Japans Unsuccessful Attempts to End Deflation - Essay Example

Japan’s Unsuccessful Attempts to End Deflation Introduction Japan’s unsuccessful struggle with deflation over the last twenty years has shown how costly deflation could be for any economy, especially if economic conditions at the time are unfavourable. Nishizaki et al (2014: p27) note that while price levels do decline temporarily in developed economies as part of normal re-establishment of equilibrium, Japan has found it hard to recover from such a decline for many reasons, including bad debt burdens and the daunting task of restructuring its economy. This inability to reverse the decline in price levels, in turn, has led to a cycle of recession and the evolution of deflation. Some of the treatments that Japan has attempted in combating deflation are fiscal expansion, reduction of interest rates, depreciating the Yen, bank restructuring, two rounds of quantitative easing, and Abenomics. However, with the exception of the last measure whose effect is yet unclear, the situation has not changed much with a continuous economic recession reflected by its balance sheet (Botman et al, 2015: p32). This paper will explore the reasons why monetary and fiscal policy measures, as well as economic restructuring measures by Japan, have failed to end the deflationary pressures on its economy. Use of Monetary, Fiscal, and Structural Policies in treating Deflation As Japan’s consumption rate tax increased in 1997 followed by an economic recession and a deflationary spiral, Krugman (1999b: p1) stated that Japan had entered into a liquidity trap, in which the demand for currency was increasing dramatically, while resulting increases in the supply of currency failed to effect any changes in interest rates. This assertion was an extension of liquidity trap theory advanced by Keynes, where an economy’s general demand continues to decline despite a reduction of nominal interest rates to zero with production capability being higher than the general demand. Therefore, this definition would attribute Japan’s deflationary spiral to inadequate effective demand in relation to consumption and investment. Although Japan kept its interest rates low, this was still not enough to stimulate consumption and investment, while expansion of currency supply by the Bank of Japan was equally ineffective (Murota & Ono, 2012: p344). Krugman (1999c: p1) attributes this phenomenon to the fact that the Japanese public was more likely to save due to uncertainty about the country’s economic future, as well as fears that their income would reduce, despite having stable liquidity preference at the interest rates critical point. Therefore, the underlying factor driving this liquidity trap was the expectation and confidence of investors. Makin (2014: p1) notes that it is possible to change currency flow velocity in a short time period and that in the event of a sudden drop in GDP growth, investors tend to lose confidence, reducing loan demand dramatically and increasing the reluctance of banks to lend, thus slowing down the flow of currency in a relatively short time. Therefore, adjustments of interest rates and other monetary policies may fail to portend required temporary effects during an increase of currency supply velocity and, as a result, they cannot counteract declines in currency flow velocity simultaneously (Flath, 2010: p21). Moreover, traditional currency policies may fail to have the complete, desired effect in market economies like Japan (Flath, 2010: p21). For example, international flows of capital could impact the currency policy’s effectiveness, especially if the currency policy is based on the state’s domestic economy. In addition, Japan’s noticeably low rates of interest failed to draw capital towards investments and away from savings, instead stimulating increased outflows of capital and intensifying deflation. Mikuni and Murphy (2012: p33) further stress that fiscal policies have an inherent time lag, meaning that the effect of fiscal policies is only felt after changes in the economy have already occurred. In this case, one may conclude that fiscal measures would be difficult to implement in time for them to treat identified economic changes, especially given the difference in requirements in the fiscal policy decision stage and the reality recognition stage (Mikuni & Murphy, 2012: p34). These stages occur prior to the government taking fiscal measures and after changes to the economy respectively. Implementation of traditional fiscal measures and policies may bring the balance sheet recession to an end, arguably because of their obvious short-term effects. However, if the demand expansion policy is used as the lone long-term measure in restructuring the economy, the economy may worsen and result in a deflationary spiral. Greenwood (2006: p150) raises serious doubts about the consistency and credibility of Japan’s fiscal policy, noting that the Bank of Japan’s fiscal expansion policy in 1995 resulted in a 3.6% growth of the economy but worsened the bad debt burden. As such, attempts to solve this problem by implementing a free financing policy could lead to a deflationary spiral. As such, when the government looks to expansionary fiscal policies again as its main instrument of macro control, the inconsistent fiscal policy changes hurt investor confidence in the country’s financial system (Meltzer, 2001: p19). Reasons for Continued Deflation One of the most effective measures used in treating deflation is fiscal expansion and this was one of the initial measures taken by the Japanese government. Ito et al (2014: p6), however, argue that the outstanding debt crisis bedevilling the Japanese government, along with a fiscal deficit, made the use of fiscal expansion measures by the government difficult. Around the same time as the Asian financial crisis in 1997, the Japanese government decided to tighten fiscal controls by reversing previous reductions to special income taxes and increasing consumption tax, which Makin (2008: p1) attributes to a mistaken belief by the government that the economy was developing normally. For the first time in Japanese history, GDP underwent negative growth and the net result was economic recession and a deflationary spiral. The Japanese government, in response, reduced interest rates to zero in 1999 in an attempt to stimulate investment and consumption. However, by that point, the official interest rates set by the BOJ were already at historic lows and, therefore, this treatment was too late. In addition, monetary policy measures tend to have minimal impact on the economy when interest rates are below zero (Makin, 2008: p1). Kanaya and Woo (1999: p14) investigate the relationship between short term market interest rates in Japan and the currency base, noting that Japan’s currency base stood at 7-9% of GDP prior to the adoption of interest rate reduction measures. However, even as the interest rate reduction reached zero, the currency base continued to rise, reaching up to 8% of Japan’s GDP. Beginning in 2001, the BOJ adopted a currency supply expansion policy but by 2004, there was no further decline in interest rates despite concerted efforts at increasing the supply of currency. In this case, interest rates were not affected any further by expansionary currency policy. The country also adopted a weak Yen policy with the expectations that this measure would stimulate Japan’s exports and stop the deflationary spiral by making exports more competitive on the international market (Kanaya & Woo, 1999: p14). However, depreciating the Yen led to an increase in costs of raw material imports. Indeed, initially, depreciation of the Yen led to an increase in domestic price levels, while the costs of imports also increased, in turn reducing deflationary pressures on the economy to some extent. However, Meltzer (2002: p94) argues that in order to achieve an inflation rate of at least 1%, Japan would have had to further depreciate the Yen to between 170-180 Yen for $1, which would have been an unacceptable exchange rate for importers of Japanese products. Krugman (1999a: p1) further states that the main reason why Japan’s economy found it difficult to effectively deal with deflation was due to poor economic performance in their traditional markets. Combined with delayed restructuring of their economy as required by changing external and internal environment, Japan found it difficult to adapt to declines in export volumes. Thus, depreciating the Yen should have been a short-term measure supported by economic restructuring as a long-term measure. Japan then turned to bank restructuring as a means of treating deflation, as the financial system’s weakness became increasingly clear from the failure of previous treatments. Deflation in asset prices was the main cause for Japan’s recession, particularly due to its strong influence on debt balance and capital for both borrowers and lenders (Krugman, 1999a: p1). In turn, both borrowers and lenders had to contend with worsening balance sheet status, further restricting investment in equipment by Japanese corporations. Restructuring programmes by Japanese banks allowed for voluntary transfer of assets and reluctance by lenders to take losses on loans. Compared to the nationalisation and re-privatisation of Swedish banks in 1992 and the American compulsory takeover in 1998 of the Resolution Trust Corporation, Japan’s measures were moderate in nature (Makin, 2003: p1). Indeed, it may be argued that this was a missed chance by Japan to restructure their financial system. Rather, the moderate bank restructuring undertaken by Japan had little chance of successfully reversing deflation because nominal interest rates were at their lowest and bank loans were not performing. The bank of Japan in 2001 implemented a quantitative easing policy aimed at stimulating the country’s economy, specifically by setting their current account balance targets above the required levels of reserve for Japanese banks. QE policy may have an influence by enhancing confidence that, until the economy achieves inflation levels, the interest rates will stay at zero (Makin, 2003: p1). However, QE policy failed to encourage Japan’s banks to extend increased loan facilities thus did not halt the decline in bank lending. In addition, it is also possible that quantitative easing policy negatively influenced the banking restructuring measures. This phase of quantitative easing may also have failed for several other reasons, including lack of economic and political leadership. Moreover, the Bank of Japan Policy Board members seemed reluctant and cautious in implementing a bold QE policy and seemed anxious to re-establish traditional policies, rather than more unorthodox policies (Makin, 2003: p1). Moreover, allowing a decline in currency supplies and delayed interest rates cuts may also have reduced the potential impact of QE, while it may also be possible that QE sought to tackle the symptoms of the balance sheet recession, rather than the causes. In 2009, the Bank of Japan embarked on a second phase of QE, in what Makin (2009: p1) refers to as a mini-QE policy. The government bought more corporate bonds and government bonds in a move that was expected to be more effective since non-financial corporations and consumers were less leveraged compared to the previous period of QE. Krugman (1998a: p1) argues that an export-oriented economic structure and Japan’s high dependence on the international market were the main cause of Japan’s stubborn deflationary spiral. Due to the Asian financial crisis and the global financial crisis, export-oriented economic development became difficult and the focus turned to increasing domestic demand. However, demand recovery faced a number of barriers, including extremely low levels of domestic demand beginning in the early 90s with price levels consistently falling from levels witnessed in the 70s and 80s. Following collapse of the asset price bubble in the 90s, asset values remained low for a very long time, which had a negative psychological influence on the consumption of fixed assets, currency exchange, and stocks (Krugman, 1998a: p1). As a result of long-term reduction in price levels, an imbalance of demand and supply arose because of the economy’s low consumption. In spite of attempts initiated by the Bank of Japan to increase domestic consumption, a lack of economic and political leadership at national level greatly hampered the recovery process (Krugman, 1998b: p1). As noted, the Bank of Japan’s Policy Board members were anxious about using unorthodox policies, thus undertaking moderate measures especially in bank restructuring, while other measures were too short-term or too late. Japan’s fiscal deficit meant that the government could not rely on fiscal expansion policies as a long-term measure to reverse deflation, while a continuous decline in price levels reduced government revenues leading to a relative increase in fiscal deficit. Government debts also increased to significantly high levels as a result of the government’s use of fiscal stimulation as a long-term policy. With government levels of gross debt to GDP standing at 190.7% in 1999, further fiscal expansion risked increasing government debt and the fiscal deficit, in turn harming the economy. Interest rate reductions were also, arguably, too late and too little (Lachman, 2014: p1). The reduction of the interest rates, while restricting deflationary pressures on the Japanese economy, was stopped in 2002 as the BOJ turned its focus to expansion of currency supply. However, the latter policy failed in its intended purpose due to the impact of non-performing debt, as well as difficulties in meeting currency demands in the market (Lachman, 2013: p1). Thus, Japan entered a liquidity trap, in which monetary policy had minimal effect due to fears among financial corporations that credit deflation and bad debt would hinder any serious transmission of the intended monetary policy effects. Japan was able to repair its economy’s monetary base through QE policy between 2001 and 2006, although currency growth tailed off as bank lending was de-leveraged, further frustrating efforts to reverse deflation. A further phase of QE was undertaken in 2007 through the purchase of government bonds, with the government intending to stimulate nominal demand and expand currency supplies (Lachman, 2013: p1). It now remains to be seen whether this latest treatment will work in reducing deflationary pressure on the Japanese economy. Conclusion In the past decade, Japan has struggled with a stubborn deflationary spiral, especially since measures meant to return the economy to inflation have been restricted by the balance sheet recession. As a result, households, banks, and corporations preferred to repair their over-leveraged balance sheets caused by the asset-price bubble. Over time, impairment of the credit system led to conventional treatments losing their potency and the BOJ policies were not as credible. Indeed, the BOJ failed to take consistent measures, which harmed consumer and business confidence in Japan’s financial system. Moreover, macro-economic policy in Japan was too late and too moderate to have the desired effect. References Botman, D. P., Danninger, M. S., & Schiff, M. J. A. (2015). Can Abenomics Succeed? Overcoming the Legacy of Japans Lost Decades. Washington, D.C.: International Monetary Fund Flath, D. (2010). The Japanese economy. Oxford: Oxford University Press Grenwood, J. (2006). 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Metroeconomica, 63(2), 335-357 Nishizaki, K., Sekine, T., & Ueno, Y. (2014). Chronic deflation in Japan. Asian Economic Policy Review, 9(1), 20-39 Read More