Deflation and Debt in Japan May Hamper a Quick Recovery

In January, the rating agency Standard & Poor’s warned Japan that it may downgrade it's credit ranking due to the new Democratic Party of Japan inability to fix its finances. Yet, not only increasing public debt but also deepening deflation may hamper economic outlook and long term recovery.

Indeed, Japan's government debt has been steady rising in the last few years, reaching 174% of the Gross Domestic Product in 2008. In fact, it may reach 220% in 2010 with new spending plans. For example, Japan's Lower House of Parliament approved an extra budget at the end of January aiming at new Y7.2 trillion stimulus package. And although there is no reason to worry yet about the sustainability of debt since Japanese have large household savings, it may change in the future since its population is ageing.

There is also another danger by the corner: deflation. Consumer prices have been falling in the last few months, and even with some boost from rising cost of crude oil, they were still negative in December. And while little inflation is healthy for growing economies, the prolonged period of deflation may have bad consequences in a recovery period. For instance, declining prices may depress corporate earnings, lead to wage cuts and as a consequence make consumers to put off purchases and stimulate further deflationary spiral.

To make things even worst, there is no perfect solution to fight with deflation. The government can expand further quantitative easing program, but it may lead to higher public debt in the future. Indeed, with more money in circulation, already low interest rate would need to go below zero, which would cause higher bond payments in the next few years. The Bank of Japan could also start charging banks for deposits in the central bank, but that would increase interest rates and depress investments further. So, because there is no easy way out of deflation, the Japanese government needs to be prepared to make some structural changes and difficult choices. The country needs more labor flexibility, more hospitable immigration laws and above all Japan needs to recognize the fact that China is changing the power dynamics across the World.

Anna Fedec,
1/28/2010 11:45:17 PM