Japan is at War. Infact it has been at this war for more than two decades now and the enemy is the kingdom itself.
Japan, the third largest economy and probably the most technologically advanced nation in the world, has been marred by deflation and sluggish growth for more than thirty years. Despite constant efforts by Bank of Japan and the Government, the economic growth refuses to pick up. More than any economic or technical factor, it is the mindset of its own citizens that Japan is trying to battle (and hopefully change). Each day in Japanese government circuits probably begins with new plans on how to make Japanese customers spend and get them away from saving their money. In fact, the recently elected Japanese government along with BoJ has declared a kamikaze style war on deflation and promised to do whatever it takes to rein in inflation, by pouring in more than 11 Trillion Yen or equivalent of about 1.4 Trillion Dollars in the economy and promising to double the monetary base within next two years. The mandate which Japan has cut out for itself is probably the biggest financial experiment ever conducted and its outcome cannot be predicted because there is no precedent to it in history. To put it in simple words, Japan is ‘craving’ for inflation and is prepared to give an arm and a leg in return.
What exactly is Japan upto?
Why does it want inflation?
Yes it is, all that still holds true, but Japan’s economy and its problems are probably the most peculiar. To understand this anomaly, it is important to take a step back and understand how this problem of deflation started in Japan and the dangerous mindset which sets in, once the deflationary signals begin to appear.
- How it all began?
After the second world war, the value of Yen was fixed to a highly devalued rate of 360 to a dollar. Interest rates were slashed to extremely low levels. This was done in an effort to stabilize the economy, promote export industry and curb speculation. At the peak in the year 1989, the ground beneath the Imperial Palace in Japan was famously valued more than all of the real estate in California combined! The easy credit flow directly fuelled the stock market of Japan, Nikkei rose to an all-time high of 39000 in year 1989 (by comparison, even after two decades of economic advancements, it is presently around 14500).
Nikkei 225 Index
Source: Yahoo Finance
Though this ultra-loose monetary condition led to an unprecedented industrial growth in Japan, a massive property bubble was brewing in the Japanese economy. The Japanese officials started to become increasingly concerned about the bubble-like conditions in the economy and the Bank of Japan began to tighten the monetary policy. At the same time, under intense international pressure led by US to revaluate its artificially low currency, Japan entered into the Plaza accord. As a result, Yen began appreciating sharply. These two factors combined together created a perfect storm for the Japanese economy which was operating in a slush of cheap liquidity. The bubble economy began to implode rapidly. Nikkei collapsed about 50% in less than a year. Because of the rapidly appreciating domestic currency, Japanese industries lost their competitive edge against their international competitors. Hundreds of companies had to be bailed out by government on a continual basis. Property prices collapsed all over Japan. By 2004, the real estate prices in Tokyo for example were only 10% of what they were during the 1989 peak levels.
This unprecedented economic collapse resulted in paltry or even contractionary growth for most of the past 20 years. These are famously known as ‘The Lost Two Decades’ for Japan. The economy of Japan has been in a painful decline for the past two decades, where people have seen wages declining along with the prices of goods and services.
- The Battle in Minds:
At this point, to understand what really was(and is) happening in Japan,it is important to think from a Japanese consumer’s psychology.
Imagine yourself in place of a consumer who wants to buy something, say a house. For a long time in the past, you have seen the prices of real estate fall, on an almost daily basis. In a rational mindset, you would almost certainly defer your buying decision in hope of lower price for that house. The same will be done by some other consumer who wants to buy a car, because prices of cars have been falling too! Now extend this very psychology to every consumer, every manufacturer or anybody who wanted to spend money. Each one of them will put off their buying decision to sometime later in future, in hope of finding lower prices for the same stuff. Now when the demand in the economy is receding and prices are falling, what is the incentive for the manufacturer to produce or service provider to offer a service? When such conditions exist for a prolonged period of time in an economy, this mind-set grips the citizens of the country with increasing intensity. Everybody starts saving money instead of spending it. And for any economy, this means disaster. It is of little wonder that Japanese are the biggest savers of money in the world.
- Japanese Government: Inflating its way out of trouble:
For years, successive governments have tried their best to make people spend, but it never has worked out. In December 2012, Japan elected Shinzo Abe as the prime-minister, who came aboard with a single promise - to pull Japan out of its macroeconomic problems which have plagued it for more than twenty years. The policies advocated by Shinzo Abe are popularly referred to as ‘Abenomics’ and consists of monetary, fiscal and economic strategies. Specific features include setting ultra-low interest rates, an annual inflation rate target of 2%, huge public spending by the government and bond buying by the central bank and rapidly devaluing the Japanese Yen.
All this sounds sophisticated, but it is crucial to understand that the only aim is to make everybody believe that tomorrow, the prices of stuff will be more than today. So better spend your money today or it will lose its value due to inflation. But a Japanese consumer can always come back to the government and say, ‘Hey wait, where is the inflation? I can find that prices are falling, so the buying power of the Yen in my pocket is going up tomorrow instead of going down. So i don’t really believe in what you say. I better spend my money tomorrow instead of today.’ So we are back to square one again. Inflation will occur only when people start spending; people don’t spend because there is no inflation. This sets the country in a deflationary spiral. Given a choice, a country would always prefer high inflation against even a mild deflation. That’s because once a deflationary trap sets in, it is extremely difficult to break the mindset of consumers and make them spend.
- Dangers are lurking close-by:
The scale and the method which Japanese government and the Bank of Japan have adopted to defeat this decades old problem are both mind-boggling and unprecedented. Already, there are signs that these massive efforts are running out of steam.
High Inflation In wrong places:
The inflation is oozing out of all the wrong areas in the economy. For example, the energy costs in Japan are rising rapidly. The energy guzzling economy is even more dependent on energy import from outside now, after the Fukushima crisis in 2011 made Japan shun away the nuclear power altogether. The falling Yen is helping to worsen the import bill of the country.
International Backlash:
The trade competitors of Japan, viz, South Korea, China, Philippines are feeling the pinch of rapidly falling Yen on their export industries. This is sure to create diplomatic friction between the nations.
Bond Market collapse:
A higher inflation always makes the interest rates and the Bond yield to go up. Suppose the Japanese government succeeds in its efforts, the rising inflation can easily push the yields on Japanese bonds to an unsustainable level. This can prove catastrophic for the second largest bond market in the world.
These are just some of the dangers which can result from the uncharted route Japan has decided to take. It is quite possible that the enormous strains which are getting created in the process, erupt out of a totally different area of the economy, whether in Japan or in some other part of the world. For now, the world can just wait and see whether the ‘land of the rising sun’, actually sees the sun shining on its economy.
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