Working Paper No. 23.C.B. Johnsson, Richard (2003). Deflation and Japan Revisited.

Abstract: Deflation counts among the worst things that could happen to an economy, the conventional wisdom tells us. But are falling prices really that bad? According to the Austrian School of Economics, this is not necessarily the case. A distinction is commonly made between (1) growth, (2) cash-building, (3) bank credit and (4) confiscatory deflation. When it comes to the first three kinds, falling prices are regarded as benign free market responses to changing circumstance, whether these are positive or negative by themselves. When it comes to the latter, it is often regarded as something negative. Lately, the word deflation has become almost synonymous with Japan and its economic problems. In this paper, the development of the Japanese economy of 1990-2001 is revisited. While consumer prices fell in 1995 and 1999-2001, if other prices are taken into account, it appears that the overall price level actually fell during most of the years throughout the period, 1997 and 2000 being exceptions. When it comes to the causes of the deflation, any confiscatory deflation created by the government is ruled out, since the money supply has been rising throughout the period. Instead, it is suggested that the deflation of 1994, 1995 and 1996 was exclusively caused by rising supply, i.e. there was growth deflation. This could also have been the case in 1991 and 1992, but the evidence is somewhat inconclusive. Moreover, deflation in 1993, 1998 and 2001 appears exclusively to have been caused by falling aggregate demand, suggesting cash-building or bank credit deflation. Finally, deflation in 1999 might have been caused by a combination of growth, cash-building and bank credit deflation. In all of these cases, the falling prices are to be regarded as benign. Although based on the same set of data, these findings diverge sharply from the official Japanese view of the economy at the time. This is ascertained by studying the official records of the time the consumer price index moved into the negative domain for the first time recorded. Instead of seeing this as something possibly benign, the conventional fear of deflation on the part of the Bank of Japan came to dominate its actions. And if it is true that falling prices are a benign response to the changes that actually occurred in Japan at the time, then any measures taken to make prices not fall cannot be of the benign nature. And if there were one thing most economists would agree on it would probably be that Japan’s economic malaise is not over. This seems to be an important lesson for the future – preventing a free market adjusting, including deflation, to changing circumstances could possibly prevent or prolong a recovery.