JEI's Spin on the News

Inflated Claims of Deflationary Spiral Enliven Japanese Economic Debate

Wednesday, September 9, 1998

Economic Planning Agency Minister Taichi Sakaiya, a novelist in private life, gave September 8 an unusually graphic description of the Japanese economic situation, saying "Japan is not in a deflationary spiral, but is near the entrance. There is a danger of being sucked into one, and the main reason for that is the international environment."

Mr. Sakaiya is not alone in discussing the possibility of a "deflationary spiral" in Japan. Not a few analysts have ventured the opinion that one already exists there. Mr. Sakaiya and others believe that turmoil in Russia and Latin America could lead to one.

One critical aspect of a "deflationary spiral" is missing, however, in these discussions: a definition. Nor will one find one in most standard economics textbooks. In fact, the phrase has different meanings to different speakers. Most of the possible meanings imply much less negative impact than that suggested by Mr. Sakaiya's colorful language and some even imply that Japan would benefit if one were to develop.

The most intuitive definition is based on standard Keynesian economic logic of movement to a new equilibrium level of employment. For example, If employment goes down, purchasing power declines, consumer spending drops and wages and/or employment go down once again in a vicious cycle. However, history records few, if any instances, of this process lasting all the way to "meltdown," a total cessation of economic activity. More typical is movement from one Keynesian equilibrium to a lower one, the extent of the movement determined by the initial "shock" that sets the process off as well as variables relating the size of that shock to change in gross domestic product. Mr. Sakaiya probably is referring to a deflationary spiral of this type, with the shock coming from dropping demand in Russia, Asia and Latin America for Japanese exports. Yet exports comprise only about 11 percent of Japanese GDP, with more than half going to relatively unaffected countries in North America, Europe and elsewhere.

Another type of "deflationary spiral" involves falling prices because the money supply shrinks. In this case, demand might suffer because consumers adopt a pattern of waiting for prices to fall even more. This, too, is very rare, although the Great Depression in the United States provides an example. However, the Bank of Japan is not now reducing the money supply, suggesting that this explanation does not fit Japan's current circumstances.

A third type of deflationary spiral is actually beneficial and one in which Japan can reap big benefits if it plays its cards right. The weak economies overseas have greatly reduced global demand for raw materials. The resultant price declines on international markets means that Japan can buy more imports for the same dollar expenditure than it could previously. Japanese consumers will see a benefit to the extent that electricity prices reflect the reduced cost of oil, corn flakes the drop in corn prices, etc. The higher real incomes such lower prices would imply could provide a much needed boost to aggregate demand. In fact, however, regulation and other factors limit the extent to which drops in international commodity prices get reflected by retailers' price tags.

Japan's chronic economic difficulties make it unlikely that policy makers will change these rules in a way that would permit this economic stimulative effect to be felt. Although lower import prices would be an overall benefit, importers and buyers of imported inputs will want to pocket the gain rather than pass it along to consumers. Given that many have suffered through seven or more years of economic hardship, they are likely to prevail with policymakers.

"JEI's Spin on the News" are the opinions of one of more members of JEI's staff and do not necessarily represent the views of the organization.

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