1. Introduction
The
Japanese economy has been underperforming for more than a decade. The average
growth rate of real GDP over the past 12 years has been just above 1 percent,
and the nominal GDP has been shrinking since 1997 due to deflation. In order to
stimulate the stagnant economy, the government has cut taxes and increased expenditures.
As a result the government debt/GDP ratio has risen to an unprecedented level
for an advanced country in peacetime. The CPI has been declining since 1998, while
the GDP deflator has been declining since 1995. Stock prices and land prices
have been declining for the decade. There is no doubt that the economy is in
deflation. The consumption tax rate increase and repeal of income tax cut in
April 1997 is often regarded as a fiscal policy mistake. Slow structural reform
in regulated sectors is another problem for the Japanese economy. The most
likely cause for deflation in Japan is a failure of monetary policy, since
inflation or deflation is ultimately a monetary phenomenon. The Bank of Japan
(BOJ) was unable to stop the inflation rate from turning negative, despite its
various efforts. The Bank of Japan’s actions were too little too late, at least
in retrospect, in preventing deflation from emerging and fighting out of
deflation.
2. Monetary Policy to overcome the
Deflation
More
than two decades after the collapse of the 1980s asset price bubble, Japan
remains stuck in deflation, with asset and consumer prices continuing to
decline despite a virtually zero policy interest rate and the central bank’s
quantitative easing (QE) measures. Sluggish output growth and rising public
spending, due in part to population ageing, have pushed gross public debt above
200% of GDP, raising serious concerns about fiscal sustainability. Figure 1
shows deflation measured by CPI and GDP deflator. The inflation rate measure by
the GDP deflator has moved lower than the CPI inflation rate. The deflation was
the result of a beneficial supply-side effect. The deflation was due to
insufficient demand or ever-expanding supply, on the other hand, the demand
side was more responsible for deflation and stagnation. Meanwhile, structural problems,
including rapid population ageing and weak integration in the world economy,
reduce growth potential. The government has pledged a three-pronged strategy of
bold monetary policy, flexible fiscal policy and a growth strategy that
encourages private-sector investment to exit from deflation and revitalize
Japan. In 2013, the Abe administration has implemented a non-traditional
monetary policy through buying operation. Due to the BOJ, monetary base was
planned to increase to 270 trillion yen in 2014 as shown in figure 1. But, the
BOJ plans to continue this monetary policy until to achieve 2% inflation
target.
Figure1. Monetary
Base and Monetary Supply Figure2. Deflation measured by CPI
and GDP deflator
Figure
3. Exchange
Rate and Stock Price Figure4. Corporation income
The
nominal interest rate cannot become negative, because at a negative interest
rate cash would dominate holdings of any debt instrument. Zero percent is thus
a lower bound for the interest rate. When the rate of deflation rises, then the
real interest rate, which is the difference between the nominal interest rate
and the inflation rate, rises as shown in figure 2. The worse deflation
becomes, the higher is the real interest rate, thus leading to an unintended
tightening of monetary policy. A higher real interest rate and expectation of
future deflation discouraged investment and consumption in Japan. Lower
aggregate demand widened the GDP gap, contributing to lowering prices. This is
the first part of a deflationary spiral. Since the nominal interest rate cannot
be lowered below zero, the traditional monetary policy instrument, that is, the
short-term interest rate, loses its effectiveness in combating the deflationary
spiral. Conventional monetary policy, using short-term interest rates as the
policy instrument, is not effective in combating the deflationary cycle and
debt deflation after the short-term interest rate has reached zero because the
policy instrument cannot be lowered further.
3. Fiscal Policy to overcome the
deflation
The
Japanese economy has been stagnant since early 1990. Besides the collapse of
the real estate bubble in the first half of the 1990s, Japan faced five successive
negative shocks — sharp appreciation of the yen in 1994–95, the financial crisis
of 1997–2002 triggered by the successive failures of major Japanese financial institutions,
the global financial crisis of 2008–09, the Great East Japan Earthquake in 2011,
and, finally, a recession in the EU coupled with diplomatic problems with China
in 2012. To over the deflation, prior to the lower-house elections in December
2012, Mr. Abe would introduce measures to stimulate the economy, including a
bold expansionary monetary policy, a flexible fiscal policy, and structural reforms.
His election saw the start of the so-called “Abenomics.” Prime Minister Abe
appointed Mr. Haruhiko Kuroda as the new governor of the BOJ, and the BOJ adopted
an extremely expansionary monetary policy. The BOJ adopted the following strategy
in response to the Abe administration’s request.
- The BOJ promised to achieve 2 percent CPI inflation in two years (by the spring of 2015). Since the 3 point hike in consumption tax in April 2014 would push the CPI up by about 2 points, the BOJ promised to achieve its 2 percent inflation target after excluding this tax-hike effect.
- In order to achieve the above inflation target, the BOJ would double the monetary base by the end of 2014.
The
consolidation of budget deficits requires that the contractionary effect of tax
hikes be offset by other policy instruments such as monetary policy. However, since
short-term interest rates are already close to zero, conventional monetary
policy tools are almost ineffective. The BOJ has been facing the zero lower
bound of the policy interest rate since the spring of 1999. As Japan faced
rapid disinflation in the mid-1990s, the BOJ tried to stimulate the economy by
cutting nominal short-term interest rates. Figure 3 shows
how it reduced the policy interest rate as the GDP deflator inflation rate
declined to zero and eventually turned negative in 1994.
Under
a zero lower bound constraint, even a massive open market purchase of long-term
government bonds is ineffective in halting deflation, unless it can somehow change
expectations regarding the future inflation rate. One possible instrument to raise
the public’s inflation expectations is the expansion of assets bought by the
BOJ through its trading desk. This policy has weakened the yen exchange rate
and driven up stock prices Table 1. An instrument that is effective under a
zero-interest rate regime is foreign exchange intervention. If the Japanese
government and/or the BOJ were to buy a large amount of foreign currency assets
in order to weaken the yen exchange rate against the US dollar and the Euro,
they can stimulate the net exports of Japanese industries.
Figure 5. Government
Investment (Nominal & real) Figure 6. Government Investment
(Deflator)
Source:
Japan
4. Growth Policy to overcome the
Deflation
Growth policy is an industrial policy through
deregulation as well as the Japanese central government has implemented in the
past. Deregulation on Japanese agricultural cooperative, TPP and revitalization
of local areas are targeted for the growth policy, but it has not been
clarified as a long term growth policy. The growth policy would be main policy
to improve the structural deflation in japan but the Abe government could not
clarify the long-term growth policy. Thus, the Japanese economy could not
escape from the long-term economic deflation. The Abe administration is
planning to raise it again from 8% to 10 % in 2017 and it will accelerate the
economic deflation more and it could negatively impact on the economy.
5. Income distribution to overcome the
deflation
After
the end of the bubble, nominal wage increases became very low, and they even
fell after the shock of the Asian crisis.
Only after 2005 did nominal wages stop falling. They have increased only very slightly since
then. Nominal unit labor costs are the
most important factor in the determination of price levels. Unit labor costs depend, on productivity
changes and on changes in nominal wages.
Trend productivity in Japan increased continuously even after the end of
the bubble. Taking nominal wage
development into account, it is no surprise that unit labour costs in the
second half of the 1990s started to decrease substantially in Japan as shown in
Figure4. The potential role of minimum
wages in preventing a deflationary development was not brought to bear in
Japan. During the deflationary periods,
the National Council, which recommends the annual changes, froze minimum
wages. The minimum wage was not used as
a mechanism to prevent the deflationary development, but it certainly
contributed to preventing the widening of the wage gap and was at least able to
protect the lowest-paid from any such widening.
Aggregate
demand-induced deflation raises unemployment when nominal wages are rigid downwards.
With sticky wages, price declines cause real wages to be risen, profit margins
to fall, and employment to be cut back. Because of wage rigidities, an economy
facing a demand shock would have to undergo a larger adjustment in output and employment
under deflation than it would under a comparable magnitude of inflation. Labor
market adjustment to deflation has been difficult in Japan owing to downward
wage rigidities. Figure 7 shows different measures of real wage developments
during the past decade. During the 1980s, real wages grew by about 15 percent
in an environment of economic growth and price stability. During the
post-bubble years, however, as growth slowed down and price pressures
dissipated, real wages did not adjust commensurately. Nominal wage rates have
begun to decline in the face of prolonged deflation, real wages are still at
about (or above) the levels prevailing at the peak of the bubble around 1990. The
relative inflexibility of wages has squeezed corporate profits, and may have
been partly reflected in rising unemployment. Of course, an increase in
unemployment in itself is not necessarily caused by deflation. However, to the
extent that deflation requires firms to make even larger nominal wage cuts than
they would have to under inflation (for a given real wage adjustment), it is
plausible that in the presence of wage rigidities, they would be more inclined
to lay off workers. The unemployment rate has risen markedly over the past ten years
in Japan as shown in figure 7, imposing a range of social and economic costs,
including rising real expenditures on safety net measures.
Figure
7. Different
measures of real wage developments
6. Possible solutions to overcome the
deflation
- To overcome the prolonged deflation and revitalize the Japanese economy is to:
- Target a primary budget surplus large enough to stabilize the debt ratio and set out a detailed and credible plan, including a timetable for tax hikes, to reach the target.
- Implement the planned hike in the consumption tax rate, while maintaining a single rate to avoid the distortions associated with multiple rates.
- Reform social security programmes, including hiking the pension eligibility age, to contain spending growth.
- Rely primarily on the consumption tax but also on other indirect taxes, such as environment-related levies, as well as the broadening of personal and corporate income tax bases, in order to boost government revenue.
- Implement the “quantitative and qualitative monetary easing” to achieve the new 2% inflation target as early as possible.
- Promote the consolidation of farmland to lower production costs.
- Increase female participation by reforming the tax and social security systems, encouraging better work-life balance, increasing the availability of affordable childcare and breaking down labor market dualism.
- Encourage greater use of flexible employment and wage systems, in part by abolishing mandatory retirement at age 60, to lengthen the careers of older workers.
- To break down labor market dualism by upgrading training programmes and increasing the social insurance coverage of non-regular workers and reducing effective employment protection for regular workers. Moreover, to enhance the redistributive power of tax and benefit systems by increasing the share of net benefits received by low-income persons, while providing training and incentives to leave assistance for those able to work.
7. Discussion
Controlling
expenditures, particularly for social security in the face of rapid population
ageing, is the key. Substantial tax increases will be needed as well, although
this will also have a negative impact on growth. The Bank of Japan’s new
commitment to a 2% inflation target and “quantitative and qualitative monetary
easing” is good. The planned doubling of the monetary base, through expanded
purchases of government bonds with longer maturities and private assets, is
aimed at achieving the inflation target in about two years. Aggressive monetary
easing will boost growth and inflation, in part through a weaker yen, although
Japan is not targeting the exchange rate. Boosting labor force participation
and productivity are essential. With the working-age population projected to
fall by 40% by 2050, measures are needed to make the most of Japan’s human
resources, including women, older persons and youth. The tax and social
security systems and inadequate childcare facilities create work disincentives
for secondary earners, primarily women. For older workers, mandatory retirement
at age 60 ends careers prematurely, especially as Japan has the highest life
expectancy in the world.
Fiscal consolidation may adversely
affect inequality and poverty. Both have risen in recent years, and the
redistributive powers of the tax and benefit systems are weak in Japan, while
the high share of low-paid, non-regular workers contributes to inequality. Labor
market dualism is driven in part by higher employment protection for regular
workers, encouraging firms to hire non-regular workers to enhance employment
flexibility, and by the lower labor cost of non-regular workers. Given the
declining working-age population, Japan has to impose higher and higher social
security taxes on workers. In order to partially compensate for its declining
population, a possible policy option for Japan is to implement an immigration
policy that would encourage educated foreign workers to migrate to Japan.
If
Japan’s economy thus does not suffer from supply-side ails, and an economy
stifled by over regulation then Shinzo Abe’s measures will be largely
fruitless. If the demand-side stimulus measures hit the economy fast, the
microeconomic reforms will be redundant. If however, implementation of the fiscal
and monetary attacks wavers, the microeconomic reforms could cripple the
situation and prolong the pain even further. The reality stabs policymakers in
the face every day. Japan’s problems are demand-side, failing to recognize this
jeopardizes the livelihood of millions of people.
8. Conclusion
In
conclusion, inflation and deflation are monetary phenomena. They depend upon
the way the central bank creates money. The BOJ can end deflation by raising
money growth. To do so, it would need to abandon its current policy of limiting
base money creation to the amount demanded by the public. Instead, it should
adopt an explicit target for the price level and a policy of monetary base
creation to achieve that target. In order to partially compensate for its
declining population, a possible policy option for Japan is to implement an
immigration policy that would encourage educated foreign workers to migrate to
Japan. The minimum wage was not used as a mechanism to prevent the deflationary
development, but it certainly contributed to preventing the widening of the
wage gap and was at least able to protect the lowest-paid from any such
widening. Higher profit shares on national income reflect the increased power
of the financial system and the firm sector in Japan which allowed a higher
profit mark-up. The more unequal income
distribution also added to the poor demand in domestic goods markets, together
with the deflation in goods and asset markets and the increase in the number of
people living in precarious working conditions. In order to survive, Japanese
businesses kept cost (and wage) increases to a bare minimum while paring back
on capital spending and also shifting the locus of manufacturing production to
emerging economies in Asia.
Myo Min Thein, 2016, International University of Japan
Myo Min Thein, 2016, International University of Japan
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