Robert W. Gordon wrote:

>What is deflation?
>
RK:

DEflation means a DROP in the average price of the goods and services that a country produces and consumers every year, from cars and refrigerators to food and sweaters to haircuts and movie tickets.
INflation means a RISE in those prices. It does NOT refer to a speculative rise or fall in the prices for financial assets like stocks, or physical assets like land. It does not mean recession (i.e. a drop in
GDP) or economic stagnation. Some people use the term "deflationary conditions" when they really mean to say "recessionary conditions" or stagnation.

Japan's deflation has been very mild. Since January 1999, consumer prices in Japan have fallen an average of 0.3% per year for a total drop of 4.1% over 14 years. During the same period, so-called core inflation (consumer prices except for food and energy) have fallen an average of 0.6% per year for a total drop of 8%.

Deflation should not be confused with term "DEFLATIONARY SPIRAL" which some people mistakenly applied to Japan some time ago. Deflation just means a drop in prices. A "deflationary spiral" means a situation like the US suffered in the early years of the 1930s Depression. Double-dip drops in prices caused firms to lose lots of money, which led them to cut investment and jobs. The loss of jobs, in turn, meant less spending on consumer goods and services. That deep drop in real demand led to further drops in prices (via the law of supply and demand) which, in turn, caused jobs and spending and demand to drop even further. As deflation and depression fed each other in a vicious cycle, they both dropped by DOUBLE-DIGITS PER YEAR in the first years of the Depression.

RG:

>Is it bad for "Japan"? If so, why?
>
RK:

Virtually every economist would agree on one bad effect from deflation.
It prevents the central bank from using "negative real interests" to stimulate the economy and help it recover from a recession. Real interest rates are the nominal interest rate minus inflation. So, if inflation is 2% and nominal interest rates (the ones you read about in the newspaper or pay on a car loan) are 0%, the "real"
(i.e.
inflation-adjusted) interest rate is negative 2%. That is the case in the US at present. Sometimes, an economy is in such a deep slump that it takes negative real rates to spur companies to invest more or consumer to buy more big-ticket items, like cars and homes

Beyond that views differ. The majority view--with which I disagree--is that deflation causes firms to invest less and consumers to buy less.
The idea is that a consumer says to himself: why should I buy a car today when the price will be lower a year from now. That very reluctance to buy means that fewer cars are built, workers have jobs and that weak demand causes prices to fall even more. In, on the other hand, consumers expected prices to rise, then would want to buy now instead of waiting.
Their purchases would increase demand and help push prices up. So, higher inflationary expectations are a self-fulfilling prophecy. PM Abe and BOJ Governor Kuroda have adopted this theory of inflation. Some economists, including Abe's core economic advisers, believe that deflation is THE PRIMARY source of the seeingly intractable economic stagnation. Others believe that it makes things worse, but that it is just one of many problems. Still others believe it is relatively insignificant.

By the way, this "rational expectations" view of inflation adopted by Abe and Kuroda has become popular among economists only in the past couple decades. It is very different from either the Keynesian view or the Friedmanite monetarist view. I think all the evidence shows that "expectations uber alles" view is false for the following reasons:

1) An average 0.3% or 0.6% fall in prices is too tiny to have an effect of spending behavior

2) If consumers were really refusing to spend as much because of deflation, then the savings rate in Japan should have gone up (less spending out of a given level of income means more savings). Instead, the opposite has happened. The average savings rate has steadily fallen from about 13% in 1997 to about 2% now.

3) The Cabinet Office does a survey of consumer expectations of inflation every month. For years and years, consumers have consistently and wrong expected prices to rise in the following 12 months. There is absolutely no correlation between what people expect prices to do in the coming year and how much they spend.

4) The evidence shows that deflation is a SYMPTOM of Japan's weak economy, not a CAUSE of it. If you trace out the ups and downs of both demand and deflation, you can see that worse deflation is NOT followed by weaker demand. On the other hand, weaker demand is followed a couple quarters later by worse deflation. Trying to cure inflation by raising expectations of future inflation is like trying to cure a patient's fever by telling the thermometer you expect it to read 98.6 degrees.

RG:

>Hhow does one square that with this article here,
which claims
>deflation can actually be "good"?
>
>See: http://mises.org/daily/4618/
>
RK:

The so-called "Austrian" economists like von Mises and Hayek are beloved by conservative and libertarian Anglo-American political circles, from Maggie Thatcher to the Cato Institute. But most mainstream professional economists--from liberal Keynesians to conservative Friedmanites--regard it as akin to astrology. I read recently that only about 2% of American Ph.D economists regard themselves as "Austrians" and, when they try to write for respectable academic journals, they hide some of their real views. You can safely disregard the article you cited.

RG:

>What about the idea that 0% inflation should be a
target?
>
RK:

Most monetary economists regard a target of 0% as reckless. Most major central banks that target an inflation rate try to keep it at 2%. First of all, 0% means that negative real interest rates are impossble in a recession, reducing the ability of the central bank to fight the downturn. Secondly, 0% is too close to outright deflation. An economic shock can easily send it into deflation. We've learned from bitter experience that, when it comes to deflation, an ounce of prevention is worth a ton of cure.

I hope this helps.

Richard Katz
The Oriental Economist Report