If a wave of deflationary threatens the global economy’s rebound, will Japan be the canary in the coal mine. Probably. It’s certainly a high risk country, in part because it’s already loaded to the gills with debt from efforts at fighting deflation over the past 20 years. There are no guarantees in macroeconomic analysis, but if Japan’s already cheerless outlook takes a turn for the worse, it may signal that deflationary winds are set to blow harder in the rest of the world.

Gross public debt in the Land of the Rising Sun is at 200% of the Japanese economy–the highest in the developed world. “It is difficult to continue our fiscal policies by heavily relying on the issuance of government bonds,” Japan’s prime minister, Naoto Kan, said last week. “Like the confusion in the eurozone triggered by Greece, there is a risk of collapse if we leave the increase of the public debt untouched and then lose the trust of the bond markets,” the former finance minister advised.
The FT’s Martin Wolf argues that Japan could easily inflate away its debt problem…if it chooses to. But it’s not obvious that Japan is willing to embrace higher inflation as a way out of its debt problems. In fact, some economists say that Japan’s long-running on-again/off-again troubles with deflation, and weak economic growth, are self-inflicted. Scott Sumner, for example, laid out the case this way:

The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation. The BOJ behaved exactly like a central bank who wanted to keep CPI inflation at 0% or slightly below, and they have succeeded in that objective better than almost any other central bank in the world. Here’s the evidence:

1. They twice tightened monetary policy (in 2000 and 2006) when Japan did not have any inflation. They did this by raising interest rates. What does that tell you?

2. The monetary injections of 2002-03 were temporary, and withdrawn in 2006, despite the fact that there was no inflation. Temporary currency injections are not stimulative.

3. They let the yen appreciate sharply from about 115 to 85 to the dollar, despite falling prices in Japan.

4. They continually refuse to set a positive inflation target, as the Fed and ECB have either implicitly or explicitly done.

5. They refuse to do level targeting, which is known to be very helpful during deflation. This would force them to make up for past deflationary mistakes.

When will people stop talking about the BOJ as some sort of helpless victim of deflation who did all they could, and recognize that they are an extremely reactionary central bank, much more so that the Fed or ECB?

Why is this important? Because if you recognize that a regime of level targeting can prevent deflation, even during a financial crisis, then you also recognize that it can prevent a severe demand-side recession in the wake of a financial crisis. And you will also see the current fall in inflation to levels far below “price stability” as a failure of monetary policy, not some sort of inevitable side-effect of a recession that was caused by financial distress.

Is Japan’s reluctance to go the full nine yards with monetary stimulus the result of a cultural bias? Political? Economic? Perhaps part of the answer can be found in reviewing America’s debate over monetary policy. Although the deflationary threat seems to be running a bit higher these days, some economists are calling for a tightening of monetary policy. But this risks repeating the Fed’s monetary mistakes of the 1930s, others respond. “The attitude on display from quite a few economists [calling for higher rates] bears a distinct resemblance to Depression-era liquidationism,” writes Paul Krugman.
What does the Fed think? James Bullard, president of the St. Louis Fed and a voting member of the FOMC, today said that “the global economy is now in the middle of a powerful recovery led by Asia.” Meanwhile, he worres about the red ink on the U.S. balance sheet, defined as “high deficits and a growing debt-to-GDP ratio.” But a double-dip recession risk looks low, while inflationary troubles down the road are looking stronger, he advised. Bullard continued:

The U.S. has exemplary credibility in international financial markets, built up over many years. Now that the U.S. economy is about to achieve recovery in GDP terms, it is time for fiscal consolidation in the U.S. Irresponsibly high deficit and debt levels are not helping the U.S. economy and could damage future prospects through a loss of credibility internationally. A substantial and credible fiscal adjustment could set up the U.S. for a sustained period of growth, as it did in the 1990s.

It sounds like one FOMC member is leaning toward higher rates. What does the market think of all this? If we look at the inflation forecast based on the spread between the 10-year nominal and inflation-linked Treasuries, the jury’s still out on whether the deflation worries of May were a blip or the start of a new threat. The market’s inflation forecast is still hovering at just under 2%–the lowest since late-2009.

In the stock market, last month’s sharp correction has, at least for the moment, been put on hold. The S&P 500 has been moving sideway for the last several weeks.

What might change the market’s outlook, one way or another? More economic numbers, of course. The May data are still rolling in. Tomorrow we learn how housing starts and industrial production fared in May, followed by an update on Thursday on last month’s consumer price inflation. Next week brings word of durable goods orders for May.
Meanwhile, the latest numbers on manufacturing in the New York region suggest there’s more strength in the economy than some thought. “The manufacturing recovery is continuing at a pretty rapid pace into the middle of the year,” Zach Pandl, an economist at Nomura Securities tells Bloomberg News. “So far, we have seen no signs of spillover from Europe to the U.S.”
In fact, it’s going to take a few months to make an informed decision. Till then, it’s debatable if deflation is the new new threat. Economists have learned a lot in recent decades about what works and what doesn’t in macro policy. Maybe. But there’s still the old problem of uncertainty. Enlightened economic policy still relies heavily on waiting for the numbers…and forecasts about the future.
That said, history suggests it’s best at times like these to lean on the side of promoting more inflation rather than less. When and if higher inflation rears its ugly head, which it undoubtedly will one day, the central bank can quickly and effectively deal with the threat. If—if—it’s willing and able. That’s a big if, of course. But it’s hardly a solution to let deflation build a head of steam. Decisions, decisions…