Deflation warning is no cause for alarm in Japan

Things aren’t as dire as they seem. In fact, a return of deflation may offer benefits to Japan’s outlook. That also could go for other developed nations experiencing mild price drops. Japan’s latest inflation figures will be released tomorrow.

Deflation was the unheralded catalyst behind the restructuring that fueled Japan’s longest postwar recovery. Officials in Tokyo have been quick to blame the US credit crisis for Japan’s recession. An explanation that deserves equal weight is that the positive side effects of deflation didn’t have enough time to assert themselves.

To make such an argument is to delve into the territory of economic heresy. It’s true that falling prices are rarely, if ever, good for the broader economy. They are a nightmare for debt holders and property owners. They can hurt corporate profits, cut wages and eat into government tax revenue.

Yet Japan benefited from deflation in two ways. First, it offered a kind of stealth tax cut for consumers, who gained more purchasing power between the late 1990s and mid 2000s. Second, it forced major change in the bloated, inefficient economy.

Deflation’s benefits

China’s rise was among the forces that prompted Japanese executives once and for all to restructure. Companies streamlined a labyrinthine distribution system that involved many middlemen and inflated prices. Banks also realized in the early 2000s that they couldn’t grow their way to health. They stepped up efforts to dispose of bad loans.

There’s a reason, though, why Japan’s political and corporate establishments were so frightened by deflation and obsessed about ending it. It was an uncertain and destabilizing force they couldn’t control or understand.

Policy makers wasted several years acting as if deflation was the cause, not a symptom, of Japan’s malaise. It was more about a malfunctioning credit system and increased global competitiveness. Whether officials know it or not, Japan’s growth in recent years owes much to deflation.

Inflation’s return

The return of inflation, albeit mild price increases, in recent years prompted the popping of champagne corks from Tokyo to Washington. It also took pressure off the government to continue efforts to modernize the economy.

As deflation threatens to make a comeback, officials in Japan and elsewhere need not panic. The key is to keep the trend modest. Aggressive drops in consumer prices won’t help business or investment confidence. And they certainly wouldn’t bode well for stock markets.

Like it or not, falling prices are something with which governments around the globe will need to grapple. Hungary, Iceland, Ireland, Spain and Turkey will experience “severe” economic declines, many because of housing slumps that “still have a long way to go,” the OECD said. It added that deflation has become a greater risk than inflation.

Deflation in China is certainly a threat if the global crisis gets worse. In Japan, Taro Aso certainly won’t appreciate being remembered as the prime minister who oversaw the return of deflation. And yet he’s taking very doctrinaire steps to stabilize growth, like fiscal pump priming.

Changing world

Lacking in Tokyo these past couple of years has been long-term planning to prepare for an aging population and boost entrepreneurship. The Bank of Japan also is reluctant to take more drastic steps to fight deflation – such as returning interest rates to zero from today’s 0.3 percent.

The world is changing faster than Japan’s policy makers can adjust. The return of deflation will make it harder to remove structural impediments to growth with lax monetary and fiscal policies or a weak currency. Such measures offer short-term gains at the expense of long-term prosperity.

The good news is that Japan’s deflation didn’t turn into the global nightmare the US feared. In October 2002, for example, Nikkei English News reported that the Central Intelligence Agency was investigating the effects of Japan’s deflation.

It had all the makings of a Tom Clancy novel and showed just how concerned the US was about the dynamic hurting American consumers. Now, of course, economists are left wondering if the US is headed toward deflation.

Japan is the more immediate risk. The BOJ didn’t formally end its deflation-fighting policy of pumping extra cash into the economy until March 2006. It’s worth noting that it took record increases in oil and food prices to produce a bit of inflation.

Now, “there is a high probability that Japan’s economy will slip into deflation in the third quarter of 2009” as core consumer prices turn negative, says Kyohei Morita, chief economist at Barclays Capital in Tokyo.

It could happen sooner if the global outlook turns even gloomier in the months ahead. While not good news for Japan’s leaders, history shows that may not be the disaster it seems.

By William Pesek*

* William Pesek is a Bloomberg News columnist. The opinions expressed are his own.