While there is good reason to be concerned about the state of Japan's economy, analysts mistakenly target deflation as the principal villain in this tale. Contrary to popular wisdom, Japan's ongoing economic slump is not the result of price deflation. Nor are aggressive expansions of fiscal and monetary policies the best response to these conditions. Indeed, relying on just these measures in the past is at the heart of Japan's chronic economic slowdown.
Actually, several points can be raised in defense of falling prices. In all events, deflation is a result rather than a cause of current economic conditions.
By any reckoning, Japan's economy is underperforming. For example, capital spending, a harbinger of future business activity, was down by 14.5 percent in the last quarter of last year. Similarly, year-on-year machine-tool orders fell by over 40 percent in January after a similar decline in the previous month. And year-on-year bank lending is down nearly 5 percent in January after falling by just over 4 percent in December, the 49th consecutive monthly decline. Meanwhile, Japan's consumer price index declined by 0.7 percent last year, its third consecutive annual decline.
Perhaps the bits of data that cause the most alarm are the decline in asset values. The average index for land prices in six of the largest cities was down 33.1 in the first half of last year, representing a drop of more than 68 percent from the second half of 1990. And Tokyo's benchmark Nikkei stock-market index has returned to levels not seen in almost 20 years.
Part of the confusion concerning Japan's economic condition arises from equating declining prices with deflation. Many economists and most observers mistakenly fret about declining prices since they believe that they will induce people to spend less. This, along with a drop in business investment, is wrongly interpreted to be the cause of an economic slowdown. In both instances, the low levels of spending are effects instead of causes of slow growth.
Linking sluggish economic activity with deflation in this way leads to an erroneous conclusion. One of the most oft-repeated misperceptions is that halting the fall in prices will raise household demand for goods and services and jump-start Japan's economy. So many analysts have encouraged boosting inflationary expectations to encourage households to spend.
Yet falling prices are one of the most enduring elements of free market economies. Throughout history, industrialized market economies have experienced persistent declines in general prices.
These price declines occur due to a combination of competition, increased capital accumulation and improved technology that lead to expansions in the amounts of goods. Declining prices lead to increased purchasing power of money, and since more goods can be produced for sale at prices that more people can afford, people become wealthier. A vivid recent example is the dramatic fall in prices of computers, mobile phones and other electronic goods. Similarly, the real prices of most raw materials have been declining since the beginning of the industrial revolution.
It is peculiar for analysts to depict an expansion in real wealth from falling prices as the cause for consumers to delay purchases. Especially since many of the same commentators suggested that increased purchasing power, a so-called wealth effect, was behind the now-defunct economic boom in the US.