Why Japan's nightmare is worrying the world

IMAGINE a world in which house prices have ceased to rise. Instead, the housing market bubble has burst and there is a quiet, insistent downward drift in prices.

Suppose that interest rates have fallen so low there is no longer any point in holding a bank or building society account. The charges and fees more than wipe out any interest credited.

Consider an economy where prices are falling steadily, relentlessly, every year, and where the public has lost confidence in making a major purchase. Imagine what it is like in a world where saving has ceased to have logic, and where people keep money in a safe deposit box - or even, as in Japan, in the fridge.

Welcome to the world of deflation: a condition in which prices are in a state of continuous and seemingly unending decline.This is the enervating malaise that has gripped Japan for years. Few ever thought it would cast its shadow over other economies. But now it looks to be rolling silently, insidiously, unstoppably westwards, like a muffling, engulfing fog.

This is the prospect that has become the top concern of the world’s central bankers and economic policymakers. For more than 30 years, the cornerstone of policy was the fight against inflation. Now the worry is a slide into deflationary sclerosis.

And the example of Japan worries the world: 15 years on from the asset bust, prices are still falling, few trust the banks with their savings, deposit rates have dropped to just 0.01 per cent, the economy is barely growing and millions of Japanese households keep their money in safe deposit boxes or in gold bars.

Just a few years ago, the consensus among economists was that this was a deflation unique and exclusive to Japan, and that it could not spread here. Now they are not so sure.

In America, the Federal Reserve is running out of ammunition to revive the US economy by way of interest rate cuts. In Germany, which has just reported a fall in first-quarter GDP, there is a growing sense of entrapment and helplessness.

Earlier this week, the International Monetary Fund said Europe’s largest economy faced a "considerable" risk of "mild deflation". For the country’s four million unemployed, there is nothing "mild" about it. Germany’s output is no higher than it was in the first quarter of 2001 - and with no sign of a pick-up.

Adding substantially to its problems has been the strength of the euro - or more accurately, the weakness of the dollar, under the guise of what the US administration in Orwell-speak persists in describing as a "strong dollar" policy. In fact, the dollar has fallen 30 per cent on its level a year ago and looks set to fall further. While this will give a big boost to US exporters and thus to a general recovery across the US, it is not without huge risk - an accelerating exodus of global investors out of dollar assets.

And it is causing huge problems for the eurozone, Germany in particular, which relies on exports for a third of its GDP. Eurozone politicians still see the euro rally in macho terms, slow to realise how America is effectively getting Europe to pay for the Iraq war. And European Central Bank officials, loath to admit of any problem, continue to insist in their make-believe world that the strong euro is "consistent with economic fundamentals" and "a sign of confidence in the European economy and the monetary policy of the ECB".

But across the Group of Seven major industrial economies there is now something close to policy panic. The worry is over a creeping and generalised stagnation that could have profoundly adverse effects on employment and living standards across America and Europe.

For more than 30 years the central concern of economic policy across the G7 was inflation. Now there is growing pressure for central banks for a reverse thrust of the engines and a co-ordinated policy of stimulus to check incipient deflation before it takes hold.

In an extraordinary pronouncement earlier this month, Alan Greenspan, chairman of the Federal Reserve, said that "the probability of an unwelcome substantial fall in inflation" now exceeds that of a pick-up in inflation. This shift of perceived risk marks a fundamental change. But it poses huge problems for a generation of policymakers who have no experience whatever of how to deal with deflation.

Meanwhile, the policy dilemmas are growing. The yield on 30-year US government bonds fell to a new all-time low this week and there is pressure for a further cut in interest rates, already down to a 41-year low of 1.25 per cent.

On Tuesday, Greenspan said he was still unsure that a recovery in the underlying economy is under way. Behind the scenes, Fed officials are locked in an "extensive" study of what happened in Japan and the lessons to be learnt. The problem for Greenspan is that with few rate shots left in the locker, he has to make sure that any future cuts will have an effect. For there are many already asking why it is that a 13th cut in rates should succeed where the previous 12 since 9/11 have so signally failed.

The US economist Robert Samuelson says the US economy is gripped by a "new stagnation": not quite in free-fall, but not quite in recovery, either. Since late 2000, annual US economic growth has averaged about 1.5 per cent compared with an average of 4 per cent in the 1996-2000 period. Some 2.1 million jobs are reckoned to have vanished.

What makes Japan so worrying is the absence of any evident solution. There was much hope in the early Nineties that financial reform and fiscal stimulus would lever the economy back to growth. But despite more than 100 "stimulus packages" and almost £200 billion being pumped into the economy, prices continue to fall - and the economy to languish. Since 1992, Japan’s annual growth has averaged just 1 per cent. The average through the Eighties was 3.8 per cent. As for the stock market, it hit a new low earlier this month, down 80 per cent from its late Eighties peak. Unemployment has climbed, as has government debt, civil servants are facing pay cuts, department stores have been closed or mothballed - and sales of safe deposit boxes are booming as households give the fragile banking system a wide berth.

In Britain, deflation still seems a far-off prospect. House prices continue to rise, albeit at a more modest rate, and core inflation is still running at 3 per cent. But the economy is showing little growth and there is a strong expectation that interest rates will be cut next month to 3.5 per cent - and possibly down to 3.25 per cent by the year-end.

It is not deflation in the strict sense. But it would be another sign that we have moved into a new era, with different dynamics - and risks.

We should expect a triple hit of rate cuts over the next few weeks - in America and Europe as well as the UK. Let’s hope they work. For if they fail to spark a recovery, we could truly be in serious trouble.

I sure do remember reading all those scare stories back in the 1980s about how Japan was going to become a bigger economic power than even the United States. ...Even Tom Clancy saw fit to start writing about them once the Soviet threat began to diminish. All those concerns seem kind of silly now.

I read Debt of Honor and remember Rush plugging it on his show many moons ago. Michael Crichton also had a Japan-as-boogeyman book in Rising Sun. That caused quite the controversy, especially when the movie starring Sean Connery and Wesley Snipes came out.

As Alan Blinder of the Federal Reserve Board noted on CNBC earlier this week, it's perfectly conceivable that the American economy could feature price deflation alongside a depreciating currency. Imports/Exports only comprise some 10% of the U.S. economy - with only about 5-6% once parsing out nations (such as China) which peg their currency to the dollar or energy imports which are globally priced in dollars. In short, the absolute size of the U.S. economy is such that only extreme global economic pressures are likely to have a meaningful impact on domestic inflation/deflation.

Regarding real estate: Don't know about the rest of the country, but right now in Southern California we have a huge price inflation — some 20% or more over the past 12 months, with most of that coming in the last six months. Prices are breathtakingly, extraordinarily high, even for so-called starter homes. They are continuing to rise, with no end in sight according to real estate analysts. This is fine for people who already own property, but for someone like me — solidly in the middle of the middle class, with one income and a modest down-payment — who wants to buy a house, it's a dream-killer.

As I comment frequently, Greenspan is in deep trouble. A one-trick pony, his only control is/was to turn the Fed interest rate down. He has been doing this for a decade or so, to the point where the knob is nearing zero.

A negative fed rate would be amusing but hardly possible.

So he is out of control authority, and he seems to know it.

In other words, the only way anyone can turn the 'knob' is UP, i.e., increasing interest rates. This amounts to deliberately trying to start an inflationary period because they've been deflating so hard there's nowhere else to go.

--Boris

"Wage deflation is very much here in high tech. I made a total of over $300k last year consulting to big telecom firms. "

Since most of the "consultants" to dotcom companies in the past have resulted in the companies losing money or going broke, I'm not very surprised that they give you less up front - and if they get rich you deserve it !

If they had done the same thing 15 years ago we would not have had the bubble !

show me where the devalued dollar is causing import prices

It isn't noticeably yet. And while the price of oil is dropping, the price rise will not be felt because the cost transportation of goods is declining even as the price level is rising on average.My fear is that the unnerving price increases won't really get going until time to trash Republican electoral chances in W's second term. Mrs. Clinton would then be looking like a shoo-in in 08 and she would have a Congress she can work with.

The Carter inflation really got going in Nixon's presidency and contributed a little to Ford's loss to Carter. It really got roaring in Carter's term and, along with the hostage thing, gave us Reagan. It starts with a government trying to improve a national trade position and continues as a tactic for defaulting on part of the national debt by repaying borrowed money with cheaper dollars. It ends with economic crisis. Reagan nipped that crisis by stabilizing the dollar and by reducing the costs of doing business by deregulating. Other countries' economies have failed because their governments knew only to keep shovelling out money in ever increasing amounts to take up the slack. Democrats as we know them could not conceive of sound money as benefitting their goals and the Democrat who follows W will convert bad inflation into hyperinflation.

"...so that the dollars that go to repay the debt are worth less than the dollars that were borrowed. That is the classic manner for governments determined to cheat their creditors. "

But yet dollars themselves are evidence of debt. So one debt goes to pay another debt? If one debt goes away how does one get rid of the other debt? I have $10 in my pocket. Because of inflation it buys less as time goes by.
Is this how creditors are cheated? And am I a creditor just by virtue of the fact that I have $10 of government "obligatons" in my pocket? I don't want another debt as a store of value, I want something that is not debt. But the government has set us all up to be its creditor. Because it knows it can destroy the value of the debt by inflation. My 401K is denominated in government debt. Where's the vaseline? I'll need it when I become of age to access that money. There is something not right about setting up the people of an entire nation to be the creditors by virtue of holding government currency. Creditors face risk of default. Or gradual partial default in the form of inflation. Only holders of anti-debt are immune from default. What is anti-debt? My krugerrand for example is anti-debt. And in the Constitution, by instructing the Congress to COIN Money, and the states to make nothing but gold and silver coin a tender in the payment of debt the founders sought to ensure that the people would not ever be forced to use debt as money, or be unwilling unwitting creditors subject to constant risk of default.

Unless and until the Japanese government let's go of Japan's economy they will stay in this neverland limbo state.

Maggie Thatcher sold off the British government owned industries in the eighties. It hurt the coal miners like hell for the government to admit that many of their coal mines were just sucking money in subsidies and never able to break even, let alone make a profit. 70,000 miners lost their jobs, but their pain and those of others in the other industries cut loose helped save England's economy.

Deregulation here in the eighties did the same thing, as a company regulated to the point where it is illegal for a competitor to cut prices, is essentially a state run economy.

Now we are going to see if free market enterprise capitalism has more resilence than socialism.

But counting on our export market to rise in the face of a world economy that hasn't the spare change to buy our stuff may be foolish.

We are going to be affected by the world economy. I am hoping that the return of cheaper oil will help ease the blows all over the globe, not just here at home.

The Carter inflation really got going in Nixon's presidency and contributed a little to Ford's loss to Carter.

That's a good point. The difference between then and now, though, is that the U.S. government inflated the dollar simply as a means of paying of the enormous cost of the Vietnam War. Despite the monumental cost of war in Afghanistan and Iraq, those are relatively small efforts from a historical perspective.

"There might be a linkage between the gov't deficit, interest rates, and the real estate bubble"

Deficit is a fucntion of Expansionary Fiscal policy (Spending money into an ecnomy). Interest rates have all kinds of effects that are too numerous to be easily enumerated here. Real estate ... you may have somthing there.

"The deficit will have to be covered by issuing bonds, the bonds will sell better with higher interest."

Deficits generally don't matter. Look at the United States. I don't know about how Japan controls it's money supply though (which could eliminate or exacerbate the scenario that you envision). If they have a tight money policy (which i doubt) then that could be the problem.

Wolfstar wrote: "Regarding real estate: Don't know about the rest of the country, but right now in Southern California we have a huge price inflation — some 20% or more over the past 12 months, with most of that coming in the last six months. Prices are breathtakingly, extraordinarily high, even for so-called starter homes. They are continuing to rise, with no end in sight....."

......my daughter is going thru it right now Wolfstar...trying to get her first home just outside Washington DC.....she's paying $2200/month house rent with nothing to show for it at the end of the year.....to get something decent her mortgage will be around $4000/month, and that will be for a home that needs work....sounds nuts I know, but that's the market in her area....and BTW a lot of this is driven by the high crime rate in Washington....so much of the city has gone to hell that people have to pay thru the nose to get into a "safe" neighborhood [if there is such a thing]

It's perfectly conceivable that the American economy could feature price deflation alongside a depreciating currency.

Count on price inflation (in education, health care, other things that aren't imported from China), price deflation (on imports and industries with over capacity), gold inflation (the ultimate store of value now that paper is going out and "things" are coming in), money supply inflation (a 90 year trend likely to continue until we have the will to stop it), and continuing devaluation of the dollar against other major currencies (a long-term 30 year trend that would have been a 60 year trend, but for Bretton Woods).

Primary trend for next 10 years = Inflation or depression. There is no other way out

Oh, Greebean's in trouble all right, but your charactisation of him as a financial 1-trick pony is inaccurate. The Fed -- any day it likes -- can start buying back Treasury securities of various maturities, thus increasing the 'actual' money supply.

Add a trillion in liquidity over, say, 6 months' time, and watch what happens.

Boris, old boy, it's intellectually that Greenbean is a 1-trick pony. Throughout his career, only inflation was a menace.

Not that deflation is a menace now (or, at least, not to the US economy). First, there isn't any. Second, Japan's pernicious deflation was started, and continued, and will continue for the foreseeable future until such time as Koziumi or one of his successors ORDERS the liquidation of failing companies and institutions.

Unpopular, sure, and dipsticks want nothing more than to be re-elected. The US had its own situation like Japan's, once. The SecTreas of the day told the President and the Fed chairman to '...liquidate. Liquidate debt, and capital, and labour, and farms. But above all, liquidate debt'.

The President who ignored this explicit advice was, of course, Hoover. Then the second Roosevelt came along and tried to inflate his way out of deflation. Politics aside, never mind left, right, or center, this can never work ... indeed, the worldwide record of this dubious policy is consistent in one point only -- its utter failure.

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