Japan's Deflation Dogfight

Aft

er years of wandering in the policy wilderness, Japan's financial wizards think they have discovered what's really wrong with Japan's economy. It's deflation. In January, Prime Minister Junichiro Koizumi called falling prices Japan's "most urgent policy task" and declared he was taking all possible steps to curb its ravages. Such posturing drew praise from experts ranging from Japan's economics czar, Heizo Takenaka, to the chairman of the U.S. President's Council of Economic Advisers, R. Glenn Hubbard. Front and center in Koizumi's new war is the Bank of Japan (BOJ), where Governor Masaru Hayami ends his five-year term on March 19. In a string of a barely veiled critiques, Koizumi has said he intends to appoint by month's end an "aggressive deflation fighter" to replace the unpliant Hayami.

Unfortunately, this new deflation-busting zeal may be nothing more than a reformist fad that mistakes a symptom for the disease. No doubt Japan is experiencing deflation. But with consumer prices falling less than 1% annually for the past four years, it's hardly a deflationary spiral. In fact, much of the price decline stems from increased competition in newly deregulating industries, such as telecom and retailing. What's more, falling prices are generally good for consumers and businesses alike if they come with productivity gains that allow companies to preserve profits even as they cut costs. So today's antideflation rhetoric seems peculiarly misguided. Indeed, the main benefactors of high prices, economist Richard Katz argues in his new book, Japanese Phoenix, are precisely the inefficient manufacturers and suppliers that have helped make Japan's economy so uncompetitive. If prices rise, these companies will be able to stay exactly as they are, instead of facing the reality that they must be more productive or die. "That is one reason," writes Katz, "why the defenders of Japan's backward industries have pounded so hard on the deflation issue."

To push the burden of inflating the economy onto the central bank not only underestimates Hayami's efforts but overestimates the options available to his successor. The deflation busters insist that the BOJ can jump-start growth by encouraging more investing and spending. But a central banker has a relatively small number of imprecise tools at his command, and the current governor has exhausted virtually all of them. Over the past five years, Hayami has consistently kept interest rates at nearly zero in a desperate bid to get people spending. Money in Japan is practically free for anyone who wants to put it to work, yet growth continues to lag. If monetary policy were going to ignite inflation, it would have started to work a long time ago.

Not so, argue the deflationistas. As they see it, there is plenty more the BOJ should do. It can engage in "quantitative easing," they say, which is fancy talk for flooding the system with money, either by printing yen or buying huge slugs of government bonds. Former BOJ official and current Diet member Kouhei Ohtsuka snickers at the first option, calling it "helicopter money." "Just because you fly around sprinkling the ground with cash doesn't mean people are going to spend it," he says. And the second option? The BOJ has been quietly buying greater quantities of government bonds since early 2001, expanding the monetary base by 38%—to no avail.

The deflation hawks still fundamentally misunderstand the nature of Japan's economic stall. Companies here make more than can be consumed, and the Japanese customer simply does not want what is on offer, however cheap it may be. What still is required is a national commitment to structural reform. Revising corporate-governance rules would be a good start. Right now, for example, bank managers need never fear for their jobs no matter how poorly they perform; that's because extensive cross-ownership between banks and affiliated companies minimizes publicly available shares, making corporate takeovers, especially by foreigners, exceedingly difficult. Shielded from competition, lame banks are free to limp along with little incentive to reform. Another example strikes right at the heart of the country's pocketbooks. Using the dubious justification that the nation's food supply needs to be more "self-sufficient," Japan's inefficient agricultural sector has successfully lobbied for tariffs and subsidies to protect it from outside rivals. The result? The food budget for the average Japanese household is now 23% of income, compared with 10% in the U.S. By deregulating the food market, prices will fall—bad news for cosseted farmers but a windfall for the typical family and, eventually, a more productive economy.

A BOJ governor who accepts the role of single-handedly righting the Japanese economy through monetary policy alone is setting himself up for a long fall. Contrary to the current sentiment in Tokyo, there is only so much impact a central-bank governor can have on a dysfunctional economy in the first place. And in Japan, the new governor will quickly discover that more than half the arrows in his quiver have already been spent.