Japan's new inflationary strategy: wrong target

The cause of Japan's deflation isn't monetary, it's demographic. Inflationary policy won't work in the long term.

Kim Kyung-Hoon/Reuters/File
People exercise with wooden dumbbells during a health promotion event to mark Japan's "Respect for the Aged Day" at a temple in Tokyo in September. The population of Japan is expected to fall by 30 percent to less than 90 million by 2060, with 2 in 5 people being 65 or older, a government agency survey showed in January.

Japan has during the latest decade lagged most countries in GDP growth and it has also had low but relatively persistent price deflation. This has by some been interpreted as evidence that even low levels of deflation is harmful to the economy.

However, if you adjust for population growth, Japanese growth has actually been in line with U.S. growth and somewhat higher than the average for Western Europe. And if you further adjust for the fact that Japan's population is aging much faster than elsewhere, growth has actually been higher. Total GDP may have grown slower, but GDP relative to its working age population has been growing somewhat faster than the average for rich countries.

As a result, unlike both the U.S. and Western Europe it has a higher employment to population (in the 15 to 64 year age span) than a decade ago, and a lower unemployment rate. This clearly indicates that the source of Japan's economic stagnation is demographic, not monetary.

This didn't stop Japanese voters from electing a new government that promised to create at least 2% in yearly inflation and has threatened to remove the Bank of Japan's formal independence unless it does a lot more to inflate. Since an "independence" that depends on it following orders isn't really independence, this means that the Bank of Japan's independence has in effect already been abolished.

One interesting aspect of this is that it shows that merely by creating expectations of more inflation, you can create it. During the latest month the yen has fallen by 4% against the U.S. dollar, by 5% against British pound and the South Korean won (I've included the won because South Korea is Japan's most important competitor in its export markets) and by more than 6% against the euro.

Compared to a year earlier, the declines are even more dramatic, falling by nearly 10% against the dollar, by more than 10% against the pound and the euro and by more than 15% against the won.

By raising import prices and raising nominal export revenues this will raise price inflation and nominal GDP.  However, real GDP won't be increased other than at best temporarily, because prices are likely to increase about the same as nominal GDP.

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