Japan's economy under Prime Minister Shinzo Abe has taken a new twist. Reuters/Toru Hanai

For five years now, Japan investors bet the central bank could swap deflation with inflation. Yet signs that it is having some success had them running for the exits.

Selling on Friday chopped US$200 billion off share prices amid signs the Bank of Japan is halfway to its 2% inflation goal. The Nikkei Stock Average is down almost 15 percent since Jan. 23. Since then, Donald Trump’s White House sent headwinds Tokyo’s way with its weak-dollar policy and trade tariffs. But Friday’s plunge after what should be stellar news was paradoxical indeed.

One possible explanation: Nice as it might be to have some inflation, the BOJ is still seriously behind schedule. When it set the goal in 2013, the BOJ was sure it could succeed by 2015. Well, not so much. But here’s a more intriguing possibility: Investors are realizing they might actually miss deflation.

The mere suggestion is anathema to an affliction Milton Freidman called a “scourge.” Clearly, falling prices are a nightmare for debt holders, corporate executives trying to maximize profits and workers hoping for higher wages.

In Japan’s case, though, deflation, bad as it is, served three under-appreciated purposes.

First, it made Tokyo’s crushing debt load seem manageable. Two, it acted like a stealth tax cut for households that haven’t had a good raise in 20 years. Three, it actually spurred innovation, forcing industries to adapt. That’s why, today, Fast Retailing’s Uniqlo brand is expanding quicker than Toyota Motor.

Deflation: The background

Context is also important. Deflation, remember, is not the cause of Japan’s problems – it’s a symptom of a dearth of confidence and demographic decline. Since December 2012, Prime Minister Shinzo Abe’s revival scheme focused overwhelmingly on monetary easing. Abenomics has three phases: ultra-low interest rates, fiscal pump priming and a deregulatory big bang.

Since 2013, BOJ Governor Haruhiko Kuroda provided phase one in droves, driving the yen sharply lower. Construction ahead of the 2020 Olympics represented phase two. Yet monetary and fiscal jolts were meant to set the stage for the most important: The supply-side revolution Japan avoided for decades.

Other than a few modest tweaks to corporate governance, Abenomics punted on loosening labor markets, rekindling innovation, catalyzing a startup boom, empowering women and cutting bureaucracy. Lots of chatter about more flexible work schedules, gender equality and affordable education – but few bold moves to resurrect Japan’s animal spirits or shake up its staid corporate culture.

Now, complacency confronts inflation. Just as planned, you might say. But an organic increase in consumer prices reflecting rising demand and greater vibrancy – that is one thing. Inflation engineered for the sake of checking a box on a checklist – not so much. Most of the government’s efforts, after all, have been on perking up old-economic industries, not creating a Japanese Silicon Valley.

Inflation’s cure may be worse than deflation’s disease

Deflation was really a choice by lawmakers, not some plight delivered on Japan Inc. Long ago, they could have imposed disruptive structural reforms. Instead, legislators took the path of least resistance – a generalized downshift in costs from the bubble years of the 1980s and lots of debt-accumulation to soften the blow. Even today, bureaucrats are trying to hold at bay the global sharing economy for fear Uber, Airbnb and others will lower costs. Tokyo is once again choosing price protection over creative destruction.

Count the ways inflation could backfire. Households worried costs are rising might spend less and save more. The 0.02 percent yield on 10-year debt could skyrocket, a major challenge for a government facing a public debt more than two-and-half times gross domestic product. Also, an emphasis on job protection at the top of the food chain, rather than job creation from the ground up, is a recipe for mediocrity in the app economy.

And what about the tension between Abe’s efforts to lower trade barriers and the BOJ’s inflation goal? If ratified, when all is said and done, the Trans-Pacific Partnership would lower consumer prices as greater competition permeates Japan’s rigid system. That could muddy Japan’s deflation battle.

It’s a quandary Abenomics has yet to tackle. Japan wants inflation, but what happens when it really gets it? Friday’s sellout suggests it’s time to do some serious brainstorming.

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