Simultaneous Deflation in East Asia

Faculty Fellow, RIETI

A friend of mine working for an international organization recently asked me the following question: "I know very well that deflation is continuing in Japan. However, Japan is not alone in suffering from deflation. Prices are falling at a similar or even greater pace in mainland China, Hong Kong, and Taiwan. In certain corners of Asia, or I should say in the economies that surround China and are more advanced than China, deflation is still going on. Is this just a coincidence? Or does this have anything to do with the rapid industrialization of China?"

He posed this question to me in the hope of getting some clues from Japan where deflation is a huge issue and thus, he thought, there must be active discussions on deflation in East Asia. Feeling a bit guilty about my inability to give a prompt answer, I fumbled for relevant reports and materials. But then I realized that my friend was completely wrong in his inference. What was wrong, however, was not the remark on deflation in East Asia, but his inference that the issue must be the subject of active debate in Japan.

Commonsense of Otemachi People vs. Commonsense of Scholars

There certainly exists the notion of trying to explain deflation in Japan by linking it to the industrialization of China. People holding this notion, however, do not have much authority. This impression of mine is based on the following observation. For those in the Otemachi business district in Tokyo, it is self-evident that prices in Japan are falling due to China; so obvious, in fact, that they would not even think twice about the matter. Thus, my friend's view is generally supported by those in the workplace.

A step outside the business districts, however, and there is a totally different world where the notion is no longer self-evident. Worse than that, the idea may be labeled as a, "businessman's misconception." Such a tendency seems to be especially strong in the Kasumigaseki administrative district in Tokyo, but the true ringleader behind it is economists. Business practitioners would rarely put their thought into writing. For economists, however, authoring ideas is part of their profession. Thus, bookstore shelves are dominated by the idea that Japan's deflation has nothing to do with China.

A typical assertion by economists is this: It is true that products mass-produced in China are falling in price. The industrialization of China explains the price fall of these products relative to the overall price level of other products. This, however, does not explain the fall of the overall price level. In other words, economists are contending that relative prices and overall prices are two different things.

If there are readers who are fully convinced by what they have read up to this point, they must be either genius or economics geek. Or it might be the case that they simply took it wrong. Ordinary people must have been puzzled. I should not be the only one who feels helpless in the economics corner of a bookstore.

It's an ill wind that blows nobody any good

Professor Milton Friedman, a famed monetarist, offers an easy-to-understand argument in this regard. Defying the idea that a sharp increase in import prices of crude oil and related products following the first oil crisis is responsible for overall prices, Friedman presented the following argument in Newsweek magazine in 1975:

A rise in the price of crude oil-related products certainly works to push up the overall level of prices. But this is a view derived by focusing only on a single aspect of the state of affairs. When imported products go up in prices, consumers would be left with less money to spend on other products. Therefore, demand for domestic products would decrease, subsequently bringing down the prices of these products. Since the price fall of domestic products offsets the price hikes in crude oil-related products, consumer prices - aggregation of imported and domestic product prices - would not fall.

If we focus on the beginning and end of the above explanation, we could draw the conclusion that a rise in the price of crude oil-related products cannot change the overall level of prices. Furthermore, if we replace the terms, "rise," and, "crude oil-related," in this sentence with, "fall," and, "China-related," respectively, the conclusion sounds identical to an assertion made by many Japanese economists that the ongoing deflation in Japan has nothing to do with China.

One of the important conclusions that can be derived from Professor Friedman's view is an assertion that both inflation and deflation are monetary phenomena. According to his argument, the scarcity of certain products should have no impact on the overall level of prices. Thus, the only factor that affects the overall price level is the scarcity of money. Thence, from here emerges an argument that all changes in the overall price level are caused by changes in the degree of scarcity of money. In recent debates on deflation, we have often heard it said that both inflation and deflation are monetary phenomena. Also, it is frequently argued that deflation continues because of an insufficient money supply. All of these arguments can be traced back to Professor Friedman.

Non-monetary factors of deflation

I wonder what reactions readers will have after reading Professor Friedman's view. Some people might have been impressed by the renowned economist's foresight. Indeed, only the brightest economists such as Professor Friedman could focus on the falling prices of other products at a time when everybody else was concerned about the rising prices of crude oil-related products. The value of the idea of general equilibrium in economics is that it enables us to notice what we fail to see in ordinary observations.

On the other hand, however, some people may feel a bit suspicious about Professor Friedman's theory, which they believe is saying that any price change is, "an ill wind that blows nobody any good"; that is to say, when certain products rise in price, other products will correspondingly fall in price. This might be true in theory, but reality reveals deviation from this.

I am among those suspicious about Professor Friedman's theory. Would the prices of products unrelated to crude oil actually fall? This question prompted me to start studying the issue together with Kaoru Hosono, associate professor at Gakushuin University.

After closely analyzing data on six economies - Japan, the United States, Britain, South Korea, Hong Kong and Taiwan - we concluded that a change in the prices of certain products does not prompt an offsetting change in the prices of other products. More precisely, a change in relative prices, in accordance with changes in technologies and peoples' tastes, produces at least a short-term impact on the overall level of prices. Both the industrialization of China and the advance of information technology have affected the overall level of prices.

An entry-level economics textbook I happen to have to hand says that an excessive money supply causes inflation, and an insufficient money supply causes deflation. Our analysis results contradict this.

It may be needless to say so, but when a phenomenon that contradicts a textbook is observed, we should not doubt the phenomenon but the textbook.

May 20, 2003

May 20, 2003