It is rising inflation that typically causes problems for countries, whether it is demand-pull or cost-push. However, one country that has not been subject to problems of rising prices is Japan. Instead, this economy has been suffering from the gloom of deflation for many years and many argue that this is worse than high inflation.
Falling prices are popular among consumers. If you see a product whose price has fallen from one day to the next, you can use your income to buy more goods. What’s the problem with this? The Japanese economy has experienced largely stagnant growth for two decades and a key cause has been falling prices. When the prices of goods begin to fall over and over again, people start to form expectations about the future direction of prices. If I expect the price of a good to fall next week, then why would I buy now, if I can buy the same good next week at a lower price? 
But, when next week arrives and the price has fallen as expected, why would I purchase the product, if I think that the price fall is set to continue? The problem of deflation is that with continuously falling prices, consumers stop spending. Aggregate demand therefore declines and economic growth all but disappears. This is the problem that the Japanese economy has been faced with for more than 20 years.
However, the latest data from Japan shows core consumer prices growing faster than expected in December 2013, compared to the previous year. This figure was above market forecasts and was the fastest rate of growth in the past 5 years. These data, together with those on unemployment have given the economy a much needed boost.
Recent government policy has been focused on boosts in government spending, with an aim of reducing the value of the currency (click here for a PowerPoint of the chart). Such policies will directly target aggregate demand and this in turn should help to generate an increase in national output and push up prices. If the price trend does begin to reverse, consumers will start to spend and again aggregate demand will be stimulated.
The future of the economy remains uncertain, though the same can be said of many Western economies. However, the signs are good for Japan and if the recovery of other economies continues and gathers pace, Japan’s export market will be a big contributor to recovery. The following articles consider the Japanese economy.
Japan inflation rises at fastest pace in over five years BBC News (31/1/14)
Benchmark Japan inflation rate hits 1.3% Financial Times, Jonathan Soble (31/1/14)
Japan’s inflation accelerates as Abe seeks wage gains Bloomberg, Chikako Mogi, Masahiro Hidaka and James Mayger (31/1/14)
Japan inflation quickens to over 5-year high, output rebounds Reuters, Leika Kihara and Stanley White (31/1/14)
Japaense inflation rises at fastest pace in over five years at 1.3% in December 2013 Independent, Russel Lynch (31/1/14)
Why Abenomics holds lessons for the West BBC News, Linda Yueh (18/12/13)
Questions
- Why is deflation a problem?
- Using an AD/AS diagram, illustrate the problem of expectations and how this contributes to stagnant growth.
- How will a lower currency help Japan?
- What is the likely effect of a sales tax being imposed?
- Does the fact that unemployment has declined support the fact that consumer prices are beginning to rise?
- What government policies would you recommend to a government faced with stagnant growth and falling prices?
- How important are expectations in creating the problem of deflation?
In a speech in Edinburgh, Mark Carney, Governor of the Bank of England, considered the implications of Scotland retaining the pound if the Scottish people vote yes for independence. His speech was intended to be non-political. Rather he focused on two main questions: first whether a currency union of Scotland and the rest of the UK (RUK) would be an optimal currency area; second how much economic sovereignty would need to be shared with RUK as a consequence of Scotland keeping the pound.
On the first question, Mark Carney argued that the current UK is close to an optimal currency area as there is a high degree of economic integration and factor mobility. Sharing a currency eliminates exchange costs, improves pricing transparency and hence encourages competition, promotes cross-border investment, improves the flow of technology and ideas, and increases the mobility of labour and capital.
But sharing a currency involves sharing a monetary policy. This would still be determined by the Bank of England and would have to geared to the overall economic situation of the union, not the specific needs of Scotland.
There would also need to be a banking union, whereby banks in difficulties would receive support from the whole currency area. In Scotland’s case, banking accounts for a very large proportion of the 
economy (12.5% compared with 4.3% for RUK) and could potentially place disproportionate demands on the currency union’s finances.
And then there is the question of fiscal policy. A shared currency also means pooling a considerable amount of sovereignty over taxation, government spending and government debt. This could be a serious problem in the event of asymmetric shocks to Scotland and RUK. For example, if oil prices fell substantially, Scotland may want to pursue a more expansionary fiscal policy just at a time when its tax revenues were falling. This could put a strain on Scotland’s finances. This might then require RUK to provide support from a common pool of funds, such as a ‘regional fund’.
Being in a currency union can amplify fiscal stress, and increase both the risks and consequences of financial instability. In the situation just described [a fall in demand for exports], fiscal policy would ideally help smooth adjustment to the external shock. But its ability to do so could be limited by the budgetary impact of the falls in output, prices and wages. To maintain credibility, fiscal policy may even become pro-cyclical, with the resulting austerity exacerbating the initial fall in demand. In the extreme, adverse fiscal dynamics could call into question a country’s membership of the union, creating the possibility of self-fulfilling ‘runs’ on bank and sovereign debt absent central bank support.6 Such adverse feedback loops turned recessions into depressions in several European countries in recent years.
A separate Scottish currency, by contrast, would, according to Carney, be a valuable shock absorber if domestic wages and prices were sticky.
For example, suppose demand for a country’s exports falls. All else equal, its output will fall, unemployment increase and current account deteriorate. With an independent currency, exchange rate depreciation can dampen these effects by improving competitiveness, and monetary policy can become more accommodative, supporting demand and employment. However, if the country were part of a currency area with its foreign market, its exchange rate would by definition not change, putting the full weight of adjustment on wages and unemployment – a significantly more protracted and painful process. In addition, the responsiveness of monetary policy to weak demand in that country would be diluted by the needs of the broader membership.
But despite the problems of ceding a degree of monetary and fiscal sovereignty, Scotland and RUK are well placed to continue with a successful currency union if Scotland becomes independent. Economic conditions are very similar, as are language, culture and institutions, and there is an effective banking union – assuming such a banking union were to continue post independence.
The existing banking union between Scotland and the rest of the United Kingdom has proved durable and efficient. Its foundations include a single prudential supervisor maintaining consistent standards of resilience, a single deposit guarantee scheme backed by the central government, and a common central bank, able to act as Lender of Last Resort across the union, and also backed by the central government. These arrangements help ensure that Scotland can sustain a banking system whose collective balance sheet is substantially larger than its GDP.
The desirability of Scottish independence is a normative question for the Scottish electorate to decide. Nevertheless, economists have an important part to play in informing the debate. Mark Carney’s economic analysis of currency union if the Scottish electorate votes yes is a good example of this.
Video of speech
Speech at lunch hosted by the Scottish Council for Development & Industry, Edinburgh Bank of England, Mark Carney (29/1/14)
Text of speech
The economics of currency unions Bank of England, Mark Carney (29/1/14)
Articles, podcasts and webcasts
Independent Scotland would be forced to cede some sovereignty if it keeps pound, says Carney The Telegraph, Szu Ping Chan (29/1/14)
Scottish independence: Currency debate explained BBC News, Andrew Black (29/1/14)
Scottish independence: Key extracts from Mark Carney speech BBC News (29/1/14)
Scottish independence: Carney says Scots currency plan may lead to power loss BBC News (29/1/14)
The sterling price of Scottish independence BBC News, Robert Peston (29/1/14)
Independent Scotland ‘needs to cede sovereignty’ for currency union with UK The Guardian, Severin Carrell (29/1/14)
Mark Carney warns Scotland over currency union hopes Financial Times, Mure Dickie and Sarah O’Connor (29/1/14)
How independent would Scotland really be? Channel 4 News (29/1/14)
BoE’s Mark Carney in currency sovereignty warning The Scotsman, Tom Peterkin (30/1/14)
Carney Says Scotland Must Heed Euro Crisis in Pound Debate Bloomberg, Emma Charlton and Jennifer Ryan (29/1/14)
Independent Scotland ‘meets criteria’ for currency union BBC Today Programme, Gordon MacIntyre-Kemp and Iain Gray (29/1/14)
Scotland must play a high-stakes poker game with Westminster over the pound The Guardian Larry Elliott (12/2/14)
Questions
- What are the conditions necessary for a successful currency union?
- To what extent do Scotland and RUK meet these conditions?
- What are meant by asymmetric shocks? Give some examples of asymmetric shocks that could affect a Scotland–RUK currency union.
- Why is there a potential moral hazard in a whole currency union providing fiscal support to members in difficulties?
- Why is banking union such an important part of a successful currency union? What lessons can be learned here from the eurozone currency union?
- What constraints would currency union impose on Scottish fiscal policy? Would such constraints exist in an optimal currency area?
A few months ago, in a post on this site I reported that the Competition Commission (CC) had completed their provisional investigation into the concrete and cement market in Great Britain. As I discussed, they concluded that coordination between the main cement producers was resulting in high prices. They are particularly concerned about the impact of high prices in this market because:
Cement is an essential product for the construction and building sectors and the amount of such work that is funded by the public purse only underlines the importance of ensuring that customers get better value for money. We believe our measures can bring about a substantial, swift and lasting increase in competition in this economically vital market.
The next step was for the CC to consider how they could remedy the situation and hopefully improve competition in the market.
Earlier this month, the CC announced the remedies they intend to impose. Having previously suggested that they intended to impose hard-hitting measures, they have been true to their word. The market leader, Lafarge Tarmac, will be required to sell one of its cement plants to facilitate a new entrant into the market. According to Professor Martin Cave, the CC’s Deputy Chairman who led the inquiry:
We believe that the entry of a new, independent cement producer is the only way to disturb the established structure and behaviour in this market which has persisted for a number of years and led to higher prices for customers.
In addition, the CC is also putting in place measures to limit the publication of production data and price announcements. It is hoped that these measures will reduce transparency in the market.
However, Lafarge Tarmac disagrees with the sale they are being forced to make. This is in part because, as I discussed in the earlier post, they had previously been allowed by the CC to form a joint venture (JV) with one its main rivals:
We are disappointed that the Competition Commission has asked Lafarge Tarmac to divest another cement plant only a year after it allowed the creation of the JV. This is not reasonable or proportionate and we have not been given a fair opportunity to defend our position.
In addition, Lafarge Tarmac is quoted in the above article as suggesting that the end result of the CC’s intervention will be harm to consumers. It will be extremely interesting to monitor how this market develops.
Articles
Competition Commission confirms plan for new cement producer The Construction Index, (14/01/14)
Competition Commission improves competition in the UK. Again. Global Cement, (22/01/14)
Report
Aggregates, cement and ready-mix concrete market investigation, Final report, Competition Commission, (14/01/14)
Questions
- Why might the publication of production data and price announcements help to facilitate coordination between firms?
- Would you expect the new entrant or the measures to limit the publication of production data and price announcements to have more impact on competition in the market?
- Using a supply and demand model, describe the impact the CC’s intervention could have on the construction market.
World markets were taken by surprise by a large rise in Turkish interest rates on 28/1/14. In an attempt to combat a falling lira and rising inflation, the Turkish central bank raised its overnight lending rate from 7.75% to 12%. Following the decision, the lira appreciated by over 3%.
Since the start of this year, the Turkish lira had depreciated by 7.1% and since the start of 2013 by 22.8%. Along with the currencies of several other emerging economies, such as India and Brazil, speculators had been selling the Turkish currency. This has been triggered by worries that the Fed’s tapering off its quantitative easing programme would lead to a fall, and perhaps reversal, of the inflow of finance into these countries; in the worst-case scenario it could lead to substantial capital flight.
Consumer price inflation in Turkey is currently 7.4%, up from 6.2% a year ago. The central bank, in a statement issued alongside the interest rate rise, said that it would continue with a tight monetary
policy until the inflation outlook showed a clear improvement.
The Turkish Prime Minister, Tayyip Erdogan, has been opposed to rises in interest rates, fearing that the dampening effect on aggregate demand would reduce economic growth, which, as the chart shows, has been recovering recently (click here for a PowerPoint of the chart). A slowing of growth could damage his prospects in forthcoming elections.
World stock markets, however, rallied on the news, seeing the rise in interest rates as a symbolic step in emerging countries stemming outflows of capital.
Articles
Turkey raises interest from 7.75pc to 12pc The Telegraph (28/1/14)
Emerging markets forced to tighten by US and Chinese monetary superpowers The Telegraph, Ambrose Evans-Pritchard (28/1/14)
Turkey Gets Aggressive on Rates The Wall Street Journal, Joe Parkinson (28/1/14)
Turkish central bank raises lending rate to 12% BBC News (28/1/14)
Asian stock markets stage relief rally after Turkey rate rise BBC news (29/1/14)
Turkey raises rates to halt lira’s slide Financial Times, Daniel Dombey (29/1/14)
Turkey Rate Increase Stems Lira Drop as Basci Defies Erdogan Bloomberg Businessweek, Onur Ant and Taylan Bilgic (29/1/14)
Fragile economies under pressure as recovery prompts capital flight The Observer, Angela Monaghan (2/2/14)
Data
Main Economic Indicators (including Turkish data) OECD
Data on Turkey, World Economic Outlook database IMF
Turkey price indices Central Bank of the Republic of Turkey
Questions
- Why did the Turkish central bank decide to raise interest rates by such a large amount?
- Why has the Turkish lira been depreciating so much over the past few months? How has this been linked to changes in Turkey’s balance of payments and what parts of the balance of payments account have been affected?
- Why did global stock markets rally on the news from Turkey?
- What will be the impact of the central bank’s actions on (a) inflation; (b) economic growth?
- How has the USA’s quantitative easing programme affected developing countries?
Christine Lagarde, managing director of the IMF, has warned of the danger of deflation in the eurozone. She also spoke of the risks of a slowdown in the developing world as the Fed tapers off its quantitative easing programme – a programme that has provided a boost to many emerging economies.
Speaking at the World Economic Forum, in the Swiss Alps, she did acknowledge signs of recovery across the world, but generally her speech focused on the risks to economic growth.
Some of these risks are old, such as a lack of fundamental bank reform and a re-emergence of risky behaviour by banks. Banks have taken steps towards recapitalisation, and the Basel III rules are beginning to provide greater capital buffers. But many economists believe that the reforms do not go far enough and that banks are once again beginning to behave too recklessly.
Some of the risks are new, or old ones resurfacing in a new form. In particular, the eurozone, with inflation of just 0.8%, is dangerously close to falling into a deflationary spiral, with people holding back on spending as they wait for prices to fall.
Another new risk concerns the global impact of the Fed tapering off its quantitative easing programme (see Tapering off? Not yet). This programme has provided a considerable boost, not just to the US economy, but to many emerging economies. Much of the new money flowed into these economies as investors sought better returns. Currencies such as the Indian rupee, the Brazilian real and the Turkish lira are now coming under pressure. The Argentinean peso has already been hit by speculation and fell by 11% on 24/1/14, its biggest one-day fall since 2002. Although a fall in emerging countries’ currencies will help boost demand for their exports, it will drive up prices in these countries and put pressure on central banks to raise interest rates.
Christine Lagarde was one of several speakers at a session titled, Global Economic Outlook 2014. You can see the complete session by following the link below.
Articles
Lagarde warns of risks to global economic recovery TVNZ (27/1/14)
Lagarde Cautions Davos on Global Deflation Risk Bloomberg News, Ian Katz (26/1/14)
Davos 2014: Eurozone inflation ‘way below target’ BBC News (25/1/14)
IMF fears global markets threat as US cuts back on cash stimulus The Guardian, Larry Elliott and Jill Treanor (25/1/14)
Davos 2014: looking back on a forum that was meant to look ahead The Guardian, Larry Elliott (26/1/14)
Speeches at the WEF
Global Economic Outlook 2014 World Economic Forum (25/1/14)
Questions
- Why is deflation undesirable?
- What are the solutions to deflation? Why is it difficult to combat deflation?
- What are the arguments for the USA tapering off its quantitative easing programme (a) more quickly; (b) less quickly?
- How is tapering off in the USA likely to affect the exchange rates of the US dollar against other currencies? Why will the percentage effect be different from one currency to another?
- What are Japan’s three policy arrows (search previous posts on this site)? Should the eurozone follow these three policies?
It is rising inflation that typically causes problems for countries, whether it is demand-pull or cost-push. However, one country that has not been subject to problems of rising prices is Japan. Instead, this economy has been suffering from the gloom of deflation for many years and many argue that this is worse than high inflation.
But, when next week arrives and the price has fallen as expected, why would I purchase the product, if I think that the price fall is set to continue? The problem of deflation is that with continuously falling prices, consumers stop spending. Aggregate demand therefore declines and economic growth all but disappears. This is the problem that the Japanese economy has been faced with for more than 20 years.
