Deflation May Hamper Japanese Economic Recovery

In the third quarter of 2009, Japan’s economy expanded at the fastest pace in more than two years boosted by a rebound in global demand and government stimulus. However, growing GDP hasn't stimulated consumer prices which during the last few months have been falling at record pace bringing into the light the danger of prolonged deflation.

Indeed, recently Japanese authorities finally acknowledged that the economy is in mild deflationary phase. In fact, consumer prices have been falling since February, speeding up in the summer, and dropping at the average pace of 2% from June to October. And while little inflation is healthy for growing economies, the prolonged period of deflation may have bad consequence in a recovery period.  Declining prices may depress corporate earnings, lead to wage cuts and as a consequence make consumers to put off purchases and stimulate further deflationary spiral.

To make things even worst, there is no perfect solution to fight with deflation. The government can expand further  quantitative easing program, but it may lead to higher public debt in the future. Indeed, with more money in circulation, already low interest rate would need to go below zero, which would cause higher bond payments in the next few years. The Bank of Japan could also start charging banks for deposits in the central bank, but that would increase interest rates and depress investments further. So, because there is no easy way out of deflation, the Japanese government needs to be prepared to make some structural changes and difficult choices. The country needs more labor flexibility, more hospitable immigration laws and above all Japan needs to recognize the fact that China is changing the power dynamics across the World.

Anna Fedec,
11/28/2009 12:17:48 PM