Monday, May 23, 2011

Why Japan-style deflation is not a risk in the U.S.

These two charts show why a Japanese-style deflation is not a risk in the U.S., because they illustrate the source of Japan's deflation: an extraordinarily strong currency. The strong yen, in turn, is a direct consequence of decades of tight monetary policy. With the U.S. dollar now trading at all-time lows against other currencies in both nominal and real terms, it is a safe bet that U.S. monetary policy is not at all like the monetary policy that led to decades of very low inflation and even deflation in Japan. There are no valid monetary parallels between Japan's decades of deflation and the current state of the U.S. economy.

The top chart compares the yen/dollar exchange rate to my estimate of the Purchasing Power Parity of the yen. Note that the yen's PPP (green line) rises almost continuously beginning in the late 1970s. This is a function the fact that Japanese inflation has been consistently lower than U.S. inflation since the late 1970s. (If country A has lower inflation than country B, then the currency of country A needs to appreciate vis a vis the currency of country B just to keep prices steady between the two countries.) The yen needed to appreciate against the dollar just to keep prices in both countries from deviating significantly.

Arguably, the most significant event in Japan's modern monetary history was the huge appreciation of the yen vs. the dollar beginning in 1985. The yen was 260 to the dollar in Feb. '85, and it had soared to 85 to the dollar by June '95—a tripling of the value of the yen in dollar terms. An appreciation of this magnitude, followed subsequently by decades of zero or negative inflation, is powerful evidence of very tight monetary policy.

Deflation is possible in Japan because for decades the value of the yen has risen enormously. That's the definition of deflation: when a unit of account buys more and more goods and services. In the U.S. we have exactly the opposite problem: the dollar is depreciating against most currencies and against gold and most commodities. The fact that the U.S. economy is weak is helping to keep some prices from rising, but not all. The prices that are the most depressed happen to be related to the sectors of the economy that are the most depressed (e.g., housing and construction-related sectors). That's not deflation, that's a relative change in prices that is helping redirect resources away from construction and towards other areas of the economy (e.g., mining and manufacturing).

The only constructive parallel between Japan and the U.S. today is that both countries are burdened with large and growing budget deficits, which in turn are the product of too much spending. Too much government spending can suffocate an economy, leading to many years and even decades of sub-par growth.


Bill said...


Would it be better for the PIGS countries to just go ahead and default to clear this from the market or do you think it's better to keep bailing them out from a systemic risk analysis?

Benjamin Cole said...

I wholeheartedly concur that federal spending needs to curtailed to some percent of GDP. I suggest 16 percent and a balanced budget, requiring we whack about 25 percent of federal outlays.

That said, Nobel Prize Winner and right-wing monetarist Robert Mundell says the US will face deflation again, when QE2 ends, and the dollar appreciates. That does look like Japan--a lot like Japan.

So why not QE3? Why stop what is working?

The right-wing has erroneously conflated "tight money" with restraining federal taxes and spending (except military outlays) The left-wing just wants to spend all the time, and thinks the Fed is unimportant.

Is there another party I can vote for?

Rich said...

Looking through the rear view mirror isn't the best way to construct a forecast. The US$ is a carry trade currency now, and thus has a large embedded short position. If the commodity run reverses, and risk-off becomes the trade for a sustained period, US$ strength would prevail as the short unwinds, and that factor, along with a drop in commodities, could self-reinforce to a persistent deflationary environment.

Read Richard Koo's work, or Mark Lapolla, to get a sense of the dynamic that might play out. said...

Looks as if the price of yen in dollars since has tracked pretty much in line with gold. It would be interesting to see a chart of gold priced in yen over the period of your chart.

Stone Glasgow said...

It looks as though Japan has been successful in keeping the value of its currency flat vs goods and services. That's not deflation, except if you only compare the yen to other (inflating) currencies.

Scott Grannis said...

Stone: You correctly note that Japan's Consumer Price Index has been essentially stable for many years (since 1994). However, the broadest measure of inflation, the GDP deflator, has actually declined by 15% since the end of 1994.

Stone Glasgow said...

Why do the CPI and GDP deflator show such different results?

Stone Glasgow said...

I suspect they yield different results because the GDP deflator would include government spending in its calculation.

If government becomes more efficient, the GDP deflator would show deflation (in the same way, computers show deflation), whereas the CPI does not include government spending and would not be affected by the efficiency of government.

It's hard to imagine that the Japanese government is becoming more efficient over time, but this is what the difference in these numbers seems to indicate.

Scott Grannis said...

The CPI measures only a relatively small number of items that are given fixed weights, whereas the deflator measures a very large number of items and adjusts their weights dynamically. They can produce very different results over short periods, but tend to show the same results over very long periods. The GDP deflator and the Personal Consumption deflator are better measures than the CPI, which in the U.S. has tended to overstate inflation.

Stone Glasgow said...

The BLS has this to say about the GDP deflator:

"The CPI measures inflation as experienced by consumers in their day-to-day living expenses... the Gross Domestic Product Deflator (GDP Deflator) measures inflation experienced by both consumers themselves as well as governments and other institutions providing goods and services to consumers."

This seems to indicate that according to the BLS, the main difference is the inclusion of government costs in the calculation.


Scott Grannis said...

Not the inclusion of government spending per se, but the prices of things that government purchases. The deflator takes into account the prices of all the things purchased in the economy by consumers, government, and businesses.