Monday, December 14, 2009


"But how do you explain Japan's deflation?"

Those of us who have been warning of impending (and large) price inflation have thus far been kept at bay by the apparent counterexample of Japan. It's what Scott Sumner brings up to me when we really go at it (that and the bond market), and it's how Paul Krugman dealt an apparent death blow to Alan Meltzer back in May.

At the time, I didn't know how to process it, because I hadn't really done much research on Japan. But in doing the research for my Depression book, I knew that Krugman's discussion of the "lessons of the 1930s" was often the exact opposite of what I ended up believing after looking at the data myself, so I remained skeptical.

In response to Arthur Laffer's WSJ op ed, Krugman attacked with this chart showing (apparently) that in Japan the monetary base also shot up like a rocket. So again, the idea is that Japan is a counterexample to all of the deficit hawks' warnings.

But wait a second. Look closely at that chart. Japan's monetary base went up by about 90% from 1997 to 2005. That's a growth rate of about 8.4% per year. In contrast, under Bernanke the monetary base almost tripled in a little more than a single year.

So it's still true that Japan provides an interesting case study; I admit I would not have thought those charts--especially the M1 chart--could be right. However, it's misleading to say, "Japan had a big growth in the monetary base, just like we have now, and their currency didn't tank."

Of course, the other main difference is that we are currently experiencing price inflation. Absent another major terrorist attack or a financial panic, I don't see why the demand for USD would rise, meaning I don't see how its purchasing power can remain stable if those excess reserves begin leaving the banks, as I expect they eventually will.

Japan is an interesting case... but there's one important note: Japan's Year-over-Year growth in M2 never exceeded 4.5% from 1999-2003. In contrast, in the US our YoY growth in M2 has never been BELOW 4.5% since 2006.

I'm very happy to grant that inflation won't happen as long as the monetary base growth stays in the monetary base. But, the data suggests that it's NOT staying in the monetary base.

Japan has tried all the monetary and deficit levers over the last twenty years without success, just like the US in the thirties. The big difference is that its trading counterparties have been buying Japanese goods, so it has been kept afloat not by government intervention but by its export markets and investment returns on its foreign manufacturing operations.

We should be so lucky.

The population is savings-driven and is therefore fundamentally different from us Anglo-Saxons. This means that when the Bank of Japan pumps money into the system, it is not spent, but saved and invested, for example, in the carry trade. This is why, I think, that the performance of the Yen defies western logic.

Using Japan as a precedent for US economic policy decisions is very foolish.
And Japan's terrible deflation was, what at most a percent a year? Wow, something to be terrified of. I can see where people would be jumping off tall buildings under those conditions.
There was a discussion about Japan's case on Gary North's website a few weeks ago. Here's a comment I posted on Gary North's Banking and Politics forum: In Why the Deflationist Argument is Wrong in Both Theory and Practice, on today, Gary North wrote, "you should dismiss the entire deflationist position as crackpottery".
Two of his 6 arguments are "2 The FED has chosen to imitate post-1990 Japan.
3 Japan has has never had a year since 1990 in which consumer prices went negative by as much as 2%." The arguments (all 6) are convincing.

Can someone then explain this headline today on the Nikkei website: Hatoyama 'Shares Views With BOJ' On Need For Beating Deflation.

Prof. North's response was, Japanese central bankers are Keynesians and don't know what deflation is.
Japan could survive because it exported. The yen was not a reserve currency. The dollar is. The world was not ready to dump yen. The world is ready to dump dollars. That is a huge difference.
Gary North also addressed the issue in an article entitled "Spooked by Headlines" (this may be behind a membership wall).
I thought the reason Japan did not experience excessive price inflation was mostly due to the Yen Carry trade?
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