For several years, Princeton economist Paul Krugman has been preaching that what Japan needs to fix its economy is a good dose of inflation to cure its demand-side problems. Japanese policymakers -- along with most mainstream economic experts -- dismissed his initial 1998 proposals as unnecessary, difficult to pull off and potentially dangerous. This July, however, Krugman was welcomed as a far-sighted prophet on a visit to Tokyo, and Prime Minister Junichiro Koizumi, strengthened by an Upper House electoral victory, is likely to consider his inflation solution seriously.
Krugman is certainly right that Japan needs to boost demand. But his prescription is incomplete. Without a coordinated dose of true supply-side reform, his inflationary medicine will only prolong Japan's decade of economic stagnation. Japan needs supply-side reform to shift its economy away from its current reliance on deflation-prone manufacturing sectors toward increased emphasis on services. Absent this, additional purchasing power in the Japanese economy will only prop up inefficient industries, while shifting some of Japan's domestic macro-economic imbalances onto its global trade partners.
Why has Krugman suggested inflation as a fix for Japan's economic problems? Other potential solutions -- most notably bank recapitalization and fiscal pump-priming -- have been tried and failed. These fixes have not reduced the volume of bad loans at Japan's near-insolvent banks, but they have pushed Japan's public debt to 130 percent of GDP by wasting trillions of yen on useless public works. Krugman argues that a little inflation, about 4 percent a year, would reduce the burden of all of these debts, making them easier to service. Inflationary expectations would also push Japanese consumers and firms to begin spending and investing their money, rather than hoarding their cash in anticipation of continued deflation.