Deflationary lessons: what Japanese deflation did and did not do.

• Author: Posen, Adam
• Position: Economy

When deflation hit Japan and persisted, it was quite a shock. The loss of the central bank's apparent capabilities to do anything about it with the Bank of Japan's instrument interest rate at zero made the situation even more interesting. So did Japan's bad loan problems shutting down the credit channel of monetary policy. Monetary economists were captivated by the phenomenon, the concept of the liquidity trap was dusted off, and numerous remedies were proposed. Now that the Japanese economy has been in recovery, and deflation is ending--and the Bank of Japan is slowly (one hopes) readying itself for its first round of policy tightening since August 2000--it is a good time to take stock of what deflation did and did not do.

What have we learned from this natural experiment, if not natural disaster, in Japan? Do we better understand deflation and its impact? Do we have an improved assessment of the capabilities of central banks and their non-interest rate policy instruments? Can we design monetary policy frameworks so as to prevent it happening again? Or was it no big deal after all? I would suggest that there are a dozen lessons monetary economists and central bankers should take away from the Japanese experience with sustained deflation--some confirming the analyses of mainstream macroeconomics at the time, a few surprising to most or all observers.

[1] Deflation is very inertial. Though many economies dip in and out of measured deflation for a couple of months at a time, sustained deflation is rare. Thus, no one could confidently predict the dynamics of prices once deflation set in in Japan during the mid-1990s. Contrary to some expectations (including my own), ongoing deflation was not only slow to start, but it was hard to stop, and it did not gain momentum. That is, once deflation took hold, it was sticky at a low level (between 0.5 and 1.5 percent a year) rather than accelerating.

[2] Deflation is bad but not disastrous. Deflation in Japan proved less costly to the real economy than some feared. Best estimates of the drag on consumption directly from deflation were small, once growth and interest rates were taken into account; the feedback from deflation onto debt burdens and then back into deflation (via the sell-off of loans and collateral) was also limited in magnitude. Of course, this largely reflected the low level of deflation in Japan. That said, deflation did result in a drag on consumption, an increase in debt burdens, and uncertainties for investment, none of which was good for the economy.

[3] Deflation is not conducive to restructuring. Some ideologues insisted that deflation would get the "rot" out of the Japanese economy by forcing out of business overly indebted or uncompetitive firms. Most mainstream economists recognized this as the liquidationist fallacy, disproved during the Great Depression. Recent developments in macroeconomics by Caballero and Hammour, Bernanke and Gertler, and others, gave a better understanding of why...