Japan can't teach us how to handle deflation

Foreign visitors are often bewildered by Japan. Its reputation for conformity is belied by Tokyo's teenage fashions while its consumer electronics industry displays near-anarchic creativity. While European consumers struggle to get to grips with phones that take pictures, their Japanese counterparts are already into net-linked video phones.

But living standards in Japan are surprisingly low for the world's second largest economy. The average cramped and poorly constructed Tokyo apartment would not look out of place in many east Asian countries with far lower per capita incomes.

Even more puzzling for the rest of the world is how a country which in the late 1980s seemed on the brink of challenging America's economic superiority could have made such a hash of its economy over the past 10 years.

Since the bursting of the bubble economy in 1989, Japan's economy has grown by a measly 1.5% a year on average, with three dips into recession. When it last looked like pulling itself out of the mire, in 1997, it was hit by the double whammy of an increase in sales tax and the Asian crisis, which combined to send it sprawling again.

The aftermath of the crisis exposed the weakness of Japan's rotten banking system. Five years on, the latest plan to tackle the problem has run into entrenched political opposition.

The rest of the world is watching with growing alarm now as Japan provides an object lesson in how not handle the west's latest worry - deflation. With the world awash with cut-price manufactured goods, and companies and consumers straining under enormous debt, some commentators fear that deflation, not inflation, is the biggest threat.

Prices have been falling in Japan since 1999. Interest rates have been cut to zero, but with deflation, real interest rates remain positive - no central bank can charge people interest to hold cash. The impotence of monetary authorities once prices turn negative has led international observers including the Organisation for Economic Cooperation and Development to warn that deflation is harder to stop than inflation.

"The costs associated with possible policy errors are assymetric," it says, in its latest assessment of the world economy. "They are far higher when erring on the conservative side than when loosening too much: if deflation sets in, the central bank's control over real interest rates is undermined, while a rise in inflation expectations can be more easily headed off."

Coordinated actions

Gerard Lyons, the chief economist at Standard Chartered, says there are three actions Japan must take to get out of its mess. The Bank of Japan must print more money, the government must spend more money, and must reform the country's financial system.

But this coordinated approach seems almost unthinkable in the current environment in Tokyo, where the ministry of finance and the Bank of Japan seem to be more interested in blaming each other for the crisis than in cooperating.

Meanwhile a long overdue plan for tackling the banks' bad loans problem is being sabotaged by vested interests within the ruling liberal-democrat party who fear it will lead to widespread, painful job cuts.

Unable to cut rates below zero, the Bank of Japan has started targeting an increase in the money supply. According to the textbooks, this should lead to inflation. But with banking system clogged up with bad loans, the money isn't getting to where it is needed. It wants the ministry of finance to step in with another fiscal expansion.

The ministry, however, seems to be more concerned about telling the central bank how to run monetary policy than coordinating a fiscal expansion to reinforce its cheap money policies. After a decade of failed public works programmes, they argue that fiscal policy no longer works.

Alarmingly, Junichiro Koizumi's government appears to be considering tightening fiscal policy. Worried by the mounting burden of public debt, it has promised to curb spending next year.

Mr Lyons says the worries about Japan's debt are overdone. The government may owe nearly one-and-a-half times' annual GDP, but the Japanese are still the world's biggest savers and most of the debt is held domestically. There is no danger of an east Asian-style crash caused by foreign investors pulling out.

"I'm not pessimistic about Japan, beccause as the world's biggest saver, they have got the funds at home to solve their problems," he says.

But while this cushion of domestic savings offers the luxury of time to sort out Japan's problems, it also appears to have reduced the immediate sense of crisis. Mr Lyons says Japan is changing but not fast enough.

The opposition to Heizo Takenaka's plan for tackling bad loans is a case in point: Mr Takenaka has been forced to issue an ultimatum to the banks giving them four months to sort their problems out or face nationalisation.

Mr Lyons says either the government must take the banking systems's bad loans on to its balance sheet or allow foreign banks to take them over, in effect encouraging the Wimbledonisation (in which domestic players never win) of Japan's financial system.

It is now a race against time for Mr Takenaka: will he be able to enact his radical reforms before his enemies bring him down? Some reformist politicians argue that Mr Koizumi, while publically backing Mr Takenaka, does not have the appetite for painful reform. It suits him to allow the old guard within his party to sabotage reform because he has a scapegoat to blame for his own lack of progress.

The iron triangle of entrenched interests - the bureaucracy, the LDP and the businesses that feed on their patronage - which make reform so difficult may be unique to Japan, but its economic problems are becoming a global worry.

Is there a danger that other big economies could follow it into deflation? While the lack of urgency in dealing with Japan's problems is infuriating policymakers in Washington, it has also provided a lesson. The US Federal Reserve has acted far more quickly to head off economic weakness since the bursting of the American stock market bubble, and as Alan Greenspan has made clear is already considering unconventional measures like easing the money supply if interest rates cuts don't work.

In the UK, the authorities are also alive to the dangers of deflation, although with service sector prices rising at above 4%, the Bank of England does not consider it an immediate threat. The chief candidate for the economy most likely to follow Japan down the road to deflation is Germany, which has many of the same weaknesses: a manufacturing sector being wiped out by the flood of cheap goods from China, a banking system burdened with bad loans and, most worryingly of all, a central bank stuck in a 1970s timewarp in which inflation is still a bigger danger than falling prices.

Most worrying of all is the fact that the closest parallel for institutional breakdown between monetary and fiscal authorities that is paralysising Tokyo is the fight between the European Central Bank and Europe's politicians over the stability and growth pact.

Just as Europe's depressed economies find themselves in need of a fiscal boost the ECB is threatening to respond to any watering down of the pact by keeping monetary policy tight.

Hopes that the introduction of the euro would allow Europe to challenge America's position as the world's leading economic power now seem premature. The OECD expects Europe to grow more slowly than the US over the next three years. The ECB blames Europe's politicians for their reluctance to undertake painful reform. But without monetary and fiscal authorities working in harmony, the Japanese experience suggests that economies can very quickly dig themselves into a deep hole.