It is no doubt that Japan’s deflation in the last two decades was a quite significant case which can be used to study on the world economy. Japan has struggled against deflation for 20years since the exploded of real estate price bubble in 1991. Many problems of deflation caused by the “bubble economy”, so it is worth to look at the process of it . As shown in figure 1, the land prices bubble was created during the period of 1986 – 1990. The reason of increasing in real estate price is that banks in Japan extended mortgage lending at very low interest rate in order to keep their profit when more and more companies showing preference to raise capital by issuing bonds other than borrowing from banks during the period of 1975 – mid 1980s. Under this situation, fast increased bank loans contributed a large percentage to high growth rates of GDP. The CPI inflation was also relatively high during that period, (Figure 2)
Figure 1. Growth in residential land prices ( Vattipalli, 2004 )
As the result of extreme high real estate prices, Bank of Japan started to pursue a regulation that restricts banks on the growth of their real estate loans. After that, banks had to slow the rate of their real estate growth, so that many house owners cannot get enough cash borrowed from banks to repay the interest of their estate loans when their rental incomes cannot cover the loans interests. Under this cirmantance, many of those house owners prefer selling the houses to holding them with high cost. Both reduction in the growth rate of real estate and “distress sales” of those real estate created the sharp reduction in the real estate prices.
At the same time, stock price also began to fall from 1990. The growth rate of GDP moved down from the peak since that year although the land prices still kept rising and BOJ also continuously raised the discount rate at that time. But after 1990, as the GDP growth fell off more sharply, the inflation began to decrease.
Figure 2 Rate of inflation in Japan
Sources: Economic and Social Research Institute, Cabinet Office; Statistics Bureau, Ministry of Public Management, Home Affairs, Posts and Telecommunications.
In Japan, the high growth rate of GDP, CPI and the high ratio of capital to output accumulated by 1990 was high, it lead to high expectations of the output for the following several years was much higher than what happened in reality. (figure 3)
Figure 3. US & Japanese Investment as % GDP
Source: DATASTREAM
Also, the fast decreased prices of real estate caused balance sheet problems for both households and companies. The reason is that the decreased value of real estate which usually be used as collaterals by householders and companies will create problems for companies get new loans.
Caused by a large number of bankruptcies and balance sheet problems, banks in Japan had non-performing loans problems. In addition, the declined in stock and real estate price means that bank capital declined, so that banks much more constraint on their loan making, so they do not have ability to recover the economy ( Kwon, 1998, Brunner and Kamin, 1998, Bayoumi, 2000).
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In addition, the yen strengthened dramatically since early 1990, these phenomena increase the further downward pressure on prices. All factors mentioned above lead to a sharp decline in CPI in 1993. Figure 2 shows the changes of CPI and GDP during that period. According to the statistics, the CPI inflation rate dropped to around 1 percent by the end of 1993, and the GDP deflator decreased even much faster than CPI.
Since1991, the average growth rate of Japanese economy stayed at only around 0.9 percent for 7 years (Song and Jiang, 2009). Although the growth rate moved up to 2.5 percent in 1995 and 3.4 percent in 1996, it fell to 0.2 percent again in 1997, when hit by the financial crisis in Asia. In 1998, the growth rate increased slightly to 0.6 percent, 0.5 percent in 1999 and 0.9 percent in 2000. In 2001, the GDP growth rate dropped to be negative (-0.9 percent) because of the 911 in US. During that period, the consumer price index (CPI) also declined significantly. In order to recover the economy, Japanese government pursued some policies, but it was not as effective as what expected. From 2003 to 2007, the growth rate of GDP in Japan stayed in a low level. In 2008, Japan’s export amount to US decreased sharply, in 2009, its net export to China also declined by 21.4 percent compared to last year. At the same time, the unemployment rate kept increasing. All those problems are hard to solved, so that Japan spend a long time to struggle against the deflation.
There were several reasons lead to fail in solving the problems of deflation.
The failure of monetary policy and interest rate policy could be blamed.
In order to make economic recovery, Japanese economic policy was loosened (Ahearne et, 2002). BOJ decreased the overnight call money interest rate. Figure 4 shows that the interest rate started to decrease from the peak in 1991 and sharply declined to roughly 0.5 percent by 1995, and further decreased to nearly 0 by 1999. In April of 1999, the BOJ pronounced that they would maintain the interest rate stay at zero until the deflation gone, that is what people called as zero interest rate policy (ZIRP). Under this policy, the economy in Japan recovered and started to grow since the end of 1999; however, it dropped into a serious recession again in 2003 after the ZIRP was abolished. (Baba, Nishioka, Oda, Shirakawa, Ueda, Ugai, 2005). After the ZIRP, BOJ also pursued quantitative easing policy (QEP) in 2001 in order to increase and provide an ample liquidity supply and maintain it until the rate of change in CPI go back to positive. (Baba, Nishioka, Oda, Shirakawa, Ueda, Ugai, 2005).
Some scholars argue whether these interest rate policy and monetary policy are effective on economic recovery. Krugman (1998) said that a permanent increase in money supply can help raise inflation rate, but increase in money supply only in a short term would not be an effective way to decrease the rate of interest and achieve that goal. The decline of interest rate in 2003 also supports the view mentioned above.
Figure 4. US & Japanese policy rates
There are some arguments on whether the monetary policy was effective to the economic recovery. Some economists believe that the monetary policy was ineffective because the interest rate was already very low during the recession period(Krugman, 1998). He advocated that the BOJ should set an inflation target in order to take the economy get rid of the liquidity trap. (Miyagawa and Morita, 2010). Also, BOJ itself tested the relationship between the money factor and some other economic indices, such as real GDP, interest rates. The result of this test conducted by using Vector Error Correction Model showed that the long-run equilibrium relationship among money and those variables could not been found during the “lost decade”, especially after1997 (Miyagawa and Morita, 2010). That is, the monetary policy did not significantly affect the economy. Another scholar Miyao (2005) also did a similar test to examine the relationship. The result of his test also showed that there is no significant relationship between money stock and prices. Also, the money stock cannot precisely predict real GDP or price level in the economy since the period of late 1990s. Fujiwara (2006) found that monetary base do not significantly affect the economy when the interest rate was zero during the recession period. He got this result by using VAR model and run the monthly index of CPI, long-run interest rate collected from 1985 to 2004.
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In contrast, some studies argue that the monetary policy created positive effective on economic recovery. Baig (2002) believes this conclusion based on his test result generated by using VAR model. But there was a limitation of his sample collection. That is, the data he used in the test is collected from period from 1980-2001 without much data from the zero interest periods after 1999.
Honda and some other scholars also performed the test on the quantitative easing policy by using the same model. In the estimation process, industrial production, consumer price, stock prices and current asset balance target are variables chosen by them. The result showed that the monetary easing positively affected the stock price although there are some limitations in their data collection.
Based on these debts and what happened in Japan’s economy, the monetary policy pursued by BOJ when the interest rate at zero was not effective, because there were no other economic tools to simulate the borrowing, so that monetary policy could not help the economy exit from the deep recession.
Failure in fiscal expansion policy was another factor lead to unsuccessful solving problems of deflation in Japan. In 1992, the real GDP sharply declined, then the fiscal policy started expanded in that year. Although Kuttner and Posen tested the effectiveness of fiscal policy on real GDP, tax revenues and public expenditures with data collected from the period of 1976-1999 by using VAR model. The test result showed that the expansionary fiscal policy could effectively affect the economy. But it could not bring a strong positive effect on the economy. The reason is that japanese government pursued temporary tax cuts but not permanent. A permanent tax cut can bring significant positive impact on consumers’ income so that simulate their consumption, but the objective factor existed in Japanese society (i.e. rapid aging of the population) limited government pursued a permanent tax cuts(Ahearne et. 2002). So the contemporary tax cut as a part of fiscal policy could not positively affect the economy. During 1990s, public debt in Japan increased while the orivate expenditure decreasing.
Combined with these economic factors, some economists believe that the fiscal policy has lost its ability to affect the economy in Japan during 1990s.
Lack of political leadership also made Japan could not exist from the recession.The Japanese government could not correctly recognize the main reason of Japan’s recession. For instance, Koizumi government believe the way to stop the deflation is to reform the structure of the economy, especially the supply side. However, the supply side reforming has started around 20 years ago ( Koo, 2003).
Also, if the Mr. Koizumi could realize that the balance sheet recession was an invisible problem hided behind the deflation and kept the fiscal stimulus at the level of Prime Minister Mori, the balance sheet recession would be solved earlier. At the same time, if most economists who tried to solve the problems of deflation in Japan tried to not only look at company balance sheets. They only focused on those indices of GDP, inflation rate, CPI and other economic factors.
The lack of political leadership also can be found in some policy mistakes. For instance, the consumption tax hike in 1997, which stifled nascent signs of recovery; the unparalleled slowness in disposing of NPLs; and the heavy-handed reliance on interest rate cuts from 1985 to 1987 to deal with the deflationary impact of sharp yen appreciation following the Plaza Accord. While it would be unfair to blame the bubble, asset deflation, and the liquidity trap solely on Japan’s politicians and policymakers, it is accurate to say that policy mismanagement has aggravated the problems and prolonged the processes of recovery.
Although the real estate bubble burst in the early 1990s, many forecasters still kept optimistic toward Japan’s economy in the following years. Comparing the forecasts of growth and actual growth in GDP, those policy board members underestimated the declining in GDP growth. Survey done by some institutes improved that the forecasts decline much slower than actual GDP growth rates.
Also, those Federal Reserve Board staffs did not make precise forecasts for inflation changes when Japan’s economy fell into recession. In mid-1990s, some of them forecasted that there would be no inflation in Japan, but they never tried to think about that there might be a deflation in Japan before it actually appeared. In Exhibit 1, it can be observed that some analysts even started to forecast a deflation until the late of 1990s.
Exhibit 1. Inflation Forecasts (…)
(The first bar in each year is actual inflation rate, the second one is the forecasted one-year previously, the third one is the forecasted one-year previously)
In conclusion, Japanese macro-economic policy was too timid. Those policy board staffs were not brave enough to foresee the deflation after just experiencing the inflation in “bubble economy”. Some of them even still foresaw inflation in late of 1990s, when the deflation has appeared before the prior year. Fiscal expansion policy did not created large and long impacts on the economy, so it was unsuccessful to help the economy exit from the deflation. The monetary policy BOJ pursued only lasted for a very short time, so that it could not stop the continuously deflation in Japan. Also, increased in money supply could not bring significant positive effects on economy when the interest rate has fall to zero. Political factor was also one of reasons lead to unsuccessfully stop the deflation.
BOJ tried many ways to solve the problems of deflation. When the real estate bubble exploded in 1990, they decreased the interest after that. However, it was too late, declined in stock price and regulation restriction on growth rate of loans before the bubble bust has made a large number of bankruptcies. Decreased in interest rate after that could not effectively simulate investments and get the economic recovery. In order to pursue interest policy at exact right time, it would require those analysts in policy board forecast more precisely. In addition, Japan was in a “balance sheet recession”, some more radical measures of evaluating should be introduced, and supervision power should be increased as well.
Japan was still on its way to recover the economy, however the tsunami and the Chernobyl accident may lead to a decline in growth rate of the economy. The CPI index may also decrease in the following time.
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