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Japan Can't Inflate Away Its Woes

October 29, 1999

[From the Asian Wall Street Journal;
October 28, 1999,
Page 10]

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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Mr. Herbener is professor of economics at Grove City College, Pennsylvania,
and a senior fellow of the Ludwig von Mises Institute in Auburn, Alabama.

Copyright (c) 1999, Dow Jones & Company, Inc.


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