The Implications of low Inflation

04.10.19 Publication:

We are living in a world of seemingly permanently low inflation. It is quite a contrast, at
least for Europe and North America, to the world of the 1970s, 1980s and even 1990s. But it
means that the rest of the developed world is converging on the Japanese experience.

When the European Central Bank and the Federal Reserve Board began their massive
monetary expansions after the 2008 Lehman Shock, many critics, including many
Republicans now closely associated with the Trump administration, warned of the risk of
inflation. Yet now, a decade later, as both central banks find themselves forced to cut
interest rates (in the Fed’s case) and to re-start quantitative easing (at the ECB) no one is
worrying about inflation. In fact, President Trump himself is complaining that the Fed is
proving too slow to resume credit expansion, not too fast.

Low inflation is good for business: price stability brings greater certainty, making planning
easier. But, as the Japanese experience over the past 20 years shows, it can also bring
problems. And it can reflect policy mistakes too, both by governments themselves and by
the business organisations that seek to influence them.

We need first to reflect upon why inflation is so low, even at times of high employment or,
in Japan’s case, labour shortage. For many years, the aftermath of the financial crash could
be blamed for making businesses risk-averse hoarders of cash. That remains somewhat valid
in Europe and America but is now a poor explanation in Japan.

Two better explanations are demography and technology. Ageing populations, which are
now declining in Japan and some European countries too, have tended to depress consumer
demand as more people retire, a trend boosted in cases like Japan and Italy where the birth
rate has fallen low. Digital technology has lowered costs radically in many industries and
artificial intelligence promises to accelerate that process even further.

As we can be pretty sure our societies will carry on ageing for many decades and as the
advance of technology looks set to be rapid, these conditions of low inflation do look likely
to remain. But we can see also that in Japan government policy in the labour market,
encouraged by corporate advice and lobbying, has also contributed to this disinflationary,
even deflationary process. That is also where the chance exists to deal with some of the
associated problems.

The development of the dual labour market, divided between regular and non-regular
employees, has contributed greatly in Japan to the low level of wages and so to the
weakness of household demand. So too, as low wage levels became entrenched, did the
absence of any effective minimum wage: compared with minimum wage levels in Europe
and even in some parts of the United States, Japan’s minimum wage is remarkably low.

Power has shifted in all of our countries away from labour and towards capital, in other
words towards corporate profits and away from wages. That is a trend that can be viewed
neutrally, as simply an outcome of market forces. But it has consequences, especially at a
time when societies are ageing and technological progress is rapid. The main consequence is
that household demand growth becomes permanently weakened, which in turn means that
the market for consumer products becomes depressed.

That is what the Japanese experience shows. This weak household demand can also be seen
in several European countries, including Italy and Germany. Government intervention
cannot counter this trend completely, but it should be possible to reinforce the power of
labour and to help support wages in various ways.

Japan’s biggest mistake, in my view, has been to try to do this simply by calling for
companies to raise wages rather than by intervening directly in labour markets. As I have
written before in this column, with full employment and labour scarcity, a substantial
increase in the minimum wage would be one effective method. Another would be to restrict
the use of non-regular, short-term contracts for employees much more strictly than has yet
been attempted. Part-time work is popular among retired people and many married
women, so it would be wrong to restrict that. But intervention could boost regular
employment quite effectively.

Similar methods are going to be needed in the United States and Western Europe if low
inflation is not to become synonymous with low, slow economic growth. Central banks
cannot solve every problem. Public spending can help, but worries about public debts put
some limit on that too. Direct intervention in labour markets needs to be used as a strong,
supplementary tool. And if it boosts demand, this will end up being good for business, too.

Image by Gerd Altmann from Pixabay