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LONDON — Economists like limited inflation. They reckon it helps growth. Perhaps it may in some circumstances. It also benefits those who have borrowed against assets, which rise in value in an inflationary environment. But even limited inflation can be damaging, especially to those on fixed incomes, such as annuities, without provision for increases linked to inflation. Falling prices can be beneficial, and may indeed be necessary after a period of asset-price inflation, such as has been the case in Japan.

Most observers accept that the high cost of living in Japan has forced up wages and salaries. High labor costs have made it difficult for Japanese companies to compete internationally. They have had to compensate with increased productivity. This has been largely achieved through high levels of education and training and by capital investment.

Expenditure on training has benefited the economy both in the short and the long term. Capital investment has also brought economic benefits and contributed to growth. But there are limits to the extent to which these two factors can counteract the negative impact of high labor costs. The impact could be reduced by a fall in the value of the currency, but in the case of Japan, with its generally favorable balance of trade, the yen seems likely to remain relatively strong. Moreover, currency volatility can undermine competitiveness over the longer term.

Falling prices can induce greater consumption. The real prices of many electronic goods and communications services have dropped dramatically over the last decades. This has been due to improved methods of manufacture, enhanced quality and a higher level of service. These improvements could continue at least for a limited time. Lower prices for such goods induce households either to buy something they have never had before or to upgrade the things they already own. Of course, if prices fall too quickly consumers may be tempted to put off purchases in the hope of further drops, but prices rarely fall that quickly.

Electronic equipment and services, important though they increasingly are for all of us, are not basic features in the cost of living. These are, first, food, clothing and household essentials and second, accommodation.

Japanese food prices are kept unnecessarily and undesirably high by Japan’s agricultural policies and protectionism. There is a natural limit to an individual’s consumption of food, but if prices seem unreasonable many individuals and families will look for cheaper substitutes. As a result, the purpose of the protection afforded to producers is reduced, if not nullified, and there is no benefit to the consumer.

Japanese prices for food and other household essentials have also been kept up by the complexities and costs of the Japanese distribution system and limits on competition resulting from protection given to small shopkeepers and to manufacturing companies catering essentially to the domestic market (mostly small and medium-scale enterprises).

As the Bank of Japan has pointed out, recent price drops in many foodstuffs and household items have been due to increased competition and improvements in distribution, brought about by cutting out some of the middlemen and streamlining distribution systems.

Falls in prices caused by the growth in discount chains can trigger greater consumption. If a man can buy two suits at a discount shop for the price of one in a department store, he is liable to eschew the expensive suit unless it is of so much superior quality or he attaches undue importance to the prestige of the label.

Reductions in the cost of accommodation depend on land prices and construction costs. Japanese land prices had risen during the bubble to absurd and unsustainable levels. In many areas, despite significant and continuing drops, they are still well above those prevailing in comparable places in North America and Europe.

Land prices probably need to fall further before the average salary earner can feel comfortable in borrowing to finance his/her purchase of a house or apartment. The problem about falls in the prices of houses and apartments is that they may leave existing owners with negative equity, i.e., where the amount borrowed exceeds the current value of the property.

They also exacerbate the bad-loan burden of the financial institutions that lent against real estate. I remember a president of a large bank once boasting to me before the bubble had really burst that Japanese banks did not have any really bad loans as they only lent against real estate. The belief that prices only go up is a dangerous fallacy and inspires inflationary attitudes that are just damaging to everyone as mild deflation — if not more so.

Land suitable for building on in Japan is expensive, partly because of geography but also because of restrictions imposed by the special privileges given to farmers and by excessive Japanese taxes, including the inheritance tax. Another reason for the high cost of housing is inadequate competition in the construction industry resulting from the cartel-like arrangements that flow from the “dango” system of awarding contracts.

If land prices and construction costs were to fall further, there could well be increased demand in Japan for housing. Families sharing accommodation could be tempted to set up separate households. Grownup children remaining at home might be persuaded to rent or even buy a small apartment. Families with children who feel cramped in their current accommodation might look for more spacious premises. More land could become available for parks, which are not as easy to find in Japanese cities as in Western cities.

According to Sir Roy Denman at the European Commission, the “rabbit hutches” in which Japanese lived some 20 years ago have improved vastly, but they generally seem small and cramped compared to houses and flats in Europe, which in their turn seem small in comparison to what is widely available in the vast spaces of North America.

Economists should beware of criticism of falling prices. They are not necessarily bad. They can induce increased demand. They can help individuals and the economy. By cutting living costs, they can improve overall competition. Falls in prices due to improvements in the supply chain should be welcomed. They do not necessarily mean overall deflation, which reflects a real contraction in demand.

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