Saving Japan: forget inflation targeting. Tokyo instead needs to implement a one-two, monetary-fiscal punch.

• Author: Katz, Richard

Japan's deflation is back. And during the worst recession in Japan's post-war era, deflation is correspondingly almost twice as bad as during any previous decline. In fiscal 2009 (which ended on March 31), the deflator for the domestic components of GDP fell by 3 percent from a year ago.

Like his Liberal Democratic Party predecessors, Naoto Kan, the Democratic Party of Japan's Minister of Finance [now Prime Minister], has put the onus on the Bank of Japan to cure deflation. He talks as if deflation were the root cause of economic stagnation and as if the Bank of Japan had a magic wand (sometimes called "inflation targeting"). Kan and the Ministry of Finance are reluctant to use fiscal stimulus. On the contrary, Kan is talking about raising the consumption tax as soon as possible ill the next few years, thereby risking a repeat of the recession-triggering tax hike of 1997. It's easier to justify this stance by claiming that monetary ease alone, not a fiscal-monetary combination, is the pivot for recovery.

NO DEFLATIONARY SPIRAL

The good news is that there is no "deflationary spiral" like the United States suffered in the 1930s. In such a spiral, a collapse of jobs and demand sends prices plunging. That, in turn, makes people and companies postpone major purchases (just like fewer Americans bought homes during the recent crash). That leads to even more drops in demand.

Fortunately, Japan's mild deflation merely reflects the long stagnation, but has not made it worse. The best way to see this is to compare the course of deflation to the "output gap." That is the gap between actual GDP and what GDP would be at full employment and full use of factories, office buildings, and so on. Today, the gap is about 7 percent of GDP. When demand weakens, prices turn soft. So, the past twenty-five years have seen a very high 86 percent correlation between the ups and downs of the output gap and those of inflation/deflation two quarters later (see Figure 1). While a worsening output gap has worsened deflation, the reverse is not true.

The major problem is that deflation prevents the Bank of Japan from using negative real interest rates (that is, interest rates below the rate of inflation) to stimulate demand. Since 1995, the Bank of Japan has pushed overnight interest rates down to near-zero and then zero. But nominal rates cannot go below zero. Deflation renders conventional monetary policy impotent.

To get around this "zero bound" problem, some monetary economists claimed that "quantitative easing"--printing tons of money--would be the magic bullet. The Bank of Japan tried this and it failed. The proposal was based on the fact that, prior to 1995, nominal GDP grew in tandem with the money supply in textbook fashion. But deflation has broken that normal linkage. Since 1995, the Bank of Japan hiked the money base 115 percent, but nominal GDP has fallen 8 percent.

THE SIREN SONG OF INFLATION TARGETING

When quantitative easing failed, the call went out to combine quantitative easing with "inflation targeting." If only the Bank of Japan would set, say, a 2 percent target for inflation and promise to create enough money until the target was reached, then surely inflation would return--or so it was claimed. Bank of Japan Governor Masaaki Shirakawa has rejected such calls, as did his predecessors.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

In countries with inflation, central banks have the tools to reach their target. If inflation is too high, they can raise interest rates and lower demand; if it is too low, they can lower rates and boost demand. However, because of the "zero bound" problem, there is no precedent for inflation targeting curing deflation (and no modern case except Japan of a rich country suffering prolonged deflation.) As Alan Blinder, former Vice Chairman of the U.S. Federal Reserve, replied to us in 2003, "I have not been an advocate of inflation targeting in Japan. If the Bank of Japan said it had a 3 percent inflation target, market participants would ask: 'Tell me how we're going to get to 3 percent inflation?' It would be very...