It's officially over. After 15 years -- yes, 15 years -- of no growth, Japan's economy is poised to grow by as much as 5% in 2006. After eight years of slowly but steadily falling prices, Japan can now smell a welcome whiff of inflation. And after years and years of 0% short-term interest rates, the Bank of Japan is widely expected to finish the year raising those same rates to 0.5%. So take a moment to cheer for the end of what has been called the lost decade in Japan. Then buckle your seat belts. Because what's good for the Japanese investor and the Japanese CEO and the Japanese consumer isn't at all good for international financial markets. The recovery in Japan is likely to usher in hard times in financial markets and economies around the globe. And no economy is at greater risk of taking a body blow from a Japanese economic recovery than that of the U.S. The problem is that during Japan's lost decade the world has gotten hooked on ridiculously cheap Japanese cash sloshing around the financial markets.
The Downward Spiral
The Bank of Japan pursued two strategies as it fought to bring the country out of the deflationary slump that gripped the nation after its stock market started collapsing in the 1990s. The bank cut short-term interest rates to 0%. This move received the most attention around the world. The problem that the Bank of Japan ran into is one that keeps central bankers around the world up late at night worrying: Once deflation has really taken hold of an economy, cutting interest rates won't help. With prices falling steadily and consumers convinced that they'll keep falling, there's no incentive to borrow today to buy today; prices will be lower tomorrow. With consumer demand slumping, businesses have no incentive to borrow, even if the money is effectively free, since they are looking at falling, and not growing, customer demand in the future. The lack of consumer and business spending increases the level of worry about the future. That, in turn, encourages consumers and businesses to hold on to their cash rather than spend it.