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Why Japan-style deflation is not a risk in the U.S.

These two charts show why a Japanese-style deflation is not a risk in the U.S., because they illustrate the source of Japan's deflation: an extraordinarily strong currency. The strong yen, in turn, is a direct consequence of decades of tight monetary policy. With the U.S. dollar now trading at all-time lows against other currencies in both nominal and real terms, it is a safe bet that U.S. monetary policy is not at all like the monetary policy that led to decades of very low inflation and even deflation in Japan. There are no valid monetary parallels between Japan's decades of deflation and the current state of the U.S. economy.

The top chart compares the yen/dollar exchange rate to my estimate of the Purchasing Power Parity of the yen. Note that the yen's PPP (green line) rises almost continuously beginning in the late 1970s. This is a function the fact that Japanese inflation has been consistently lower than U.S. inflation since the late 1970s. (If country A has lower inflation than country B, then the currency of country A needs to appreciate vis a vis the currency of country B just to keep prices steady between the two countries.) The yen needed to appreciate against the dollar just to keep prices in both countries from deviating significantly.

Arguably, the most significant event in Japan's modern monetary history was the huge appreciation of the yen vs. the dollar beginning in 1985. The yen was 260 to the dollar in Feb. '85, and it had soared to 85 to the dollar by June '95—a tripling of the value of the yen in dollar terms. An appreciation of this magnitude, followed subsequently by decades of zero or negative inflation, is powerful evidence of very tight monetary policy.

Deflation is possible in Japan because for decades the value of the yen has risen enormously. That's the definition of deflation: when a unit of account buys more and more goods and services. In the U.S. we have exactly the opposite problem: the dollar is depreciating against most currencies and against gold and most commodities. The fact that the U.S. economy is weak is helping to keep some prices from rising, but not all. The prices that are the most depressed happen to be related to the sectors of the economy that are the most depressed (e.g., housing and construction-related sectors). That's not deflation, that's a relative change in prices that is helping redirect resources away from construction and towards other areas of the economy (e.g., mining and manufacturing).

The only constructive parallel between Japan and the U.S. today is that both countries are burdened with large and growing budget deficits, which in turn are the product of too much spending. Too much government spending can suffocate an economy, leading to many years and even decades of sub-par growth.

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