Government Must Target Spending
Ryuzo SATO (Professor, New York University)
The term "inflation target" has gotten a lot of mileage recently. It is a bit like arguing over how to determine what a sick person's temperature should be. But whereas a normal temperature is roughly the same for all human beings, an inflation rate depends on local economic conditions and so differs from country to country. However, a deflationary situation in which the annual composite price index is falling, or a negative inflation rate, is clearly abnormal-continuing our analogy, it is like a person whose body temperature keeps dropping.
Since prices fall in a deflation, setting an inflation target to halt this process is intended to try to estimate economic performance by looking at deflation's effects, rather than searching for its causes. This would have to be called a heretical approach.
Consider the ABCs of economics, which everyone knows: the law of supply and demand. The reason prices fall in a deflation is that demand (those who want to buy) is lower than supply (those who want to sell). No matter how much money the Bank of Japan pumps into the market, prices will not rise unless domestic consumers and companies and overseas consumers of Japanese goods (experts), start buying. In short, as long as ordinary people have no desire to buy more goods and services than they are now, it will be impossible to emerge from deflation, even by setting an inflation target.
Japan first began to be interested in inflation targeting when the idea of adjusted inflation was proposed by several economists a few years back. Their proposal was based on behavioral patterns seen in Western economic and cultural frameworks; namely, that people will buy more if they expect prices to rise. What is more, prices in Western societies have continued to rise since 1930. The psychological pattern for people's behavior under these conditions may be called a long-term mini-bubble mentality.
But whether prices rise a little or not, a buying mentality does not exist in Japan today. In short, even if a mini-bubble mentality could be created artificially, consumers probably still would not buy. This is a basic difference between societies with continuing inflation and the Japanese economy, where the opposite tendency (deflation) prevails.
I might mention in passing that all past instances in which policies of inflation targeting have been successful have been in economies where such policies were needed to rein in inflation. There have been no examples of countries adopting inflation targets to escape from deflation.
Advocates of inflation targeting base their argument on the idea that, since Japan cannot rely on increasing government expenditures any longer because of the budget deficit, it is impossible to halt the recession by creating inflation through the Bank of Japan's monetary policies. But the current state of nation is such that creating inflation would be difficult. And even if inflation were created, such so-called stagflation (inflation during stagnant demand) would be the worst possible situation.
What I propose instead is a government spending target, according to which the government would increase expenditures and the budget at a rate of few percent - 2 percent or 3 percent - every year over the next five to 10 years. Such a plan slowly but surely would improve the economy, increase income and expand tax revenues. It also would help ease consumers' current pessimistic tendencies. When the economy improves and aggregate demand exceeds supply, this will create inflation. In other words, inflation should be result, not the aim.
Demand-pull inflation will be produced only when the economy takes a turn for the better. That is my contention, and in a recent article for a Japanese newspaper, Paul Samuelson made much the same point. The economic policy he proposed was similar to the Marshall Plan: Japan should give a free grant to North Korea, which it could use to buy Japanese goods. This would have the effect of increasing Japan's effective demand. The idea of giving free money to North Korea seems highly unrealistic given current sentiment toward that country; still, I agree with the logic behind Samuelson's proposal.
That said, however, I cannot agree with sudden lavish increases in government spending, like those the Obuchi government put into effect. The reason I propose a plan that sets a ceiling of a few percent over the next five years is that I believe Japan has run out of options. This country now has no choice in terms of macroeconomic policies other than to take a gradual approach to emerging from deflation while preserving fiscal discipline.
(This article originally appeared in the March 7, 2003 issue of The Daily Yomiuri)