Most of the following is from a comment in reference to an earlier post about the similarities between the U.S. policy response to the credit crunch ushering in the Great Recession and Japan's response to their downturn in the early 1990s. I think the issue so important, however, that it deserves its own post.
The author of the NYT piece about Japan's loss of vigor asserts:
For nearly a generation now, the nation has been trapped in low growth and a corrosive downward spiral of prices, known as deflation, in the process shriveling from an economic Godzilla to little more than an afterthought in the global economy.
Later the author writes:
The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the rational way to act when prices are falling is to hold onto cash, which gains in value. But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people instinctively reluctant to spend or invest, driving down demand — and prices — even further.
The misery and human costs however are not the result of deflation. They are the direct result of Japan's failure to allow the liquidation process to occur. The Japanese government has kept unprofitably invested capital in place with fiscal and monetary stimulus as well as central bank policy that continues to keep bad debt frozen on the books of zombie banks.
Recessions as the necessary consequence of capital consumption via malinvestment resulting from artificially low interest rates. In both Japan and the US, entrepreneurs were led astray by central bank credit expansion to undertake too much investment at higher stages of production and not enough investment at lower stages. The end result is that a large number of investment projects were begun at stages farther away from the consumption that were simply not sustainable. These projects must be liquidated if we do not want to continue to consume capital and make the situation even worse over time. Recession is the beginning of the necessary restructuring of capital toward its most highly valued uses.
Additionally, whatever the cause of the misery in Japan, it is not due to deflation. The claim that there has been a generation of deflation in Japan is simply wrong. As French notes, in 1989 the annual CPI in Japan was at 91.3. In 2009, it was 100.3. There have been ups and down along the way, but prices are higher now than they were in 1989. The monetary base of Japan is now more than 244 times what it was in July of 1991. M1 in Japan almost trippled from 1990 to 2002 and then increased every year after until 2009. In no way can this be construed as deflation.
We should also not forget that liquidation does not have to cause prolonged misery. That is the lesson of the recession of 1920-21 that followed the inflation of the war years. Historian Tom Woods documents that during 1920 unemployment increased from 4% to 12% and GDP fell by 17%. Warren Harding's response was to cut government spending, cut taxes, and reduce the national debt and the Federal Reserve did not act to inflate in an attempt to forestall deflation. Unemployment was back down to 6.7 by the end of 1922 and fell to 2.4% in 1923. The reason we did not have two decades of misery following the recession of 1920-21 is that the government by-and-large allowed the malinvestment to be liquidated and for the necessary capital restructuring to commence.