Correcting Robert Samuelson on Japan and Deflation

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Monday, 12 March 2012 04:21

Robert Samuelson rightly calls attention to the decision of Japan's central bank to target a 1.0 percent inflation rate, although he doesn't get a few of the key points right. First, this decision, if accurately described, will provide a huge test of an economic policy first proposed by Paul Krugman and later endorsed by Federal Reserve Board Chairman Ben Bernanke when he was still a professor at Princeton.

The question is whether by setting a higher inflation target, a central bank can bring about a set of self-fulfilling expectations that actually produce this higher rate of inflation. If Japan's central bank is actually committed to this policy, and it proves successful, it would have enormous implications for the conduct of monetary policy elsewhere.

For example, it would mean that if the United States wanted to run 3-4 percent inflation to reduce debt burdens and lower real interest rates, the Fed would have the power to bring this about [thanks JMiner]. That would make a huge difference for the pace of the recovery.

Samuelson gets some of the other aspects of this issue wrong. For example, he says that Japan's deflation is a problem in part because falling prices cause people to delay purchases since items will be cheaper in the future. This would be true for rapid rates of deflation, but Japan's deflation has almost always been less than 1.0 percent a year. In 2011 its inflation rate was -0.2 percent. This means that if someone was considering buying a $20,000 car, they could save $40 by waiting a year. It is unlikely that this rate of deflation affected the timing of many purchases to any significant extent.

The main problem with deflation is simply that the inflation rate is too low. In a weak economy it would be desirable to have a negative real interest rate, however nominal interest rates can't go below zero. (The real interest rate is equal to the nominal interest rate minus the inflation rate.) This means that the lower inflation rate, the higher the real interest rate. In this respect, a decline in the inflation rate from 0.5 percent to -0.5 percent is no worse than a decline in the inflation rate from 1.5 percent to 0.5 percent.

Samuelson also wrongly claims that a fall in the value of yen is one desired possible outcome from a higher rate of inflation since it would increase net exports. This does not follow. If prices in Japan rise by 1.0 percent and the value of the yen falls by 1.0 percent then the competitiveness of Japan's products will remain the same. Japan's competitiveness would only improve if the value of the currency fell by more than the rise in the inflation rate. (What actually matters is relative inflation rates, but this is the basic point.)

Finally, Samuelson includes some of his standard misplaced demographic warnings. He tells readers that Japan is suffering from a declining population. It is difficult to see this as a cause of suffering in Japan at the moment. Japan is a densely populated island where land is extremely expensive.

A decline in population will help to reduce this crowding, leading to higher living standards. Also, the problem of a declining population is supposed to be a shortage of workers. Japan does not have this problem as, by all accounts, it continues to suffer from an underemployed workforce.

Finally, Samuelson warns that Japan, like the United States, suffers from a severr debt problem. Samuelson notes that Japan's ratio of debt to GDP is well over 200 percent. This is more than twice as high as the projected debt to GDP ratio for the United States in a decade.

Japan can still borrow long-term in financial markets for around 1.0 percent. Its interest burden is around 1.5 percent of GDP. (The net burden is probably around half of this, since much of this interest is paid to Japan's central bank, which then refunds the money to the Treasury.) If there is a cautionary tale for the United States with Japan's debt, it is difficult to see what it is.