Japan Offers a Window Into Deflation’s Effects

What would a deflationary world look like? Perhaps like Japan for the last seven years.

When that country’s “bubble” economy burst in 1990 with the global recession triggered by the Persian Gulf War, Japanese stock and real estate prices collapsed. Seven years later those assets still are depressed, and the Japanese banking system, weighed down with bad loans, remains in awful shape.

Japan’s economy registered almost no growth from 1992 through ‘94, as consumer spending dried up.

But did prices of everyday goods collapse? Not as measured by Japan’s consumer price index: It registered periodic deflation, but on a calendar-year basis it fell in just one year--1995, when it dipped 0.1%. The index had inched up just 0.7% in 1994, and it followed 1995’s drop with a minute 0.1% rise in 1996.

That performance suggests that, as bad as things got in Japan, prices of goods and services overall didn’t go into a free fall.

Even so, Japanese corporate profits remained severely depressed for much of that period, which is a big reason why stock prices have failed to rebound convincingly.

Most economists concede that, were the high-flying U.S. stock market to collapse, consumer spending would be affected to some degree, perhaps triggering recession. What most don’t see is a concurrent plunge in U.S. real estate values that would lead to a serious, economy-wide deflation. (We’ve had plenty of recessions before, after all, without actual deflation.)

What Japan’s experience should remind investors is of the merits of portfolio diversification: Bonds have been the one Japanese investment that has shined in the 1990s. They appreciated handsomely as market yields plunged with the weak economy and with nonexistent inflation. The yield on 10-year Japanese government bonds has slid from 6.5% in 1990 to 2.4% now.