Paradox of Calls for Inflation

As deflation continues, there have been growing calls for inflation among politicians, business people and economists. In this article, I would like to examine, from a critical point of view, the following two questions concerning deflation, especially focusing on the second one:

(1) Is deflation causing economic stagnation such as shrinking consumption and growing unemployment?
(2) Can the Bank of Japan pull Japan out deflation and generate inflation alone with its monetary polices?

Concerning the first question, Mr. Kazuo Mizuno, chief economist at Kokusai Securities Co., has compiled an interesting data. It shows that real consumption is rising in many sectors whose products are falling in prices, while only few suffer a decline both in real consumption and product prices. Mr. Mizuno further points out that sectors with a sharper drop in product prices tend to enjoy an increase in profits whereas those with increasing product prices suffer decreasing profits.

This may stand evidence that deflation is not a cause of shrinking demand (a decrease in corporate profits and shrinking consumption) (Note 1). On the other hand, however, there seems to be certain logic behind the argument that the proceeding of deflation increases real burden of indebtedness, thus, deteriorates economy. Why do we have these two contradicting arguments? This is because of the mixing up of the "deflation of general prices" and the "deflation of asset prices."

At present, those saddled with excessive debt burdens -whether companies or individuals - are cutting down on expenditures, contributing to the deterioration of economy. But this does not mean that excessively indebted companies are coming under the increasing burden because their profits decrease due to the "deflation of general prices" (a fall in their product prices). Rather, their debt burden is swelling because of their wrecked balance sheet, a result of the "deflation of asset prices" (a plunge in land and stock prices). In other word, the principal cause of the deterioration of real economy is the asset deflation rather than the general deflation.

So, it is clear that stopping the asset deflation (boosting land and stock prices) is an effective means of propping up economy. This is nothing new but what Japanese people have been yearning for since ever the burst of the economic bubble. However, we have yet to see any effective policy capable of inducing a sustainable rise in land and stock prices, as we all know from our experience of the decade following the bubble burst.

Then, there emerged calls for measures to boost general prices to indirectly stimulate asset prices, a substitute policy in the absence of means to directly control asset prices. This is the logic behind the ongoing argument yearning for inflation.

The ongoing debates concerning inflation in Japan stand on a tacit but significant premise that changing the Bank of Japan's monetary policy is enough to generate inflation. For instance, behind the growing calls in the past several years on the BOJ to take pro-inflationary measures lies the idea that the monetary policy must do something to lift economy now that Japan can neither afford nor expect much effect from fiscal measures. The tacit preposition is that inflation can be induced by the BOJ's monetary policies without increasing the government's fiscal expenditures.

Is this preposition valid? To put the conclusion first, the answer is no. Expanding the government's fiscal expenditures (reduction of fiscal leeway) is also necessary to generate inflation. (Note 2)

To begin with, why is it perceived that increasing money supply by the BOJ will lead to inflation? Concerning the whole Japanese economy, the following equation concerning money quantity applies:

PY = MV

P stands for price level, Y real GDP, M money supply, and V money velocity, a rate at which money supplied by the BOJ - by way of the banking sector - penetrate to the every corner of the economy. In this equation, if Y and V are constant, an increase in M (money supply) raises P (price level). In today's Japan, we see a syndrome in which the more M (money) the BOJ supplies, the further V (money velocity) goes down. But for the moment, we ignore this and assume that an increase in M generates inflation (increase in P). (Note 3)

This is the reason behind why some people say that inflation can be generated only if the BOJ does what it needs to do. But we still don't know whether fiscal policy is completely irrelevant to inflation. To find this out, let's think about the following equation concerning a government budget:

B = Ps

B stands for the outstanding balance of government debts at present, while P and s respectively show price level and expected net fiscal surplus both in the future. This equation simply shows that the present government liability (fixed at a nominal price) will be redeemed by nominal budget surplus in the future (Ps).

In this equation, B (government's debt balance as of today) does not change. Thus, when P (future price level) goes up, s (expected net government surplus) goes down. That is, should inflation take place, net budget surplus would have to be reduced. This kind of approach to analyses the movement of price levels using budget equations is called "fiscal theory of price level."

Various patterns can be assumed as to how inflation relates with a decrease in budget surplus. For instance, the government may not have to increase budget surplus because inflation reduces its effective debt burden. Or it may be the case that the continuation of the government's lax fiscal policy and subsequent shrinking of budget surplus may generate inflation. What is certain, however, is that the government cannot continue austere fiscal policy if it wants to generate inflation.

This means that those calling for pro-inflationary policies cannot be fulfilled in their desire to have economy propped up by the BOJ's monetary policy in place of the government's fiscal policy, which they believe have now come to its limit. This is because the government inevitably has to shift to expansionary fiscal policy if it wants to generate inflation. It is thus highly questionable that the government can stimulate economy without increasing fiscal burden. And provided this, the merit of argument urging for pro-inflationary policy would be halved.

To generate inflation, it is necessary to reduce net budget surplus (expansion of fiscal expenditures). But how should we reduce net budget surplus? Conventional public works projects would have a small multiplier effect and provide only a temporary support for the economy. Furthermore, continued expenditures on conventional public works projects would allow for prolonging the life of inefficient, and otherwise invalid companies, resulting in a further delay in structural adjustment and constraining Japan growth potential over a long period of time.

In this respect, a study on the 1997 Asian currency crisis (Note 4) may provide a good hint. Prior to a drastic fall of local currencies in Thailand and South Korea, market players had come to hold a shared view that massive state fiscal expenditures would become necessary for the disposal of bad loans held by local banks. Local currencies were quite stable when market players were unaware the need of massive government fund for the disposal of banks' bad loans. When they came to recognize the scale of amount necessary to solve the problem, however, expectation for inflation and the fall of the local currencies instantly spread. These phenomena can be described by the following two equations:

B = Ps ------------ (a)
B + D = P's ----- (b)

B is the outstanding balance of government liability, P price level, s net budget surplus. Before potential government expenditures for bad loan disposal surfaced, the government's budget equation was (a). But then, it became clear that additional state expenditures (D) would be necessary to save the financial system, meaning that the government's equation suddenly shift to (b). If B and s are constant, the price level must sharply rise from P to P'. This way, inflation broke out and the local currency plunged.

The lesson that can be derived from this is that inflation (PP') occurred when the amount of fiscal costs (D) necessary for disposing of bad loans and stabilizing the financial system became clear. With D, I do not simply mean public fund in narrow sense such as fund that needs to be injected into commercial banks to rev up their capital base. D includes fiscal costs in much broader sense that includes potential expenditures, for instance, on safety net to cope with rising unemployment such as the increasing payment of unemployment allowances. Here, it must be noted that D is not a new increase in fiscal expenditures but a deficit that already exists and is necessary to solve the banking problem. Because the problem had been hidden, both the government and market had been holding a wrong recognition as described by (a), and then, the equation shifted to (b) when their recognition was corrected. That is, D has been always out there as implicit fiscal burden. And now, it has simply become explicit.

Here, we hit a paradox as I predicted in the title for this article. One of the promising policy options for generating inflation is to clarify the scale of fiscal expenditures required to solve the bad loan problem and stabilize the banking system, then, quickly establish a (b)-type government budget equation. In this context, accelerating bad loan disposals can be defined as a counter-deflationary measure.

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