Economic Theories of Deflation

The comedian Tsurube appears on a TV commercial for a drug for knee aches. He sits on the stairs of Spanish Plaza in Rome watching peole climbing up, and wonders "Do people have knee aches because of obesity, or do people have obesity because of knee aches ?" I learned that a similar heated discussion is going on among economists and between the Government and Bank of Japan (BOJ) "Does deflation cause recession, or does recession cause deflation ?"

Under the deflation of 1% a year, if ten thousand yen borrowed today in zero interest rate will be returned in one year, the returned ten thousand yen will buy 1% more things and will be 1% more valuable. Therefore, the effective interest rate is 1% even in the zero nominal rate. In deflation, people with debts will have more difficulty in repayment year by year. Therefore, people suppress purchase, and it causes recession. On the other hand, recession decreases demand and causes decreased prices and deflation. Like obesity and knee aches, either of deflation and recession can be cause or result. Which way is more dominant is the subject of heated discussion and it dictates the countermeasures differently. Concerning this point, I learned with surprise, the mainstreams of the economists in the world and in Japan take quite the opposite standpoints. Let's call them tentatively "the international school" and "the national school".

The international school asserts as follows; Since deflation is a problem of the currency. it can be terminated by financial easing by BOJ, and as the results, recession shall be remedied and Japanese economy shall revive. It is inexcusable that BOJ has never been serious enough for financial easing. For high officials of BOJ, deflation must be welcome because they get fixed monthly salaries despite deflation. But they should seriously think of people in general who suffer from recession.

Recently I read a book by Professor Emeritus of Yale University, Dr. Hamada. His assertion is typically of the international school. He has long played a brain for Mr. Abe, the Prime Minister, since Mr. Abe was the chief secretary a decade ago. The "first arrow of Abenomics" is "daring monetary policy", meaning financial easing. It stems from the assertion of the international school. BOJ was strongly against this idea and asserted that monetary policy could not annul deflation in Japan. But Mr. Abe wrenched BOJ and let them pronounce the inflation target at 2% a year on January 22nd.

The Nobel prize economist in US, Professor Paul Krugman of Princeton University is the backbone of the international school, and has often contributed to Japanese newspapers to assert that Japan should set the inflation target. Now he highly praises Abenomics. He believes in QTM=quantity theory of money. It says, increased amount of currency --> decreased interest rate, annulment of deflation and cheaper Yen --> termination of recession. Most national school economists believe in this theory as well, if the interest rate were not near zero as in Japan. But in Japan in the near zero interest rate, they say, this theory doesn't hold in the very first arrow sign. "Liquidity trap" is the economic term for the situation where the interest rate is already near zero with little room for further lowering, and therefore for effects of increased money supply. In the zero interest situation, commercial banks need not lend money and the increased money will just stay in the banks.

Professor Krugman therefore published a paper in 1998 on the liquidity trap. Even though the interest rate can not be lowered below zero, he asserted, it is possible to let people believe that inflation will arise in the future, and then QTM will hold true regarding the future economy. This way, economy could get out of the liquidity trap, deflation and recession. This idea was followed by Mr. Abe according to Professor Hamada's advice, and he seems to be gaining initial successes.

The national school denounces QTM saying as follows; (1) In the past twenty years of near-zero interest rate, no correlation can be observed between increase of monetary amount and increase of prices or GDP. (2) Future QTM anticipation under zero interest rate is interesting only qualitatively but is quite weak quantitatively. (3) The monetary amount is passively determined automatically for the purpose of stabilization of prices and unemployment rates. But the common ground of the national school economists ends here, and they quite differ in what causes the recession. In November 2011, BOJ held an international study conference on Japanese economy and its conclusions were published in June 2012 in a paper titled "Chronic Deflation in Japan". It can be referred to at
"www.boj.or.jp/en/research/wps_rev/wps_2012/data/wp12e06.pdf".

The paper asserts; weak growth prospect --> decreased demand --> recession --> deflation. The reasons for the weak growth prospect varied among scholars attending the conference as follows; (1) Decreased population and its aging --> Decreased potential growth rate --> Decreased natural interesst rate, (2) Commercial banks avoid committing risks in lending money, (3) Regulations in distribution industries, (4) Rise of developing countries, (5) Government proclamation of deflation in 2001 and 2009, etc.

Professor Yoshikawa of University of Tokyo published a book to propose a more persuasive reason than any of the reasons above.Professor Hamada's earlier book described only his assertion, but Professor Yoshikawa's book explained in detail theories in opposition to his assertion.
Deflation, Hiroshi Yoshikawa, Nikkei Publishing, 2013/1/18
His theory goes as follows; Globalized economy --> Collapse of traditional Japanese employment schemes --> Decreased bonus and increase of irregular employment --> Decreased per-capita nominal wages(only Japan in the world) --> Decreased demand --> recession --> deflation.

Discrepancy between the international and national schools may be attributed to the distance to the zero interest rate. Abenomics seems successful in "Inflation prospect" in the near future and the stock and real estate markets have begun to move. Mr. Abe has indeed bought the time, in which, I hope, he could start the third arrow of Abenomics, the growth strategy.

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