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Explaining Japans DeflationCould it happen in Lebanon?

Deflation is a rare economic condition that indicates general deterioration of


the economy manifested in a general decline in prices (broad-based). No
country in recent times has been hit by deflation as hard as Japan has; two
decades of sluggish growth, rising unemployment, and loss of global
competitiveness were dubbed chronic deflation era or the lost decades.
The causes of deflation reveal structural weaknesses in Japans financial and
socio-economic systems; and the failure of the monetary policy 1 where Bank
of Japan failed to manage inflation expectations (a key tool in monetary
policy) was due to its slow and inefficient responses and loss of credibility.
Roots of Japans Economic Downturn
The run up to deflation starts in the mid-80s when core inflation in Japan (CPI
excluding food) fell to zero due to the following factors that also lead to an
asset price boom2:
1- Tight monetary policy
2- Aftermath of earlier oil shocks
3- Rapid buildup in capacity (positive supply shock or negative output
gap)
4- Appreciation of the yen
5- Gradual removal of trade barriers (supply shocks from emerging
economies)
Effects
The subsequent burst of the bubble in the early 90s revealed huge amounts
of non-performing loans that eroded banks balance sheets.
Transfer of wealth did not add up to a zero-sum game as deflation increased
the real debt burden for debtors while the sharp decline in collateral values
eroded balance sheets of lenders.
In fact from 95-98 several housing loan companies, credit unions, banks
(large3 and small), and securities firms (large and mid-size) failed.
On the macro level this lead to curtailed spending and investment and to a
decline in aggregate demand.

1 Ito, T. and Mishkins, F.S. (2004) severely criticized the monetary policy and
dubbed its failure as the most likely cause of deflation in Japan (Ito, T. and
Mishkins, F.S. (2004). NBER Working Paper Series: Two Decades of Japanese
Monetary Policy And The Deflation Problem).
2 Baig, T. (2003). IMF Working Paper- Asia and Pacific Department:
Understanding the Costs of Deflation in the Japanese Context.
3 Hokkaido Takushoku, Long-Term Credit, Nippon Credit

As short-term interest rates hit zero, real interest rates remained positive 4
and conventional monetary policy based on pure manipulation of short-term
nominal interest rates does little to turn the tide (Bernanke, 2002) 5.

Remedies
The monetary policy is not limited to conventional tools to stimulate the
economy (S-T interest rate manipulation). Bernanke (Bernanke, 2002) argues
that the central bank either alone or in cooperation with other parts of the
government can further stimulate the economy by:
- Managing expectations which necessitates a credible central bank
- Expanding asset purchases and menu of buys: S-T and L-T bonds to
bring down L-T interest rates, equities, foreign-currency denominated
bonds, NPLs, etc.
- Extending loans to banks at low interest rates
- Imposing explicit ceilings on interest rates of L-T treasury debt
- Influencing yields on L-T privately issued securities through the
discount window (central bank lends to banks that in turn lend to
companies that issue securities)
- Cooperating with fiscal authorities that implement broad tax cuts or
increased government spending paired with open-market purchases to
avoid any interest rates hikes (stimulates consumption)
- Implementing structural economic and financial reforms
Note that Bernanke does not recommend manipulation of the foreign
exchange to fight deflation although it was done back in 1933-1934 by
Franklin Roosevelt when the dollar was 40% devalued against the gold.
Why It Took So Long
When S-T interest rates hit zero, the economy would be in need of nonconventional monetary policies to jump-start the economy.
The BoJ is often criticized as not being proactive enough or not having taken
preemptive measures to control neither the asset bubble nor the recession
that followed its burst: Bernanke and Gertler (2001)the central bank
waited too long before tightening monetary policy during the bubble period,
and delayed in easing once the economy headed downward (Baig, 2003).
Series of mistakes6:
- Slow structural reform in regulated sectors

4Real interest rate = nominal rate inflation; in Japan real = + deflation


(nominal = o and deflation is negative inflation)
5 Bernanke, B. (2002). Deflation Make Sure It Doesnt Happen Here. Before
The National Economists Club, Washington, D.C.
6Ito, T. and Mishkins, F.S. (2004).

Slow policy response to NPLs (cleanup process of the banks balance


sheets took 15 years to complete- Nishizaki et al, 2012 7)
The August 2000 interest rate hike
Newly independent BoJ (April 1998) was more conservative, timid, and
tentative thus fell in the independence trap
Inefficient communication by the BoJ destroyed its credibility
Wrong expectations of the economic conditions
Consumption tax rate increase and the repeal of income tax cut in April
97

In addition, the demographic deterioration lowered the natural rate of interest


and expectations for future income growth (Nishizaki et al, 2012), and the
additional shocks of the Asian financial crisis (July 97) and the default of the
Russian debt (August 99) aggravated the recession and hampered recovery.
Abenomics
In 2013, Japan seemed to have gotten out of its deflationary spiral generating
positive inflation of 0.4% (IMF data) and on its way to recovery as GDP grew
1.54% (IMF data). Even the stock market rebounded with the Nikkei 225 rising
77% and the Topix index rising by 70% (Hausman and Wieland 2014 8).
However, the Prime Minister Shinzo Abes three arrows to restore Japans
economic health fell a little short of expectations in part because Japans
new monetary policy is not yet fully credible (Hausman and Wieland 2014).
The three arrows consist of:
- Monetary regime shift:
i.
Setting an explicit inflation target of 2% (by 2015)
ii.
Aggressive quantitative easing including BoJ acquiring
construction bonds
iii.
Doubling the monetary base (by 2015)
iv.
Correcting the excessive Yen appreciation
v.
Setting negative interest rates
vi.
Revising the BoJ Act
- Fiscal stimulus measures:
i.
Public works package of $100 billion
ii.
Social welfare spending: pensions, health care, nursing care, and
family benefits
iii.
Increasing consumption tax to 10% (by 2015)
- Structural reforms:
i.
Stimulating private investments
ii.
Increasing womens share of leadership positions to 30% by
2020
iii.
Joining the Trans-Pacific Partnership (TPP) which would liberalize
and deregulate protected industries such as agriculture,
healthcare and open up utilities to competition
Could it happen in Lebanon?
7 Nishizaki, K. et al (2012). Chronic Deflation in Japan
8 Hausman, J.K. and Wieland J.F. (2014). Abenomics Preliminary Analysis and
Outlook. Brookings Papers on Economics Activity, Spring 2014 Conference.

We conducted a brief comparison between Japan and Lebanon in the table


below and we comfortably conclude that deflation is unlikely to occur. In
addition, Bernanke (Bernanke, 2002) presents 3 measures that a country
should take to prevent deflation:
- Preserve a buffer zone for the inflation rate, that is, during normal
times it should not try to push inflation down all the way to zero
- Ensure financial stability in the economy: healthy, well capitalized
banking system and smoothly functioning capital markets are an
important line of defense against deflationary shocks
- Central bank should act more preemptively and more aggressively
than usual in cutting rates when inflation is already low &
fundamentals of eco suddenly deteriorate
BDL is in line with all these measures even though its capital markets are less
developed; however the establishment of the Capital Market Authority (CMA)
is aimed at reinforcing the markets, attract FDIs, and galvanize BSE.

Factor
Exchange Regime

Japan
Floating

Lebanon
Pegged to the $

Note
The Yen's appreciation during recession aggravated the situatio

Reactive
Conventional

Proactive
Conventional &
Non-conventional
Inflation-target

Private Debt

Does not set


inflation
target
Available

During Japan's deflationary spiral, BoJ stuck to conventional m


economy while non-conventional methods like buying L-T bon
needed. BDL takes the lead in creating non-conventional tools
subsidized loans, circular 331.
Only recently with Abenomics has Japan set a target for inflatio
expectations, a key tool in MP.

Negligible to nil

Contributes to Lebanon's low NPLs rate.

Central Bank

Newly
Independent
Low
credibility

Independent since
inception
High credibility

Sovereign Debt

Internal

Internal

Only in April 1998 was BoJ given independence to be able to t


frequent political deadlocks; a situation familiar to Lebanon.
To this day the BoJ is trying to restore its credibility that was lo
mistakes committed amid the recession especially not committ
target and the August 2000 interest rate increase. BDL convers
credibility as its MP and financial engineering consistently help
2008 global crisis, its prolonged instability and frequent politic
Both Japan and Lebanon protect themselves from foreign credi

Asset Bubble

Late 80s

None

NPLs & Collateral

High

Low

Monetary Policy

Japan's deflation has been triggered by the burst of the asset bu


though Lebanon's real estate boomed from 2008-2010, it is har
today the real estate sector in Lebanon has stabilized without a
to the economy.
Japan's NPLs have been decreasing from their high in 2002 of
regional banks according to KPMJ Loan Portfolio Advisory: G
Japan) to 4.9% in September 2011. Lebanon's NPLs in 2013 ar

Demographic Conditions

Aging
population

Aging
population

The aging population lowers the natural rate of interest and exp
income growth. Lebanon should take note of that especially tha
2015-2020 is expected to have a negative growth of 0.71% acc
Population Prospects: The 2012 Revision and thereafter from 2
maximum rate of 0.67%.

Sources:
Shiratsuka, S. (2003). The asset price bubble in Japan in the
1980s: lessons for financial and macroeconomic stability.
Bernanke, B. (2002). Deflation: Making Sure It Doesnt Happen
Here. Washington, D.C., USA.
Okina, K., Shirakawa, M. and Shiratsuka, S. (2000). The Asset Price
Bubble and Monetary Policy:
Japans Experience in the Late 1980s and the Lessons.
The Economist (March 18, 2013). Once more with feeling.
Nishizaki, K., Sekine, T., Ueno, Y.
deflation in Japan.

and Kawai, Y. (2012). Chronic

Ito, T. and Mishkin, F. S. (2004). Two Decades of Japanese Monetary


Policy and The Deflation Problem. NBER Working Paper Series
10878.
Baig, T. (2003). Understanding the Costs of Deflation in the
Japanese Context. IMF Working Paper WP/03/215.
.

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