Page last updated at 23:26 GMT, Monday, 23 March 2009

Japan's economic battle with deflation

By Dr Seijiro Takeshita
Director, Mizuho International

Ginza district of Tokyo
The main Ginza shopping district in Tokyo saw prices fall

To the man on the street, deflation does not seem like a bad thing - prices are falling, so what can be so bad?

However Japan has been through the experience of deflation, in the late 1990s, and has a different tale to tell.

It came after the country had first gone through a banking crisis meltdown, when the government had to take unprecedented measures in what was then "the field of the unknown".

Then, just when it seemed the worst was over, at the end of the decade deflation gripped the economy - and its effect filtered through all sectors of society affecting all parts of life.

In the early stages of deflation in Japan, "cheap chic" (or offal pot) became the fad on the restaurant scene.

Price cuts

McDonald's had lowered the price of a burger to 59 yen (about 39 pence or 47 US cents) by 2002.

Of course, other fast foods like Yoshinoya - specializing in Japanese beef bowls - fought back fiercely, which resulted in the phenomenon of price destruction where companies cut prices so much that they went into meltdown.

Homeless man in Japan
Deflation is only welcome if you have a job and security

Meanwhile 100-yen shops - the equivalent of a pound shop, but with much more variety and surprisingly good quality goods - flourished.

At the beginning of deflation, I could even sense the optimism, and many were actually enjoying it.

However, this was like a cheery toast at midnight before a very bad hangover the next morning.

Deflation is a good thing, provided that one still has a stable income and a job.

Worsening cycle

As corporations went through the vicious deflationary cycle of falling prices, declining sales and, subsequently, plunging profits; they were forced to make lay-offs and pay cuts.

Many firms also outsourced to make full use of cheaper overseas labour, which in turn exacerbated unemployment.

The reason why economists... worry about deflation is because it's much harder to combat than inflation
Economist Graham Turner

This cycle resulted in an unprecedented jump in the jobless rate - from around 2% in the early 1990s to above 5% by the beginning of the new millennium.

Many corporations could also no longer handle the burden of a traditional life-long employment and seniority system.

"Kata tataki" - which means tap on the shoulder, or encouragement of early retirement - became a frequent occurrence in the Japanese corporate arena, and the number of part-time workers surged.

In such circumstances, not only did incomes drop, but consumers cut back on their spending as they locked themselves into a tight self-defending mode.

Job losses

Thus, the vicious cycle was kicking in on an individual level as well.

Things were getting nasty, as in Japan losing a job has serious social consequences.

In the case of deflation, other problems may spread through the system - consumers can stop spending, investment can grind to a halt and in turn unemployment will rise - spiralling almost out of control.

It is the only country where one can track a positive correlation between the jobless rate and suicide rate. This was most evident amongst the middle-aged men.

While job rigidity and ageism throughout the system played their part, a society that is unforgiving of failure led to rising numbers of suicides.

In 1998, there were 30,000 suicides and a decade later the figure has yet to simmer down.

As the decade was coming to an end everyone was desperately looking for an antidote to deflation.

Intervention

Japanese authorities went as far as dropping interest rates to virtually zero for some time, but its infamous zero interest rate policy is known to have had little effect to boost the economy during the long lost decade of the 1990s in Japan.

This is because, however low the nominal rates were, the real interest rate in Japan remained high as a result of deflation.

Shop in Tokyo's Harajuku shopping district
Deflation can cause consumers to stop spending

Unless deflation stops, the real interest rate remains high or even creeps up, regardless of economic growth.

As the real interest rate remained high, companies lacked the appetite for capital expenditure and investment and cut back on spending too.

In fact in some ways, deflation is like diabetes. Just like diabetes, deflation induces other complications and makes it worse.

Increasing woes

In the case of deflation, other problems may spread through the system - consumers can stop spending, investment can grind to a halt and in turn unemployment will rise - spiralling almost out of control.

So when a country gets trapped in deflation it is very difficult to get out.

In the end, financial policies like quantitative easing seemed to have helped drag the country out of its deflationary spiral, despite many people viewing the move as too little too late.

Moreover, weakening of the yen caused by these financial policies gave life back to the export sector in Japan.

So after much pain, Japan seemed to be out of deflation - only to be welcomed by the world wide economic storm created by another overconfidence and arrogance, this time from the other side of the Pacific.



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