The Japanese deflation myth

Unlike the rest of the world, Japan has been a special case for the last couple of decades and has experienced more or less stable prices. This section looks at the story in more detail and examines what implications it might have for prices elsewhere in the world. It shows that the tale of woe frequently told about Japan’s deflation is missing a few key details.

Japan’s economy has not grown significantly. However this ignores the fact Japan has a declining workforce and an ageing population, both of which depress consumption and GDP. In addition, Japan has not actually experienced much deflation. This section highlights alternative explanations for the lower prices seen in Japan and in particular the impact of the historical strength of the Yen.

The 1980s financial bubble

Post World War II, the US poured money into countries like Japan to ensure they became economically sound and depended on world trade in order to resist the onslaught of communism.  Japan became the world’s centre for producing tech goods and during the 1980s was regarded as one of the most successful countries in the world.

During the 1980s, money supply was allowed to grow sharply in Japan (around 8-11 per cent in most years). In addition, the Bank of Japan slashed interest rates to 2.5 per cent in 1987 in order to try to stem the appreciation of the Yen. Not only did it fail to do that, it helped stoke the already growing bubble in asset prices as speculators took advantage of the low interest rates to borrow and invest in property and shares. From 1984, the Nikkei almost quadrupled in value in the space of five years.

Japan bubble

Sources: Nikkei and Japan Real Estate Institute (nationwide urban land prices).

Finally at the end of December 1989, the Bank of Japan raised interest rates to 4.25 per cent. Within days the Nikkei peaked at its record high of 38,957. Within a year it had nearly halved. Over the coming years it continued to decline and it reached lows of just above 7,000 in both 2003 and again later in that decade. House prices also peaked in the early 1990s and have since been in decline for nearly two and a half decades.

The aftermath of the bubble

There has been much discussion about the response of the Japanese government to the bubble bursting. Initially it allowed many financial companies to ignore their losses and indeed to carry on lending. However, eventually, bank collapses ensued and the government nationalised those banks.  Companies followed a policy of paying back their debts, as did consumers.

The net effect of all this was a marked contraction of the economy. GDP growth stagnated within a few years. The revival of 1995 was hit by the effects of the Asian financial crisis of 1997 that finally forced Japan into recession in 1998. However for much of the mid-noughties Japan grew by around 2 per cent a year until the Great Recession hit.

Nearly all historical reporting now focuses on “the lost decades” and blames deflation as one of the main causes. For example, as I write, deflation is back on the front cover of The Economist magazine. Their lead article highlights the “struggling” Japanese economy and how it fell into “deflation with unpleasant… consequences for both itself and the world economy.” (Source: The Economist, “The world’s biggest problem: Deflation in the euro zone is all too close and dangerous“, 25 October 2014).

A key part of the argument is that when deflation took hold in Japan people stopped buying goods and awaited cheaper prices and that this caused the economy to falter.  The BBC website’s article about “Japan’s economic battle with deflation” is similar to most others. It claims: “deflation gripped the economy – and its effect filtered through all sectors of society affecting all parts of life… As corporations went through the vicious deflationary cycle of falling prices, declining sales and, subsequently, plunging profits; they were forced to make lay-offs and pay cuts.

The evidence however does not back this up and suggests the story is more complex.

What deflation?

A key part of the above argument centres around the deflation that Japan has suffered during the lost decades. The following chart shows the Japanese prices index since the bubble burst in late 1989. Far from showing deflation, it shows that prices actually carried on rising for five years until 1994, during which time they rose by 10 per cent. In the last 20 years there have been dips but no overall deflation, with prices now almost higher in Japan than they were before.

Japan prices

Source:  IMF Database. Annual data. 2014 data refers to September.

Perhaps a better description of Japanese prices during the latter part of the lost decades is that they were largely stable. In years when they went down, the declines were all less than 1 per cent a year, with the exception of 2009 when they declined by 1.4 percent. (But remember, in 2009 worldwide prices declined due to the recession – e.g. UK RPI was down 0.5 per cent.)

It seems unlikely that such small price changes would have caused the Japanese consumer to delay purchasing products. Instead what did significantly affect Japanese retail sales were increases in sales taxes such as the hikes in 1997 and 2014.

The myth of the lost decade

The other part of the argument often cited about Japan’s deflation is that it caused wages to decline. Undoubtedly the country went through tough economic times due to the recession resulting from the asset bubble. This caused structural changes in the jobs market; for instance more Japanese were employed on short-term contracts. This resulted in slightly lower actual average wages during the first part of the noughties. At the same time however, this was the time when prices edged lower temporarily. Therefore the net effect on wages after inflation was again negligible—see chart below. A better description of average Japanese wages was that in terms of purchasing power, they were largely stable after the crisis.

Japan wages

Source: OECD Stat Export. Wages at 2013 constant prices.

However, the main criticism of the Japanese economy has been that its economy has declined because of the deflation. A recent economics article in The Guardian said:  “Japan, a country gripped by deflation, which over the past two decades has struggled with stagnant growth…” Again the answer is more complex than this superficial comment implies.

In absolute terms the GDP in Japan in 2013 was almost the same as in 1991, very much supporting the notion of lost decades of economic growth. However this ignores a key characteristic of the Japanese economy: its ageing and declining workforce. GDP is the sum of things produced in an economy. If there are less people working, GDP will be lower. Over the last 15 years the Japanese labour force has declined over 3 per cent. In contrast, the workforces of most other developed countries have continued to increase. Over the same period, the US workforce grew by 13 per cent and that of the UK by 14 per cent.

When you fully take the declining workforce into account and instead examine GDP per worker, you end up with a very different story about Japan. As the chart below shows, this measure shows a GDP increase of 20 per cent in Japan, a figure that outstrips most major European countries such as Germany, France, Italy and Spain.  Only in the UK and the US did apparent output increase more*.  Moreover, in absolute terms at Purchasing Power Parity, the level of output of Japanese workers seems very similar to that of other developed countries, the US being an exception.

Japan GDP

Source:  OCED Stat extracts.  Data shows GDP at constant prices, constant PPPs divided by total civilian labour force.

The impact of the demographics

Another factor rarely considered when interpreting events in Japan is the true impact of demographics on purchasing. It has an impact on production and GDP as noted above, but it also has a major impact on consumption. The decline in consumption in Japan has been significantly influenced by demographics.

Births peaked in Japan after the war and to a lesser extent during the 1960s Baby Boomer period. By 1990 however the birth rate had declined to a half that of the 1970 level. In 2014, only 1.4 babies were being born for every woman. The falling birth rate is causing the population to decline and has already reduced the number of workers in the population as the post-war boomers move into older age. The average age of a Japanese citizen was 46 in 2012. This was higher than any other country in the world and had increased from just 38 when the bubble burst in 1990.

Ageing Japan

Sources: Nikkei Research Institute of Industry and Markets and CIA World Factbook.

The average age matters, because consumption in the economy is strongly correlated with age. Research in many countries has shown that around 46 is the peak age for consumption for an individual, being the age when the demands of supporting children are at their greatest. Consumption changes as people get older and eventually becomes focused on basic commodities and healthcare. However the net effect is that total spending steadily declines with age. (See chart here).

The increasing average age of Japanese citizens since the crisis will also have had an impact and must have in part contributed to decline in consumption levels. Given this, it is actually somewhat surprising that GDP has not declined more during the period.

So the story of Japan is not as simple as portrayed in the media. Not only has the Japanese economy performed predictably for one with a declining workforce and ageing population, but it has not actually experienced much deflation, merely a period of more stable prices. Admittedly government debt has increased significantly in Japan but it is debatable whether its economy has really suffered lost decades as often depicted.

Why prices have stabilised in Japan

One is still left with the question of why price rises remained so low in Japan and inflation did not return despite all the best efforts of the Japanese government to increase it by printing money over the last decade. Indeed it could be argued that there should be substantial latent inflation built into the system following the attempts to expand the money supply.

The answer probably lies in something unique about the Japanese currency and perceptions of the government’s economic control. Despite the evident woes with the economy, the Japanese Yen has continued to be perceived as a safe-haven currency – that is one that people park their assets in during times of turmoil. Unlike most other developed countries, it has run a balance of payments surplus for decades, and hence owns many assets abroad. This has caused the Yen to continue to appreciate against virtually all other currencies since the Bretton Woods currency agreement broke down in the early 1970s.

Yen exchange rate

Source: Bank of England

This has had a major impact on inflation rates in Japan, as over time the cost of key imports has declined.  This effect appears so great that it is likely that this has contributed more than anything else to the lower level of price rises in Japan versus other economies.

The chart below shows the inflation rate in Japan and compares it to the average for other G7 developed countries (+ China). The results are striking, particularly for the period before the asset crisis struck. Japan had an inflation rate about 4 per cent less than the rest of the developed world before its crisis struck. It even experienced deflation two years before it in 1987.

Lower Japanese inflation

Source: IMF World Economic Outlook Database, April 2014

An alternative explanation for the reasons for Japanese deflation (or more correctly, stable prices) is that this differential continued as the Yen has carried on appreciating. Worldwide prices declined markedly in the 1990s, partly as a result of central bankers’ actions and partly due to deflation being created by China’s cheap exports. Therefore, assuming the differential of 4 per cent less inflation in Japan after the crisis, it was forced towards near-zero inflation rates as world inflation rates came down.

A key implication of this is that prices probably declined in Japan not because of the effects of the crisis, but more because of the continued appreciation of the Yen and the flood of very cheap imports from China. The logical response of the consumer to such cheap prices (and the resulting proliferation of 100-yen shops) was probably not as portrayed in the media i.e. a decline in consumption. They just bought more cheaper goods, the sum total of which may have been the same as it was before, so that GDP didn’t change.

* Some have argued that the UK and US growth figures only appear higher due to the manipulation of their GDP deflator statistics.