IanM | 
02 2nd, 2010| 
For too long inflation has been a dirty word, and perhaps for Australia it still should be but, for Australia’s important trading partners perhaps this needs to change.
Financial markets are starting to look with concern at sovereign debt, particularly with the attempts to restructure Greece’s debt and install some much needed fiscal austerity.
A recent blog by the economist’s Buttonwood presents an interesting perspective on sovereign debt, ranking countries by the difference between nominal GDP growth and their cost of debt (http://www.economist.com/blogs/buttonwood/2010/02/debt_crisis_-_how_countries_rank). Once again, Australia ranks extremely well, and those currently in trouble are the usual suspects coming out of the GFC: Ireland, Greece, Portugal and Spain. However there is also forewarning of the perilous long-term situation of Japan, whose sickly nominal GDP growth has been brought about by stagnant population growth and deflation, as well as the lingering effects of the financial bubble of 20 years ago.
Japan has struggled to address deflation pressures in its economy, although perhaps it is now seeking the tools to address it. The Bank of Japan has made noises that it may finally be undertaking inflation targeting to address the deflation. Inflation targeting was used successfully by Sweden, and the United Kingdom in managing monetary policy after the European Exchange Rate Mechanism (ERM) breakdown in the early nineties, and is also pursued successfully by Australia’s Reserve Bank.
Japan’s steps are tentative, targeting only a zero inflation rate, and are undertaken through transactions with the banking sector. As such they are unlikely to be successful, but they do indicate that Japan may finally be exploring its tool box more creatively after 20 years of failure.
Increasing the funding available though Japan’s financial sector has been ineffective in the past, and is unlikely to be effective in the future. With virtually zero interest rates, Japan is in a self-inflicted liquidity trap and has destroyed the relationship between asset values and asset returns that encourages the economically efficient deployment of an economy’s scarce capital. Poor productivity growth is therefore no surprise. Unfortunately, the near-zero interest rate path is now being trodden by the central banks of the United States and United Kingdom. Beware zombie capitalism!
While the monetary policy lever is broken, Japan continues to pull at it because there is a belief that Japan’s capacity for additional fiscal policy measures has been exhausted. Japan’s public debt now stands at 192.1% of GDP, second only to Zimbabwe according to the CIA’s World Factbook. Deflation, Depopulation, Default.
The conundrum is why should a country with low inflation, with its debt denominated in its own currency and low interest rates default. The explanation I propose is that its economy has been made structurally dysfunctional by the low interest rates and deflation so that it is unable to grow in real terms. Like the planned economies of the Soviets, an economy without the discipline of the markets starts to wither on the vine; and having lost the discipline associated with a genuine cost of capital, Japan’s economy is also withering. The perversity of extremely low interest rates also drives Japan’s poor consumption growth. With long life expectancy and low interest rates, the burden of saving for retirement is higher, and consumption lower as a consequence. Better returns on capital would boost both consumption and future retirement incomes
The solution is to push up inflation, push up interest rates, and in doing so purge the economy of sclerosis. This involves inflation targeting, but rather than implementing the expansion of the money supply through the broken banking sector, it should be undertaken through the government using seigniorage. Seigniorage is where the Central Bank buys government debt or pays the government higher dividends to increase the money supply. A normal inflation rate of 2 to 3 per cent could be targeted, although a higher rate of 5 per cent may also be feasible. Raising the central bank lending rate to somewhere between 3 per cent and 6 per cent would then force normal market discipline on the use of capital in the economy.
The combination of seigniorage and inflation would reduce the public debt burden, allowing fiscal policy to be more flexible. A clear policy direction on addressing deflation could also lead to a nominal depreciation of the yen and improve Japan’s international competitiveness. A critic would argue that inflation represents a partial default on Japan’s debt, particularly given low nominal interest that they earn. This is true, but given the high level of public debt and poor economic growth prospects, some level of default is unavoidable. The question is what approach can produce the best chances for sustained economic growth in the Japanese economy.
Japan’s economic doldrums are not an idle question for Tasmania. Millions of dollars worth of high value agricultural and aquaculture products are delivered to north east Asia every month and the extended shut downs at Gunn’s wood chip mills are a direct consequence of poor state of the Japanese wood chip market. The monetary policy of Japan means money on the table for Tasmania’s forest contractors.