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Unformatted text preview: apan.12 Another channel from deflation to output and employment is through corporate activities that suffer from unexpected disinflation and deflation. In general, unexpected disinflation leads to income redistribution from borrowers to lenders.13 Borrowers that borrowed long11. Kuroda and Yamamoto (2003a, 2003b) established the existence of downward rigidity of wages, and quantified its extent by applying econometric methods to control for individual characteristics and measurement errors. They argued that the rigidity in regular monthly salaries of full-time male and female employees was subject to a threshold: the monthly salary will not be cut as long as the notional (desirable from the employers point of view) wages do not decline by more than about 7.7 per cent and 4.0 per cent, respectively. However, when the notional wage rate change exceed these threshold values, nominal wage cuts do occur. 12. The literature that questions the Akerlof et al mechanism includes Lebow, Stockton and Wascher (1995), Groshen and Schweitzer (1996, 1999), Card and Hyslop (1997), Crawford and Harrison (1997), Lebow, Saks and Wilson (1999) and Fares and Lemieux (2000). 13. Corporations that borrowed long-term funds expecting that their product prices would rise at a constant positive rate, and planned nominally-contracted repayment to banks based on the growth in nominal revenues, would suffer from an increasing real burden of repayments if an increase in product prices falls short of expectation. For example, think of a firm that contracted a 10-year loan in 1990 at a 6 per cent interest rate, hoping that the prices would continue to rise at 3 per cent for the following 10 years. Prices rose only 10 per cent from 1990 to 2000, instead of 30 per cent. If product prices behave similarly, revenues are lower than expected by 20 per cent by the end of the borrowing period. However, the amount of interest and principal payment to the bank would not change. Corporations may go bankrupt if the revenue shortfalls become serious or if interest payments cannot be made. Deflation is clearly bad for borrowers. Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 229 term funds at high interest rates suffer from low profits, and would not raise wages. Lower wages depress consumption and therefore output. The number of corporate bankruptcies in Japan rose from about 6 500 in 1990 to about 19 000 in 2001, an almost three-fold increase. Not only did small and mediumsized firms go bankrupt, but large corporations also started to fall victim of stagnation toward the end of the 1990s. The total amount of bankrupt companies debt increased from 2 trillion yen in 1990 to 26 trillion yen in 2000, a 13-fold increase. While unexpected disinflation is not the sole cause of bankruptcies, the combined impact of weak economic activity and disinflation does explain a major part of the dramatic increase in corporate bankruptcies. When many corporations go bankrupt, unemployment will increase, which is likely to be sustained for some time. What makes the Japanese case more complex is that asset prices have fallen much faster than the general price level. Asset-price deflation hit the construction and real estate sectors hard. The non-performing loans common in these sectors by the mid 1990s dragged some financial institutions into insolvency. Deteriorating collateral values made recovery of loans more difficult. As the balance sheets of banks started to deteriorate quickly in the mid 1990s, the economic problem spread through the financial system. Large and medium-sized financial institutions failed in 19971998 and again in 2003. The protracted systemic instability also damaged potential growth. The general deflation and asset-price deflation were obviously intertwined and reinforced each other.14 If asset values fall below the nominal amount of debt, those who borrowed and invested in assets (such as real estate, equities, paintings, etc) will find it difficult to repay debts. Unexpected disinflation or deflation is a mechanism for unintended transfers of wealth from borrowers to lenders. This is quite harmful to the macroeconomy just like unexpected inflation and also to the functioning of capital markets. If investors are unable to sell their property, payments to banks would cease, creating non-performing loans. The fall in asset prices also discourages investment in assets, until new buyers are convinced of a bottoming-out in the market; in the process, prices will fall further. The banks with non-performing loans will become reluctant to extend any kind of bank loans and a credit crunch would result. The debt problem arising from asset-price deflation and nominal debt contracts is known in the literature as debt deflation, and is especially relevant in the context of the Great Depression.15 In addition to the costs of lost output, deflation may have other negative consequences for the economy. Deflation now may cause people to expect further deflation in the future. With expectations of deflation, if interest rates have already reached...
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