On Japanese Debt and Deflation

T'is a rare gift: to write, and write accessibly, and never once write anything mundane.

Peter Tasker has it.

Furthermore, I find that his every composition there is one sentence that cuts through the tangle, undoing the Gordian Knot inside one's head. In his latest essay for the Financial Times on the relative sustainability of Japan's debt burden, he writes:

The buyers of these bonds - deleveraging corporates, de-risking financial institutions, individuals turning their backs on equities and real estate - are hardly speculators. They have sound reasons for the choices they made. Not least is the fact that deflation - which is understated by Japan's outmoded CPI calculations - generates an invisible tax-free gain to holders of cash and bonds.

I have heard several dozen specious explanations of why the citizenry, business and policy makers have tolerated deflation these past two decades. I have found these explanations wanting and almost always demeaning of the people's ability to think. After a while one is no longer thrilled by minor boon of the can of soda getting larger every decade, or new cheaper low-end goods. The economic literature warns against deflation. Deflation cripples the mechanisms of borrowing capital for business activity, crushing borrowers beneath ever heavier real burdens. It also makes central bankers doing plain vanilla central banking operations look like total fools.

Given the erosion of economic animal spirits, why would any nation long accept deflation, except when it is the consequence of technological change leading to increases in productivity?

Because, for bond holders and equity holders, it represents an untaxed net gain.

Oh yeah. That would make deflation worth the pain for some folks, wouldn't it?

My stupid.

Richard Katz's essay for the Asian Wall Street Journal (behind the subscription wall, but excerpts appear in a posting to the NBR Japan Forum), offers some sad facts for Kan Naoto and others who seem to believe that there is a quantitative easing free lunch. As Katz points out, consumer inflationary expectations are chronic: despite twenty years of evidence to the contrary, the public still believes that price rises are just around the corner. He is also right in saying that the public considers inflation a tax -- and they cut their consumption now in order to have the savings to cover the tax later.

Katz is probably wrong, however, in arguing that deflationary expectations do not erode spending. As evidence he cites the decline of the savings rate. A decline in the savings rate says little about a propensity to spend and a great deal about declines in disposable incomes. If one makes 10 million yen one year and save 10% of one's income, then only 8 million yen the next year and saves nothing, one's spending still has declined by a million yen, and your mood, quality of life and contribution to GDP has declined accordingly.

Furthermore, while deflation may be neutral for necessities and small ticket items, it stands to reason that it is devastating for big ticket items. Buying a new home or signing a rental contract or splashing out for the purchase of a new automobile will be restrained by a fear of possible of humiliation, of feeling dumb for paying too much for something that will be cheaper later on. While imperatives such as the birth of children or having to care for an aging parent may force some decisions, the threshold to taking on a life cycle-level purchase is lowered when one has the knowledge that one will in part be bailed out by the diminishing value of cash. It strikes me as unlikely that revised cultural preferences, technological shifts or regulatory limitation (or lack of space) are keeping houses small, telling consumers switch to keijidosha or convincing them to purchase white goods less frequently.