How vulnerable are we to a Japan-style deflationary spiral?

22nd July 2010

Japan is to economists what the bogeyman is to small children. It is the economic outcome that everyone most fears.

It is used to warn policymakers of the dire consequences of getting it wrong, just as the bogeyman is used to make children eat broccoli.

Keith Wade, Chief Economist and strategist at Schroders, has warned that other developed nations are at risk of some of the problems that proved so damaging for Japan, notably deflation.  

It is not the first time that the unflattering comparison has been made. The Daily Mail warned that we were at risk of falling into the same rut as Japan back in August of last year.

Nor is Wade alone. Calcaria, posting on the Motley Fool, highlights some scholarly work on the risk of deflation.

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Others are even more nervous. Goel3 says: "The US is in deflation now. We are probably facing the same outcome because the real economy is stalling…

"Now we've reached the holiday season however, that game is over. From now on we'll get a steady decline until the economy rebounds.

"Forget next year: the retailers are battening down the shutters.

"Forget 2012 because that's when the fat in contractors for the public sector will have vanished.

"Come 2013 we're into higher taxes to compensate for lower GDP."

Stephen King, a well-respected Economist from HSBC, writes in The Independent of the spiral that created Japan's persistent deflation: "To offset the private sector's caution, the Japanese government eventually chose to borrow more but, as it did so, companies merely accelerated their repayment of debt.

"For every stimulus measure, there was an off-setting leakage somewhere else."

On the other hand, King does suggest one way in which the UK is significantly different to Japan and explains why it is still seeing inflation when most other developed countries are still fighting deflation.

He says that the UK has been saved by its ‘benign neglect' of sterling, adding: "As a mechanism to avoid a Japan-style deflation, sterling's earlier decline has been rather too successful.

"But unless sterling carries on falling or, instead, the public's price expectations become dislodged, it's doubtful that higher inflation will be around for very long."

The yen remained stubbornly strong throughout Japanese lost decades. This point is also made here, in a Business Week article, by former MPC member Adam Posen. 

Although this is in the UK's and Europe's favour, it could be bad news for the US, which has seen its currency remain stubbornly strong.

Nevertheless, overall debt is undoubtedly far higher in Japan, even if its budget deficit is lower.

Overall public debt is approximately twice the size of the economy. It is possible to interrogate economic data from the IMF here to do a comparison.

The figures from the International Monetary Fund shows Japanese 2010 gross government debt at 227% of GDP. The equivalent figure for the UK is 72%, for the US 66% and for Germany 69%.

Japan has never committed to any debt management programme and political intransigence has kept the private sector relatively inefficient.

Credit agencies have finally begun to warn of downgrades for the nation, as reported on Reuters.

The UK has already announced painful cuts to public spending and has managed to keep the credit agencies at bay. But The FT reports that there is still a 'material risk' of the UK losing its prized trip A rating.

As Mindful Money has discussed in Why a double dip could leave us in the same mess as Japan, the US's reluctance to address its deficit has worrying echoes of Japan's inability to take tough decisions on public spending.

Japan is different, but it doesn't mean that developed nations are not vulnerable to a deflationary spiral. Indeed, Ben Bernanke's gloomy prognosis on the US economy seems to make that more likely, as reported here on the BBC site. 

But as with the bogeyman, as a symbol of an economic horror-story, Japan can be over-used. 

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