As Bank of Japan governor Haruhiko Kuroda, pictured, tries to spur the country's inflation rate, he faces a worrying question: What if his predecessor was right about why he will fail?
In June 2011, then-BOJ governor Masaaki Shirakawa faced extreme pressure to double the monetary base, a step Kuroda took just days after replacing him in March. When Shirakawa, a University of Chicago-trained economist, was asked why he'd refused to budge, he offered a surprising excuse: Japan's ageing population, whose fixed incomes would be eaten away by rising prices. Politicians thought the rationale was a cop-out. Shinzo Abe's first act as prime minister was to dump Shirakawa.
Turns out, Shirakawa was on to something. In a new paper, Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness?, International Monetary Fund researcher Patrick Imam offers convincing evidence that ageing societies in Japan, Germany and, to some extent, the US can no longer be manipulated so easily by central bank policies.
Why? Changes in official interest rates are about influencing long-term expectations and short-term behaviour. Cutting rates is meant to make buying a new house, opening a business or betting on stocks more attractive today than next year. But such activity is disproportionately conducted by the young. That's Japan's problem. Today, one in four Japanese is older than 65; by 2060, that group will swell to more than 40 per cent of the population.
Even that isn't the whole story. Along with ugly demographics, Kuroda faces a Japanese public that has learned not only to live with deflation but also to enjoy it.
By 1990, asset prices weren't the only things that had veered into bubble territory in Japan. Arguably, the entire economy had. As the 1970s gave way to the heady 1980s, costs rose throughout the economy: food, transportation, service fees, power, telecoms, education, entertainment, apparel, you name it.
The story of Japan these past 20 years, from the government to banks to companies, has involved keeping consumer prices steady. Deflation has acted like a stealth tax cut for households and restored some sobriety to costs.
When economist Kosuke Motani made this argument in his 2010 book, The Real Face of Deflation, it fell with a thud in Nagatacho, Tokyo's Parliament precinct. Motani thinks Japan is experiencing "non-monetary deflation" on account of a national cost structure that overshot to the upside decades ago, a greying population that favours falling prices over rising ones, and a political system that doesn't understand deflation is a symptom of Japan's malaise, not the cause.
The theory among neoclassical economists that quantitative easing can overcome deflation, Motani argues, is "just like a religion". (He could as easily have said "cult".) As odd as it sounds, Japan's deflation has been as much a choice as a punishment. In order to avoid big, destabilising reforms, the government has amassed mountains of debt. Deflation, which lowers nominal bond yields, makes that burden easier to service.
This is the paradox facing Abe and Kuroda. Until now, the focus has been on how bond traders will react as a nation whose debt is approaching 250 per cent of GDP, and which enjoys sub-1 per cent 10-year bond yields, begins to produce sustained inflation. Equally important is how the nation's 126 million people, many elderly, cope.
"In Japan, all players have adapted to a deflationary environment: Households are used to increasing living standards without expecting higher wages, companies live from cost-cutting without fighting for bigger markets, the government needs low interest rates for most of its finance," says Martin Schulz, a former BoJ researcher and now senior economist at Fujitsu Research Institute. "Turning all this around will not be easy."