The Economist updated the report on the Japanese economy which again suffered from monthly deflation (link). The forecasts for the end of the year forsee deflation as a structural problem of the Japanese economy and not as a short-term phenomena that would reflect temporary declines in domestic or foreign demand. True, the financial crisis and the recession depressed Japanese exports but the real cause of the deflationary persistence is to be found in the design of the monetary policy which pushed the Japanese economy in deflationary trap back in early 1990s.

The OECD’s preliminary report on the Japanese economic outlook (link) suggested the Bank of Japan to keep interest rates low and immediately implement quantitative easing measures to boost the economic activity as long as the expected inflation remains firmly positive.

In 2009, the IMF’s inflationary forecast is -1.1 percent. Recently, Deutsche Bank released an interesting report on the Japanese economy (link), emphasizing annual decrease in output by 7 percent country’s record high public debt as well as its tearing debt scenario. Japan easily maintained high public debt because of low interest rates. In fact, most of the net value of the public debt has been denominated in yen which reduced government’s interest payment risk and decreased the probability of government’s debt default. Before the crisis, gross government debt stood at 172 percent of the GDP. The net debt, for instance, stood at 87.7 percent of the GDP mostly because public pension assets are counterbalanced by spending commitments.

The question is how to tackle Japan’s disease of low output growth and persistent deflation that last well over the latest decade?

First, it is difficult to implement further quantitative easing for the Bank of Japan. If the Bank eventually decided to do so, the interest rate would go beyond zero ground, leading to higher future value of bond payments and, hence, higher indebtedness of the Japanese government. The Bank of Japan recently left the interest rate steady at 0.1 percent and decided to purchase government bonds to keep the monetary policy strongly accomodative.

Second, the Japanese experience with a long period of falling prices began when the Bank of Japan kept driving the expansionary monetary policy when temporary shocks in domestic and foreign demand led to lower capacity of the Japanese corporate sector. When output and prices started the recovery, excess reserves were compensated by further lowering of the central bank’s policy rate. Low interest rates were not offset by the closing of the output gap so the measure to boost the aggregate private consumption, investment and exports hindered the goals of the economic policymakers. The result was a depressing decrease in the price level that couldn’t be offset by quantitative easing and fiscal stimulus. The former would cause negative real interest rates while the latter would increase government spending, cause crowding-out effect and further increased the country’s soaring public debt.

And third, Japan’s unfavorable demographic trend pose a significant risk on the sustainability of government’s pension system. As Japan’s population is in decline, the overall private consumption decreases which leads the retail sector to cut prices to gain the market share. The rising aging population certainly endangers country’s public finances, marred by budget deficits and the highest public debt in the OECD.

Japan’s looming public debt and deflationary trap are the main inhibitors of country’s long-term macroeconomic recovery. Pulling the economy out of deflation rate would require huge steps to reflate the prices such as charging banks for deposits at the central bank. That would raise the interest rate at the expense of decline in aggregate investment. However, the goal is not the mission impossible. What can save the Japanese economy from double D-trap is strong, persistent and high productivity growth. It would surely ease the burden of public debt, since the Japanese government’s revenues would grow and thus, its borrowing abroad and raising the level of public debt were anchored. It would also allow for greater spending cuts. On the other hand, Bank of Japan could finally pursue the real credibility of the monetary policy and avoid the mismanaged quantitative easing.