Notes

Conclusion
Preventing or combating deflation poses some unique difficulties for the
monetary authorities - difficulties that are not present in preventing or combating
inflation. Nevertheless, deflation can always be prevented and, if it has taken hold,
can always be overcome by co-ordinated actions of the monetary and fiscal
authorities.
Monetary policy alone cannot always prevent or cure deflation, if we restrict
ourselves to conventional monetary policy, that is, reductions in the risk-free short
nominal interest rate or a devaluation of the nominal exchange rate. Monetary policy
alone is likely to prevent or cure deflation if the monetary authority is willing and able
to monetise (if necessary without limit) the outstanding stock of public debt (short,
long, nominal or index-linked), and/or perform open market purchases of a wide
range of foreign and private domestic securities. If the monetary authorities are
willing and able to contemplate an even more unconventional monetary instrument -
the payment of negative nominal interest rates on base money through the imposition
of a carry tax on currency - the zero lower bound on nominal interest rates disappears
as a constraint on monetary policy.
To say that deflation can be prevented or cured using conventional monetary
and fiscal policy is not to say that all economic problems faced by the most prominent
current example of a deflation-afflicted economy - Japan - can be solved using
conventional monetary and fiscal policy. The Japanese banking sector is paralysed by
a massive overhang of bad debt. Other financial intermediaries, especially insurance
companies, are suffering the cumulative impact on their balance sheets of the most
spectacular asset boom and collapse in modern history – the stock market and real
estate boom of the 1980s and its unravelling since 1989 (see Figure 1).



Cleaning up the balance sheet of the Japanese banking sector, reducing the
size of the banking sector and recapitalising key viable non-bank intermediaries will
be a painful and protracted process. In the non-financial economy it will manifest
itself as increased redundancies, idle capacity, bankruptcies and business failures. It
does not seem plausible, however, that this inevitably painful structural adjustment
would be facilitated by persisting with the deflationary demand management policies
of the last few years.
Deflation is problem that can be avoided. If it has taken hold, it is a problem
that can be solved. A tax cut (or transfer payment) directly aimed at households and
financed by increasing the stock of base money will surely boost aggregate demand.
So will a base-money-financed increase in public spending.
Achieving a sustained reduction in inflation is likely to require tax increases or
public spending cuts. It therefore tends to be politically unpopular. Anti-deflationary
policies involve tax cuts, increased transfer payment or increased public spending.
They will tend to be politically popular. It is therefore somewhat of a mystery why a
policy programme that makes economic sense and should be politically popular does
not get implemented. The clue to solution of this mystery probably lies in the fact
that, with conventional monetary policy nearly exhausted, further effective anti