Japan’s Struggle with Deflation
Inflation has reached a 40 year high of 8.6% in the U.S and 8.1% in Europe, which has largely been seen as bad for the economy. Consumers are rankled by the high prices and the Fed has been raising interest rates throughout the year to bring inflation down. Japan, on the other hand, is envious of inflation that high. The Asian economic superpower has been suffering from very low inflation and sometimes even deflation for the past couple decades. Let’s dig into why the third largest economy in the world has been struggling with deflation.
A Little History
Throughout the 80s, Japan’s economy was roaring, with Japanese GDP growing at an annual rate of 3.89%. However, the bursting of asset bubbles in real estate and the stock market in 1989 led to a massive slowdown. These bubbles were formed because the Bank of Japan (Japan’s central bank) consistently lowered interest rates from 1986 to 1989. When interest rates are low, people don’t save money because they will earn very little interest on that money. Instead, they will begin investing in other assets such as stocks or real estate. If a lot of people do that and over-inflate the prices of those assets, a bubble is formed, which is exactly what happened in Japan in the late 80s. In December of 1989, the Bank of Japan realized that asset bubbles had been created and increased interest rates to stop them. They were too late, and the bubbles popped in 1989 (the popping of an asset bubble means that the asset prices go down rapidly). The Nikkei 225, one of Japan’s main stock exchanges, plummeted 35% from January to December of 1990. The crash led to a period of economic stagnation in Japan known as the Lost Decade.
The Lost Decade
Throughout the 1990s, Japanese unemployment rose from 2.1% to 4.6%, while inflation decreased from 3.08% to -0.34% (the minus sign is not a typo, Japan actually experienced deflation). The high unemployment persisted until 2014, at which point it began to consistently decrease. The extremely low inflation, on the other hand, has remained doggedly low even in recent years. In 2020, the inflation rate was -0.02%.
The Bank of Japan has taken several actions in an attempt to spur inflation.
1. Quantitative easing. In 2001, The Bank of Japan bought a ton of bonds from banks in a program known as quantitative easing, pumping trillions of yen (billions of dollars) into the economy. The central bank bought bonds from Japanese banks and gave them money in return, adding to the banks’ reserves. It was reasoned that the banks would lend the money out, the money would trickle out through the financial system, and the economy would begin to grow once again. This didn’t happen. The banks, which had heavily invested in the stock market and real estate bubbles of the 80s, were still reeling from the losses of the asset bubble pop. Even with the money being handed out by the Bank of Japan, banks still didn’t have enough money to cover loans.
2. Stocks. In 2010, the Bank of Japan began investing heavily in the stock market. This was an unprecedented move as central banks almost never buy stocks. The Bank of Japan reasoned that buying stocks and ETFs would boost stock prices and give companies more money with which to invest in more capital and growth. They also thought that regular Japanese consumers who held stocks would see their shares rise in value and would be more incentivized to spend. Once again, this didn’t happen. Today, the Bank of Japan owns 7% of the entire Japanese stock market. It will be incredibly difficult for them to get rid of those holdings because if they attempt to sell, the markets will nosedive, along with the Japanese economy.
3. Negative interest rates. In 2016, Japan instituted negative interest rates, where a lender literally pays money to the borrower for the privilege of lending out their money, instead of the borrower paying interest to the lender. Also, people would not save their money in banks because they would have to pay the banks interest for holding their money instead of the banks paying the depositor interest. This disincentivizes people to save their money because it would actively cost them money to deposit it in banks; the Japanese government hoped that people would spend their money instead of saving it. Negative interest rates may seem insane, but at this point Japan was so desperate to stimulate economic growth that it was willing to try anything. The theory was that negative interest rates would incentivize more consumers and businesses to borrow money. Consumers would spend that money and businesses would invest that money in capital, fueling the economy. You can probably guess how it went: not well. Negative interest rates couldn’t increase wages or labor productivity. Without higher wages, the Japanese people simply could not spend at the levels the government wanted them to. The Japanese economy continued to stagnate after negative interest rates were instituted.
Abenomics
Japan’s central bank wasn’t the only institution trying to induce inflation in the economy. In 2012, Shinzo Abe was elected prime minister of Japan on a platform of growing the economy and raising inflation. His policies, collectively known as Abenomics, included 3 main tenets.
The first was expanding the money supply. The reasoning behind this policy was pretty simple: there will be more money in circulation, and that money has to go somewhere. It won’t be saved because of the super low interest rates, so people will spend it. The second was increasing government spending. It was believed that this expansionary fiscal policy would stimulate demand and consumption across the economy. The last was a complex combination of reforms and regulations to increase competition among the Japanese industries and spur investment in the private sector.
Abenomics helped the Japanese economy somewhat. The Nikkei 225 rose about 55% from October 2012 and October 2014. The expansion of the money supply helped lower interest rates, which depreciated the yen. This may sound bad, but this was actually good for Japan because it increased net exports (exports - imports). A lower yen leads to more exports because Japanese goods are cheaper for foreigners. It causes less imports because foreign goods are now more expensive for Japanese consumers. When the yen depreciated, other currencies appreciated in comparison to the yen, which made foreign goods more expensive for Japan. This is good for the economy because Japanese businesses are now making more sales, which will incentivize them to produce more goods and stimulate the economy further. While these effects were beneficial to the Japanese economy, businesses were not making enough money to raise wages, which was a key factor to raising inflation.
BOJ vs Fed
The Bank of Japan’s efforts to stimulate inflation for the past few decades are similar to the Fed’s efforts following the Great Recession. Directly after the Great Recession, the Fed began rolling out waves of quantitative easing, just like the BOJ. They lowered interest rates to near zero levels (though they never went to negative rates like the BOJ did). And the Fed had similar results as the BOJ. Throughout the 2010s, stagnation persisted throughout the American economy. The US inflation rate following 2008 wasn’t as low as Japan’s, but it was often below the target rate of 2%.
Finally, Inflation
At long last, Japan is seeing some inflation, with a current inflation rate of 2.4%. This is a good, moderate inflation rate, but there is a worrying sign that all is not well: rapidly rising food and energy prices. Japan imports 94% of its energy and 60% of its food. The global disruption in supply chains from the pandemic and the Russian invasion of Ukraine have made it much harder for Japan to get those key resources, leading to rising prices.
To make matters worse, the yen has greatly depreciated against the dollar. The Fed has been hiking interest rates all year, while the BOJ has decided to remain in a low interest rate environment. When a central bank raises interest rates, the currency appreciates because more people want to park their money with that currency and earn a greater return. Due to the Fed hiking interest rates, the dollar has appreciated against the yen. Earlier, we said that was good because it would help Japanese companies. Now it’s bad because with a lower yen, it is much more expensive for Japan to buy energy and food imports from other countries. This has also contributed to the higher prices.
Japan has been fighting a long, brutal battle against deflation for the past 3 decades. They have used both fiscal and monetary policy to try to stimulate demand and achieve inflation, mostly to no avail. There is some inflation right now, but unfortunately it is cost-push inflation (higher costs for suppliers) instead of demand-pull inflation (increase in demand by consumers). The demand-pull inflation is the desired type of inflation, and hopefully Japan will be able to achieve it one day.