Raghuram Rajan bares Japan deflation paper tiger in Sri Lanka oration

ECONOMYNEXT – Reserve Bank of India Governor Raghuram Rajan dealt a decisive blow to interventionist criticism of Japan’s ‘deflation’ showing that ‘growth’ was no lower than inflating developed nations, but unemployment was sharply lower.

He said authorities in developed nations were obsessing for ‘growth’ fearing deflation.

"The canonical example here is Japan, where many are persuaded that the key mistake it made was to slip into deflation, which has persisted and held back growth," Rajan said in published remarks of a lecture in Sri Lanka’s capital Colombo.

"A closer look at the Japanese experience suggests that it is by no means clear that its growth has been slower than warranted let alone that deflation caused slow growth."

But even available state statistics showed that growth in Japan was not much lower than the US or Europe except in the 1990s when over-leveraged firms were clearing up their balance sheets after a burst credit bubble.

The Low Growth Lie

"It is true that after its devastating crisis in the early 1990s, Japan may have prolonged the slowdown by not taking early action to clean up its banking system or restructure over-indebted corporations," Rajan said.

"But once it took decisive action in the late 1990s and early 2000s, Japanese growth per capita or per worker looks comparable with other industrial countries."

From 1996 to 2000, growth in the US averaged 3.10 percent and the Euro area 2.41 percent, while Japan lagged behind at 0.63 percent.

From 2001-2005 Japan posted 1.05 percent growth compared to 0.99 percent from Europe and 1.56 percent for Japan.

From 2006 to 2010 Japan’s growth was 0.35 percent and the US was in negative territory at minus 0.12 after a burst credit bubble and the Euro area was 0.41 percent.

In 2014 Japan posted growth of 0.91 percent and the US 1.38 percent and the Euro area 0.13 percent.

Some classical economic analysts have pointed out that low gentle deflation is the best economic condition to have for the poor.

When monetary conditions are neutral private sector productivity partly driven by availability of real capital or capitalism can drive productivity up and bring prices down, boosting living standards and making state calculated price indices fall.

A central bank which tries to generate positive inflation during such a period will generate a credit bubble and economic collapse.

Economists have pointed out that the low inflation in the late 1990s with falling oil prices and gold after the collapse of the ‘tech bubble’ made Greenspan-Bernanke engage in their now-infamous ‘mother of all liquidity bubbles’ which generated the post 2008 economic collapse.

The Jobs Lie

Unemployment on the hand was sharply lower in Japan than Europe despite the so-called deflation bogey.

"What about the deleterious effects of deflation?," Rajan asked. "One worrisome effect of deflation is that if wages are downwardly-sticky, real wages rise and cause unemployment.

"Yet Japanese unemployment has averaged 4.5 percent between 2000-2014, compared to 6.4 percent in the US and 9.4 percent in the Euro area during the same period."

In Europe state regulation is tighter than the US and tax-to-GDP ratios are also higher which may destroy job creating investible capital especially through higher income tax rates.

Meanwhile Rajan said downward sticky wages can be addressed by flexible contracts, which also happened in Japan.

The Savings and Consumption Lie

"Another concern has been that moderately low inflation spirals down into seriously large deflation, where the zero lower bound on nominal interest rates keeps real interest rates unconscionably high," Rajan said.

"Once again, it is not clear this happened in Japan."

Another argument was that in a period of deflation it may cause customers to increase savings in anticipation of a lower price in the future.

"Again it is hard to see a sustained pattern of higher savings with higher deflation," Rajan said.

Classical economists have said that Japan’s rate of savings is partly related to its ageing population which tends to save more than younger people and it can also lead to a trade surplus.

Such problems should not be corrected by monetary policy but if necessarily in migration should be allowed, as would have happened in a less-nationalist country such as the US where borders are porous millions of so-called poor ‘illegals’ come in, generating a virtuous cycle.

As the yen appreciated, Japanese firms which had global brands and sales networks with loyal customers, instead of importing labour invested in countries like Vietnam literally creating millions of jobs in a ‘greater Japan’ and lifting them out of poverty.

Low gentle deflation is the best possible economic outcome to have, since it also limits the ability of state to borrow and destroy their real debt and steal from savers especially older people who save more.

Deflation: A problem for rulers

There is usually no problem with low gentle inflation for the ordinary people or the poor, but it is a problem for grandstanding deficit spending, regulating control-minded, elected ruling class and their intellectual backers including economists.

Meanwhile Rajan said many developed countries had pension commitment to the public sector which could only be met with ‘growth’.

If the problem was debt, it should be re-structured instead of resorting to money printing (inflation).

"Finally, it is true that deflation increases the real burden of existing debt, thus exacerbating debt overhang," Rajan said.

"But if debt is excessive, a targeted restructuring is better than inflating it away across the board. Regardless of all these arguments, the spectre of deflation haunts central bankers.

"When coupled with the other concerns raised above, it is no wonder that the authorities in developed countries do not want to settle for low growth, even if that is indeed their economy’s potential."

He said growth potential can be increased by real changes to the economy that give more freedom for people to act.

"Structural reforms, typically ones that increase competition, foster innovation, and drive institutional change, are the way to raise potential growth," Rajan said.

"But these hurt protected constituencies that have become accustomed to the rents they get from the status quo.

"Moreover, the gains to constituencies that are benefited are typically later and uncertain.

"No wonder Jean-Claude Juncker, then Luxembourg’s prime minister, said at the height of the Euro crisis, “We all know what to do, we just don’t know how to get re-elected after we’ve done it!" (Colombo/Oct06/2015)