Japan Learns to Live with Deflation

Ben Bernanke has been lecturing on deflation's perils since he joined the Federal Reserve in 2002 and has often held up Japan as Exhibit A. When the Fed launched QE2, the quantitative easing program to promote credit expansion in the U.S., in November, the central bank chief hoped to avoid the scourge that has devastated Japan's economy. U.S. consumer prices, excluding food and fuel, climbed at their slowest pace since records began in 1959, the Commerce Dept. reported on Dec. 22.

There's something curious about the way the deflation syndrome has played out in Japan, though. The Japanese don't feel that threatened anymore. "Everyone knew deflation was bad for jobs and bad for the economy, but gradually households and companies just got used to it," says Martin Schulz, a senior economist at Tokyo's Fujitsu Research Institute.

Deflation—the steady drop in prices of goods, wages, and services—has many ill effects. Households are stuck paying off mortgages, car loans, and other debt even as their take-home pay has declined. Also, as housing values fall, consumers have smaller nest eggs for retirement. Companies, meanwhile, are unable to raise prices, which puts pressure on profits.

Yet the Japanese have discovered the benefits of deflation as well. Monthly pay dropped to an average 315,294 yen ($3,800) in 2009, the lowest level since the government began tracking wage data in 1990. "It's not like I'm promised any pay raises," says Momoko Noguchi. The 24-year-old Tokyo resident gets by on two part-time jobs by shopping for everything from nail polish to dinner plates at her local 100-yen outlet (the Japanese equivalent of an American dollar store), and she pays 400 yen or less for lunch. "I hope prices keep falling." Four out of five Japanese say higher costs would be "unfavorable," according to a central bank survey.

Faced with consumers such as Noguchi, companies in Japan have actually accelerated deflation. Retailers "have poured a lot of energy into offering products that are cheap but still have high value," says Naozumi Nishimura, an analyst at TIW in Tokyo. "We're seeing some good effects from that."

To help reverse a seven-year decline in same-store sales, McDonald's Holdings Japan, a unit of McDonald's (MCD), introduced a 100-yen menu in 2005. The chain's 100-yen hamburger sold for 210 yen in 1990. "We wanted our customers to know that we've changed," says Kazuyuki Hagiwara, Tokyo-based senior marketing manager at the company. Since the debut of the lower-priced menu, same-store sales have climbed every year. McDonald's Japan shares have returned 17 percent in the past three years.

Price cutting by companies has helped Japanese consumers adjust to deflation. The average household owns 1.4 cars and 2.4 color TVs, about a quarter more than in 1990, a Cabinet Office survey shows. Deflation has helped home buyers, too, by forcing prices down from their peaks in 1990: According to calculations based on yearly Land Ministry data, Japan's residential land prices have dropped by an average of 2.9 percent a year over the past two decades.

Golfers pay 26,800 yen ($324) to play on the weekend with a caddy at the Bobby Jones Jr.-designed Oak Hills Country Club, 90 minutes' drive from central Tokyo. Twenty years ago the fee was about 40,000 yen, says Katsutoshi Ohira, acting manager. All told, the proportion of people content with their standard of living was 63.9 percent last year, compared with 63.1 percent in 1989, a government report said.

Deflation is so entrenched in Japan that companies are exporting it. Fast Retailing plans to open 44 Uniqlo stores overseas this fiscal year. Supermarket chain Aeon has earmarked about $2.5 billion over three years to open stores in China and Southeast Asia. Daiso Industries, which dominates the 100-yen retail sector, now has outlets in more than 20 countries.

In Japan, where 23 percent of the population is over 65, a sudden rebound in prices would hurt pensioners and retirees especially hard. "It's amazing what you can buy with 100 yen now. We didn't have 100-yen stores before," says Sachiko Enokida, 80, who lives on her bimonthly pension checks from the government. "I would hate for things to get expensive again."

So is deflation a blessing in disguise? Not to analysts such as Richard Jerram, head of Asian economics at Macquarie Securities (MGU). He points out that as businesses cut prices to compete, it becomes harder to borrow and invest. "It's extremely corrosive," he says. Deflation, adds Jerram, will steadily sap Japan's nominal growth and deprive the government of tax revenue. Eventually, Japan may no longer be able to finance its borrowing. The country will then either have to default on debt that's about twice the size of the economy or devalue its currency to reduce the real value of liabilities. "That's the unavoidable endgame," says Jerram, who has analyzed the Japanese economy since 1987. "As long as it's in the future, everybody can pretend it's someone else's problem."

The bottom line: Although deflation ultimately poses a serious threat to Japan, ordinary consumers are benefiting from lower prices.

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