Japan shows we can’t rely on inflation to tame rampant government debt

Paul Ormerod
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THE DEBT problem currently afflicting the UK and Europe is essentially a question of political economy. Basically, there is a lot of debt around and everybody is wondering who is going to pay for it. All the economic theory in the world fails to get around this fundamental issue.

Traditionally, bondholders took the hit when governments were unwilling or unable to pay back what they had borrowed. The real value of debt has historically been eroded by inflation. In 1945, for example, the UK’s public sector debt to GDP ratio stood at a massive 250 per cent. Slow but steady inflation ensured that, by 1970, this had fallen to 67 per cent – lower than it is today. This was before the inflationary surge of the 1970s, but 3 to 4 per cent average annual inflation doubled price levels over the course of 20 years. This, on its own, halved the real value of the debt.

The case of Japan is instructive. In the crash of the late 1980s, the Nikkei share index fell 80 per cent – imagine the FTSE at just 1,400 – and land values dropped a stunning 90 per cent. The country was awash with debt, accumulated to buy these assets at their peak prices.

Almost ever since, Japan has followed an expansionary monetary policy, with interest rates close to zero. It has carried out quantitative easing on a huge scale, ever since three big banks collapsed in the late 1990s. Yet since 1990, Japanese inflation has been barely positive, averaging just 0.3 per cent a year. Japan’s government needed 3 per cent and got just a tenth of it.

The evidence suggests very strongly that, in general, inflation is not purely a monetary phenomenon. We can identify special historical cases where it has been, like during civil wars or sieges. But, in developed economies, very lax monetary policy can go hand in hand with low inflation.

Inflation in the UK, and the West in general, fell in the early 1990s. It has remained low ever since, despite unemployment falling more or less continuously for over a decade up until the crash of 2008.

Low inflation is not due to the brilliance of politicians or central bankers. After Gordon Brown and Sir Mervyn King, who could believe that anyway? Low inflation exists for purely structural reasons. Globalisation has led to a flow of cheaper goods from emerging markets. It has restricted the ability of the labour force in industries which compete with this trends to enforce wage increases. This, in turn, enables companies to raise their profit share and hold real wages down.

In short, we are in a regime of low inflation which no amount of monetary expansion will overturn. We must look elsewhere for the answer to the question: who pays for the debt?

Paul Ormerod is an economist, a partner at Volterra, and author of Positive Linking: How Networks Can Revolutionise the World (Faber and Faber, July 2012).