The Japanese economy: what needs to be done
Gerard Jackson
The state of the Japanese economy should have helped expose the poverty of Keynesian thinking. Unfortunately the likes of Gregory Clark appear impervious to any criticism of Keynesianism. According to Clark Japan's main problem is "weak domestic demand".
In other words, it's the old demand deficiency fallacy (Blame supply-side policies, Japan Times, 6 September 2004). The Austrian school of economics has an alternative explanation.
Clark is apparently unaware that Japan was in a similar situation in the 1920s. Policies that gave Japan a boom that was followed by seven years of stagnation from 1920 to 1927 are basically the same policies that created the current economic situation. Understanding the events of the 1920s should therefore provide some guidance to what needs to be done.
World War I sparked off a boom in Japan that was fuelled by cheap credit policies. In 1913 the wholesale price index stood at 100; by March 1920 it had risen to 322. This leap in prices was a sure sign that credit expansion had been out of control. It was also in March of 1920 that commodity prices broke.
The boom came to an abrupt end and by April deflation had driven the price level down to 190. Even so, this rapid and steep drop of 132 points was insufficient to bring Japanese prices in to line with those of her trading partners, whose prices had fallen even further.
What is not generally understood is that booms create malinvestments. 'Cheap money' policies mean that banks create excessive credit which is then loaned out at below market rates of interest.
This in turn causes firms to undertake investments that will later prove to be unprofitable. The reason for this is that the artificially lowered rate of interest has caused them to embark on projects that cannot be completed because there is insufficient capital available, i.e., producer goods. (Ludwig von Mises, Human Action, Contemporary Books Inc. 1949)
Eventually, these firms find themselves in a financial vice as returns fail to cover their rising costs. Unemployment begins to rise and idle capital appears as consumers reassert their savings consumption ratio.
What usually happens, however, is that in an attempt to battle inflation government halts the boom before it plays itself out. Nevertheless, the result is still the same. (Fredrich von Hayek, Prices and Production, Pub. Augustus M. Kelley 1967).
Unlike America after its 1920-21 depression (one of the severest in its history) Japan did not recover. So what happened? Basically the same thing that is happening today. Government, the great banks and industrial conglomerates came together to freeze the adjustment process. The zaibatsu, highly organised industrial groups who also controlled some of the banks, were determined to obstruct any policy of liquidation.
Their success caused Japan seven years of economic stagnation and helped fuel Japanese militarism. By halting the deflation and paralysing the adjustment process, the Japanese locked-in boom-created malinvestments, freezing maladjusted costs and prices thus trapping capital in unprofitable lines of production, denying other lines of production the necessary capital for expansion.
As I have pointed out many times before, so-called cheap money misdirects investment. In an economic sense, artificially lowering interest rates distorts time for investors. This not only means that savings will be invested in what will become unprofitable projects but that capital combinations throughout the economy, i.e., all stages of production will also be distorted to a lessor or greater degree, depending on their distance from the initial monetary injections.
So the inflation will have basically two effects during the course of the boom: a) it will expand some stages of production at the expense of others; b) it will cause firms to change their capital combinations in response to changing prices induced by the inflation.
By halting the price decline and maintaining many unprofitable lines of production other companies were denied profitable opportunities for expansion. It should now be clear why halting the adjustment process results in economic stagnation. Therefore, blaming free market economics for this situation is both perverse and dangerous.
Thus for seven painful economic years Japan held its prices above the world level. Then in 1927 the internal contradictions of this policy were finally resolved by what was probably the severest financial crisis in Japanese history.
The crisis brought down industries and wiped out many branch bank systems. Thus ended Japan's first New Deal policy, all because she did not follow the American example of the time and allow market processes to fully liquidate her unsound investments and eliminate excess inventories. Nevertheless, the 1927 crisis finally eliminated the war-time boom's malinvestments resulting in about 18 months of consolidation.
Substitute 1980s boom for war-time boom and we are back in the 1920s. It seems to me that Japan will now undergo a necessary crisis similar to that of 1927. (I say necessary because it liquidates the malinvestments generated by the boom.) Unfortunately the siren voice of Keynesian economics has provided a plausible alternative explanation for Japan's present economic plight.
According to most of our unrepentant Keynesians Japan is suffering from a liquidity trap. For these economists "Keynes' famous ’paradox of thrift' is alive and well, and living in Tokyo" (John Stone, Flouting the forecasters, Australian Financial Review, 14/10/93), despite the fact that von Hayek had utterly demolished this economic fallacy in 1929 (see The "Paradox" of Saving, Profits, Interest and Investment, Pub. Augustus M. Kelley 1975).
The idea that the liquidity trap is keeping Japan in recession does not hold water because there is no such animal. Commentators who adhere to this fiction are basically claiming that Japanese interest rates have fallen so low that they have raised the demand for cash balances to the extent that additional monetary injections end up in hoards instead of spending streams.
Accepting this fallacy is but a tiny step to recommending inflation as a cure for Japanese ills. And this is precisely what has happened, with the ubiquitous Professor Krugman leading the pack. His suggestion was that the government should print billions of yen with which to buy the banks' bad loans, overvalued assets and just about anything in sight.
This Weimarian policy of flooding the country with paper money was expected to create negative interest rates and raise prices (Krugman suggested an inflation rate target of 4 per cent a year for 15 years) hence stimulating production.
As we have seen, the Austrian view is that Japan's economic malaise is due to it not liquidating malinvestments. It follows from Austrian analysis that for inflation to stimulate output it must restore profitability to these unsound investments.
For this to happen prices would have to rise high enough to cover the costs of production, meaning costs would have to fall relative to the monetary value of the output. But this also means that not only are the current malinvestments being temporarily rescued new ones will be created thus making the next depression even deeper.
The main aim of this inflationary package is to stimulate consumption. But Austrian analysis reveals that a policy of stimulating consumption is incompatible with rescuing malinvestments. In fact, it will only worsen their condition.
The Austrians stress that production takes place in stages, with consumption being the lowest stage of production. Concentrating spending at this stage directs resources from the higher stages, which in turn raises their costs of production thus aggravating their financial situation; even endangering companies that would have other wise survived the crisis.
Therefore any policy based on increased consumption would not have improved the market for the likes of Toa Steel. In any case, the Bank of Japan would eventually be forced to apply the monetary breaks, sending the economy into another recession..
The Bank of Japan and the Japanese government should ignore the Keynesians, cut taxes and allow the market to liquidate the malinvestments.
Inflationary policies are part of the disease, not the cure.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 11 October 2004