A Long War

10 March 2006



Bank of Japan Declares Victory over Deflation

When the economic history of Japan is written, the period of the 1990s and first years of the third millennium will be known as the Lost Years. The enemy was deflation, the chronic drop in prices that prevented economic growth. A policy known as “quantitative easing” essentially flooded the banking system with free money for five years. GDP growth is finally up and sustainably so. So, the Bank of Japan abandoned the policy, but kept interest rates at 0% for now.

“Given that the effects of the quantitative easing policy on economic activity and prices now mainly result from short-term interest rates being zero, there will be no abrupt change as a result of today’s policy decision,” the BoJ stated. It will continue, according to the Financial Times, the outright purchases of government bonds of ¥1,200 billion as a sop to the finance ministry. Moreover, the BoJ has said that if there is any slide back toward deflation, it would accept slight inflation as a counter-policy. Its new target is inflation under 2%, more or less what Germany and the US target.

This is undeniably good news for the Japanese economy. Exports are up, consumer spending is up, profits are up, and new capital investment will follow. The decision to drop the ultra-loose money policy even cheered the stock market – the Nikkei average rose 2.6 per cent to 16,036.91. Bonds were stronger, and the yen was stable (which is good since it left the strong export position of Japan intact).

Economics is known as the dismal science, though, because every silver lining has a cloud about it. In this case, there is a concern that there will be a ripple effect outside Japan. With interest rates at zero, there has been a lot of borrowing in Japan for spending, investing and speculating done elsewhere. With this policy shift, a great many of these positions have to be unwound. If done quickly, this can be a source of financial stress internationally.

By the same token, the BoJ’s victory over deflation offers economists and policymakers a case study in the phenomenon, one that hasn’t been seen much since the end of World War II. Indded, two generations of economists had no firsthand experience of deflation until Japan’s troubles started. What the BoJ got right and what it got wrong will be debated for decades. However, there is no denying that deflation was a huge problem, that other nations ignore this lesson at their peril, and that the BoJ truly has won.

© Copyright 2006 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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