Economists have been counseling inflation to cure Japan's ills, while warning of the grave dangers of deflation. This is sheer nonsense. Nothing apart from war has damaged economic prosperity in the 20th century as much as the loose money and credit policies of the world's central banks, from Germany in the 1920s to China in the 1940s, to various South American countries in the 1980s, to Indonesia and Yugoslavia in the 1990s.
It is precisely because of these policies that Japan now finds itself in the midst of a financial debacle. Having inflated the yen money stock by 10.5% per year from 1986-90, and having brought the discount rate down to 0.5% in 1997 from 6% in 1991, the Bank of Japan essentially inflated the nation into an artificial boom. Rather than allow this boom to be corrected, however, economists are calling for even more of what caused it. The alternative -- deflation -- is deemed such a fearsome enemy that even perpetual central-bank monetary inflation is an acceptable defense against it. There are two schools of thought with explanations why this should be so.
Monetarists claim that an insufficiently elastic money stock will retard business activity. Economic growth requires money to finance it and so the money stock should be inflated each year at the average rate of economic growth, which would leave prices in general neither higher nor lower. With a market economy whose monetary regime is a gold standard, the money stock does not increase fast enough and thus, prices in general fall and since costs do not, losses ensue and growth is retarded.
The basic fallacy of this view is its failure to recognize that any amount of money is sufficient to make all the necessary exchanges in society. A greater stock of money simply means that all exchanges will be made with a structure of prices for consumer goods and factors of production at a higher level. If the money stock is smaller, the same set of exchanges will be made with a price structure at a lower level. Profits persist in either case.
Entrepreneurs come to expect lower prices when the money stock increases "too slowly" just as they anticipate higher prices when the money stock increases "too rapidly." In the latter case, price inflation does not result in excessive profits and in the former case, price deflation does not lead to insufficient profits.
Moreover, capital accumulation drives economic growth. As the supply of capital goods increases, their prices-and thus, costs of production-fall. Thus, wages do not need to decline in order to maintain profitability and employment. This point is illustrated by the American economy of the 1880s where prices of both consumer goods and capital goods fell as more of both were produced, allowing wages and profits to be maintained. Another example is the computer industry of the past two decades.
When price deflation occurs in an unhampered market economy, it simply means that people enjoy the benefit of having a money whose market value increases.
One can agree with Milton Friedman's triumphant declaration that a general price deflation is impossible as long as central banks inflate the money stock with sufficient exuberance. But if his monetary rule were a panacea for depression, then Japan would not be suffering one now, since the Bank of Japan has inflated the yen sufficiently to keep prices in general at the same level throughout the 1990s; nor would the Federal Reserve's credit expansion during the 1920s have resulted in the depression of the 1930s since prices in general remained stable throughout the 1920s.
John Maynard Keynes had a different view of the horrors of deflation. He claimed that the market economy's deficiency is not an insufficiently elastic money stock, but the paucity of capital accumulation. The central-bank could rectify this by generating a credit expansion to stimulate capital accumulation. Under a gold standard, however, its hands are tied, since the money stock cannot be inflated sufficiently. The "barbarous relic" must therefore be banished, removing all restraints on central-bank monetary inflation.
Contra Keynes, instead of genuine capital accumulation, central-bank credit expansion generates the boom-bust cycle. Newly-created money is used to buy securities from banks, expanding their supply of credit and lowering interest rates. Entrepreneurs and consumers borrow the money and spend it on capital projects and consumer durable goods, respectively. Prices rise for capital goods and consumer durables which makes their production more profitable and brings about a shift of productive factors into them and out of other goods. If energetic enough, as the Bank of Japan's efforts were in the late 1980s, central-bank credit expansion leads to a bubble in asset prices.
The boom ends when the central bank's credit expansion can no longer maintain artificially low interest rates. Typically this happens when the monetary inflation results in significant, widespread price inflation. Once people realize that money's purchasing power will be lower in the future, they adjust interest rates upward. Sometimes, as in Japan in 1989, the central bank cuts off the monetary inflation. In any case, these higher interest rates collapse capital values, including stock and asset prices. With their prices smashed, the production of capital goods and consumer durables suffers losses and must be cut back.
The true financial corrective to the artificial and unsustainable inflation of asset prices induced by central-bank credit expansion during the boom is deflation of asset prices. No longer distorted, prices now reveal misallocated factors and malinvestments and make profitable the transfer of the former and the liquidation and reinvestment of the latter into valuable activities. In short, asset-price deflation is the market economy's way of restoring its function of effectively satisfying consumer preferences.
But what really frightens Keynesians is not, strictly speaking, asset-price deflation but its complement: credit contraction. When the central bank inflates paper money during the boom, banks expand credit and checkable deposits. Assets valued at inflated, boom-level prices serve as collateral against these loans. When asset prices collapse and borrowers default, banks' net worth becomes negative. They retrench in the face of bad loans by scaling back their lending. Customers, realizing the banks' distress, cash out their checkable deposits, further reducing bank reserves and adding to the financial pressure on banks.
With distressed banks, reflation fails to induce another bank credit expansion. Keynesians have mistaken the impotency of the Bank of Japan to restart credit expansion in the 1990s as a liquidity trap. But the problem is not that interest rates are so low everyone expects them to rise and therefore hoards cash. Banks refuse to lend because of the overhang of bad debt. Any cash infusion is held as reserve against it. Businesses refuse to borrow because of their debt burden, built up to expand capacity during the boom, and their over-capacity resulting from their malinvestments.
Even if the Bank of Japan succeeds in reflating outside the banking system by purchasing debt directly from the market, it cannot counteract monetary deflation or credit contraction. Instead, reflation begins a separate stream of distorted prices and production that will some day need to be liquidated itself. Consider, for example, the yen-carry trade from 1995-1997 by which Japanese banks expanded credit in Asian countries, greatly aggravating the malinvestments of their booms. When the financial crises came in Asia, Japanese companies were left with over-capacity in their Asian facilities and Japanese banks were saddled with more bad debt.
Once the malinvestments of the boom are made, losses must eventually be suffered by liquidating them. If the government does not interfere, liquidation will proceed apace, as it did in the American recession of the early 1980s. But when the government attempts to prevent liquidation with bailouts, socialization, fiscal expenditures, reflation and like policies, as in Japan in the 1990s and America in the 1930s, then the depression will linger. If Japan expects to restore prosperity for the long term, central-bank monetary inflation and credit expansion, whether justified on Monetarist or Keynesian grounds, must be repudiated.
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From the Asian Wall Street Journal; October 28, 1999, Page 10]
Copyright (c) 1999, Dow Jones & Company, Inc.
