The Return of Deflation.

Andrew Smithers
Nikkei Veritas - Market Eye column, 17th July 2009

In June consumer prices in Tokyo were 1.5% below the level of a year before. This news was generally greeted with concern by the world’s financial press. Although such worries are usually reasonable, in today’s conditions falling prices may prove to be moderately good news for the Japanese economy.

Consumer deflation, which is when the prices of goods and services fall, presents different problems from asset price deflation, when share, land and prices fall. The latter was the problem after 1990, but not today. When consumer prices fall, real interest rates become positive, even when nominal interest rates are near zero. The faster prices decline, the higher real interest rates become. As increases in real interest rates usually dampen demand, the increased pace of deflation indicated by the latest data suggest that monetary policy is being tightened, without the Bank of Japan being able to do anything about it. If, however, one looks at the ways in which different sectors of the economy react to deflation, there is a case that its impact today might even be helpful.

The economy is divided into the household, corporate, government and foreign sectors, with the latter being largely unaffected by falling prices. Over time, the impact on the government finances is bad. Deflation means that nominal GDP is likely to fall even if real output rises and, as government debt is almost entirely expressed in nominal terms, this means that the ratio of the national debt to GDP rises with deflation, making the longer term problems of the government sector even worse. In the short-term, however, the effect is minimal.

Prices tend to respond more quickly than wages so, with deflation, businesses find that their sales’ income falls faster than employment costs. This means that profits suffer. When profits fall, companies cut back on investment and employ fewer workers. At the moment, however, companies are cutting back on investment anyway. In these articles I have often pointed out that Japanese companies have been investing too much. Growth in output has been the lowest among the major developed countries, despite corporate investment being much higher than elsewhere. In practice, therefore, much of the investment has really been wasted, as it has produced no benefit in terms of output or profits. Although higher real interest rates may cause investment to fall faster and further than it otherwise might, this has at least the advantage of improving the long-term balance in the economy. There is, however, usually a short-term cost; lower investment reduces demand and will weaken the economy, unless the effect is offset by some other form of demand.

One possible offset is consumption, which may actually be helped by falling prices. When it comes to costly items, such as automobiles, the prospect of falling prices may cause consumers to delay their spending, but falling prices mean that households with stable nominal incomes have rising real incomes and can therefore afford to spend more in real terms. The impact of deflation on consumption is therefore twofold. Incomes will be hit if companies cut back on employment or cut nominal wages but, if these cuts are mild, they may then be less than the rise in real consumer incomes caused by falling prices.

The real wealth of Japanese households tends to rise with deflation, as their financial assets are largely held in bank deposits and life insurance policies. As deflation makes households richer, it’s unlikely that households today will increase their savings, which means that they should spend any improvement in their real incomes. The short-term impact of deflation on the economy thus depends mainly on the way companies respond. If they concentrate on cutting investment expenditure rather than their wage bills, the negative impact is likely to be small and, looking longer term, should be positive, by encouraging the move towards a better balance in the economy with consumption rising at the expense of investment.

Because Japanese companies have invested so heavily in the past, they have very high levels of depreciation. As investment falls, so will companies’ depreciation expenses. As a result, profits could actually improve, even if wages take a higher proportion of total output than they have in the past. Higher wages and consumption balanced by lower investment and depreciation are needed and the process of adjustment may actually be helped by the fall in consumer prices that is currently occurring.