Germany's Inflated Pride

Over the past decade, perceptions of the Japanese economy have been turned completely around. Once a world leader and a model for everyone to follow, Japan is now seen as the weak sister of the G-7.

But the scarier thought for each member country in the G-7 is this: Just who is next? Which country is about to fall into the same black hole as Japan?

The main candidate is pretty obvious. The country with lowest growth rate among the G-7 (except Japan) turns out to be — Germany.

Of course, Germany is quite different from Japan — as a great many Germans are rushing to reassure the world. But the key differences that these Germans point to are not necessarily reassuring.

One of Japan's key problems is deflation. Japanese prices are falling. At first blush, that seems rather better than the inflation that many countries used to suffer from.

But it really creates some very difficult problems: What happens when prices are actually falling? In that case, the real interest rate is higher than the market interest rate. In Japan, for example, the official discount rate that indicates monetary policy is just 0.1%.

That sounds like it costs nothing to borrow money. But the current rate of deflation is 0.7%. In fact, prices in Japan have been falling at that rate over the course of the past year.

So a borrower must return yen that are actually worth more — in terms of purchasing power — than the yen originally borrowed.

(To account for the fact that the yen have become more valuable, it is necessary to add the rate of deflation to the central bank's official rate to reach the effective — or real — interest rate that borrowers face.)

For the most creditworthy Japanese short-term borrowers, that means that the real interest rate on short-term loans is actually almost 1%.

And unfortunately, the Bank of Japan no longer has any power to affect the economy. It cannot lower interest rates any more. Yet, it is a disturbing fact that the economy is still stalled.

Deflation poses other serious problems. Take borrowers. A business has taken out a loan. But, as time goes on, the prices it charges for its goods or services fall.

As a result, it has to sell more than it expected — just to repay the fixed loan that it borrowed when its prices were higher. That can make repaying loans quite difficult.

If the borrowers are large, their lenders — the banks — can find themselves in big trouble. That is precisely what happened to Japanese banks. Their loans went sour, as falling prices left Japanese companies unable to keep up revenues.

Past attempts to manage deflation have not had happy results. Falling prices were a reason for the length of the Great Depression, for example.

So, naturally enough, Germans are seeking to protect themselves against the Japanese virus — by proclaiming that Germany does not have this problem. Instead, it has the good fortune to be experiencing significant — and rising inflation.

Generations of German economic policymakers must be rolling over in their graves at this scene. After all, the German hyperinflation of 1923 had one silver lining. It inoculated Germany against inflationary monetary policy.

Germans, everybody knew, would never stand for the fast and loose approach of countries like France and Italy. Indeed, Germany's Bundesbank was the world's foremost inflation fighter.

And Germans — seared by their pre-war experiences — put fighting inflation at the top of their list of requests from their central bank. That was quite different than anywhere else in the world. But, after all, Germans knew just how bad things could get because of hyperinflation.

Now, however, it is all being thrown away, as Germans embrace inflation — to prove they are not Japanese. This shift in and by itself is probably the clearest indicator for how desperate things have become in Germany.