You know how to raise inflation? I'm listening.

Photograher: Kiyoshi Ota/Bloomberg

Japan's Endless Struggle to Spark Inflation

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Why does Japan need inflation? Usually, economists think of inflation as a bad thing -- at best, they see it as an acceptable byproduct of efforts to stimulate economic growth. Mainstream theory says that when you have idle resources -- empty offices, unemployed people sitting at home wishing they had jobs -- you can use monetary and/or fiscal policy to stimulate the economy, putting those workers into those offices. Inflation, the theory says, will be a natural consequence of the stimulus. 

But Japanese unemployment is very low, and the economy is expanding at or above its long-term potential growth rate of around 0.5 percent to 1 percent. So according to mainstream theory, inflation would be an unnecessary and pointless negative for Japan’s economy. Why, then, are there always voices calling for Japan to raise its inflation rate? 

Actually, there are several reasons. The main one is that inflation reduces the burden of debt. Japan’s enormous government debt represents the government’s promise to transfer resources from young people (who work and pay taxes) to old people (who own government bonds).  Since Japan is an aging society, there are more old people than young people. That makes the burden especially difficult to bear. Young people also tend to have mortgages, the repayment of which is another burden. 

Sustained higher inflation would represent a net transfer of resources from the old to the young. That would increase optimism, and hopefully raise the fertility rate, helping with demographic stabilization. It would also decrease the risk that the Japanese government will eventually have to take extreme measures to stabilize the debt. 

So despite having low unemployment, Japan could use some more inflation. The question then becomes: How does it get it? 

The usual solution, loose monetary policy, isn't working. Japan has engaged in an asset-buying program of quantitative easing so vigorous and aggressive that it puts former Federal Reserve Chairman Ben Bernanke’s efforts to shame. Although inflation has accelerated, Japanese core inflation (excluding food and energy) hasn't yet hit the 2 percent target, and is drifting lower again.
QuickTake Deflation 

That  decline might be due to the slowdown in China, which is probably hurting demand for Japanese products and services. If that’s the culprit, then the Bank of Japan simply needs to redouble its efforts and assure everyone of its resolve to raise inflation. 

Another possibility, of course, is that the mainstream macroeconomic theory is all wrong, and that Japan’s permanently low interest rates are actually the cause of the low inflation -- a theory called Neo-Fisherism, referring to the monetary theories of economist Irving Fisher. If that strange new theory is right, then Japan should actually raise interest rates if it wants inflation. 

A third idea, which also rejects mainstream thinking, has been put forward by Paul Krugman and other advocates of a theory called secular stagnation. This theory, originally promoted by Harvard’s Larry Summers, says that declining population and stagnant productivity make the economy naturally prone to deflation. According to Krugman, the best solution is to convince the public that the Bank of Japan really does want higher inflation. But if this can’t be done, he suggests that a burst of government spending might jump-start the process:

[W]hile the goal of raising [Japanese] inflation is, in large part, to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion...What Japan needs (and the rest of us may well be following the same path) is really aggressive policy, using fiscal and monetary policy to boost inflation, and setting the target high enough that it’s sustainable. It needs to hit escape velocity.

Mainstream macroeconomic theory has absolutely no room for any concept of “escape velocity.” In mainstream theory, everything is nice and smooth -- if you lower interest rates by X percent, inflation increases by Y percent. There is no threshold to reach, no psychological barrier to be broken. So Krugman’s idea represents a turn to a radically new kind of thinking. 

There is one more suggestion floating around. The University of Michigan’s Miles Kimball has suggested creating a negative interest rate on electronic money (so that your savings account would decrease in value every year). To do this, it would be necessary to put a tax on paper money, to prevent people from avoiding negative interest rates by turning their checking accounts into cash. This would be a very dramatic step, but people I meet in Japan are beginning to discuss it seriously. 

Any of these solutions for raising inflation -- electronic money, “escape velocity,” Neo-Fisherism -- would represent a dramatic departure from standard monetary policy. The latter two would also require a deep rethink of everything we know about macroeconomics. 

It boils down to this: Japan could use some inflation, but because macroeconomists don't yet understand how inflation works, any attempt at getting that inflation would require some pretty radical steps. It all boils down to our macroeconomic ignorance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net