Monday, April 11, 2016

What's wrong with deflation?

By Jerald Schiff, Ph.D.

In Japan, the overall price level in the economy has declined steadily since the bursting of a massive real estate and stock market bubble in 1991. That means that a college student in Japan today has never experienced a time of rising prices.

Why is that a problem? After all, many of us complain about rising prices, so falling prices should be welcome, right? Well, there a couple of problems with this view. First, wages are also prices of a sort--the price of labor. And with deflation, wages also tend to fall. Second, when expectations of falling prices become entrenched in people's minds, that can lead an economy into a deep hole, from which it can be difficult to emerge. Consumers, expecting prices to fall, will hold off on buying things. And businesses, seeing this declining demand--and expecting prices to fall further--will put off investing in new machinery and equipment or hiring new workers. This is precisely what we've seen in Japan for two-plus decades, a period often referred to as the country's "Lost Decades."

Since 2013, the Abe administration has sought to reverse this process, by raising inflation into positive territory and increasing demand within the country, turning a vicious circle into a virtuous one. But, despite some early success, this has proved quite difficult, in part because changing people's mindsets is hard. Despite an extremely stimulative monetary policy put in place by the Bank of Japan, inflation remains close to zero. Businesses have been reluctant to raise their prices, knowing that consumers have become extremely price sensitive over the decades of deflation. And when prices have risen, these same businesses have resisted wage increases or new investment, in part reflecting fears that any gains will be temporary.

The attached video provides a really interesting example of this problem. In mid-March, a Japanese ice cream company, Akagi Gyunu (famous for its unusual favors, such as spaghetti and potato stew!) announced its first price rise in 25 years--a hike of less than 10 cents. The increase was accompanied by this heart-felt apology video to its many customers. While many of us might wish that companies here would take a similarly socially-oriented approach, the video can also be viewed in a much less positive light--as a reflection of the challenges Japan still faces in exiting deflation and its Lost Decades.

(Jerald Schiff, Ph.D. was previously Deputy Director of the Asia and Pacific Department at the International Monetary Fund (IMF) and was Mission Chief for Japan. He currently teaches at American University in the SIS.)

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