[paper] How Should We Avoid a Critical Deflationary Spiral?

Kazumasa Iwata

The continuous fall in prices in Japan is an extraordinary situation for postwar industrialized countries. I see three factors behind this deflation. They are the burst of the stock and land price bubble at the beginning of the 1990s, a sharp hike in the yen during that period, and the stringent monetary policy in the first half of the 1990s that caused the deflation to accelerate further. These factors combined made deflation settle in Japan from 1995. There are arguments that the fall of the prices have been caused by the regulatory reform and the global market expansion, including China, but they are not the main causes; I believe that the deflation is fundamentally a monetary phenomenon that can only be addressed by monetary policy. According to my economic model, the Japanese economy has been in an unstable deflationary equilibrium since 1995. My calculation indicates that this equilibrium will definitely be broken once the deflation rate breached 3% points and will go into a critical deflation spiral. As long as we remain on our present track, the equilibrium will hold up to a 3% deflation rate, but once we get off this track, we could fall into a spiral at any time. Today there are three risk factors for such possible deviation from the deflationary equilibrium. The greatest shock would be a U.S. attack on Iraq. Also, the disposal of non-performing loans would have an effect, though it cannot be avoided for radically reforming the Japanese economy. The most problematic of all, however, is that not all power is put into anti-deflation policy measures. The top priority must be placed on “checking deflation,” and a desirable policy package would be one that drastically changes the BOJ’s conventional policy and implements more comprehensive and daring tax cuts than in the past. Looking back at the time of the Showa Depression and the U.S. Great Depression, the BOJ’s enormous purchase of government bonds had checked deflation and lowered the exchange rate to a large extent. With the government and the BOJ coming to share common awareness about non-performing loans around the time of the earlier Cabinet reshuffle, the required conditions are beginning to be met. A concrete package covering taxation, monetary policy, and the disposal of non-performing loans must be presented to the nation in a visible form; the faster the better. It is my belief that the period from the end of this year to January or February of 2003 will be the last chance.