November 11, 2002
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 of deflation and generate inflation alone with its monetary polices?
Concerning the first question, Mr. Kazuo Mizuno, chief economist at Kokusai Securities Co., has compiled 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 as evidence that deflation is not a cause of shrinking demand (a decrease in corporate profits and shrinking consumption). At the same time, we intuitively accept that deflation increases the real burden of indebtedness, thus, deteriorating the economy. Why do we have these two contradicting arguments? This is because people mistake deflation of general prices with deflation of asset prices.
At present, those saddled with excessive debt burdens - both companies and individuals - are cutting down on expenditures, contributing to the deterioration of the economy. But this does not mean that excessively indebted companies are burdened by a drop in profits due to a deflation of general prices (a fall in their product prices). Rather, their debt burden is swelling because of bad balance sheets, a result of the deflation of asset prices (a plunge in land and stock prices). In other words, the principal cause of the deterioration of real economy is the asset deflation rather than the general deflation.
Halting asset deflation (boosting land and stock prices) is an effective means of propping up economy. This is only what Japanese people have been yearning for since the burst of the economic bubble. But 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 burst of the bubble.
Calls have been growing louder for measures to boost general prices to indirectly stimulate asset prices, a substitute policy in the absence of a means to directly control asset prices. This is the logic behind the argument that favors inflationary policy. But can monetary policy alone generate inflation?
The ongoing debate concerning inflation in Japan stands 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 for the BOJ to take inflationary measures lies the idea that monetary policy must do something to lift the 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 assumption valid? The answer is no. A new economic theory, Fiscal Theory of Price Level says that expanding the government's fiscal expenditures is also necessary to generate inflation. (See Box 1 for details)
Several patterns can be assumed as to how inflation relates to fiscal policy. For instance, the government may not have to increase its 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 the economy cannot be propped up by the BOJ's monetary policy in place of expansionary fiscal policy. 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 its fiscal burden. And provided this, the merit of the argument urging an inflationary policy would be halved.
What kind of fiscal policy would induce inflation?
To generate inflation, it is necessary to expand fiscal expenditures. But how should this be done? Conventional public works projects would have a small multiplier effect and provide only temporary support for the economy. Furthermore, continued expenditures on conventional public works projects would allow for prolonging the life of inefficient 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 may provide a hint. Prior to a drastic fall of local currencies in Thailand and South Korea, market players came to share the 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 of the need for massive government funds for the disposal of bad loans. When they came to recognize the amount necessary to solve the problem, however, expectations for inflation and the fall of the local currencies instantly spread. (See Box 2 for details)
The lesson that can be derived from this is that inflation occurred when the amount of fiscal costs necessary for disposing of bad loans and stabilizing the financial system became clear to market participants. By fiscal costs, I do not simply mean public funds in the narrow sense, such as funds that need to be injected into commercial banks to rev up their capital base. Rather fiscal costs are to be understood in a much broader sense, one that includes potential expenditures, for instance, on a social safety net to cope with rising unemployment such as the increasing payment of unemployment allowances.
Here, we hit a paradox as I predicted in the title for this article. If you want inflation, you must first dispose of the bad loans. 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. In this context, accelerating bad loan disposals can be defined as an anti-deflationary measure.
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* BOX1:
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).
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.
* BOX2:
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.
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Author, Keiichiro Kobayashi
Fellow
Research Institute of Economy, Trade and Industry (RIETI)
Editor-in-Chief, Ichiro Araki
Director of Research
Research Institute of Economy, Trade and Industry (RIETI)
e-mail: araki-ichiro@rieti.go.jp
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The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).
