The Sun is at last rising, albeit slowly, or so it appears. The Japa-nese economy is slowly emerging out of its more than a decade old deflationa deflation that was once considered a remote possibility in a fiat-economy since there is a plethora of policy instruments available for Central Banks to support aggregate spending in a fashion that best suits its given context. Even Ben S Bernanke, the present Fed Chairman, in one of his presentations before the National Economists Club, Washington, DC on November 21, 2002 said: "Under a fiat money system, a Government should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero and hence positive inflation." Yet, the Japanese economy defied all the theoretical underpinnings by realing under deflation for pretty long that, too, in the post Bretton Woods free exchange rate system, leaving many Pundits in wilderness. Thankfully, all this look like coming to an end but merit a relook for bettering our understanding of the changing canvas of inflation and deflation.
It all started way back in the 1980s when appreciating yen against the dollar made Japanese exports less price-competitive in the international markets hurting its exports. It is to bail out the exporters that the Bank of Japan (BOJ) in 1986 initiated an easy monetary policy by cutting discount rate. Unwittingly, this easy monetary policy resulted in real estate and share price bubble. To cool the markets, the BOJ was to reverse its easy monetary policy by raising discount rate-thirteen times during May 1989- to August 1990to 6%. But this resulted in fall in Nikkei by around 39% in 1990. This caused further problems: The moneys that were said to have been lent recklessly by banks during the bubble period turned out to be bad loans, resulting in banks not undertaking fresh lending. All this cumulatively resulted in stagnation. The subsequent lack of demand triggered deflation-a general decline in prices.
By 1999, it became clear that the economy cannot be kicked out of deflation unless drastic monetary policies are adopted which culminated in bringing down the overnight call rate to zero by the BOJ. But to the surprise of everybody, nothing could halt the slide in falling prices. It is at this juncture that the BOJ initiated an unprecedented and untested policy of "quantative easing" in the year 2001. Under this policy the BOJ simply flooded the system with more money-liquidity went up to ¥35000 bn which is almost six times the amount that is actually needed to push the overnight interest rates to zero. However, nothing positive happened: No discernable economic activity in terms of spending/investing could be traced. One reason cited for such dismal performance is the failure of banks that were by then heavily loaded with non-performance loans, to pass it on as credit to the broader economy. In hindsight, it appears that the failure of even "quantative easing policy" in pushing Japan out of deflation was perhaps more due to "the massive financial problems that the Japanese banking and corporate sectors faced coupled with a large over hang of Government debt."
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