14 Dec 2009

"But how do you explain Japan’s deflation?"

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Those of us who have been warning of impending (and large) price inflation have thus far been kept at bay by the apparent counterexample of Japan. It’s what Scott Sumner brings up to me when we really go at it (that and the bond market), and it’s how Paul Krugman dealt an apparent death blow to Alan Meltzer back in May.

At the time, I didn’t know how to process it, because I hadn’t really done much research on Japan. But in doing the research for my Depression book, I knew that Krugman’s discussion of the “lessons of the 1930s” was often the exact opposite of what I ended up believing after looking at the data myself, so I remained skeptical.

In response to Arthur Laffer’s WSJ op ed, Krugman attacked with this chart showing (apparently) that in Japan the monetary base also shot up like a rocket. So again, the idea is that Japan is a counterexample to all of the deficit hawks’ warnings.

But wait a second. Look closely at that chart. Japan’s monetary base went up by about 90% from 1997 to 2005. That’s a growth rate of about 8.4% per year. In contrast, under Bernanke the monetary base almost tripled in a little more than a single year.

So it’s still true that Japan provides an interesting case study; I admit I would not have thought those charts–especially the M1 chart–could be right. However, it’s misleading to say, “Japan had a big growth in the monetary base, just like we have now, and their currency didn’t tank.”

Of course, the other main difference is that we are currently experiencing price inflation. Absent another major terrorist attack or a financial panic, I don’t see why the demand for USD would rise, meaning I don’t see how its purchasing power can remain stable if those excess reserves begin leaving the banks, as I expect they eventually will.

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