Harding directed me to the example of Belarus, which like Japan has a falling population in recent years:

And yet Belarus has lots of inflation:

Not as bad as the 100% inflation of 2012, but still running around 10% per year in recent years, despite a falling population.

So why do demographics cause deflation in Japan but not Belarus?  Simple, demographics don’t cause deflation in Japan, or anywhere else.

If you have the right model of money, the world is a much less confusing place.

[This post will make more sense if you first read my new Econlog post.]

Zimbabweans have shown that there are no limits to the amount of inflation that a central bank can create.  BOJ Governor Kuroda agrees:

Bank governor Haruhiko Kuroda said things were looking brighter as exports and factory output gather steam — the bank said they were “sluggish” in a November statement.

That was its first upgrade to its view on the economy since May 2015.

The negative impact of a slowdown in emerging economies and Britain’s vote to exit the European Union were fading, Kuroda said.

“There were headwinds in the first half of the year, but they’ve now disappeared,” he added.

Japan has been on an unsure recovery path and the central bank remains way behind reaching a two percent inflation target that is a cornerstone of government efforts to revive the economy.

There are also questions about whether the BOJ can keep buying government bonds at the current pace without shocking debt markets.

Kuroda on Tuesday brushed aside talk about tapering the BOJ’s massive 80 trillion yen annual asset-purchase scheme and suggested there was no limit to what measures the BOJ can take. “We have to press on with strong monetary easing to reach the inflation target as early as possible,” he said.

“I do not subscribe to the view that policies face limits, like walls standing in the way.”

The metaphor I like is a prisoner sitting for years in his cell, assuming the door is locked.  Then one day he tests the door, and finds that he can walk out any time he wishes.  His imprisonment was all in his mind.

Some central banks see iron bars, others see no limits.

Just a couple of months ago, pundits were writing off the Bank of Japan, and particularly Kuroda’s policy of 2% inflation.  Now things are looking much more positive for the BOJ.  Since plunging on the night of the Trump election, the Japanese stock market has taken off like a rocket.

It’s not hard to understand why—the yen has been in almost free fall, down from about 100 to the dollar to 118 today.  To put that into perspective, back in April 1995, the yen was at 84 to the dollar.  As recently as September 2012, right before Abenomics was announced, it was at 78 to the dollar.

But those numbers don’t even come close to showing what’s going on with the yen. What really matters is the real exchange rate.  And since 1995, Japan has had an inflation rate that ran almost 2% a year lower than in the US.  The US CPI is up by more than 57% since 1995, while the Japanese CPI is barely changed.  Thus the real exchange rate for the yen has gone from 84 in 1995 to something like 180 or 185 today.  At these levels, the exchange rate is a gold mine for Japanese exporters, which explains why the Japanese stock market is doing so well.

The big puzzle here is why PPP is failing so abysmally in terms of explaining the dollar/yen exchange rate.  Generally when a country has persistently lower inflation than the US, its exchange rate tends to appreciate of time, and vice versa.  Thus the Swiss have low inflation and the Swiss franc trends upwards.  The Brazilians have high inflation and the Brazilian real trends downwards.  And over the very long run that’s true of Japan as well.  I recall when the yen was 350 to the dollar.

But since 1995 the yen has depreciated dramatically, even while Japan has had inflation rates that are roughly two percent less than the US.  Of course during this period Japan has had much lower nominal interest rates than the US (at least the Fisher effect works!), and the yen has generally been expected to appreciate (due to the interest parity condition).  Thus we’ve had a 21-year period where investors expected steady appreciation in the yen, and (on average) they got the exact opposite.

Going forward, one of two things will happen.  Either the BOJ will persist with its inflation policies, or it will not.  If it does persist, eventually investors will have to throw in the towel and admit that they were wrong about Kuroda.  The yen will no longer be expected to appreciate, and the level of Japanese interest rates will be much closer to US rates.

Or, the BOJ will abandon it goal of 2% inflation, and the yen will start appreciating, just as investors have been predicting for 21 years.  In that case, interest rates in Japan may stay close to zero.

It’s entirely up to the BOJ which road they prefer to take.  A few months ago, many people thought they had given up.  Today that’s much less clear. The higher global interest rates following Trump’s election, combined with the BOJ policy of pegging the 10-year bond yield at zero, has caused the yen to plunge in value.  PPP is elastic, but not infinitely elastic.  The yen can’t stay here indefinitely without generating serious inflation.  Otherwise at some point a Lexus 430 would be as cheap as a candy bar.

My instincts tell me that this weird discrepancy between market predictions and actual outcomes can’t go on much longer.  Within the next decade it will be clear whether Japan is seriously committed to a 2% inflation target.  At that point, either Japanese interest rates will rise sharply (success), or the yen will appreciate sharply (failure).

PS.  At Econlog, I have a post on Nick Rowe’s reply to John Cochrane, which might be seen as loosely relating to this post.

Ramesh Ponnuru sent me a WSJ article by Greg Ip:

If workers lose their jobs to imports and central banks can’t bolster domestic spending enough to re-employ them, a country may be worse off, and keeping those imports out can make it better off.

This occurs only in certain conditions, says a new paper by Harvard University’s Larry Summers and two co-authors, but those conditions may now be present.

Mr. Summers, a former Treasury secretary, is no protectionist and no fan of Mr. Trump, whose election, he warns, could lead to recession in the U.S. and financial crisis abroad. But he does worry that chronically weak demand could make protectionism both respectable and irresistible.

Others, such as New York Times columnist Paul Krugman and Michael Pettis at Peking University have already noted how in a world with too little demand, one country’s trade surplus inflicts unemployment on the country with a deficit.

Even if Summers, Krugman and Pettis are correct (and I think they are wrong) the argument does not apply to the world we live in today.  Thus Greg Ip is mistaken when he says “but those conditions may now be present.”  They are not.

Let’s start with the US.  The US is not at the zero bound, and the Fed is expected to raise rates in a few days because they think that failing to do so would result in excessive AD.  So if protectionism somehow miraculously boosted AD in the US, the Fed would simply raise rates even faster to prevent any stimulative effect on AD.

Now it’s true that the Eurozone and Japan are both at the zero bound.  But both economies have very large current account surpluses, so obviously trade deficits are not depressing output in those two regions.  Even very depressed areas such as Italy run surpluses.

In fact, unemployment has almost nothing to do with trade “imbalances” (a term I hate).

Update:  Dilip sent me the following, from Jared Bernstein and Dean Baker:

In this context, the trade deficit was subtracting from demand in the domestic economy. Spending that could have employed people who needed jobs in the U.S. was instead employing people in Germany, China, and other countries from which America imports goods and services. In principle, the U.S. government could have looked to spur other channels of demand to offset the trade deficit, but as a practical matter this is often not easy to do: The most straightforward way to generate demand is through additional government spending, but there are major political obstacles to running large budget deficits even at times when it would be beneficial to the economy.

No, the most straightforward way to boost demand is to adopt a more stimulative monetary policy.  But that won’t happen because the Fed currently thinks it’s better to slow the growth in demand by raising its target interest rate.  (And they may well be correct.  The consensus of private sector forecasters was that we were roughly on target for 2% inflation, even before the recent bump up in TIPS spreads):

Most people will think this post is sour grapes on my part, but I’ve never cared what most people think.  I simply offer my honest opinion.  I was skeptical of Kuroda’s plan to peg bond yields.  (In this post I suggested that it was a positive step, but likely to have only a very small impact.)  But as of today the policy seems to be working.  The yen has lost about half of the ground gained over the last year. Recall it moved from about 125/dollar a year ago to 100 in late summer.  Now it’s plunged to 112.8.

So was I wrong?  I still don’t think so; rather I think that Kuroda got lucky.  Just after the policy shift, US bond yields started rising, in both real and nominal terms. Rates in some other important countries also started increasing.  This made the pegged 0% yield on 10-year JGBs look increasingly unattractive.  The yen depreciated.  If that change in global debt markets had not occurred, I doubt the policy would have had much impact.  Still, give Kuroda credit, as he was right and I was wrong.  (The markets were also wrong, and I’m a market monetarist.  Hence my incorrect prediction.)

If there’s a silver lining, it’s that I was less wrong than NeoFisherians who think a policy of lowering bond yields is disinflationary (I say never reason from a bond yield).  Keynesians who thought the BOJ was out of ammo were also wrong.  I always thought they had plenty of ammo, I just saw other tools as being more promising.

I’m not going to totally change my views based on this one data point, but I’ll file it away as one argument in favor of Ben Bernanke’s view of monetary policy.  (He’s the one who suggested this idea to Kuroda.)

PS.  If Japan were to hold the yen at around this level, then in the long run Japan would have about the same 2% inflation as the US is likely to have.  Markets currently don’t think the Japanese will do so, and thus they expect lower inflation in Japan.  But it’s entirely up to the Japanese where they want to set the exchange rate, and their inflation rate.  That’s a lesson I hope we can all agree on, except Noah Smith.

PPS.  Here’s another way of explaining my “lucky” argument.  The yen has fallen only slightly against the euro.  Europe also got lucky.