Remedies for the Asian Deflation:
Revisiting Old Ground
by Christopher Lingle
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The Case Against Keynesian Remedies for the Asian Crisis

A consensus seems to be forming that a continuing deflationary cycle is the most serious threat from the Asian crises. Many would carry this argument further and suggest a worst case scenario where possible spillovers from regional deflation lead to global depression.

In turn, a bundle of policy remedies have been proposed that include increased government spending, credit expansion or increased monetary growth to ÔreflateÕ Asian economies, and perhaps some form of foreign exchange and capital controls. Even China has announced its intention to undertake deficit spending in the hopes of averting a slowdown in its economy.

This overall assessment indicates that old habits die hard, and the worst habits are the hardest to shed. This appraisal betrays Keynesian bias in both diagnosis and cure that is deeply flawed. It turns out that AsiaÕs battered economic terrain may become the Ômother of all battlesÕ in the latest round in the debate over the feasibility and viability of Keynesian policies.

Behind these proposals is a presumption that the nature and level of economic involvement by governments in the region is basically sound. The Keynesian model projects a world of static conditions and its remedies assume that the economic status quo remains unchanged.

Therefore all that is needed is that governments must do a bit more of the same or perhaps expand their intrusions into economic affairs. Of course behind this reasoning is a set of propositions grounded in Keynesian macroeconomic analysis that justify government involvement to remedy recessionary cycles. In short, proposed government actions to reflate their economies are portrayed as both necessary and sufficient to resolve the ongoing turmoil in Asian markets. History suggests otherwise, and objective conditions in most of the Asian ÔcrisisÕ economies implies that reflation is the wrong cure and guarantees that it will be an expensive mistake.

As in medicine, the choice of appropriate economic remedies requires a sound diagnosis. Admittedly there is as much ground for concern about deflation as for the dread of inflation. However, some clarity is needed in order to avoid misinterpreting current circumstances. When deflation arises, its underlying causes must be understood before proposing corrective steps.

First, it is important to distinguish deflation from falling prices that might occur in a few sectors of the economy or may occur only once. Deflation is a measurement of declines in the overall price level that are widespread and persistent. One-time declines in the prices of commodities will have real impacts on the income of their owners or the workers who handle them. However, the observed decline in the prices of manufactured goods or for oil, mineral and some basic commodity prices does not necessarily constitute deflation. Indeed some price declines are being offset by increases for services or for other goods. So it is crucial not to confuse the self-perpetuating momentum of deflation (negative inflation) with disinflation where the rate of inflation is falling.

Second, when it does occur, deflation occurs for at least two reasons. On the one hand, a beneficent form of deflation may result from gains in productivity through technological advance or deregulation that push down costs for services or for goods such as computers or semiconductors. When this occurs, falling consumer prices and rising real income can prompt or prolong an economic boom.

On the other hand, a malignant form of deflation may arise from a sharp fall in aggregate spending due to over building of industrial plants, collapsed speculative bubbles, steep rises in real interest rates or a shrinking real money supply. Any of these could set off a self-fulfilling momentum where buyersÕ expectations of falling prices induce them to delay purchases until the next round of declines. Manufacturers and sellers of resources then find themselves holding excessive inventories and may be unable repay their accumulated debts. This would lead to increased layoffs, rising loan defaults and subsequently a greater number of bankruptcies.

Unfortunately, those who warn of the dangers of deflation in the current circumstances in East Asia only have it half right. Where there is something like deflation, as in Japan or perhaps China, it occurs as a symptom of other fundamental problems in their respective domestic economies. Weaknesses in JapanÕs domestic economy have been exposed by increasingly globalised capital flows. Indeed, those who wish for no change in the cozy government-business relationships that provoked JapanÕs recession are pushing for controls on international capital flows. They hope to return to a world that allows selective participation in global markets while protecting certain sectors of their own economies from competition.

Now consider JapanÕs situation. This error in prognosis is most vivid there. Pleas have been made to the Japanese authorities to undertake sustained fiscal stimulus and massive monetary injections to encourage spending ignore recent experience. Neither keeping interest rates at historical lows (now nearly zero!) nor squandering nearly a trillion dollars in taxpayerÕs money in stimulus packages over the past 8 years has halted the rot in JapanÕs domestic economy.

So now it faces the frightening prospect of a continuing deflationary cycle. It is true that the key is finding a way to restore domestic spending. Even if their export engines are revved up and they cannot pull these economies out of their respective slumps, the problem is with a non-competitive and inefficient domestic economy. Keynesian tinkering cannot cure JapanÕs economic ills. The basic problem is that the current structures and objective conditions provide little impetus for new spending or borrowing by households or businesses and no new lending by the banks.

In the case of Japanese households, they will not spend more if money is to be thrown out of airplanes. (Possibly not even if guns were put to their heads.)

First, demographics work against higher household consumption. Japanese are having fewer children and the average age is rising while, on average, they are living longer. JapanÕs fertility rate of 1.5 children per woman is well below replacement level and considerably lower than in the US (2.1). According to trends, JapanÕs Ôelderly dependency ratioÕ (proportion of the population aged 65 and over relative to the population aged 15 to 64) will cause a decrease in the number of active workers relative to increasing numbers of retirees. A graying population that must soon live from its savings will consume less. To aggravate matters and add to the pressure for the elderly and others to save more, low interest rates and declines in the value of shares has caused some pension funds to close and raises questions about the viability of others.

Second, those currently employed are insecure about their jobs. This inspires them to save more. Young people face a higher likelihood of either not finding a job or finding a job that pays less. So they cannot contribute to a rise in consumption spending.

Third, taxpayers know they face an enormous bill for the costs of recapitalising banks or to pay off earlier or future rounds of old-fashioned pump priming. Their rational reaction to an expected burden of higher future taxes is to save more today. (Economists refer to this as ÔRichardian equivalence.Õ)

In the case of Japanese businesses, they cannot spend. Many already have excess capacity and face heavy debt burdens. Even with industrial production at just over 80 percent of capacity, retail prices continue to fall. Without rising household spending, there is no incentive for additional business investment or new hiring.

One widely ignored remedy is the remedial effect of cutting taxes. By undertaking radical reforms of its tax structure, perhaps by introducing a flat tax, Japanese households and businesses would gain greater control over their future earnings. This would induce them to spend more today. Printing more yen or throwing more government spending at the economy will not.

ChinaÕs economy faces similar problems with a glut of manufacturing inventories and insufficient domestic spending that have led to a decline in retail prices over each of the past 14 months. This is not surprising since industrial capacity is estimated to be almost double the current demand. Those workers in state-owned enterprises who have kept their jobs are saving more in light of planned downsizing that must eventually lead to cutting as many as 50 million jobs. Workers facing layoff from state enterprises expect to lose health care benefits and housing. It is not surprising that, although always high, ChinaÕs saving rate has climbed substantially over the past year to a remarkable 68 percent of GDP.

There is already evidence that BeijingÕs attempts to boost domestic spending are falling flat. On the one hand, increases in savings have outpaced new government spending. In January through February, savings were about half (340 billion renminbi or $41 billion) of what was saved for all of 1998 (720 billion renminbi or $87 billion). This rise in savings reflects worries about falling income and with unemployment at a record high above 4.6 percent in April 1999. There are also expectations that housing and education reforms as well as a new medical insurance system will cause overall expenses to rise. On the other hand, increases in public spending on fixed asset investment have been more than offset by declines in foreign direct investment.

Unfortunately, changing these conditions in Japan and China or elsewhere will not be easy. Putting earned income back into the hands of consumers and investors is only one step in a sustainable basis for economy recovery. There must also be a corrective restructuring of banks and commercial establishments so that they operate along lines dictated by economic and commercial logic rather than through the inspiration of bureaucrats and politicians in concert with dominant conglomerates.

The key to future growth in the global economy is to open up to competition and to unleash creative young entrepreneurs who can produce wealth and jobs by starting up small and medium sized enterprises. Printing more currency units or throwing more money and credit at the economy will not be able to accomplish this.

With all the talk on government action to reflate lagging economies, there is little concern for the fact that governments might need to disengage themselves more rather than increase their involvement in their economies. For example, extensive privatisation and the removal of government-supported monopolies combined with deep tax cuts would free up the private sector. It is important to understand that entrepreneurs, not governments, are the true source of growth in jobs and wealth in a market-based economy.

Along these lines, China has announced plans to amend its constitution to enshrine the private sector and to offer explicit protections for private property. This is a reassuring step that may herald its most significant element of its post-Mao reform yet.

It is also encouraging that Taiwan has shifted course after its dalliance with deficit spending to keep its growth rates up. Now it is pursuing fundamental restructuring with tax reform and opening up its economy to competition and foreign ownership.

Asian governments ought to put their macroeconomic houses in order. But the key is for them to undertake fundamental change in the involvement of their governments in their respective economies. They should not pursue old nostrums that have been tried and that have failed so miserably in the past.
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About the Author

Christopher Lingle is an independent corporate consultant and adjunct scholar of the Centre for Independent Studies who authored The Rise and Decline of the Asian Century.

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