Deflationary Lesson

20 THE INTERNATIONAL ECONOMY WINTER 2006
Deflationary
Lessons What Japanese deflation
did and did not do.
When deflation hit Japan and persisted, it
was quite a shock. The loss of the central
bank’s apparent capabilities to do anything
about it with the Bank of Japan’s instrument
interest rate at zero made the situation
even more interesting. So did Japan’s
bad loan problems shutting down the
credit channel of monetary policy.
Monetary economists were captivated by the phenomenon, the concept of
the liquidity trap was dusted off, and numerous remedies were proposed.
Now that the Japanese economy has been in recovery, and deflation is ending—
and the Bank of Japan is slowly (one hopes) readying itself for its
first round of policy tightening since August 2000—it is a good time to
take stock of what deflation did and did not do.
What have we learned from this natural experiment, if not natural disaster,
in Japan? Do we better understand deflation and its impact? Do we
have an improved assessment of the capabilities of central banks and their
non-interest rate policy instruments? Can we design monetary policy frameworks
so as to prevent it happening again? Or was it no big deal after all?
I would suggest that there are a dozen lessons monetary economists and
Adam Posen is senior fellow at the Institute for International Economics,
and an executive editor of The International Economy.
BY ADAM POSEN
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WINTER 2006 THE INTERNATIONAL ECONOMY 21
POSEN
central bankers should take away from the Japanese
experience with sustained deflation—some confirming
the analyses of mainstream macroeconomics at the
time, a few surprising to most or all observers.
Deflation is very inertial. Though many
economies dip in and out of measured deflation
for a couple of months at a time, sustained deflation
is rare. Thus, no one could confidently predict the
dynamics of prices once deflation set in in Japan during
the mid-1990s. Contrary to some expectations (including
my own), ongoing deflation was not only slow to
start, but it was hard to stop, and it did not gain momentum.
That is, once deflation took hold, it was sticky at
a low level (between 0.5 and 1.5 percent a year) rather
than accelerating.
Deflation is bad but not disastrous.
Deflation in Japan proved less costly to the
real economy than some feared. Best estimates of the
drag on consumption directly from deflation were
small, once growth and interest rates were taken into
account; the feedback from deflation onto debt burdens
and then back into deflation (via the sell-off of
loans and collateral) was also limited in magnitude. Of
course, this largely reflected the low level of deflation
in Japan. That said, deflation did result in a drag on
consumption, an increase in debt burdens, and uncertainties
for investment, none of which was good for
the economy.
Deflation is not conducive to restructuring.
Some ideologues insisted that deflation
would get the “rot” out of the Japanese economy by
forcing out of business overly indebted or uncompetitive
firms. Most mainstream
economists
recognized this as the liquidationist
fallacy, disproved
during the Great
Depression. Recent
developments in macroeconomics
by Caballero
and Hammour, Bernanke
and Gertler, and others,
gave a better understanding of why this view was fallacious.
Japan bore the mainstream view out. During
the 1990s deflation, new businesses and those who
could pay off their loans were shut out from credit,
while those firms that had borrowed more during the
boom and were overstretched got their loans rolled over.
Restructuring only picked up in Japan when deflationary
expectations were contained and the banking system
recapitalized.
There is no such thing as “good deflation.”
Deflation, if it is to have any meaning, has to
refer to a generalized fall in the price level (just as inflation
refers to a general rise). Such a general shift can
only distort economic decision-making at best. Former
Bank of Japan Governor Masaru Hayami, among others,
would point to specific price drops, like those
prompted by new imports to Japan of cheap clothing,
and say that this constituted “good deflation” and thus
confuse the public. There are positive supply shocks,
which can have a transitory deflationary impact on measures
of aggregate price changes, but just as with negative
supply shocks like an
oil price hike, so long as it
is a relative price shift, it is
not the central bank’s concern.
When there are second-
round effects of the
relative price shift (up or
down) being passed on to
the general price level, it is
a problem.
Reaching zero
interest rate is
not equivalent to running
out of ammo. This image
was often invoked during
the 1990s, suggesting that
when the Bank of Japan’s nominal instrument interest
rate neared zero, there was little left for the central bank
to employ. Whether or not a central bank could be effective
in fighting deflation with other than an interest rate
instrument—especially when the banking system problems
impeded the credit channel of monetary transmission—
was the most substantive as well as the most
practical dispute among monetary economists in
response to Japan’s deflation. With the benefit of hindsight,
it is now clear that hitting the zero lower bound on
interest rates is equivalent to running out of ammo for
the central bank’s biggest and most accurate gun. It does
not empty out the armory completely, even if it throws
1
2
3
4
5
Some ideologues
insisted that
deflation would get
the “rot” out of the
Japanese economy.
It is now clear that
hitting the zero
lower bound on
interest rates is
equivalent to
running out of
ammo for the
central bank’s
biggest and most
accurate gun.
22 THE INTERNATIONAL ECONOMY WINTER 2006
POSEN
the central bank back on to less dependable and lower firepower
weapons.
Even extreme monetary growth is not dependably
inflationary. In their theoretical hearts,
most monetary economists believe in some form of monetarism,
that if a central bank prints enough money, ultimately
prices must rise.
All sound empirical
investigations over the
past twenty-five years,
however, suggest that in
normal economic circumstances,
monetary
aggregates have no reliable
predictive power for
inflation. Under the
abnormal circumstances of Japan’s deflation, the Bank of
Japan printed a very large amount of money, to a chorus
of understandable approval—this was the logical next
weapon in the Bank of Japan’s arsenal. Somewhat surprisingly
to some, not so much to others, the amount of quantitative
easing had no discernable effect on deflation or
deflationary expectations.
Monetary targeting can however signal commitment.
Although the amount of yen printed
in recent years does not appear to have mattered for changes
in the Japanese price level, the fact of quantitative easing
itself was significant. Whether grudging initially or tied to
a clear commitment more recently, the Bank of Japan’s
quantitative easing policy told the markets and the public
that the central bank recognized deflation as a problem (or
early on at least was under pressure to make that recognition).
In practical terms, this meant that it would be more
difficult for the central bank to tighten policy, and that if
the banks were ever fixed such that they wanted to lend
again, there would be no constraint on the liquidity available
to them. As with Paul Volcker in the United States in
the early 1980s, monetary targeting was useful for the signal
it gave, not for actually hitting the targets.
Inflation expectations do matter. Over the last
fifteen years, both the study and the practice of
monetary policy have emphasized the critical role of private-
sector inflation expectations. Inflation targeting
regimes, for example, take into account the pass-through
of shocks to inflation expectations to judge how much to
respond to those shocks, and often rely on setting expectations
as much as interest rates to affect the economy. Japan’s
deflation experience bears out the critical role of expectations.
When Toshihiko Fukui, Kazumasa Iwata, and Toshiro
Muto took over the leadership of the Bank of Japan in April
2003, and then made a forward-looking commitment in
October 2003 not to raise rates until inflation was positive,
private-sector expectations—both household surveys and
bond market prices—responded. That response fed the
recovery of consumption, investment, and even real estate
prices, all of which were kept down by deflationary expectations
under the prior BoJ regime.
Exchange rate effects are overrated. There are
economists who believe as a matter of principle
that purchasing power parity must hold, even in the
short-run, despite ample convincing empirical evidence to
contrary (as with monetary growth and inflation). So they
proposed that Japan’s deflation could be ended by pegging
the yen at a low exchange rate—some went so far as to
claim that deflation itself was caused by expectations of
yen appreciation. That large and lasting swings in the yendollar
exchange rate had no discernable impact on Japan’s
deflationary trend constitutes strong evidence against this
position. The evident contradiction between Japan’s years
of relative deflation versus the inflation rates of the United
States, Europe, and China, and the absence of Japanese
expectations for sustained appreciation—or of any such
appreciation over the course of several years of relative
deflation—should finish off this excessive faith.
Output gaps are underestimated under deflation.
It is econometrically difficult to discern
an output gap using usual methods when prices
are falling and especially when nominal interest rates near
zero. Assuming the deflationary period follows some years
of declining growth, as it did in Japan and usually does,
top-down statistical methods will automatically infer that
potential growth has been falling (and thus inflationary
risks for a given growth level rising), whether or not there
is fundamental reason to do so. Therefore it appears challenging
for a central bank facing deflation to determine
monetary conditions, as it was for the Bank of Japan.
Frustration in pursuit of precision using normal methods,
however, masks the near certainty central banks facing
deflation can have about the sign of the output gap, i.e.,
that the economy is growing significantly more slowly than
potential (see Lesson 4, there’s no good deflation).
Moreover, since deflation is inertial (Lesson 1), it is not as
though fine-tuning to make sure that monetary policy is
too easy is necessary. Central banks facing deflation can
8
9
10
7
In their theoretical hearts,
most monetary economists
believe that if a central bank
prints enough money,
ultimately prices must rise.
6
WINTER 2006 THE INTERNATIONAL ECONOMY 23
POSEN
probably err on the thinking of there is still an output
gap until inflation actually rises. Japan’s last three-plus
years of solid growth in excess of many observers’
assessment of potential output (but not my own) with
inflation only forecast to turn positive well into the
fourth year of recovery bears this out.
Monetary discipline cannot substitute for
financial discipline. Once the Japanese
banking system became undercapitalized and started
rolling over vast numbers of non-performing loans in
the mid-1990s, the credit channel of monetary policy
shut down. The point is not so much that monetary policy
was left “pushing on a string” since the Bank of
Japan could still affect
expectations in part
through a commitment
to quantitative
easing (Lessons 7 and
8)—rather, the point
is that the Bank of
Japan could not
encourage more
responsible lending
behavior by the banking
system until the
Financial Supervision
Agency did its job
and made the banks
write off bad loans
and recapitalize. Providing ample liquidity to the banking
system probably prevented undesirable payments
difficulties, but did nothing to make bank behavior
worse. Despite the tendency for some central bankers
at the BoJ and elsewhere to view low interest rates as
a moral issue, they do not subsidize bad lending by
providing liquidity. The bad lending comes when bank
supervisors and markets fail to enforce discipline, and
there is nothing that monetary policy alone can do
about that once it happens.
People care about monetary policy goals
and results, but not methods. Agreat deal
of ink was spilled and emotion vented over whether
the Bank of Japan would have “risked its credibility”
had it undertaken more aggressive and atypical measures
(such as buying JGBs directly or making an
explicit pre-commitment limiting future interest rate
increases) during Japan’s deflation. While there were
legitimate intellectual grounds for debating the choice
and design of the best non-interest rate approaches to
fighting inflation among central bankers and monetary
economists, these concerned practicality not credibility.
The markets and the broader public do not worry
about whether what the central bank is doing can be
labeled “unconventional,” or the central bank merits
self-proclamations of “bravery” in its approach. People
quite sensibly do not care about the central bank’s balance
sheet at all, since ultimately the bank will get
funded. The distinction between sterilized and unsterilized
intervention, though much worried over by aficionados,
becomes just a matter of semantics when
money creation is great. And so on. Central banks
should only worry about how they do things to the
extent it affects policy outcomes, not how they would
appear nor what they might do to their “credibility.”
Ending deflation would help credibility, failing to
respond to deflation erodes it.
Putting these dozen lessons from Japan’s deflation
of the last decade together, what is the bottom
line for monetary policymaking going
forward? There is an asymmetry in the welfare effects
of deflation and low levels of inflation, with deflation
being worse, though it is not apocalyptic to fall into
deflation. Still, there is nothing good about sustained
deflation, not for restructuring or the banking system or
for credibility, so central banks should go to great
efforts to get out of it. Once a central bank is in a deflationary
situation, it should show clear opposition to
deflation, a willingness to use whatever means available
(if the usual interest rate instrument is blocked)
to reverse deflation, and a forward-looking commitment
to being accommodative until inflation is solidly
positive. Then the central bank will move expectations—
and if it moves expectations, it will move outcomes
in the desired direction.
Central banks under normal circumstances should
get in place a commitment to a positive inflation definition
of price stability, with a well-considered buffer
zone between it and zero inflation. They should back
that commitment with a promise that deviations from
the practical definition of price stability will be symmetrically
opposed. And at all times, central banks
should keep the public focused on goals and outcomes,
and not get hung up on the appearance of intermediate
targets or policy instruments, which in the end the public
and markets correctly discount as of little importance.
No one reasonable fusses about what their
plumber uses to stop a leak when their house is flooding,
so long as the leak stops and stays stopped. You
only fire the plumber if it keeps leaking. ◆
11
12
Despite the tendency
for some central
bankers at the BoJ
and elsewhere to
view low interest
rates as a moral
issue, they do not
subsidize bad lending
by providing liquidity.