Japan: A Sad Case Study in Deflation

The dreaded "d" word -- deflation -- is the clear and present danger for central bankers in the U.S. and Europe. And to understand the implications, just consider Japan. It's a deflation nation, where the underlying values of houses, stocks, and wide-screen color TVs keep eroding year after year. The widespread destruction of wealth from the collapse of land prices and equities is now well known. Since 1999, however, the price of general goods as reflected in Japan's consumer price index has been falling, too. That may sound like nirvana for consumers in a land long known for its sky-high prices. Yet it is cold comfort to workers with falling wages who constantly fear for their jobs.

Once deflation takes grip of an economy, it is devilishly tough to unwind. A sort of mass psychology takes over as consumers put off big purchases, knowing full well that a house or DVD player will be cheaper a year out. Companies, too, put off major investment decisions, assuming that demand will be weak. Tokyo policymakers pumped $1 trillion-plus into the economy in the past decade in public-works spending, tax cuts, and rebates -- all to little avail -- while the Bank of Japan long ago slashed interest rates to near zero. None of this has done much good. Japan's deflation is largely structural, with too much capacity and capital tied up in the wrong parts of the economy. Fixing that means forcing banks to do triage on their loan books, even if some companies fail and unemployment soars. It's difficult and painful work. Alas, Japan hasn't been able to muster the collective will to get that job done.

Deflation can be a life-altering event for millions of families, creating inequalities in the society at large. Middle-aged Japanese in their most productive years, who bought houses at the top of their market in the late 1980s and who face hefty tuition bills for their children, have been hammered. But older Japanese, who bought their houses well before the boom and bust in real estate, paid off their mortgages, and educated their kids, now control 80% of Japan's $11 trillion in household savings. As prices fall, their standards of living rise. As for the younger generation, getting a good-paying job is much harder now.

Not all of the news out of Japan is grim, of course. The big declines in land values and low interest rates have given younger Japanese -- those with secure jobs, anyway -- a shot at more affordable housing. Cheaper leases have allowed innovative companies to expand into prime locations in Tokyo. And the economy is far more open to global competition than it was two decades ago. But on balance, deflationary Japan is not a good place to be. Japan needs to get its economy growing again to boost corporate profits and wages. Until then, Japan will continue to slip ever more into global economic irrelevance.

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