Saving Japan: Forget Inflation Targeting. Tokyo Instead Needs to Implement a One-Two, Monetary-Fiscal Punch

By Katz, Richard | The International Economy, Spring 2010 | Go to article overview

Saving Japan: Forget Inflation Targeting. Tokyo Instead Needs to Implement a One-Two, Monetary-Fiscal Punch


Katz, Richard, The International Economy


Japan's deflation is back. And during the worst recession in Japan's post-war era, deflation is correspondingly almost twice as bad as during any previous decline. In fiscal 2009 (which ended on March 31), the deflator for the domestic components of GDP fell by 3 percent from a year ago.

Like his Liberal Democratic Party predecessors, Naoto Kan, the Democratic Party of Japan's Minister of Finance [now Prime Minister], has put the onus on the Bank of Japan to cure deflation. He talks as if deflation were the root cause of economic stagnation and as if the Bank of Japan had a magic wand (sometimes called "inflation targeting"). Kan and the Ministry of Finance are reluctant to use fiscal stimulus. On the contrary, Kan is talking about raising the consumption tax as soon as possible ill the next few years, thereby risking a repeat of the recession-triggering tax hike of 1997. It's easier to justify this stance by claiming that monetary ease alone, not a fiscal-monetary combination, is the pivot for recovery.

NO DEFLATIONARY SPIRAL

The good news is that there is no "deflationary spiral" like the United States suffered in the 1930s. In such a spiral, a collapse of jobs and demand sends prices plunging. That, in turn, makes people and companies postpone major purchases (just like fewer Americans bought homes during the recent crash). That leads to even more drops in demand.

Fortunately, Japan's mild deflation merely reflects the long stagnation, but has not made it worse. The best way to see this is to compare the course of deflation to the "output gap." That is the gap between actual GDP and what GDP would be at full employment and full use of factories, office buildings, and so on. Today, the gap is about 7 percent of GDP. When demand weakens, prices turn soft. So, the past twenty-five years have seen a very high 86 percent correlation between the ups and downs of the output gap and those of inflation/deflation two quarters later (see Figure 1). While a worsening output gap has worsened deflation, the reverse is not true.

The major problem is that deflation prevents the Bank of Japan from using negative real interest rates (that is, interest rates below the rate of inflation) to stimulate demand. Since 1995, the Bank of Japan has pushed overnight interest rates down to near-zero and then zero. But nominal rates cannot go below zero. Deflation renders conventional monetary policy impotent.

To get around this "zero bound" problem, some monetary economists claimed that "quantitative easing"--printing tons of money--would be the magic bullet. The Bank of Japan tried this and it failed. The proposal was based on the fact that, prior to 1995, nominal GDP grew in tandem with the money supply in textbook fashion. But deflation has broken that normal linkage. Since 1995, the Bank of Japan hiked the money base 115 percent, but nominal GDP has fallen 8 percent.

THE SIREN SONG OF INFLATION TARGETING

When quantitative easing failed, the call went out to combine quantitative easing with "inflation targeting." If only the Bank of Japan would set, say, a 2 percent target for inflation and promise to create enough money until the target was reached, then surely inflation would return--or so it was claimed. Bank of Japan Governor Masaaki Shirakawa has rejected such calls, as did his predecessors.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

In countries with inflation, central banks have the tools to reach their target. If inflation is too high, they can raise interest rates and lower demand; if it is too low, they can lower rates and boost demand. However, because of the "zero bound" problem, there is no precedent for inflation targeting curing deflation (and no modern case except Japan of a rich country suffering prolonged deflation.) As Alan Blinder, former Vice Chairman of the U.S. Federal Reserve, replied to us in 2003, "I have not been an advocate of inflation targeting in Japan.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Saving Japan: Forget Inflation Targeting. Tokyo Instead Needs to Implement a One-Two, Monetary-Fiscal Punch
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.