Ithaca: Cornell University Press, 2018. xvii, 243 pp. (Tables, graphs, figures.) US$45.00, cloth. ISBN 978-1-5017-2817-4.
Over the past ten years in both Europe and America, inflation has fallen persistently below the levels targeted by central banks, generating debates about what should be done and whether it matters. Not enough attention is paid to Japan, which fell into outright deflation more than 20 years ago and is still struggling to emerge. Taming Japan’s Deflation provides an informed and in-depth look at the institutional, intellectual, and political environment that allowed deflation to take root. It also documents the political and intellectual responses to this prolonged period of falling prices.
The book devotes surprisingly little attention to the costs of deflation, a scant three pages of theoretical points and no data. Readers should be informed that deflation was indeed very costly for Japan. Owing to downward wage rigidity, deflation created persistent excess unemployment, averaging nearly 2 percentage points over the 20 years from 1998 through 2017. Applying the standard Okun’s Law relationship of 2 percentage points of GDP for each percentage point of unemployment, Japan lost roughly three-quarters of an entire year’s income during its two decades of deflation. That is a massive waste of potential.
Japan’s deflationary episode began after the collapse of bubbles in equity and real estate prices in the late 1980s. These bubbles marked the culmination of a long period of rapid growth and catch-up in productivity toward US levels. As the economy approached the productivity frontier, productivity growth slowed and the profitability of new business investment declined. Meanwhile, a secular decline in birth rates meant that growth of the labour force was slowing sharply and was about to turn negative. At the beginning of the 1990s, the Bank of Japan was still focused on fighting the inflationary effects of the bubbles. It failed to recognize that underlying developments were creating a large deflationary shock.
After a somewhat too brief discussion of this historical backdrop, the core narrative in Taming Japan’s Deflation starts in the late 1990s, as deflation first begins to appear. Coincidentally, the Bank of Japan Law of 1997 granted full independence to the bank for the first time with a mandate that gives pride of place to price stability and only secondary importance to employment and growth. The book provides superb coverage of the mindset of the newly independent leaders of the Bank of Japan, whose professional lives were molded by the constant battle against inflation and against politicians who sometimes valued other goals more highly than price stability. These leaders felt that their anti-inflationary credibility would be tainted by any appearance of working with the rest of the Japanese government.
The core thesis of Taming Japan’s Deflation is that monetary policy in Japan retained this orthodox inflation-fighting outlook for a long time—longer than in other countries, notably the United States—because of the relatively small and closed network of academics and officials who had influence over policy. Japanese monetary policy makers and their closest professional contacts refused at first to accept that deflation would persist, then constructed arguments for why a modest amount of deflation was not so bad, and finally lapsed into skepticism about their power to fight deflation. Ben Bernanke famously referred to this skepticism as a case of “self-induced paralysis.” Outsiders with differing views did not get a hearing.
In the end, it was a political earthquake that forced change on the Bank of Japan. Inspired by the apparent success of unorthodox bond-buying programs at preventing deflation in the United States and the United Kingdom after the Great Recession of 2008–2009, Shinzo Abe made monetary policy and the fight against deflation a major issue in his successful December 2012 election campaign. As the book notes, this politicization of monetary policy is almost unique among advanced economies.
Abe’s choice for governor of the Bank of Japan, Haruhiko Kuroda, quickly introduced an aggressive bond-buying program that has since far surpassed those of other advanced economies in terms of its size relative to GDP. After an initial rapid rise, inflation has languished below its 2 percent target, but at least it remains positive and deflation has not returned. Meanwhile, unemployment has fallen to the lowest level in 25 years, despite a massive increase in female employment. The book is cautious in its assessment of “Abenomics” for good reason. It is still too soon to judge whether Japan will achieve its inflation target, whether more aggressive policies are needed, or whether no feasible policy can achieve that goal.
Taming Japan’s Deflation is indispensable for anyone who wants to understand why Japan lingered in deflation for so long and how it switched to different policies that may be leading to better outcomes.
Joseph E. Gagnon
Peterson Institute for International Economics, Washington, DC, USA