Annals of the Financial Crisis

Japan's Bold, Limited New Economic Plan

Japan's central banker is pushing for higher inflation. How much good will it do?

Japan has announced a bold new plan to halt deflation. The idea is to effectively double the amount of money in circulation, getting the country back to 2% inflation as soon as possible.

I join most economists in thinking that deflation is bad, and it will be good if Japan can stop it. Deflation causes money hoarding--if that dollar you have now will be worth more later, it only makes sense to spend it later. Deflation also means that the economy adjusts to real shocks in the most disruptive way possible.

Say a company's customer base is shrinking, or getting more price conscious. They need to shrink their real wage bill by 3%. If inflation is running at 2% a year, they can just freeze wages and hold on for a little while. But if inflation is negative--i.e., if they have deflation--then they have to do something more drastic. Either they have to give employees a pay cut, which is really hard to do, or they have to fire people.

So too with debt. Deflation is good for creditors. But it's terrible for debtors. Say that business is slow and your mortgage is really starting to pinch. If inflation is 2-3%, you just need to hold on a bit; every year, the real value of your mortgage will shrink, making it easier to pay. If inflation is negative, you'll probably have to lower your prices. But the value of your mortgage doesn't adjust in the same way, so every year, it gets harder and harder to pay. Eventually, you may default. Both you and the creditor would have been better off with moderate inflation than an outright breach.

So it's good that Japan is serious about ending deflation. That said, it's becoming clear that monetary policy has pretty limited benefits. Opening the taps wide may prevent the worst of the misery, as Bernanke has done. But it has not cured the deep underlying problems in the economy.

I know what you're thinking: that's why we need more fiscal stimulus! But fiscal stimulus doesn't really fix the problems either (at least, not when done in amounts that it is practical to borrow). Most of the discussions of fiscal and monetary policy seem to forget that in most models, these are temporary fixes. Pumping a lot of money, or government spending, into the economy temporarily boosts demand. But in between 1-3 years, the stimulus has run its course; the economy returns to trend growth, possibly with somewhat more inflation (or possibly, in our case, with asset bubbles).

Moreover, if people start expecting the stimulus, they factor it into their calculations, and start planning around it: banks charge higher interest rates, taxpayers save more to pay the taxes they will eventually owe in order to pay off all of that debt. That kills your stimulus. Stimulus works when it is novel and rare, not a permanent way of life. Countries that have high levels of government spending combined with high rates of government borrowing over the long term--or high rates of monetary creation--do not look especially prosperous.

In other words, neither Keynesian stimulus nor expansionary monetary policy are long term solutions. And at this point, Japan very clearly has a long term problem. The Bank of Japan's move may ease some of the worst of the crisis. But it is not going to put Japan back on the road to health.