On the Way to Understanding the Cause of Long-term Deflation

Faculty Fellow, RIETI

Why has deflation persisted for so long in Japan? Although a variety of theories are presented even today, controversy remains as existing theories have left many puzzles unexplained.

For example, one theory suggests that deflationary expectations are self-fulfilling. This is based on the view that if prices are expected to continue to decline in the future, consumer goods will not sell and investment will be postponed, thus prices in reality do fall. Yet it is difficult to explain the deflation that has persisted for more than a decade with this theory.

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One of the formative conditions for long-term deflation is the expectation that the money supply will decrease in the future. If the money supply decreases, the value of goods and services will decline comparatively with the value of money, which will cause deflation. This is classic 19th century deflation. However, given that the Bank of Japan is able to increase the money supply freely and has actually been doing so, with few exceptions, it is difficult to imagine that there was such an expectation.

A study conducted in 2002 by New York University Professor Jess Benhabib, Columbia University Professor Stephanie Schmitt-Grohe, et al. strictly theorized the theory of deflationary expectations and showed that long-term deflation could occur in an environment of zero interest rates. However, this paper also states that the quantity of money (public debt in the original paper) will continue to decline. In other words, the essence of this theory is the same as the theories dealing with the classical deflation.

When it comes to deflation in Japan, a paper written in 1998 by Princeton University Professor Paul Krugman is well known. Krugman argued that Japan would be able to break away from deflation even under a zero interest rate environment if the country can create expectations that the inflation rate will rise in the future. He believes that deflation was caused by a lack of demand due to a temporary shock. Although the gap between demand and supply will disappear if a sufficient reduction of interest rates is possible, the imbalance will not be eliminated if the shock is too big, as it is impossible to lower the policy interest rate below zero.

A 2003 paper written by Brown University Associate Professor Gauti Eggertsson and Columbia University Professor Michael Woodford, and a 2005 paper by the University of California, Berkeley professors Alan Auerbach and Maurice Obstfeld basically share the same theoretical structure.

The common theme among these papers is the hypothesis that the economy will normalize at some point in the future, independent of policies, thereby ending zero interest rates. Deflation is regarded as a short-term phenomenon, and if the inflation rate is certain to rise after zero interest rates are ended, this will pay off even in the current environment of zero interest rates. However, applying their theories to deflation lasting for more than 10 years is difficult, and it is unclear whether their prescription is effective.

A 2011 paper written by New York University Professor Mark Gertler and Peter Karadi of the European Central Bank, and a 2010 paper written by Gertler and Princeton University Professor Nobuhiro Kiyotaki analyze unconventional monetary policies in Europe and the United States. These papers have modeled a large-scale easing of credit, for instance, by purchasing assets as a policy in which the central bank can lend money directly to companies when banks have lost their lending ability for some reason.

According to their theories, unconventional monetary policies in the United States were effective because the central bank complemented the functions of the financial sector as it became temporarily dysfunctional. Vasco Cúrdia of the Federal Reserve Bank of San Francisco and Professor Woodford conducted a similar analysis.

However, it is difficult to say that the banking sector in Japan has become dysfunctional after the mid-2000s. If monetary easing is to expand the economy in present Japan, it is necessary to explain it with a mechanism different from the effect of unconventional monetary easing in the United States.

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So what is the cause of long-term deflation? Let's discuss it using the Fisher equation, which explains market interest rates from the relationship of nominal interest rates, real interest rates, and expected inflation rates (see Figure). The expected inflation rate will come into line with the actual inflation rate over the long term. Also, expectations about the inflation rate reflect long-term policies. These presumptions lead to the conclusion that if the zero interest rate policy persists over a long period, long-term deflation will be generated.

Figure: Fisher equationFigure: Fisher equation

This can be explained as follows: As the long-term real interest rate reflects the real economic growth rate, the former should be positive. On the other hand, the nominal interest rate will remain zero because of the zero interest rate policy. The inflation rate will then become negative, given the Fisher equation of "nominal inflation rate (zero) - real interest rate (positive)." If a policy of maintaining the nominal interest rate at zero is expected to continue over the long term, the expected inflation rate in the future will also become negative, and deflation will actually persist.

However, this logic faces the same problem as did the existing theory of deflationary expectations, namely, why deflationary expectations can persist even if the money supply increases, as deflationary expectations should continue if the money supply decreases.

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The point is the expectations about the fiscal management of the government and not about the monetary policy of the central bank.

In fact, money is simply government debt, which is the same as government bonds. A fall in prices over the long term means that the value of money continues to rise relative to goods and services. Meanwhile, money, which is simply a piece of paper, possesses value because the government guarantees its value. Therefore, the credibility of money is supported by the solvency of the government, or its ability to collect taxes. In this sense, government bonds and money have the same nature.

If the total value of money (the government debt) issued continues to increase with deflation, a tax hike will be necessary in the future to support that value. If many people think that "fiscal management will be conducted appropriately, causing no problems for the foreseeable future, even if the zero interest rate policy, which will increase the value of money, continues," this is in fact the same as expecting a tax hike in the future.

This hypothesis is similar to a concern often pointed out about the public finances of Japan. As the government debt has swollen to more than twice the level of the gross domestic product (GDP), it is generally regarded that a significant tax hike will be necessary for fiscal reconstruction.

For example, Gary Hansen, a professor at the University of California, Los Angeles, and Selahattin Imrohoroglu, a professor at the University of Southern California, estimate in their study in 2012 (unpublished) that Japan will need to raise the consumption tax rate to 35% to reduce its public debt to 60% of GDP over the long term.

On the other hand, a phenomenon derived from the Fisher equation that zero interest rates will give rise to expectations of a future tax hike is a mechanism in which public finances will have to pay for monetary policy. This is different from expectations of a tax hike arising from fiscal uncertainty. In any case, it is conceivable that if confidence in public finances breaks down, sharp inflation will arise theoretically.

If the prolonged zero interest rate policy itself leads to deflation, what policy implications can we draw?

First, to boost economic growth, raising the potential of the economy itself is necessary, and monetary easing may not necessarily be the appropriate means to achieve this. Instead, restructuring the capital markets, etc. is necessary such that the money the Bank of Japan supplies to financial institutions will be lent out to companies and spur the growth of new industries.

There is also concern that, if people believe the nominal interest rate will remain at zero into the future, a policy of working on expectations with the aim of breaking away from deflation may give rise to deflationary expectations that are contrary to the aim. The government needs to allow people to believe firmly that the nominal interest rate will become moderately positive in the future, while taking steps to stabilize public finances. There may well be limitations to the effort to manipulate expectations solely with the monetary policy of the Bank of Japan.

>> Original text in Japanese

* Translated by RIETI.

June 17, 2013 Nihon Keizai Shimbun

July 23, 2013

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