Hamish McRae: Japanese disease may be spreading quicker than we had feared

If global deflation takes hold, expect it next in Germany. And to spread to the US and UK
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The Independent Online

Japan has joined Italy as the second member of the Group of Seven to have its credit rating downgraded by Standard & Poor's to AA – the other G7 countries are all on the top rating, AAA – but because the markets expected an even steeper downgrading they pushed the yen up.

Now in one sense this does not matter much, for the rating agencies are lagging indicators of credit-worthiness. What matters is that Japan is borrowing itself into a corner, from which it will be hard to escape. Debt is already 130 per cent of GDP and on some projections will reach 180 per cent in five years time. While that is a lot lower than the 300 per cent of GDP that British national debt reached at the end of the Second World War, it would be the sharpest rise of any developed country since 1945.

To have allowed debt to rise so fast with so little impact on Japanese growth must rank as one of the most serious errors of fiscal policy by a developed country since Britain's bailout by the IMF in 1976. While the servicing cost of the debt is low because interest rates are so low, the combination of declining GDP both in money and real terms and continuing deficits makes it very hard to see how Japan will dig itself out.

Fiscal policy has failed; monetary policy has failed; in the short term, at least, structural policies such as deregulation – however essential in the medium term – may make matters worse. And all this comes as the world slithers into the worst downturn since the 1970s.

The progressive downgrading of Japanese performance as this year has worn on is shown in the top graph. In January the consensus was that Japan would grow by just less than 2 per cent next year; now it is minus 0.5 per cent. With the exception of the UK, everyone has been radically downgraded, which incidentally make a bit of a mockery of such forecasts. But Japan has fared far worse than everyone else.

Most people outside the country are unaware what has been happening to Japanese living standards over the past decade. You can catch a feeling for this by looking at monthly retail sales, expressed in yen terms, shown (on a log scale) on the bottom left-hand graph. Faced with this sort of decline it is hard for anyone in the production chain, from manufacturer through to retailer, to make money. Worse, because many of the companies in this chain have large debts, those debts have to be serviced by a smaller and smaller cash flow. In the past Japan has managed to use its strong exporting sector to pull itself out and it is intriguing that this year has seen rather strong exports (bottom right-hand graph). But it is too early to detect whether the 11 September effect will undermine this export recovery.

What does this mean for the rest of us – aside from the known fact that the world's second-largest economy will continue to be a poor performer for the foreseeable future?

Until a few weeks ago the received wisdom in the financial markets has been that Japan's problems were particular to it: a weak financial structure, over-dependence on exports, excessive regulation, poor corporate governance and so on. But in recent weeks there have been rising concerns that the worst performing of the European economies, Germany, might be catching the Japanese disease. To this should perhaps be added a further and even more disturbing possibility: that Japan may be the forerunner of the world. We may all catch the disease.

There are, of course, big differences between Japan and Germany and even larger ones between Japan and the US. Nevertheless, one central feature of the Japanese disease, deflation, is spreading to the rest of the world.

Deflation – falling prices – is now evident at a producer level in most developed countries. Commodity prices, including energy prices, are generally falling. Most consumer goods are becoming cheaper, certainly if you allow for quality improvements. Hi-tech kit is becoming cheaper, and the plunge in the price of telecommunications continues. (It is now as cheap to telephone the US on discount phone companies as is it to make a local call here.)

On a very long view there is nothing wrong with the benefits of productivity growth being felt in falling prices rather than higher wages. Indeed there is a theoretical and ethical argument in favour of this. The benefits of rising productivity should be shared by the whole community, including the unemployed and the retired, not commandeered by the employees of the companies that happen to be able to make those gains.

But there is a transition problem going from an inflationary world to a deflationary one, as Japan has discovered. Debts acquired in a world of inflation become a great burden in one of deflation and during that transition depress growth.

Maybe the central banks can stop this. In the pre-Budget report Gordon Brown stressed the symmetric nature of the Bank of England's inflation target (undershooting was as reprehensible as overshooting), implicitly criticising the European Central Bank's target which only required the ECB to undershoot. The not very heavily coded message there was: the Bank of England is a better central bank than the ECB, so who would you rather set your interest rates? It was rather missed in the sweep of the moment, but actually the Chancellor was firing one of his big guns against the euro. Expect it to find its range in the coming months.

But suppose the central banks cannot engineer a little inflation. The Bank of Japan did not try very hard in the early 1990s. But recently it has sought to drive down rates and nominal rates in Japan are minimal both at the short and long-term ends of the scale. Call rate has been about 0.25 per cent since 1996 and 10-year government bonds have yielded 2 per cent since 1997.

If global deflation takes hold, expect it to come next in Germany. It won't happen through the rest of the eurozone for a couple of years because most other European countries' price levels are below those of Germany and will have to inflate up. Then expect it to hit the rest of Europe. And finally expect it to spread to the US and UK.

Now, of course, this is not a forecast. There is little evidence yet of the Japanese disease of deflation spreading globally. But there is more evidence now than there was three months ago.

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