As Haruhiko Kuroda tries to spur Japan’s inflation rate, he faces a worrying question: What if his Bank of Japan predecessor was right about why he will fail?

In June 2011, then-BOJ Gov. Masaaki Shirakawa faced extreme pressure to double the monetary base, a step Kuroda took just days after replacing him in March. When Shirakawa, a University of Chicago-trained economist, was asked why he’d refused to budge, he offered a surprising excuse: Japan’s aging population, whose fixed incomes would be eaten away by rising prices. Politicians thought the rationale was a copout. Shinzo Abe’s first act as prime minister was to dump Shirakawa.

Turns out, Shirakawa was on to something. In the new paper “Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness?,” IMF researcher Patrick Imam offers convincing evidence that aging societies in Japan, Germany and, to some extent, the United States can no longer be manipulated so easily by central bank policies.

Why? Changes in official interest rates are about influencing long-term expectations and short-term behavior. Cutting rates is meant to make buying a new house, opening a business, splurging on a flat-screen TV or betting on stocks more attractive today than next year. But such activity is disproportionately conducted by the young. That’s Japan’s problem. Today, 1 in 4 Japanese is older than 65; by 2060, that group will swell to more than 40 percent of the population.

Even that isn’t the whole story. Along with ugly demographics, Kuroda faces a Japanese public that has learned not only to live with deflation but also to enjoy it. This will sound like economic blasphemy to many. Nobel laureate Milton Friedman sounded plenty scary when he warned of the “scourge of deflation” — a beast that slams financial assets, boosts debt-servicing costs, undermines corporate profits, dents consumer confidence and lowers tax revenue.

Just as there is good inflation, though, many in Japan have benefited from good deflation. By 1990, asset prices weren’t the only things that had veered into bubble territory in Japan. Arguably, the entire economy had. As the 1970s gave way to the heady 1980s, costs surged throughout the economy: food, transportation, service fees, power, telecommunications, education, entertainment, apparel, you name it.

The story of Japan these last 20 years, from the government to banks to companies, has involved keeping consumer prices steady. Deflation has acted like a stealth tax cut for households and restored some sobriety to costs.

When economist Kosuke Motani made this argument in his 2010 book “The Real Face of Deflation,” it fell with a mighty thud in Nagatacho, Tokyo’s Capitol Hill. Motani thinks Japan is experiencing “non-monetary deflation” on account of a national cost structure that overshot to the upside decades ago, a graying population that favors falling prices over rising ones, and a political system that doesn’t understand that deflation is a symptom of Japan’s malaise, not the cause.

The theory among neoclassical economists that quantitative easing can overcome deflation, Motani argues, is “just like a religion.” (He could as easily have said “cult.”) In fact, as odd as it sounds, Japan’s deflation has been as much a choice as a punishment. In order to avoid big, destabilizing reforms, the government has amassed mountains of debt. Deflation, which lowers nominal bond yields, makes that burden easier to service.

This is the paradox staring Abe and Kuroda directly in the face. Until now, the focus has been on how bond traders will react as a nation whose debt is approaching 250 percent of gross domestic product, and which enjoys sub-1 percent 10-year bond yields, begins to produce sustained inflation. An equally important question is how the nation’s 126 million people, many of them elderly, cope.

“In Japan, all players have adapted to a deflationary environment: Households are used to increasing living standards without expecting higher wages, companies live from cost-cutting without fighting for bigger markets, the government needs low interest rates for most of its finance,” says Martin Schulz, a former BOJ researcher and now senior economist at Fujitsu Research Institute. “Turning all this around will not be easy.”

That’s why it’s so important that Abe implement the third “arrow” of his revitalization program. The first phase — Kuroda’s huge liquidity boost — cheered markets. The second involves fiscal pump-priming, which will get a boost from Tokyo’s preparations for the 2020 Olympics. The third and most vital, though, is deregulation to encourage companies to expand and fatten paychecks so consumers can spend more. Only phase three can help the BOJ’s largess get real traction.

“The only easy part is starting to print the money because it does not hurt anyone for the first year,” Schulz says. “But after that, when prices start to go up, it really depends on the view at that time: Will people only see the higher costs, or will they see the brighter future that the government is selling with its money? If they don’t, a turn in public opinion will stop the BOJ before expectations have changed enough to get the economy on an inflationary track.”

Kuroda could yet prove his predecessor wrong, but he’s going to need help from his prime minister — and soon.

William Pesek is a Bloomberg View columnist based in Tokyo.

In a time of both misinformation and too much information, quality journalism is more crucial than ever.
By subscribing, you can help us get the story right.