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Deflation Case Study: Japan

Welcome to 2011, Deflationite readers.

Lets kick off the new year by having a look at the darling of deflation, Japan. Much has been written about the malaise that has hung over Japan for two decades. I’m not going to repeat much of it.

Essentially when talking about deflation in Japan every analyst simply talks about CPI numbers. As mentioned in earlier posts the CPI statistic is quite flawed yet has next to no greater gravitas as an economic statistic amongst economists. Not only is it considered the ‘One True Price’ it is then used to inflation adjust many other economic indicators, this flawed number can determine how much extra pension you get, or the price of your electricity. In fact many countries base their entire monetary policy on keeping within a certain band of CPI. Just think about it, the entire monetary policy of a country reliant on one statistical figure that may or may not be accurate. It is given far too much power.

As regular readers would know I have developed an alternative to CPI called M3 Inflation. This is still very much a developing idea which has a long way to go before I would be prepared to submit it for peer review. Nevertheless it is an interesting idea and has some potential.

The idea behind M3 inflation is fairly simple, the rate of inflation is the annual rate of growth of M3 minus local short term interest rates. If M3 grew 10% in one year, the addition to money supply makes all money less capable of buying goods. However you could have put your money in an account earning interest, which would have reversed the loss of buying power by the amount of interest available. Hence inflation is approximated by change in money supply minus short term interest rates.

If we calculate M3 Inflation for Japan and compare it to CPI figures we get the following graph.

M3 Inflation - Japan

The deflationary effects of the economic crisis in Japan in the early 1990s can clearly be seen in this graph. It constrasts starkly with the CPI figures which gradually dropped to finally record ‘deflation’ in 1995. It would be an interesting exercise to ask Japanese to look at this graph and ask them how it felt back in the early 1990s and which measure they consider to be a more accurate estimate of what happened at the time in terms of purchasing power.

In the early 1990s interest rates initially rose substantially while at the same time money supply growth was falling dramatically. Interest rates eventually came down again over several years, but money supply also declined in that time. Therefore, deflation was strong and persistant over several years.

In the last 20 years the M3 Inflation measure has shown approximately 12 years of deflation, whereas the CPI data shows approximately 8 years of deflation.

Perhaps if the Japanese government was looking at M3 Inflation rather than the CPI figures it may have changed some of the policy decisions they have made over the last two decades?

A mixture of money supply and interest rate measures had to be used as many of the main statistics used did not cover the full thirty five year period of this graph. This graph was compiled using Bank of Japan data.
  • Lorenzo from Oz

    Scott Sumner argues that Japan has had the inflation rate that the Bank of Japan wanted it to have. So they may not have changed their policy decisions all that much.

  • Peak Debt

    Inflation is under-reported in most countries. True inflation of the money supply is rampant in places like the UK, Canada and Australia, feeding house price bubbles in these countries.  The bigger the boom, the bigger the bust, and the global property boom that began in the nineties evolved into the greatest real estate bubble known to mankind. A major bust is coming to those countries where the bubble is still expanding. will be a doozy. As 2011 unfolds the spruikers will come to understand that real estate is dead for generations.

    Peak Debt
    http://australianpropertyforum.com/blog/main/3489065
    Australian Property Monitors

  • Jason Smith

    The whole world is deflating. GFC2 is here! Check out the GFC2 property headlines…

    http://www.australianpropertyportal.com/News

    Scary stuff!

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