Why Deflation is So Bad: Japan and the Future For the U.S.

The problems with mortgages in the U.S. are in all the news lately: foreclosures, people who owe more on the mortgages than what their houses are worth, and so on.

The problem is closely intertwined with deflation, an what may happen in the U.S. Take a look at this Japanese case, from the New York Times:

"Masato Y. enjoyed a level of affluence two decades ago that was the envy of the world. [...] bought a $500,000 condominium, vacationed in Hawaii and drove a late-model Mercedes. But his living standards slowly crumbled along with Japan’s overall economy. First, he was forced to reduce trips abroad and then eliminate them. Then he traded the Mercedes for a cheaper domestic model. Last year, he sold his condo — for a third of what he paid for it, and for less than what he still owed on the mortgage he took out 17 years ago."

Sounds familiar?

"... as the United States and other Western nations struggle to recover from a debt and property bubble of their own, a growing number of economists are pointing to Japan as a dark vision of the future. Even as the Federal Reserve chairman, Ben S. Bernanke, prepares a fresh round of unconventional measures to stimulate the economy, there are growing fears that the United States and many European economies could face a prolonged period of slow growth or even, in the worst case, deflation, something not seen on a sustained basis outside Japan since the Great Depression".

[...] as political pressure builds to reduce federal spending and budget deficits, other economists are now warning of “Japanification” — of falling into the same deflationary trap of collapsed demand that occurs when consumers refuse to consume, corporations hold back on investments and banks sit on cash. It becomes a vicious, self-reinforcing cycle: as prices fall further and jobs disappear, consumers tighten their purse strings even more and companies cut back on spending and delay expansion plans".

“The U.S., the U.K., Spain, Ireland, they all are going through what Japan went through a decade or so ago,” said Richard Koo, chief economist at Nomura Securities who recently wrote a book about Japan’s lessons for the world. “Millions of individuals and companies see their balance sheets going underwater, so they are using their cash to pay down debt instead of borrowing and spending.”

Japan has a grave probem with demographics: an aging population. This is something that is also happening with the U.S., but at the same extent. The U.S. still has a lot more immigration anda higher birth rate to alleviate the issue. However, tough economic consdiitons thend to adverselty affect both: people have fewer children, and the the more extremist and less educated parts of socitey start proposing measures against immigration.
"As living standards in this still wealthy nation slowly erode, a new frugality is apparent among a generation of young Japanese, who have known nothing but economic stagnation and deflation. They refuse to buy big-ticket items like cars or televisions, and fewer choose to study abroad in America".

That is deflation - and no more debt. No more buying silly things like cars, plasma TVs, and cable TV.

"The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the rational way to act when prices are falling is to hold onto cash, which gains in value. But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people instinctively reluctant to spend or invest, driving down demand — and prices — even further.

“A new common sense appears, in which consumers see it as irrational or even foolish to buy or borrow,” said Kazuhisa Takemura, a professor at Waseda University in Tokyo who has studied the psychology of deflation.

Deflation destroys the risk-taking that capitalist economies need in order to grow,” said Shumpei Takemori, an economist at Keio University in Tokyo. “Creative destruction is replaced with what is just destructive destruction.”