Money for Nothing
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 the extremely low level of 0.15% before dropping even lower last week, and it has aggressively pumped money into the banking system. Year-on-year, central bank 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 month.
A similar situation occurred earlier this decade in both Russia and 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, however, 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 appealing, defenders of this view have yet to explain why monetary pumping did not do the 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 like this: If demand is increased, the increased production of goods and services will follow suit, and--abracadabra!--economic prosperity will be restored. In the real world one has to become a producer first before one can demand goods and services. That is, it is necessary to produce some useful goods 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 the midst of a severe recession? After all, in terms of most key economic indicators Japan is an extremely powerful and productive economy. It has one of the most advanced production structures in the world, a highly skilled, hard-working labor force, and runs a huge balance of payments surplus. In 1998, for instance, 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 Domestic 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 of each economic slump is the previous boom that is caused by monetary pumping and 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 most profitable allocation of savings.
In a free and unhampered market, interest rates are the outcome of the supply and demand of savings. Interest rates therefore mirror consumers' preferences. In this capacity they guide businesses in the most profitable allocation of funding. By responding to interest rates, businesses are, in fact, abiding by consumers' instructions. However, once interest rates in financial markets are lowered artificially, they cease to reflect consumers' preferences.
This in turn means that businesses, by reacting to interest rates in financial markets, are committing errors--in other words, making investment decisions that 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 widespread 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 by monetary pumping and the associated artificial lowering of interest rates.
This is precisely what has happened in Japan. The discount rate has been pushed down from 9% in 1980 to near zero in 1998. In other words the BoJ has been pursuing relentless loose monetary policy for 18 years. Obviously this has generated a massive misdirection of savings. Given the fact that all attempts to revive the economy either by means of fiscal packages or monetary 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 not replace savings, it also weakens the flow of savings by stimulating consumption that is not backed up by production and if persevered could lead to depression.
If Japan is truly to recover, its central bank must stop interfering with both short-term and long-term interest rates and stop pumping massive amounts of money into the economy. Moreover, Japan's sprawling government must reduce its size to the bone and cut taxes. As far as the country's banks are concerned, those that cannot survive on their own must be allowed to fail.
This will have the positive effect of strengthening the flow of savings, therebypermitting genuine economic recovery. In short, Japan's past misallocation of savings cannot be undone by printing money. Despite claims to the contrary, loose money will only prolong Japan's economic misery.
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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.