Japan's lesson for America: a comparison of deflationary woes.

• Author: Koo, Richard C.

The concern over possible deflation in the United States and many other parts of the world has sparked a renewed interest in the Japanese experience, which has proven, to use Alan Greenspan's words, that it is possible to have a deflation without a gold standard. Many puzzled observers, however, including the Fed chairman, have resorted to the Japanese cultural aversion to bankruptcy and resultant increase in zombie companies as the explanation for Japan's deflation. The implication is that the United States will not face the same problem because it will not tolerate zombie companies.

The actual cause of deflation, however, is quite straightforward and has nothing to do with zombie companies or cultural differences. Furthermore, the same factor that pushed Japan into deflation is not only slowing the U.S. economy, but remaining equally unnoticed.

Deflation is caused when a large number of companies all at the same time decide to shift their priorities from their usual profit maximization to strengthening their balance sheets. Such a shift, however temporary, disrupts the normal workings of the economy because the corporate sector stops taking the funds the household sector has saved, even with very low interest rates. With no one borrowing, the entire savings of the household sector together with the debt repayment of the corporate sector just sits in the banks unused, effectively becoming the economy's deflationary gap.

Such a nationwide shift in coat, orate priorities typically happens after a bubble when companies see their asset values falling sharply relative to their liabilities. Companies engaged in repairing balance sheets, however, are most reluctant to publicize their problems. Their quietness, in turn, makes the detection of the problem much more difficult for the policymakers.

THE JAPANESE EXPERIENCE

In the case of Japan, the shift in corporate priorities happened after the massive drop in asset prices--especially those of commercial real estate following the bursting of the bubble in the early 1990s. The resultant damage to their balance sheets left companies with no choice but to reduce debt. With their main line of business and cash flow from building cars and cameras largely intact, the Japanese companies all began to use their earnings to pay down debt.

As a result, the Japanese corporate sector has not only stopped borrowing the money the household sector has saved, but also been a net supplier of funds to the banking system and capital market to the tune of 20 trillion [yen] per year through debt repayment. This means the entire savings of the household sector together with the debt repayment...