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Should Japan Fight Deflation?

Mises Daily: Tuesday, February 19, 2002 by


Frank ShostakIn commenting on the ongoing Japanese slump, President Bush made the worst gaffe of his presidency. Bush relayed to a news conference that he and Prime Minister Junichiro Koizumi had discussed the "devaluation issue" in their talks. As the yen sank, the White House quickly clarified that Bush had meant the "deflation issue."

It's true that declining prices--typical of a recession--are a feature of the Japanese economy. Year-on-year machine tool orders fell by 42.8 percent in January after a fall of 42.8 percent in the previous month. Year-on-year bank lending fell by 4.6 percent in January after a fall of 4.3 percent in December--the forty-ninth consecutive monthly decline. The consumer price index fell by 0.7 percent in 2001, the third consecutive year of decline. Also, the average price index of land in six big cities fell to 33.1 in the first half of 2001 from 105.10 in the second half of 1990--a fall of 68.5 percent.

Many economists hold that declining prices, labeled as deflation, are the main factor causing the economic slump. To fight the menace of deflation, Japanese government officials are planning to intensify the pace of monetary pumping.

Most experts, among them Milton Friedman and Paul Krugman, are of the view that the only way out of the economic slump is for the central Bank of Japan (BOJ) to aggressively boost the money supply. This, it is held, will raise inflationary expectations and lift people's willingness to spend, which in turn will set the economic recovery in motion. In short, the key to economic recovery is to lift the demand for goods and services by arresting the fall in prices. 

Is the fall in prices bad news?

Contrary to conventional wisdom, there is nothing wrong with declining prices. In fact, it is the essential characteristic of a free-market economy to select as money those commodities the purchasing power of which is growing over time.[1] What signifies industrial market economy under a commodity money such as gold is that prices of goods follow a declining trend. According to Salerno,

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75 percent per year, while real income rose by about 85 percent, or around 5 percent per year.[2]

In a free market, the rising purchasing power of money, i.e., declining prices, is the mechanism that makes the great variety of goods produced accessible to many people. It does not make much sense to be concerned about falling prices.

On this, Murray Rothbard wrote,

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[3]

It is argued by most experts, however, that a general fall in prices is always "bad news," for it slows down people's propensity to spend, which in turn undermines investment in plant and machinery. All this sets in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline. But does it all make sense? According to Salerno,

Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. Note that the substantial price deflation in the high-tech industries did not impair and, in fact, facilitated the enormous expansion of profits, productivity and outputs in these industries. This reflected in the fact that in 1980 computer firms shipped a total of 490,000 PCs while in 1999 their shipments exceeded 43 million units despite that fact that quality-adjusted prices had declined by over 90 percent in the meantime.[4]

Moreover, it does not make any sense to argue that a fall in prices as a result of real wealth expansion causes consumers to postpone purchases of goods and services. If this were the case, then why would producers produce so many goods and services in the first place? Furthermore, to suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present. Without the maintenance of life in the present, however, no future life is conceivable.

On this, Menger wrote,

An imperfect satisfaction of needs leads to the stunting of our nature. Failure to satisfy them brings about our destruction. But to satisfy our needs is to live and prosper. Thus the attempt to provide for the satisfaction of our needs is synonymous with the attempt to provide for our lives and well-being. It is the most important of all human endeavors, since it is the prerequisite and foundation of all others.[5]

Are rising prices prerequisite for profits?

The popular view that price deflation is the root of economic slumps seems to overlook the essential role of prices in a free-market economy and the conduct of businessmen. Whenever a businessman sets a price for his product, it is in his interest to secure a price where the quantity that is produced can be sold at a profit. In setting this price, the producer/entrepreneur will have to consider how much money consumers are likely to spend on the product, the prices of various competitive products, and the cost of production.

Producers set the price, but consumers, by buying or abstaining from buying, are the final decision makers as to whether the price set will lead to a profit. If, at a set price, a producer cannot make a positive return on his investment because not enough people are willing to buy his product, the producer will be forced to lower the price to boost the turnover. Obviously, by adjusting the price of the good, the entrepreneur must also adjust his costs in order to make a profit.

Every individual in his given circumstances decides how much of his income he will save and how much he will use on consumption. The income used for consumption, in turn, is allocated in accordance with individuals' priorities regarding various goods and services.

Consequently, a producer will secure a profit when, at the price of a good set, consumer buying will generate revenue that will exceed the cost plus interest. Profit is an indication that both producers and consumers have improved their well-being.

In short, by investing a given amount of money, producers have secured a greater amount of money. This, in turn, enables them to secure a greater amount of goods and services, which in turn promotes their lives and well-being. Likewise, consumers, by exchanging their money for goods that are on their highest-priority lists, have raised their living standards.

Consumers value goods and services according to how useful those goods and services are in promoting their lives and well-being. The importance people attach to various goods and services varies over time. Thus, if a great majority of people decide that lowering the consumption of red meat will benefit their health, then people will allocate a smaller proportion of their income toward red meat and more money toward other goods. As a result of new ideas, some goods may become obsolete in attaining particular goals, and demand for them either falls sharply or disappears altogether. As Mises said,

The business of the entrepreneur is not merely to experiment with new technological methods, but to select from the multitude of technologically feasible methods those which are best fit to supply the public in the cheapest way with the things they are asking for most urgently. Whether a new technological procedure is or is not fit for this purpose is to be provisionally decided by the entrepreneur and will be finally decided by the conduct of the buying public. The question is not whether a new method is to be considered as a more "elegant" solution of a technological problem. It is whether, under the given state of economic data, it is the best possible method of supplying the consumers in the cheapest way.[6]

In a free-market economy, price fluctuations are part and parcel of individuals striving to improve their lives and well-being. When a good makes a profit at a particular price, then it is a signal to entrepreneurs that consumers are willing to support the product , at the set price. Prices, therefore, are an important factor in establishing how producers/entrepreneurs employ their resources. The prices of goods dictate the quantity and the quality of the goods produced. On this, Mises wrote,

The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They determine precisely what should be produced, in what quality, and in what quantities.[7]

Observe that what matters here is not the general direction of prices but whether businessmen are making a profit on their specific goods and services. Once producers/entrepreneurs have discovered the "right" price, they adjust their costs in accordance with this fact of reality. Entrepreneurs, in the pursuit of the price that will yield profits, set in motion an allocation of real funding toward the improvement of people's lives and well-being. A monetary policy that aims at stabilizing price fluctuations will make it more difficult for entrepreneurs to discover the correct price. This will undermine the formation of real wealth.

Should "bad" price deflation be fought against?

Even if we were to accept that declines in prices in response to an increase in the production of goods promotes the well-being of individuals, what about the case when a fall in prices is associated with a decline in economic activity? Surely this type of deflation is bad news and must be fought against.

Whenever a central bank pumps money into the economy, this benefits various individuals engaged in activities that sprang up on the back of loose monetary policy, and it occurs at the expense of wealth generators. Through loose monetary policy, the central bank gives rise to a class of people who unwittingly become consumers without the prerequisite of making any contribution to the real pool of funding. Their consumption is made possible through the diversion of real funding from wealth producers.

Observe that both consumption and production are equally important in the fulfilment of people's ultimate goal, which is the maintenance of life and well-being. In other words, consumption is dependent on production, while production is dependent on consumption. The loose monetary policy of the central bank breaks this unity through creating an environment where it appears that it is possible to consume without production.

Not only does the easy monetary policy push prices of existing goods higher, but the monetary pumping also gives rise to the production of goods which are only demanded by non-wealth producers. Now, goods that are consumed by wealth producers are never wasted, for these goods sustain wealth generators in the production of goods and services. This is not so, however, with regard to non-wealth producers who only consume and produce nothing in return.

As long as the real pool of funding is growing, various goods and services that are patronized by non-wealth producers appear to be profitable. However, once the central bank reverses its loose monetary stance, the diversion of real income from wealth producers to non-wealth producers is arrested. This in turn undermines the demand of non-wealth producers for various goods and services, thereby exerting downward pressure on their prices. The fall in the prices of various goods and services signifies that there was never a genuine demand for these goods.

The tighter monetary stance that undermines various activities which sprang up on the back of previous loose monetary policy arrests the bleeding of wealth generators. The fall in prices of various goods and services comes simply in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. To reverse the monetary stance in order to prevent a fall in prices amounts to the renewal of impoverishment of wealth generators. As Mises said,

Prices of the factors of production--both material and human--have reached an excessive height in the boom period. They must come down before business can become profitable again. . . .  Thus any attempt of the government or the labor unions to prevent or delay this adjustment merely prolongs the stagnation.[8]

As a rule, what the central bank tries to stabilize is the so-called price index. The "success" of this policy, however, hinges on the state of the real pool of funding. As long as the real pool of funding is expanding, the reversal of the tighter stance creates the illusion that the loose monetary policy is the right remedy. This is because the loose monetary stance, which renews the flow of real funding to non-wealth producers, props up their demand for goods and services, thereby arresting or even reversing price deflation.

Furthermore, since the pool of funding is still growing, the pace of economic growth stays positive--hence, the mistaken belief that a loose monetary stance that reverses a fall in prices is the key in reviving economic activity.

The illusion that, through monetary pumping, it is possible to keep the economy going is shattered once the pool of funding begins to decline. Once this happens, the economy begins its downward plunge. The most aggressive loosening of monetary policy will not reverse the plunge. Any attempt to boost the demand for goods cannot be effective. The means to support this demand are not there.

Moreover, the reversal of the tight monetary stance will eat further into the real pool of funding, thereby deepening the economic slump. Even if loose monetary policies were to succeed in lifting prices and inflationary expectations, they cannot revive the economy while the pool of real funding is declining.

Since the key to an economic recovery in Japan is the pool of real funding, how can we ascertain its status? How does one know whether it is growing, stagnating, or declining? If the pool of funding had been growing, then the underlying growth trend of economic activity would have been following suit. This, in turn, would have made loose monetary and fiscal policies appear to be successful.

From the level of 8.22 percent in March 1991, the BOJ has lowered the interbank call interest rate to almost nil. Furthermore, various Japanese governments during this period have introduced countless fiscal packages to stimulate the economy.[9] Moreover, despite the accusation that the BOJ was not aggressive enough, on average during the past ten years, the pace of monetary pumping by the central bank stood at 18.5 percent.

Notwithstanding all these stimulatory policies, economic activity continued to deteriorate. This therefore raises the likelihood that the real pool of funding is either stagnant, or, worse, declining. Consequently, the only way left to revive the economy--
which is also the only way authorities are reluctant to pursue--is to allow wealth producers to take over. However, this means that various activities that cannot support themselves must be allowed to disappear. The worst thing that the central Bank of Japan could do is to further intensify monetary injections.


The prolonged Japanese economic slump is not due to price deflation but is the product of aggressive fiscal and monetary policies aimed at arresting the general fall in prices of goods and services. Contrary to the popular view, price deflation as a rule is always good news for the economy. Thus, when prices are falling in response to the expansion of real wealth, this means that people's living standards are rising.

When prices are falling as a result of the burst of the financial bubble, it is also good news for the economy, for it indicates that the impoverishment of wealth producers was arrested. The latest proposed Japanese policy to raise the pace of the monetary pumping amounts to furthering the economic impoverishment of wealth producers, thereby delaying any meaningful economic recovery from taking place. It can only end in devaluing the yen, thus making Bush's gaffe a reality.

Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org.  Send him MAIL and see his outstanding Mises.org Articles Archive. Dr. Shostak expresses gratitude to Michael Ryan for helpful comments during the writing of this article.

[1] Frank Shostak "How Much Money Should There Be?" Daily Articles October 10, 2001 Mises Institute.

[2] Joseph T. Salerno "An Austrian Taxonomy of Deflation" presented at "Boom, Bust, and the Future," January 19,2002, The Mises Institute, Auburn, Alabama p 8.

[3] Murray N. Rothbard What Has Government Done to Our Money?  p 17.

[4] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at "Boom, Bust, and the Future," January 19,2002, p 8.

[5] Carl Menger Principles of Economics (New York University Press) p 77.

[6] Ludwig von Mises Planning For Freedom, Profit and Loss Libertarian Press p 110-111.

[7] Ludwig von Mises Human Action, p 270.

[8] Ludwig von Mises Human Action p 568-569.

[9] Hans F. Sennholz  A Japanese Lesson  Daily Articles Mises Institute February 12 2002.