Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Riding a Japanese rollercoaster

Japan has an unusual and interesting economic history. The Japanese economy was devastated by the Second World War – much of its capital stock had been destroyed. In the postwar period, Japan went from an economic disaster to one of the world’s richest economies in under 30 years.

By the 1980s Japan hosted much of the world’s most successful electronics companies. The 1980s also saw a massive asset price bubble develop. The Nikkei, the index of the largest companies listed on the Japanese stock exchange, increased in value six-fold and reached a peak of close to 39,000 in 1989. Soon after, the bubble burst spectacularly and the Nikkei never recovered its previous high. In 2009, the Nikkei was at around 7,000, having lost about 80 per cent of its value over the previous 20 years!

The Japanese stock market crash (for details see the nearby sidebar ‘Riding a Japanese rollercoaster’) saw the start of a prolonged period of economic stagnation that has essentially continued until today. (Currently Japan is trying to revive its economy through a number of policies called Abenomics, after the Prime Minister Shinzo Abe, but whether these reforms will succeed in revitalising the Japanese economy is still unclear.)

Very low output growth coupled with low inflation or deflation led to economists talking about Japan’s ‘lost decade’, although that’s far too generous – sadly, it’s more like a ‘lost quarter of a century’ now. Although the causes of Japan’s malaise are complicated, economists have noted that deflation played a significant part. The reason is the impact of deflation on the real interest rate.

Here’s why. You can write the Fisher equation (from ‘Connecting inflation to interest rates’ earlier in this chapter) as follows:

Because the nominal interest rate (i) cannot be negative, deflation (π < 0) means that the real interest rate must be positive. What Japan really needed during these difficult years was an economic boost, which having a negative real interest rate could have provided. Instead, deflation meant that this was impossible and the resulting real interest rates led to falls in consumer confidence (why buy now, when things will be cheaper in the future?) as well as a fall in investment (firms could potentially earn more just by holding cash than from an investment project).

One of the main aims of Abenomics is to create inflation by massively increasing the money supply and thereby reducing real interest rates. Some evidence suggests that this approach is starting to work – Japan now has small but positive inflation. To ensure that deflation doesn’t reoccur, Japan now needs to entrench inflation into people’s expectations – no easy task when prices have been falling for around 15 years!

Chapter 6