|The massive recession - a full-blown deflation
|Arresting Deflation / Deflationary risks not to be underestimated
The following is the third of a seven-part series containing The Yomiuri Shimbun's emergency recommendations on how to deal with deflation.
Break the vicious circle of psychological
unrest and economic deterioration
-- Prevent deflation as a top priority
-- Introduce a system to set a target inflation rate
Deflation is a menacing monster that has the capacity to ruin the lives of citizens. The Japanese economy is on the verge of falling into a deflationary spiral.
Under such circumstances, the values of people's assets, such as real estate and shares, along with the prices of commodities plunge in tandem with a recession.
What makes a deflationary spiral a condition to avert is the likelihood that once an economy is embroiled in such a spiral, it cannot easily escape from it.
There is a bitter historical lesson from which we can learn about the risks of a deflationary spiral.
Both the Great Depression of 1929 to 1931, a global crisis that started in the United States, and Japan's Showa-era depression, which occurred as part of a global crisis, constitute one of the factors that gave rise to World War II. This is because the nations affected by the deflationary spiral could not come up with any effective countermeasures against the crisis.
However, the government and the Bank of Japan have until recently been extremely ignorant of the possibility of suffering another deflationary crisis.
The main issue shared by the world economy since the end of the war--including Japan's high economic growth period--has long been "how to deal with inflation."
The government and the central bank have long devised economic and financial policies with a view to prevent inflation, while the government and the central bank, businesses and labor unions all have accumulated know-how for countering inflation.
Nonetheless, all those concerned are vulnerable to deflation, the effect of which is far more devastating than that of inflation.
However, the world economy has totally changed since the end of the Cold War, which was touched off by the collapse of the Berlin Wall in 1989.
At the global level, the market-economy bloc, with a market of 1.5 billion consumers, has since been flooded with a 2.5 billion-strong cheap labor force from the former communist-bloc countries and Asia.
As a result, the market economies in question have been burdened with a huge pressure driving down prices.
To make matters worse, the Japanese economy has been dealt a further blow by a massive recession caused by the bursting of the economic bubble.
This is the foremost factor explaining why Japan is the first major industrialized nation since the end of the war to face the danger of full-blown deflation.
In a deflationary spiral, sales made by businesses and individual incomes do not increase while financial burdens in real terms, such as debts borne by businesses and housing loans, grow larger. In addition, the liquidation of non-performing loans by financial institutions does not proceed smoothly.
This creates a sense of gridlock that permeates throughout society, lowering stock prices and adversely affecting economic fundamentals, creating a vicious cycle.
Those in domestic economic circles have lamented over the worsening situation.
"If the nominal growth rate remains minus as it is now, the amount of banks' financing won't expand," a senior official of a major commercial bank said.
The domestic economy is caught in a vicious circle in which actual interest rates remain high and capital spending by businesses hardly increases.
The central bank decided to halt its policy of keeping interest rates effectively at zero in August. Prior to that, its Gov. Masaru Hayami said that he believed the fear of deflation had been eliminated, indicating that the most important condition for halting the zero-interest-rate policy had been fulfilled.
Since Hayami's decision, the deflationary trend has rapidly strengthened, forcing Hayami to revise fiscal policy.
"Nothing but fiscal policy can stop falling prices," said Koichi Hamada, director of the Economic and Social Research Institute at the Cabinet Office.
Fiscal policy to deal with the first case of deflation in a developed country since the end of World War II will have to be completely different from that designed to deal with inflation.
Paul Krugman, professor at Princeton University and a hopeful candidate for the Nobel Prize in Economics, has suggested that the central bank should set the target inflation rate at around 4 percent. By this he meant that the central bank should quickly decide on a target inflation rate and then carry out a fiscal policy based on that target.
Needless to say, the central bank must try its utmost to prevent the Japanese economy from being dragged further into a dangerous negative cycle. The bank should adopt every possible measure to achieve this, such as spending more money on the purchase of long-term government bonds without repurchase agreements and leaving extra liquidity derived from selling the yen on the foreign exchange market, thereby making available substantial amounts of funds for the economy.
The U.S. Federal Reserve Board issued a report on fiscal policy under the zero interest rate. It studied possible measures to deal with a hypothetical depression in the United States, learning a lesson from bitter experiences of Japan that had no choice but to adopt a zero-interest-rate policy. The report is based on the fundamental question of how much a central bank should allow prices to fall.
The report lists seven options to counter depression. They include quantitative monetary easing measures like the purchase of long-term government bonds without repurchase agreements, and intervention on the foreign exchange market, both of which are currently under di
|The report lists seven options to counter depression. They include quantitative monetary easing measures like the purchase of long-term government bonds without repurchase agreements, and intervention on the foreign exchange market, both of which are currently under discussion in Japan. The report also proposed to the Fed measures to purchase company bonds and commercial paper directly--currently prohibited by the Federal Reserve Act. The report also proposed the showering of funds on companies and the public--so-called helicopter money so named because it resembles the scattering of money to the ground from a helicopter.
What is noteworthy is that the report suggests that it is desirable for the economy to maintain a moderate 2 to 3 percent annual increase in prices because the effect of fiscal policy becomes extremely limited once a zero interest rate is introduced.
The central bank has so far kept an optimistic view toward the fall in prices, considering it as a "good fall" resulting from efforts to reduce prices by the supply side, such as those of major casual apparel maker UNIQLO, which provides consumers with clothing at reasonable prices. The central bank, however, recently revised its opinion after stock prices plummeted to a record post-bubble economy low.
"There is concern that the pressure forcing down prices might strengthen again, reflecting weak demand," Hayami said in a lecture Wednesday.
The Japanese economy has already come to a deadlock which the Fed is afraid of. The government should secure, as soon as possible, a moderate inflation level under which healthy economic activity can be conducted. It should then implement policies to pull the economy out of the vicious circle of an economic downturn combined with psychological uncertainty.
Behind Krugman's theory that the government should set a target for inflation lies his recognition that the debt-ridden government is hardly in the position to find more funds for pump-priming measures.
The 4 percent inflation rate Krugman set for Japan seems relatively high and is likely to surprise the central bank. But this target indicates how bad Japan's current economic situation actually is.
It is not rare for a nation's central bank to announce targets for economic indicators such as the consumer price index and implement monetary policies to set actual price increases in the range of projected targets.
For example, industrialized nations, including Britain, Canada, Australia, New Zealand and Sweden, have set such targets while Asian countries, which experienced the currency crisis of 1997, and South American nations, which once suffered from hyper-inflation, have also done the same.
Keio University Prof. Mitsuhiro Fukao, former central bank official, also urged the central bank to set a mid-term target for the consumer price index of core commodity goods between 2.5 percent and 0.5 percent over a period of several years.
Introducing a target inflation rate, analysts said, could push up long-term interest rates and push down government bond prices, eventually causing devastating losses for banks with large holdings of government bonds. There is another concern over whether the central bank would be able to keep prices in check at a reasonable level once they start rising.
Despite these risks, Japan is urged to "try radical monetary policy," Krugman said. The danger of Japan falling into a deflationary spiral is imminent. The central bank, whose mission is to keep prices stable, must commit itself to fighting deflation, was well as inflation.
|Global: A New Source of Global Instability
Stephen Roach (from Cernobbio)
The last thing the global economy needs is another crisis. And yet that’s exactly what it’s getting from Japan. As the world’s second-largest economy lapses back into renewed recession, it has unleashed a lethal force on the rest of the world -- a sharp depreciation of the yen. That could be the final straw for non-Japan Asia and for the global economy at large.
Signs of deterioration are evident everywhere you look in Japan. The latest came in the form of an unmitigated collapse in machinery orders in January -- an 11.8% drop from December that sends an ominous message for the near-term capital spending prognosis. This follows on the heels of a surprising upward revision to 4Q00 capex that offered a ray of hope for an otherwise beleaguered Japanese economy. But the January orders report dashes any such hopes and, according to Robert Feldman and his team, raises the distinct possibility of an outright contraction in FY2001 real GDP. That would be Japan’s first drop in four years and only the second such occurrence in the post-World War II era.
These downside risks to the real economy couldn’t come at a worse time for Japanese policy makers. With short-term interest rates close to zero, the Bank of Japan is effectively out of traditional ammunition; talk of unconventional tactics of "quantitative easing" abounds, but the BOJ seems unwilling to go down this path. A massive government budget deficit puts fiscal authorities in a similar bind. That leaves currency deprecation as the only real option -- a possibility that Messrs. Hayami (BOJ) and Miyazawa (Ministry of Finance) are openly floating. With yen/dollar now testing the ¥120 threshold, further sharp weakness in the Japanese currency cannot be ruled out. I wouldn’t be surprised to see yen/dollar moving to at least ¥130 over the next couple of months -- far in excess of our official forecast of a ¥120 low. As recessionary forces deepen in Japan, the currency looks increasingly like a one-way bet to the downside.
That spells nothing but trouble for non-Japan Asia. The region is already faltering under the weight of two adverse developments -- the first being a downturn in the US information technology cycle. Courtesy of aggressive outsourcing strategies, the globalization of the IT supply chain has already triggered sharp reductions in Asian export growth. As Corporate American continues to slash costs in the face of an unrelenting earnings carnage, there is further downside to the US IT cycle -- a development that can only exacerbate the export compression now underway in non-Japan Asia. A second constraint is the disappointing progress on post-crisis reform initiatives. The region’s banks remain largely dysfunctional, corporate restructuring has disappointed, and crony capitalism is alive and well. Largely as a result, non-Japan Asia has failed to generate autonomous support from domestic demand. That leaves the region more reliant on external demand than ever before.
Now there’s a third negative on the Asian macro scene -- a sharp decline in the foreign exchange value of the yen. While this will provide some counter-cyclical support to Japanese exporters, it comes at a real cost -- a loss of market share for exporters from non-Japan Asia. And it couldn’t come at a worse time -- just when the region’s exports have already been hit by an IT-led slowdown in global demand. Significantly, the recent compression of Asian export growth has occurred when yen/dollar averaged ¥114 over 2000. Just imagine what the region’s export picture will look like if the yen depreciates another 10% from current levels -- a distinct possibility, in my view.
Unfortunately, there’s an eerie sense of déjà vu in assessing the implications of yen depreciation on externally led East Asian economies. This smacks of exactly what happened in the pre-crisis period of the mid-1990s. Over the 1994-95 interval, non-Japan Asian export growth averaged about 20% per annum, while yen/dollar averaged ¥98. But the on the back of renewed weakness in the Japanese economy, the yen then started to tumble -- going from about ¥102 at the end of 1995 to ¥130 by the end of 1997 (on its way to ¥145 by mid-1998). Non-Japan Asia’s exports collapsed in that climate, with gains averaging just 7% in 1996-97 -- literally one-third the growth rate of 1994-95. This sharply diminished support from external demand was a critical spark to the Asian currency crisis that followed. Sadly, the rest is history.
The good news is that circumstances, in many respects, are quite different today than they were back in the pre-crisis period of the mid-1990s. Asia’s currency pegs have been largely dismantled; current-account deficits have been replaced by surpluses; and foreign-exchange reserves have been rebuilt. But the bad news is that the yen may well be conforming to the same trajectory that was evident in 1996-97: In 2000, it fell 12% against the dollar -- about the same as was the case in 1996 -- and in early March 2001 it is already 5% below last year’s average. As I noted above, I wouldn’t be surprised to see the yen hit ¥130 against the dollar in the months ahead -- precisely the flash point in late 1997.
Now for the really bad news: In the pre-crisis period of 1996-97, the global backdrop was very strong -- world GDP growth averaged close to 4% over those two years. Today, by contrast, the global economy is on the brink of recession. Our current forecast calls for world GDP growth to increase just 2.7% this year -- fully one-third slower than the pace of 1996-97; moreover, as I have stressed repeatedly, the risks, in our view, remain very much on the downside of our current baseline prognosis. But the real kicker comes in recognizing that today’s weaker global growth dynamic is very much a by-product of a sudden downturn in the global IT cycle -- precisely the opposite of what was occurring in the build-up to the Asian crisis, when IT euphoria was just getting off the ground. Needless to say, an
|Needless to say, an IT-led global downshift hits non-Japan Asia right where it hurts the most -- in the region’s principal source of economic dynamism. A weaker yen, in this climate, is like pouring salt on an open wound.
All this could spell serious difficulty for economic growth in non-Japan Asia -- a region that makes up 23% of world GDP, as stated on an IMF purchasing-power-parity basis. While we have lowered our global growth forecast by 0.8 percentage point since the start of this year -- moving from 3.5% to 2.7% -- we have made only slight downward reductions in our Asian growth numbers, from 6.0% to 5.7%. As I see it, there is now a very real risk that yen weakness will prompt us to cut our Asian growth forecast further -- possibly by a lot. Every 0.5 percentage point downward reduction to growth in non-Japan Asia lowers overall world GDP growth by 0.1 percentage point. Right now, our world GDP growth forecast for 2001 stands at 2.7%, only 0.2 percentage point away from the "official" global recession threshold. Mounting downside risks to Asia could easily push us through that threshold. A weaker yen could do just that -- and more. Competitive currency devaluation is the very last thing this sagging global economy needs.
Global Economic Forum
|Meanwhile, Laibach's God is God is recommended!
Let us pray!
When Japan's Reckoning Arrives
Morgan Stanley Dean Witter's currency economist, Stephen Jen, has been arguing that Japan's deflationary equilibrium is unlikely to last long. A dramatic adjustment in Japan's policy is inevitable, according to Stephen. The right policy mix involves restructuring and inflation targeting, he believes. The latter would offset the additional deflationary pressure from restructuring. The former would likely create a bull market and make a stable currency consistent with a loose monetary policy.
Japan's deflationary equilibrium involves (1) a strong currency, (2) low interest rates, and (3) deflation. Currency appreciation offsets the interest-rate difference for investors. Deflation validates the strong currency as the purchasing power from lower price increases offsets the low interest rate for savers. Thus, leveraged companies should survive without asset sales. Fiscal stimulus, on the other hand, has been used to keep nominal GDP from contracting, which sustains the nominal income of companies. This equilibrium freezes time and allows highly leveraged companies to stay in the same place.
The Asian Crisis was an additional deflationary shock to Japan. Nominal GDP has been contracting since 1998. MSDW Japan's economics team expects nominal GDP to contract sharply again in 2001. This is because, ceteris paribus, the fiscal stimulus has to be much bigger to maintain nominal GDP, when other Asian economies have lowered their prices by 20-30% through devaluation. Japan simply does not have the money to play the same game.
Contracting nominal GDP increases the debt burden and pushes companies and consumers to cut costs to stay solvent. Cash income for employees fell by 5.4% for firms with over 30 employees during 1997-2000 and 4.3% for those with fewer employees. While the data may not be reliable, they indicate a trend of declining nominal income. Of course, when income falls, consumers want less expensive products. Hence, the preference for cheap, imported consumer products has risen. This, then, worsens the nominal contraction, as money leaks out of Japan. Cross-border outsourcing essentially has the same effect.
The Japan of the past is gone, in our view. Viable companies are running for their lives on their own, having forsaken their keiretsu brothers. Consumers are overcoming the shame of buying cheap products and voting high-priced Japanese products out of their pocketbooks. Japan's imports from Asia as a share of GDP increased by 0.5 percentage point in 2000 in a year of nominal contraction. The trend appears to be continuing. Talking down the yen helps somewhat. However, as cross-border outsourcing carries such a huge cost advantage, the weak yen may boost exports but may not stop the inflow of cheap Asian products. As Japan's nominal GDP continues to contract as money leaks out, leveraged companies could be destabilized.
If Japan chooses reflation and restructuring at the same time, it would be a positive scenario for most of Asia. A strong stock market keeps the yen relatively strong and Japan's domestic demand high. Access to cheap Asian products helps Japan shed its high-cost industries and greatly improves the competitiveness of its strong industries. It would be truly a win-win scenario.
However, if Japan does not restructure but reflate, it could become either Thailand today or Germany in the 1920s. The former has a weak currency, weak growth, and low but positive inflation. The latter had economic chaos and hyperinflation. Either scenario would have a terrible impact on the region.
A Thailand scenario would essentially keep high-cost activities at home through devaluation. The Germany scenario would raise the risk premium on the region significantly. The difference between the Thailand and Germany scenarios would be the amount of time that depositors have to run for the exits. If Japanese savers are not alert while the BoJ is turning on the printing press, Japan could become like Thailand. The other possibility is that Japan resorts to trade protection to keep its current equilibrium. The towel industry association is already lobbying the government to limit Chinese imports.
Which direction Japan will take is a huge uncertainty hanging over Asia. If Japan makes a mistake, the consequences for the region could be considerable. Let us pray.
Global Economic Forum/Morgan Stanley