest rates on longer-term instruments.
In the real world, inflation targeting only works when most people underestimate the actual rate of inflation. This miscalculation, known as "money illusion" is necessary so that their actions have some impact on the economy.
For example, wages and salaries may rise in money terms, but these increases tend to lag behind price increases. If price rises match the increase in wages, then real purchasing power is not greater. Once consumers begin to realize that their real purchasing power has not actually increased, they will cut back on spending.
Businesses will experience a similar process. Initially, profits will rise since prices for finished products and services tend to rise more rapidly than costs. This is because labor and other input costs are often fixed by contract.
Inflation distorts the manner in which the money stream is distributed between various economic sectors and the stages of production. As such, factors of production will be directed into expanded output that depends upon the new increased spending.
The fact that this spending was artificially induced leads to distortions in the production process that are known as malinvestment. Eventually this spending increase must come to an end or it becomes insufficient to cover rising costs. As a profits squeeze develops from costs rising faster than product prices, unemployment begins to emerge. This is because the expansionary effects on spending from the inflationary policy will dry up.
Even "creeping inflation" at low levels will inevitably accelerate. As the misdirected capital and labor begin to appear as idle resources, the central banks will respond by inflating even further in an effort to restore declines in output and employment. Pursuing a moderate inflation level is like being partly pregnant. A target inflation rate of 4 percent would lead to a doubling of overall prices within 10 years or so.
It is bad enough that few of distortions arising from asset valuations and malinvestments during the years of Japan's "bubble economy" have been eliminated or liquidated. Introducing inflation targeting is likely to introduce another round of structural distortions into the economy.
In the end, this would simply lead to inflation without reductions in unemployment or higher economic growth, a condition that became known as stagflation. It is not clear that trading a deflationary cycle for a cycle of stagflation will bring long-term improvement to the Japanese economy. Under current conditions, it may be easy to forget that inflation confiscates wealth and causes distortions in prices that lead to misallocation of resources.
Ignoring the existence of malinvestment created by inflation might lead to the dangerous conclusion that price rises within a 2 to 3 percent range does not pose a danger. As it is, an inflation rate of US$0.2 a year would amount to an erosion of the purchasing power of the yen by about 50 percent within a generation.
Inflation can only "work" when it is unforeseen. When people expect a certain rate of inflation, they take evasive action to minimize its effect. Consequently, workers and unionists will demand wages adjusted for inflation while businesses would increase prices to offset the increased costs to them. At the same time, lenders require nominal interest rates that compensate for the losses in purchasing power and investors require higher nominal returns.
It is hard to imagine that any of this contributes to long-term economic stability. Attempting to maintain medium-term price stability by introducing low rates of inflation will ultimately have an adverse effect upon economic growth that is as bad or worse than the current disease.
Christopher Lingle is global strategist for eConoLytics.com and author of The Rise and Decline of the Asian Century.
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