There Is Only One Thing That Can Save Japan Now: Inflation

Japan's opposition party wants the central bank to whip deflation now with unlimited easing


The paralysis is over, maybe. Five years since the rest of the global economy started turning Japanese, and 20 years since they did, Japan wants to turn back the clock to a time when they had nonzero growth. In other words, they want the Bank of Japan (BOJ) to do something.

That something is printing money, and printing more of it. Ahead of next month's elections, Shinzo Abe, the once and perhaps future prime minister of the opposition Liberal Democratic Party (LDP), has called on Japan's central bank to do unlimited easing and to increase its inflation target from 1 percent to 2-3 percent. If Gerald Ford were in charge of PR, he might have said it's a plan to whip deflation now.

That's a plan Japan has been waiting on for quite some time. Before subprime or credit default swaps, the Japan of the go-go 1980s invented the modern bubble economy. At its peak, the ground beneath the Imperial Palace in Tokyo was famously worth more than all of the real estate in California combined. The Nikkei nearly reached 39,000 in 1989; it reached 9140 today. This historic market collapse didn't lead to a historic employment collapse thanks to aggressive deficit spending, aside from a failed experiment with austerity in 1997, though growth did collapse. That's a hell of a caveat. As Noah Smith points out, part of Japan's slowdown was inevitable -- catchup growth ends once you catchup, especially with an aging population -- but Ryan Avent of The Economist is right that this doesn't explain how much economic ground Japan lost in the 1990s.

Blame the BOJ. That's what then-Princeton professor Ben Bernanke did in 1999, when he accused the Japanese central bank of "self-induced paralysis" for allowing deflation to set in. Consumers like falling prices, but economies don't. Deflation increases the burden of debt and increases the incentive to put off purchases. That's econospeak for disaster. And a disaster is exactly what the chart below shows us. It looks at Japan's nominal GDP, which is just the total size of its economy, unadjusted for inflation, over the past two decades. Low growth and less inflation have left Japan's economy 4 percent smaller now than it was in 1994. Let's repeat that for emphasis: Japan's economy is 4 percent smaller now than it was in 1994. Consider that nominal GDP usually grows about 5 percent a year.


That's 157 percent lost growth, if you account for the annual 5 percent nominal GDP growth Japan didn't get the past 19 years. It's enough that even the BOJ tried to get the economy moving again with half-hearted attempts at quantitative easing -- basically printing money -- the past decade. Chronic economic weakness kept deficits high, to the tune of a national debt equal to 220 percent of GDP today. Investors, academics, and credit ratings agencies alike have taken their turns betting against Japan's solvency -- and have taken their turns being wrong. Even with a debt burden out of Pete Peterson's darkest nightmares, Japan can borrow for 10 years for a piddling 0.74 percent. That's not to say that low borrowing costs are a sign of economic strength; the opposite. Japan's rock bottom rates reflect the realities that it cannot default, unless it chooses to do so, because it has its own central bank, and that nominal growth is expected to remain anemic.

But you don't have to be short Japanese bonds to think that this prodigious pile of public debt could eventually be a problem. How will Japan ever pay itself back, and it does mostly owe this money to itself, without destroying its economy? Just look at Europe. Austerity has actually increased debt ratios due to falling GDP; they have less debt, but they are less able to pay off what they owe. Austerity is not enough -- you need growth too. That's where the BOJ comes in. As Greg Ip of The Economist points out, a recent IMF review of public sector de-leveraging shows that easy monetary policy is the key variable in getting out from under a pile of debt. Low real rates keep interest payments low and helps inflate away debt. That's how the U.S. and Britain paid off their postwar debts, and it's what Japan needs to do now.

It's a choice between inflation and default. The BOJ's desultory easing has pushed Japan far too close to the latter. Take their latest currency intervention back in September. Rather than targeting an exchange rate -- saying they would print yen and buy dollars in unlimited amounts until the yen was worth what they wanted it to be worth -- they announced they would print another $100 billion or so of yen to push down its value. This worked, for a few hours. Then markets remembered that the BOJ wasn't making a lasting commitment, and the yen finished up on the day. As David Keohane of FT Alphaville points out, Japan's best plan is probably a Swiss-style exchange rate target -- in other words, unlimited easing. Of course, there's nothing magical about exchange rates. The key is just to target something, and do whatever it takes to hit that target. It could be exchange rates. It could be annual 3 percent nominal growth, as Abe suggested.

Monetary policy is no panacea, but what is? It would be pretty damning if policymakers let an economy stagnate for two decades and there was a cure-all they refused to try. It's damning enough if you substitute "monetary easing" for "cure-all". But central bankers are generally a cautious breed, and the problem, as Paul Krugman observed about Japan back in the 1990s, is they have to credibly promise to be irresponsible to get the economy out of a liquidity trap. It's no accident that it took a politician to stop deflation here during the Great Depression. It might take a politician to stop deflation in Japan now too.

Politicians don't usually succumb to self-induced paralysis.