Tokyo Japan Night

What if Japan's infamous and protracted battle with deflation wasn't an accident? What if deflation was actually a silent choice made by Japan's aging society?

Morgan Stanley's Robert Alan Feldman drops just such a bomb in a new report.

It's no surprise that deflation happened in Japan immediately after its financial crisis, just as deflationary forces are seen as a threat in the U.S. and Europe right now. What's surprising is that deflation persisted for so long in Japan, says Mr. Feldman.

Morgan Stanley:

Whether actively or passively, Japan made a social decision to entrench deflation. Escape was not only possible but was actually within reach in 2006. However, Japanese society decided to return to deflation. Understanding why requires a focus on the institutional structure of monetary policy decisions and social choice.

We believe that several factors – none of which was sufficient alone to cause deflation – combined to generate the result. These four factors are central bank institutions, demographics, the electoral system’s representation of older citizens, and the current account balance.

Factor 1: The central bank is far less accountable than in the U.S., and the idea of an inflation target is just a few years old even:

In practice, the BoJ waited until 2006 to present a definition of price stability. Until December 2009, BoJ was the only body in government that had set any official definition of price stability. Then, when the newly elected Democratic Party of Japan came to power, it published a growth strategy in December 2009, with a 10-year goal of nominal GDP growth of 3% or more, and a real GDP growth target of 2% or more. The DPJ was subsequently explicit in saying that the difference, i.e. a GDP deflator growth rate of 1%, was its implicit understanding of an inflation target (i.e. price stability) for the country. However, the DPJ has been reluctant to declare an explicit inflation target, or to change the BoJ Law to reflect such a target.

Factor 2 & 3: Japan has much different demographics than the U.S.. There is a high mix of elderly in Japan's population, and due to its declining population Japan will remain a much older nation than America's relatively young one. Moreover, this elderly population has most of the political power in Japan, and actually has an incentive, as savers, to prefer deflation.

The working age population (15-64) peaked in 1995, at 87.3 mln, and has now fallen to 81.5 mln. Simultaneously, the older population (65+) has risen from 18.3mln to 29.0 mln.4 The aging of Japan’s population has increased this tendency to favor deflation, because a large share of the population live on fixed incomes. Yes, nominal interest income has fallen sharply with the drop of nominal interest rates. However, complaints about this have largely faded, as pensioners see the benefits of falling prices, relative to their fixed incomes.


These results suggest that the voting structure of theJapanese Diet is heavily weighted in favor of older voters. The key fact for investors comes in the relationship of this over-representation with the economic interests of older voters: Since older voters tend to be pensioners and hold the largest share of financial assets (such as pensions, deposits, and bonds, but hold little in equities), they as a group oppose inflation. Therefore, a legislative system that over-represents older voters is prone to adopt deflationary policies.

Factor 4: Japan has a current account surplus (net exports), which America doesn't have (America is a net importer), and this tilts the nation to favor deflation, since it allows the government to run large budget deficits instead of reforming a problematic domestic economy.

Moreover, the large deficits created a perverse incentive to go further into deflation. To the extent that deflation lowers nominal bond yields, the deficits remained easy to finance. Thus, the pressure for productivity-enhancing reforms – both in the public sector itself to contain spending and in the private sector to raise growth and tax revenue – was interdicted. So long as the current account surplus remains, the incentives to exit deflation will be weak, barring wholesale capital flight by domestic investors, which appears very unlikely.

Conclusion: Japan is unlikely to escape, or reject, deflation. America on the other hand is highly unlikely to become a Japan because it is a completely different nation demographically, politically, economically, and culturally. It takes more than a financial crisis, and falling prices as Japan once saw, to create long-term deflation, says Mr. Feldman.

Thus, the factors that produced and permitted deflationary policy seem likely to persist. The likelihood that Japan takes aggressive action to end deflation remains low. The market implication is that the tendencies for JGB yields to stay low, for equity prices to stagnate, and for the yen to strengthen, are likely to remain intact.

Mind-blowing. Using Mr. Feldman's framework, America will thus likely choose inflation, and his view is indeed that America won't have persistent deflation. The answer to the inflation/deflation debate could really be this simple, in the end, since what is paper money but a man-made construct.

(Via Morgan Stanley, The Japan Case, Robert Alan Feldman, September 6th 2010)