Fighting corrosion

Japan's deflation apathy has lessons for Euro zone

Japan's long battle with deflation has a message for the Euro zone: Avoid even mild declines in prices. They creep up, cause immense damage and can be hard to reverse.The Euro zone's 0.8 per cent inflation rate is alarming because of weak demand. The International Monetary Fund expects 2014 GDP to be 2.5 per cent below potential. That's worse than the 1.5 per cent output gap in Japan in 1998, when prices began to fall. Besides, just as the Asian financial crisis tipped Japan into deflation, turmoil in emerging markets could threaten price stability in the single-currency area.

Price slides caused by a productivity boom can be benign, like in China in the early 2000s. Some European leaders view the region's present disinflation as a similar "good" vintage. Bank of Japan Governor Masaru Hayami made the same error in 1998. He was oblivious to the more unpleasant reality that when prices fall because of insufficient demand, companies cut nominal wages, depressing consumption. Japan's annual salary bill has shrunk by 12 percent since 1997 - much more than the decline in the workforce.

Companies don't benefit, either. Deflation pushes up the real cost of capital and crushes investment. Budgets are squeezed because retirees won't accept lower pensions. Japan's social security payouts ballooned from 12 per cent of GDP in 1998 to 20 per cent in 2012. Finally, in an ageing society, even a little deflation raises the spectre of contracting nominal GDP, and a related erosion in diplomatic clout.

The BOJ's reluctance to commit itself to an inflation target was a mistake. But the European Central Bank's pledge to keep inflation "below, but close to" two per cent may also lose credibility if the target isn't hit for years.

Then there's banking. Japan took a decade to fix its broken financial system after its asset bubble burst in the early 1990s. The Euro zone's repair job might take half the time. Free-flowing credit can prevent deflation from taking hold.

If prices do fall, however, the Euro zone has fewer options to respond. Japan was able to mitigate the ravages of deflation with deficit spending because Japanese government bonds have always had willing buyers. The Euro zone has already suffered a sovereign debt crisis. That makes it all the more important for the ECB to nip the deflation threat in the bud.