Deflation Nation

If you want to get a sense of how deflation is slowly transforming the world's second-largest economy, take a stroll through central Tokyo.

At first glance, the Ginza, the city's glittery equivalent of Fifth Avenue, Rodeo Drive, or Rue du Faubourg St. Honoré, doesn't appear any different from a decade ago, when the Japanese could still pretend that recovery was just around the corner. But look a little closer, and you can see the change. Take the site of the Sogo Department Store, a high-end emporium that once sold everything from elegant kimonos to shockingly expensive packets of dried seaweed. No more. The Sogo store has gone bust, a victim of one of the biggest contractions in retail-industry revenues in the world. In its place is Bic Camera, which specializes in deeply discounted consumer electronics. Half of Bic's wares are imported from the low-cost factories of China and Southeast Asia.

Now cross into the tiny backstreets off the Ginza's main drag, a warren once packed with hostess bars where a salaryman's evening out could easily set his company back $300. Today, many of those bars are gone, replaced by fast-food outlets, inexpensive beer pubs, and kaiten sushi joints -- the ones where you pluck your raw fish from a revolving conveyor belt. "There's nothing good about deflation," says Kennosuke Arata, owner of the Ecoro hostess bar in the Ginza. His building, 24 Marugen, used to house 40 such bars. Now there are fewer than half that many. Since Arata's customers come by less frequently, he is pressing the building's owner to lower his rent from the $5,000 he now pays every month. Otherwise, says Arata, "I may have to move."

Feeling depressed? Maybe a promenade around the Imperial Palace will revive your spirits. The four-meter-thick walls are as solid as ever, and swans still glide over the moat's limpid waters. Good thing the Emperor doesn't have a mortgage to pay off. In 1990, the Imperial Palace plot was said to be worth as much as all the land in California. Now, experts say it's worth about half of Los Angeles.

Alan Greenspan is warning that deflation could hit the U.S. The European Central Bank is watching for telltale signs of price collapse in Germany. But in Japan, such warnings would be old news. Japan is already Deflation Nation and will be for years to come. Ordinary Japanese -- workers, teachers, small-business owners -- are learning how to live in this new world. How they fare will determine whether Japan sinks into economic irrelevance or emerges from deflation a stronger, more vibrant country.

The chances of deflation strengthening Japan may well seem remote. After all, the macro numbers measuring deflation's impact on Japan are ugly. Since the bursting of the country's real estate bubble in 1991, the winds of deflation have been gathering force. Economists are familiar with the chain of events. Bad real estate loans started piling up at the banks, which slowly stopped making new loans yet kept propping up sick developers, contractors, and retailers with fresh infusions of capital. Overcapacity in buildings, factories, and companies never cleared up, and prices slowly but steadily headed south. To reignite demand, the Bank of Japan slashed rates and boosted the money supply, but with banks refusing to lend, it didn't matter. Small companies dropped like flies, and major manufacturers embarked on massive restructurings. Unemployment started rising -- to 5.4% today from 2.1% in 1990 -- and strapped consumers began dipping into savings. A bargain mentality, once rare in Japan, took hold. While there's lots of interest in Nintendo Co.'s new GameCube console, for instance, sales are soft. "Japanese are waiting for the price to come down," says Nintendo President Satoru Iwata. "Spending more than 20,000 yen ($170) is a heavy outlay for a Japanese family today." Imagine a Japanese exec saying that in 1989.

Japanese know how grim the numbers are. Stocks trade at 20-year lows, real estate prices are down 80% from their value a dozen years ago, consumer prices are falling for the fourth straight year, and wages dropped in 2002 by 2.1%. For a key demographic, men aged 50-54, unemployment and income numbers look even scarier than the average. In blue-collar parts of Osaka, joblessness is past 7%. "If prices and wages really drop at the same time for a long time, then it is a very big problem," says Mamoru Yamazaki, chief economist at Barclay's Capital in Tokyo.

That's the nightmare scenario: Japan's deflationary spiral accelerates and never really reverses. At some point, Japan's government can no longer manage the decline. Major bankruptcies spike, investment evaporates, and ordinary folk rapidly deplete their savings. You have to go back to the Great Depression to find anything comparable. Deflation was a big factor in that crisis, too: It helped cripple industrial production around the world and drive unemployment sky-high. In the 1930s, the price of everyday goods fell by 10% a year in both the U.S. and Japan, which devastated corporate earnings and undermined the financial system. The planet sank into an economic funk that it took a world war to break.

Is Japan really headed for such a deflationary scenario? Perhaps, but consider this. The country has been living with deflation in one form or another for a decade now, and while there's definitely a slow-motion crisis playing out, there's no sign yet of a Depression-level blowout. Wages and prices have been declining slowly, giving individuals and the larger economy time to adjust.

In fact, the process is conferring some real benefits. Japanese now buy lower-priced Chinese and other Asian goods and supplies, reducing the cost of living. Many Japanese manufacturers are shifting production to China and elsewhere in Asia, which helps them keep prices down. That makes it easier for consumers to live with their scantier wages. "Japan is moving to a low-cost structure," says Hiroshi Okuda, chairman of Toyota ( ) ( ) Motor Corp. Although the process is painful, he and other industry captains concede, it is forcing companies to trim down, tackle excess capacity, and become much more efficient -- and profitable.

For now, Japan's adoption of a low-cost economic model is hurting plenty of Japanese -- and helping many as well. An example: Kindergarten teacher Sayo Ohuchi, 37, earns $30,000 a year, but she is buying a $280,000 condo that five years ago might have fetched $340,000. Because of Japan's rock-bottom loan rates, she's paying just 3% a year for her mortgage. "I wasn't planning seriously on buying an apartment," Ohuchi says, "but everything worked out just right."

For first-time home buyers with steady jobs, such as Ohuchi, deflation has made life sweet. She still lives with her parents -- not unusual in Japan -- so she pays no rent. And as an employee of a public school, her job security is about as good as it gets. Even though her salary is modest, Ohuchi feels confident enough in her future to spend much of her income on discount travel packages that have emerged in deflationary Japan. "I usually go abroad once a year, sometimes twice," she says. She has blitzed around Europe with friends, taken safari tours in Africa, explored Egypt and Morocco, and even made it to Alaska to see the Northern Lights. Back in Japan, she fills her free time with English lessons and computer courses or shopping at Tokyo Bay Lalaport, a shopping mall full of European luxury goods. "Sometimes I say to myself, looking at bills at the end of the month: 'Oh, did I spend so much?"'

While Ohuchi is learning the pleasures of property ownership, for many Japa-nese in their 40s and 50s, it has become a misery. Anyone who paid the going price -- about $1.5 million -- in the late 1980s for a house in the upscale suburban Tokyo enclave of Setagaya-ku, for instance, knows the pain: The house is likely worth no more than $900,000 today, often less than what the owner owes on the mortgage. Michiko Kanai thought the three-story apartment building she put up 15 years ago on a plot of land her father owned would see her through to retirement and allow her to leave something for her children as well. Instead, her debts on the building likely exceed its value by a half-million dollars because of the fall in property prices. "When I was growing up, I never worried about money," she says. "Those days are gone forever."

Hidemi Matsuhashi's situation isn't quite as dire, but he's worried. His 92-square-meter condo has lost 30% of its value since he bought it in 1995. Although he paid only $282,000 for the apartment, half what it would have cost at the market peak in 1990, he still has to dish out $900 in monthly payments for the next 22 years. Matsuhashi, 52, a consultant who helps small companies devise marketing and business-development plans, is starting to feel the pinch. His income has been steady at about $72,000 annually in recent years, but with small businesses cutting back on spending, he's not certain about the future. "It hasn't been easy these last several years," he admits, "and it doesn't look like things will improve soon."

His wife, Naoko, brings in some extra cash by teaching private physical-education classes. But she's having trouble finding new clients, even though her fee is only $25 for four sessions, exactly what she charged a decade ago. Meanwhile, they have just finished putting their daughter through college, at $8,500 a year, and their son entered Chuo University in Tokyo in April (when the school year begins in Japan).

One consolation for Matsuhashi is that unlike most of his contemporaries, he's not a salaryman. Many of these fiftysomething men have been forced out of their jobs. That's when the real pain begins. Personal bankruptcies hit a record 214,600 last year, a 30% jump over 2001 and nearly double the level in 1999. And far more families may be in financial distress than are willing to admit it -- perhaps hundreds of thousands more, by some estimates. "Bankruptcy is regarded as close to a crime in Japan," says Seiichi Yoshikawa, an attorney at Tokyo law firm Koga & Partners.

That phenomenon has led to record-high suicide rates. Over the last two years, more than 60,000 people have taken their own lives -- 50% more than in the mid-1990s. "The present economic situation breeds weak, vulnerable people," says Sumiko Kitagawa, a counselor at a Tokyo suicide hotline.

Corporate bankruptcies have nearly doubled -- to 19,000 -- since 1990. That obviously hurts those companies' workers, who are forced into unemployment or early retirement. With thousands more companies not far from going under, workers throughout the economy fear what the future may hold. Even at healthy companies, many employees have seen their workloads increase as attrition and layoffs cull the ranks of workers. Worse, wages at many large companies have been falling. Overall pay has dropped for four of the last five years, according to government statistics.

With all of the social stress, companies providing mental-health services are doing a brisk business. Nearly 90% of companies have employees taking sick leave because of mental-health problems, and three-fifths say the number of employees with mental-health issues is rising, according to a survey by the Mental Health Research Institute, a private research group in Tokyo.

To cope with growing stress in the workplace, many companies have hired outfits such as Japan EAP Systems, which counsels employees at multinationals such as Dow Chemical, Dupont, and Taisei Construction. "Employees have serious anxiety about their future," says Keiko Matsumoto, a clinical psychologist at EAP. Although many want to quit, "with such a bad economy, they feel they have no choice but to keep working, despite the pressure and stress."

Still, the paradox of Japan's experience with deflation is that for one segment of Japanese -- retirees -- life has never been better. People over 50 control 80% of Japan's $11.4 trillion in household savings, according to a report by Goldman, Sachs & Co. And if they bought a home in the 1960s or 1970s, they have realized substantial gains on their property even if they have suffered enormous paper losses over the past decade. "All in all, I am very lucky," says 64-year-old Uichi Kudo, who made his last payment on his suburban Tokyo home in 1991. "I bought a house before the bubble." If Kudo were 20 years younger, he would probably be sweating out the next mortgage payment or worrying about layoffs. Instead, he spends his free time attending wine tastings and cooking courses. And because of deflation, his income goes a lot farther than it used to.

Deflation has brought economic benefits for every class of Japanese. Just a decade ago, Japan was one of the world's most highly regulated, closed economies. A web of regulations effectively banning rice and beef imports meant that Japanese consumers had to pay much more for domestically raised products. Japanese conglomerates such as Sony ( ), Sharp, and Matsushita Electric Industrial ruled the electronics industry and could keep their prices high. And arcane rules about the size, location, and operating hours of stores meant the retail sector was dominated by mom-and-pop shops that charged sky-high prices for ordinary goods.

Today, the price of everyday existence in Tokyo remains a great deal higher than in most other major world cities. But deregulation is starting to give Japanese consumers some relief -- while fueling deflation. With more competition in telecommunications, cell-phone rates have fallen by half. Under pressure from U.S. trade officials, Japan has moved to a tariff system on rice. That still keeps out much foreign grain, but the tariffs are falling, and gaijin rice today is available for about 10% less than the local stuff. And controls on beef have been loosened, so imported meat is readily available everywhere, from supermarkets to fast-food outlets. That means restaurants such as the wildly popular Yoshinoya chain can sell a bowl of marinated beef with rice (both imported) for just $2.40 -- $1.01 less than its cost five years ago.

It's not just imported food that nudges prices down. With the explosion of electronics manufacturing in Southeast Asia and China, Japanese consumers pay far less for televisions, stereos, and computers. Sony, Panasonic, and Sharp TV sets, stereos, and DVD players are imported from China as well. Japan's imports from China -- $66 billion in 2002 -- surpassed imports from the U.S. for the first time in the latest fiscal year.

The stores where Japanese buy those goods are changing, too. Entirely new retail categories -- 100-yen discount shops, clothing chains selling low-cost imported goods, and warehouse-style department stores -- have become the norm. Sales at discount stores grew by 78% from 1995 to 2000, while sales at department stores grew by 25%, according to the Japanese External Trade Organization.

Today, 14% of men's clothing, 8% of liquor, and 9% of shoes are sold in discount stores, the trade group says. Foreign retailers such as Gap, Virgin Group, and Eddie Bauer have taken advantage of both deregulation and falling real estate prices to expand in Japan in recent years, creating greater competition and driving down prices further. The average cost of a man's suit has fallen to $353 from $425 since 1999. Kids' sneakers have dropped to $17.75 from $23, according to government data.

Discounting is the way to prosper in Japan, which again helps fuel deflation. Hiroshi Ono's Hanamasa Co. has thrived by offering cheap beef in its 30 supermarkets and bargain meals at its 60 steakhouses. And because deflation has brought property prices down, the company has been able to expand quickly. In 1968, when Ono, Hanamasa's president, took over the company his father founded, the only beef available was Japanese, at astronomical prices. A bit of a maverick, Ono built his business early on by importing beef from the U.S. and Australia, even though it was considered grossly inferior. Then, in 1996, Hanamasa opened its first wholesale meat market, where both individuals and restaurants could buy huge cuts of beef at discounts of 15% to 20%.

Ono had a tough time finding affordable leases in the heart of Tokyo, where he desperately wanted to expand. In 1996 and 1997, he started contacting banks that were slashing their branch networks to see if he could take over their space. But they were demanding about $423 per tsubo (3.3 square meters), twice what Ono was willing to pay. Now, the bad-debt crisis has softened the banks' demands: They're very happy to lease closed branches to Ono at a reasonable price, and he is expanding rapidly into the city center.

In Ono's view, Japan's economic troubles and falling prices have subverted the whole power relationship between small businesses and Japan's once-mighty banks, and he heartily approves. Big corporations gorged themselves on debt. Now, deflation is killing their balance sheets. "Small companies like us couldn't spend and borrow a lot during the bubble years," Ono recalls. "Now, everything is upside-down."

In fact, the nimblest of the small companies have been among the primary beneficiaries of deflation. True, many of them, starved of capital and overwhelmed by Chinese imports, have gone under. Yet the survivors are learning to swim in the deflationary sea. Once overlooked by the best young workers, who flocked to large companies upon graduation, small businesses are able to find top talent at bargain prices as unemployment rises.

Chisaki Corp. is a 16-employee maker of industrial furnaces and pollution-control equipment with $10 million in sales. The company once had to hire older specialists who had retired from large corporations because "younger engineers would never consider joining a small operation like mine," says founder Tatsu Chisaki. Today, Chisaki has a dozen younger engineers -- and he doesn't have to pay them top dollar, either. Thanks to the swoon in real estate prices, Chisaki is a landowner. Three years ago, he built a three-story headquarters in Tokyo's Ikebukuro business district on a 230-square-meter plot he purchased for $1.3 million, a third of what it would have cost in 1990. "This is the most difficult period since the war," says Chisaki. "But it has been good for my business."

Of course, if you lose your job, can't afford your mortgage payments, and don't get to send your children to good schools, cheap DVD players, falling property prices, and inexpensive beef bowls are small comfort indeed. Japan needs economic growth, a banking sector that's not wallowing in bad debt, and more efficient companies that can stay on top of their markets in the face of increasing competition from abroad. On May 9, the International Monetary Fund again urged the Bank of Japan to do everything it possibly can to increase liquidity and give a little inflationary kick to the economy. But investors made it clear they figure the BOJ either cannot or will not do anything. In mid-May, they bid the price of 10-year Japanese government bonds so high that yields dipped below 1% -- a first.

That's a sure sign the markets are convinced that deflation in Japan is here to stay. Of course, ordinary Japanese don't need a bond trader to tell them that. They see deflation at work every day, in every shop and office. It's a force that is both damaging and beneficial -- and it will define Japan for years to come.

Anyone who paid the going price -- about $1.5 million -- in the late 1980s for a house in the upscale suburban Tokyo enclave of Setagaya-ku, for instance, knows the pain: The house is likely worth no more than $900,000 today, often less than what the owner owes on the mortgage. Michiko Kanai thought the three-story apartment building she put up 15 years ago on a plot of land her father owned would see her through to retirement and allow her to leave something for her children as well. Instead, her debts on the building likely exceed its value by a half-million dollars because of the fall in property prices.

Coming soon to a city near you. The San Francisco Bay Area is full of people who are going to be badly underwater if there is even a 20% drop in prices - at 40% there will be an immense tidal wave of foreclosures. Thank the banks and their "qualify every borrower who can breathe and chew gum at the same time" philosophy in recent years.

We could head down the same path if we are not careful. There is only one solution to this problem, briefly alluded to in the essay above, and that is de-regulation on a massive scale unseen since the creation of the post-war welfare state.

Scrap all regulations related to capacity, workers' rights, workers' compensation, OSHA, license and regulatory fees, various permits, and zoning of commercial establishments. Let unadulterated capitalism as envisioned by Adam Smith take hold, and prosperity will return.

There have been systems like that before. Charles Dickens wrote about them a good deal.

America is not Japan.

Yup, that is a geopolitical fact. But we have our very own real estate bubble developing, at least in certain urban markets. And instead of the huge savings that have cushioned Japan's consumers, American consumers have a mountain of debt. I doubt that it would take near as much of a push in this country to tip us into deflation.

While there are many bad things about inflation and some good things about deflation, inflation and deflation affect people's timing of purchases. If people perceive that the price of a good will go up tomorrow, they are more likely to buy that good today (to beat the price increase). If people perceive that the price of a good will go down, they are more likely to wait and buy the good tomorrow (to take advantage of the price decrease).

In the mid-1980's, video games experienced extremely major deflation which wiped out many companies in the industry and crippled many others. Once people got used to the fact that hot new games would drop from $25 to $10 after a few months, they started simply ignoring the new releases and only buying the cheaper, older titles. This resulted in the newer games being marked down more quickly (since larger numbers remained unsold) which in turn encouraged more customers to shun new games for marked-down ones.

It should be noted that many businesses, including--I believe--video games now include certain "deflation" protections. For example, many magazine and greeting-card publishers buy back unsold merchandise at full retail price. This tends to discourage retailers from seeking to unload their merchandise at steep discounts to customers who would be willing to wait out good prices.

real estate values in the US will adjust only when interest rates rise, since buyers base the price they are willing to pay on the monthly mortgage payment, not on the actual price they are paying for the property.

japan has no internal consumer based economy of their own, and with China taking their export markets, they are in trouble. their propensity to save is hurting them. they should be taxing savings. hold money in an account, you pay a tax on it every year. encourage people to spend. its radical, but they need it.

Yup, that is a geopolitical fact. But we have our very own real estate bubble developing, at least in certain urban markets.

I think I'll be renting for awhile, until the bubble bursts. While the monthly payments may be the same for a $180,000 home financed at 5%/30yr as for a $140,000 home at 8% or a $98,000 home at 12%, one has a lot more options with the latter than with the former. If one buys a $180,000 home at a 5% fixed-rate mortgage and property values fall while interest rates rise, one may be pretty well stuck. The $1000/month morgage payment may be affordable, and one might keep the home even as its equity went negative, but one would be quite unable to move. By contrast, if someone gets a $98,000 home at a 12% rate, a drop in interest rates would allow one to reduce the effective cost of one's home, and rising real-estate prices would give the owner more options.

Deflation is slowly starting to be talked about here. The gorilla which nobody wants to talk about is China. For years, Japan fought to keep industry at home or at least in allied countries such as Malaysia and Thailand and limit China to production, not technology transfer. That stance was admirable.

But the stampede of non-Japanese multinationals to not only produce in China but transfer their technology as well (workers in their home countries be damned) left Japanese multinationals with the choice of screwing their own workers and following suit or falling further behind in the race to drive down costs.

In the end, they decided to go for reduced costs big time, while focusing job reductions on the 45-60 year age group who drew the highest salaries.

Meanwhile, the rest of the country apes America in Wal-Martization and China earns more capital to build up a military to dominate Asia. Ain't internationalism grand?

Another reason our higher debt makes deflation more of a threat is that deflation increases the real value of debt. Your home decreases in value, and your paycheck is smaller, but the payments on your mortgage and credit cards stay the same.

On the other hand, our low savings rate should make deflation easier to prevent. If the government increases the money supply, Americans are more likely to spend, and Japanese are more likely to stuff the money under their mattresses.

In theory, deflation might be easier to prevent here, but harder to get out of once it starts.

I know this is how most people think, but to my mind it's a recipe for personal financial disaster. Far better to get a $98,000 12%/30 yr mortgage after the bubble bursts than a $180,000 5%/30 yr mortgage before, even though both mortgages have the same $1000/month payment.

There have been systems like that before. Charles Dickens wrote about them a good deal.

Oberon, you are right, Dickens described a 19th century version of my prescribed scenario, but remember, it was a 19th century version. If we were to scrap laws enshrined since, lets say 1965, you would not have such a huge problem. After all, the class system that reduced the value of a worker's life relative to that of the capitalist does not exist in this country.

I would submit to you that the catastrophic injustices envisioned by you will not come to pass should such a reform be carried out. Entrepreneurs today are far more responsible than the left gives them credit for.

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