Akio Kawato / Former Ambassador of Japan to Uzbekistan& Former Chief Economist, Development Bank of Japan

May 14, 2024

While Japan shrank by deflation, the outside world swelled by inflation

These days in Japan, there is a string of demoralizing news stories, such as Japan being overtaken by Germany in terms of GDP or by India next year.

In Japan, the strong yen in the early 2010s caused a considerable outflow of manufacturing industries overseas, certainly reducing its GDP. Moreover, in Western countries (Europe and the United States), inflation has continued to rise due to monetary easing since the Lehman Brothers financial crisis in 2008, and the price levels have doubled (with wages rising). However, in Japan, the prices and wages have remained ultra-stable for a long time. Since the currency rates between Japan and Western countries did not change much during this period, Japan has fallen far behind Western countries in terms of the US dollar value of GDP.

In other words, Japan's declining position is just a phenomenon in numbers while the real standard of living keeps rising. Last year, an unprecedented 2.7 million foreign tourists (mostly from Western countries) visited Japan in December alone. and this is partly because Japan is a comfortable society. Japanese cities are clean and convenient, and the shops provide decent service. People seem to be reasonably happy and free. To those in the U.S. and Europe who have become weary of immigrant workers, high prices, rising inequalities, and the social climate that demands confrontation rather than compromise, Japan appears to be El Dorado, with reasonably low prices.

The delay in interest rates cut after the Lehman crisis led to the yen's appreciation and deflationary tendencies

After the Plaza Accord in 1985, Japan lost much of its export growth due to the appreciation of the yen, and it also lost much of its domestic demand when the bubble economy burst in 1991. Since then, the Japanese economy has been in an almost permanent crisis, with interest rates stuck at low levels. The short-term prime rate fell from 8% in 1990 to 2,0% in 1995 and to 1,8% just before the Lehman crisis.

In September 2008, after the Lehman crisis, the U.S. and European Central Banks promptly cut interest rates in unison. The U.S. Fed lowered its policy rate from 2% to 1.5%, half a month later to 1% on October 31, and to virtually zero on December 16. In Japan, the short-term prime rate still stood at 1,475% in January 2009, making the interest rate level higher than in the US. This has caused the yen to appreciate, from about 100 yen per dollar in 2008 to below 80 yen per dollar in 2013. This has greatly increased the outflow of Japanese companies, in manufacturing and other sectors, to overseas locations.

The Lehman crisis brought the placement of orders from overseas to Japanese companies to a halt, and Japan's GDP shrank by about 8.3% (from 2007 to 2009) in yen terms at that time. Its GDP was pushed down even further as manufacturing companies went overseas.

In 2013, with the bold monetary easing initiated under the new Abe administration, the Bank of Japan bought government bonds close to one year's worth of GDP, close to the magnitude of the Bank of England's purchase of government bonds during the Napoleonic Wars in the early 19th century and the US Fed's bond purchases during WWII. Such an extravagance is unprecedented in peacetime. With this "extra-dimensional easing, the interest rates were lowered to a negative level and the yen started to fall from its peak of 80 yen per US dollar to a level between 110 and 120 yen.

Japan and the West now live on different planets (in price structures)

In the years immediately following the Lehman Brothers crisis, Europe and the U.S. on the one hand, and Japan on the other literally took on "different dimensions" in their domestic price structures. While the inflation continued to rise and the wages followed apace in Europe and the U.S., neither the price of goods nor the wages changed in Japan. Between 2008 and 2022, the total increase in the consumer price index in the U.S. reached 47%. During that period, the U.S. nominal GDP almost doubled; this means that half of that increase was in fact like a blister bloated by inflation.

In other words, the West sustained its economy by tolerating inflation, while Japan maintained stability in its lifestyle through deflation. In Japan, companies did not want to raise wages and the people resisted raising the prices of goods. Consequently, gaps continued to widen further between the price levels of Europe and the U.S. and Japan. The average wage in Japan is now about $2,000, half of the $4,000 in Germany. However, the price of a Big Mac is $3,17 in Japan and $5,82 in Germany (eurozone). In other words, the U.S. and Europe appear to have high wages, but prices are high, and there is not much difference between Japan, the US and the EU in terms of real living standards. In other words, the price levels have doubled in the Western countries only in labels.

Extricating ourselves from the curse of deflation

That does not mean that Japan should stay the same. Japan must maintain the virtuous cycle that has finally begun: higher wages ⇒ increased domestic demand ⇒ increased investment ⇒ increased sales ⇒ higher wages.

Japan must also improve its competitiveness to maintain exports that are sufficient to cover imports. While it is inevitable that the imports of IT and AI-related products will increase, it would be nice to have the ability to use these products to generate significant added value in Japan and, if possible, export them as well.

In Japan, an increasing number of people are saying that economic growth is no longer necessary. However, if economic growth is halted at a time when pension payments will increase and defense spending will have to rise, Japan's economy will not be able to carry on. Environmental problems and widening inequality caused by economic activities should be addressed in parallel with growth, not by halting growth.

(This was written for the English-Speaking Union of Japan)