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The Historical Origins of Japan's Deflationary Trap
Should the Bank of Japan, and the Japanese government more generally, now be faulted for striving for a deliberately undervalued (beggar-thy-neighbor) currency? Are they cheating in the international money game? Essentially no to both questions. The Japanese authorities are trapped into allowing an ever-weaker yen to continue.
The roots of today's trap go back to the 1970s. Worried about Japan's increasing mercantile competitiveness and rising trade surpluses, the United States pressured Japan-by numerous threats of trade sanctions arising out of industry-specific disputes-to keep appreciating the yen. The yen rose from 360 to the dollar in August 1971 (at the end of the Bretton Woods period of fixed exchange rates) to touch 80 in April 1995, before Treasury Secretary Robert Rubin announced a new "strong dollar" policy and ended overt Japan bashing to appreciate the yen. The Bank of Japan and the U.S. Federal Reserve intervened several times in the summer of 1995 to put a ceiling on further appreciations of the yen. Rubin's new policy was, in the main, successful. In the late 1990s, the yen retreated from its extraordinary 1995 high, and has averaged about 118 to120 yen per dollar over the past eight years-albeit with the fairly wide fluctuations shown in Figure 1 [ PDF 132.2KB | 1 page ]
However, the deflationary damage, including heightened fear of foreign exchange fluctuations, had been done. In 1997, McKinnon and Ohno in Dollar and Yen: Resolving Economic Conflict between the United States and Japan described what they called "the syndrome the ever-higher yen", which arose arising from recurrent mercantile (protectionist ) pressure from the United States to get the yen up (chapter 1). Yen appreciation began forcing down the yen prices of tradable goods in the mid-1980s. The expectation of an ever- higher yen led first to reduced nominal interest rates on yen assets, and contributed to the great bubbles in Japanese stock and land prices in the late 1980s (chapter 5). When the bubbles burst in 1990-91, the deflationary pressure was reinforced by the further sharp appreciation of the already overvalued yen through to April 1995. The combination of an overvalued yen and the aftermath of collapsed asset bubbles forced Japan's economy into a deflationary slump from which it has yet to fully recover.
Japan's surprisingly long deflationary hangover can be better understood by looking at relative wholesale (tradable goods) prices in Japan and the United States arising out of yen appreciation (Figure 1). By the mid-1970s, inflation in Japan's WPI fell below the high inflation rate in the U.S. but was still positive. However, when the American price level stabilized in the mid-1980s, Japan's WPI inflation turned sharply negative from the massive appreciation of the yen over 1985-87 -coming out of the 1985 Plaza Hotel Accord to depreciate the dollar. Subsequently Japan's WPI drifted down more slowly until the international price of oil increased after 2002. But Japan's WPI inflation remained (and remains) far below that in the U.S.
Another measure of Japan's deflationary hangover is how long land prices continue(d) to fall after the property bubble burst in 1991. Figure 2 [ PDF 105.5KB | 1 page ] shows the sharp rise in Japanese land prices from 1986 to 1990 when they more than doubled, and then fell by two-thirds -albeit more gradually- from 1990-91 through 2005. Although urban land prices turned up slightly in 2006, land prices continue to fall elsewhere. Unsurprisingly, residential construction remained virtually dormant over this deflationary period.
Download this Discussion Paper [ PDF 428.3KB| 33 pages ].
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