We Won’t Suffer a Japanese Deflation

The risk here and now is inflation.

As U.S. credit markets continue to be roiled in chaos, some are bandying about the notion that America’s problems resemble those of Japan in its deflationary “lost decade” of the 1990s. “Deflation looms. It certainly does loom,” said one functionary for a major international bank. “The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very, strong negative effect on the economy.”

This analysis expresses a common fallacy that asset-price declines give rise to economic weakness, and the effect is therefore deflationary. But “deflation” is not a synonym for economic contraction. Deflation is rather a sustained decline in the overall price level, i.e., the opposite of inflation. Like inflation, deflation is a monetary phenomenon.

There is no evidence that deflationary influences are now at work in the U.S. economy. I was very familiar with the Japanese deflation, having been the first to recognize and name it in a 1995 op-ed on this page. I was exposed to considerable public criticism by the Bank of Japan at the time, but history has shown my diagnosis to be entirely correct.

Aside from some superficial similarities, the current U.S. financial market disturbance bears no resemblance to the economic misery that afflicted Japan for more than a decade, and in important ways continues to linger there. In fact, the comparison should provide some comfort to Americans. U.S. monetary conditions are nearly the exact opposite of the devastating deflation that characterized the Japanese experience.

The U.S. had its real-estate bubble through the first six years or so of the current decade, and on the surface, that might seem comparable to the real-estate bubble that preceded Japan’s decade of deflation. Our bubble had its roots in the Fed’s exceptionally accommodative monetary policy — a situation not unlike Japan through the late 1980s, when the Bank of Japan was also too easy for too long. But unlike the Fed, the BoJ turned toward tightness with a vengeance, apparently with the objective — at least initially — of pricking the bubble.

Japanese land prices began their long fall in 1991 on the heels of a sharp currency appreciation in 1990, with the yen soaring nearly 20% against both the dollar and gold. That was just the beginning. By 1995, the yen/dollar would see a nearly 50% appreciation, and the BoJ’s deflationary bias remained in place for a number of years. The relentless rise in the currency’s purchasing power magnified the real burden of yen debt, crushing borrowers and crippling the Japanese banking system.

Contrast that with the U.S. experience, in which the decline in real-estate values would coincide not with a deflationary appreciation of the dollar, but an inflationary depreciation. From the time home prices peaked in mid-2006 through the currency’s lows last spring, the trade-weighted value of the dollar fell by some 18%. Over the same period, the price of gold rose by about 75%. While the dollar has rebounded moderately in the last several months, by any objective measure it remains in a weak position. On a trade-weighted basis, it has returned to its levels of about a year ago. But before doing so, it had never been weaker. At around $830 in gold terms, the dollar has recovered a modicum of the purchasing power lost when gold soared above $1,000 last March in the midst of the Bear Stearns calamity. But at current levels the price of gold is double what it was four years ago.

The relative damage to real-estate values between the U.S. and Japan is instructive. Thus far, U.S. home prices have fallen about 12.5% from their peak. But they remain about 40% above their 2000 levels. In Japan, by 2001 the destruction of values brought land prices down to about half their levels of the late 1980s.

The U.S. housing downturn and associated financial-market turbulence is attributable not to tight monetary conditions, but to an unsustainable speculative bubble triggered by loose monetary conditions. The current market turmoil might well put the economy into at least a shallow and short-lived recession. But unlike Japan, the U.S. economy will not have to dig its way out of a debilitating, long-lasting monetary deflation.

On the contrary, the current economic climate is marked by a considerable upswing in inflation, with the headline consumer price index now running at about 5.4%, up from less than 2% a year ago. The decline in crude oil prices will keep down the reported rate for a few months. But once oil stops falling, the underlying inflationary influences will reassert themselves, and no sizeable long-lasting decline in reported inflation is likely in the foreseeable future.

The “lost decade” of stagnation and monetary deflation, and its remaining legacy today, were the product of a persistently too-tight Bank of Japan. The Fed was not tight even before the present crisis, and as the crisis has unfolded has gotten progressively easier. Today, America’s real concern is inflation.

Mr. Gitlitz is chief economist at Trend Macrolytics, LLC.

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