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Money for Nothing

February 22, 1999

From The Asian Wall Street Journal
February 22, 1999

The Japanese government made several moves last week that may
portend a shift to more aggressive efforts to expand the money supply. The Ministry
of Finance's decision to reverse course and once again begin buying government
bonds, and the Bank of Japan's decision to cut interest rates to an all-time low
of 0.08%, are both clear signs that the government is no longer willing to
sit back and watch rates climb.

BoJ Governor Masaru Hayami says that interest rates could drop
to "zero" if need be, and talk of firing up the printing presses to
aggressively expand the money supply is increasingly common. Many economists have argued
that an inflationary monetary policy is Japan's only hope if it is to pull out
of its current deflationary spiral. Others argue that the BoJ should expand the
supply to encourage commercial bank lending. What these economists fail to realize
is that Japan's so-called credit crunch is a product of a scarcity of capital
and of credit-worthy borrowers. This cannot be remedied simply by pumping more
money into the system.

Indeed, Japan's central bank has been injecting money into the
economy over the past year, but to no avail. The overnight call rate was at
extremely low level of 0.15% before dropping even lower last week, and it
aggressively pumped money into the banking system. Year-on-year, central
assets grew by 36% in November 1998. At one stage in March last year, these
assets expanded at a pace of 42% year-on-year. Yet despite this aggressive
monetary pumping, commercial bank lending continues to fall. Last December,
year-on-year bank lending fell by 4.8% after a fall of 4% in the prior

A similar situation occurred earlier this decade in both Russia
Brazil. In 1992 the Russian central bank allowed broadly- defined moneysupply
to grow by almost 600%. Yet the economy continued to deteriorate. In 1996,
Brazil's central bank allowed the money supply to grow by 60% to keep the
economy going. Yet the Brazilian economy has continued its downward slide.

The proponents of aggressive monetary expansion in Japan,
argue that it is necessary to reverse deflationary expectations, which are
blamed for depressed consumer spending. Once money is printed on a massive
scale, they argue, inflationary expectations will rise, which will induce
consumers to increase their spending. This in turn will give a kick to
production, and things will start moving again. While it is sounds
defenders of this view have yet to explain why monetary pumping did not do
trick in Russia or Brazil, or so far in Japan, for that matter.

Those in favor of monetary expansion believe that the source of
Japan's economic problems is depressed demand. The theory goes something
this: If demand is increased, the increased production of goods and
will follow suit, and--abracadabra!--economic prosperity will be restored.
In the real world one has to become a producer first before one
demand goods and services. That is, it is necessary to produce some useful
or services that can be exchanged for other useful goods. Demand therefore
cannot stand by itself and, independently of production, grow the economy.

It is
always limited by the prior production of wealth.
So if real demand is a function of production, why is Japan in
midst of a severe recession? After all, in terms of most key economic
Japan is an extremely powerful and productive economy. It has one of the
advanced production structures in the world, a highly skilled, hard-working
labor force, and runs a huge balance of payments surplus. In 1998, for
the current account surplus surged to a record $138.5 billion.

What we are currently observing in Japan is not the product of a
mysterious disease or a sudden change in the psychology of consumers and
producers, as some economists are suggesting. The source of Japan's
problems has
nothing to do with most macro- economic indicators such as the Gross
Product, Balance of Payments or the Consumer Price Index. The source of the
problem is the loose monetary policies of the central bank.

The Austrian economist Ludwig von Mises argued that the source
each economic slump is the previous boom that is caused by monetary pumping
the associated artificial lowering of interest rates. Instead of production
supporting or funding consumption, printing money turns things around. It
results in consumption that is not backed up, or funded, by production. The
ensuing imbalance weakens the flow of savings, the sole source of funding
in the
economy. It also distorts interest rates that serve as an indicator for the
profitable allocation of savings.

In a free and unhampered market, interest rates are the outcome
the supply and demand of savings. Interest rates therefore mirror
preferences. In this capacity they guide businesses in the most profitable
allocation of funding. By responding to interest rates, businesses are, in
abiding by consumers' instructions. However, once interest rates in
markets are lowered artificially, they cease to reflect consumers'

This in turn means that businesses, by reacting to interest rates in
markets, are committing errors--in other words, making investment decisions
go against consumers' wishes.

As long as the monetary pumping and the consequent artificial
lowering of interest rates remains in force, there is no way for
businessmen toknow that they are committing these errors. On the contrary, as the loose
monetary policy intensifies, it generates apparent profits and a sense of
prosperity. The longer the period of loose monetary policy, the more
will be the errors.

All this leads to a situation where entrepreneurs are committing
themselves to unprofitable businesses which ultimately must be liquidated.
It is
this liquidation that is called an economic bust or recession. The severity
of a
recession is dictated by the intensity of the previous boom brought about
monetary pumping and the associated artificial lowering of interest rates.

This is precisely what has happened in Japan. The discount rate
been pushed down from 9% in 1980 to near zero in 1998. In other words the
has been pursuing relentless loose monetary policy for 18 years. Obviously
has generated a massive misdirection of savings. Given the fact that all
attempts to revive the economy either by means of fiscal packages or
pumping have failed so far, Japan can only expect more of the same if it
continues to expand its money supply. Not only can more injections of money
replace savings, it also weakens the flow of savings by stimulating
that is not backed up by production and if persevered could lead to

If Japan is truly to recover, its central bank must stop
with both short-term and long-term interest rates and stop pumping massive
amounts of money into the economy. Moreover, Japan's sprawling government
reduce its size to the bone and cut taxes. As far as the country's banks
concerned, those that cannot survive on their own must be allowed to fail.

will have the positive effect of strengthening the flow of savings, therebypermitting genuine economic recovery. In short, Japan's past misallocation
savings cannot be undone by printing money. Despite claims to the contrary,
loose money will only prolong Japan's economic misery.

* * * * *
Frank Shostak is chief economist at Ord Minnett Jardine Fleming
Futures in Sydney, Australia. On the same day this article was printed, the paper endorsed Shostak's thesis in a separate editorial.

Here is a link to Shostak's personal site.

Just before the meltdown, the Austrian Economics Newsletter interviewed an Austrian economist in Japan. Read this very interesting interview with
Hiroyuki Okon.

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