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Japan's Bust: An Austrian Critique of the Fed's Explanation / Artikel mises.org

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Japan's Bust: An Austrian Critique of the Fed's Explanation
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by Christopher
Mayer

[Posted April 12, 2004]

<img alt src="http://www.mises.org/images3/yen.gif" align="right" border="0" width="203" height="158">Athanasios
Orphanides' recent
Fed paper touches on aspects of Japan's extended economic slump (his basic
thesis: the BOJ should have done more). This paper served as a reminder of the
inadequacies and limitations of mainstream analysis in explaining Japan's long
economic winter. Fortunately, though long unrecognized and unappreciated by
the mainstream, there is a good framework for understanding the Japanese boom
and bust. As it happens, that sequence was a classic business cycle as
predicted by Austrian theory.

The Austrian analysis
begins with the boom. The focus is on that"cluster of errors" as
Rothbard put it, where business suddenly turns for the worse in a sweeping and
wide-ranging fashion. Austrian business cycle theory focuses more on the
nature of the boom than it does on the bust and depression. There is a sound
reason for this orientation. Just as Emerson wrote"Cause and effect,
means and ends, seed and fruit, cannot be severed; for the effect already
blooms in the cause, the end preexists in the means, the fruit in the seed,"—so
too, does the bust pre-exist in the boom.

Unsustainable booms
begin with the creation of money and credit not supported by underlying
capital. It begins with interventions in the world of money. In older days, it
was easier to see that money creation beyond what was covered by specie was
false capital, but in the modern anchorless and credit-soaked economy, the
distinction is theoretical and much harder to detect. Nonetheless, this false
capital does not create wealth. However, its creation does impact interest
rates and influences the pattern of production away from what it otherwise
would have been—hence the creation of instability and of an underlying
tension.

Monetary expansion
cannot go on indefinitely or without consequence. The bust, then, is the
period where market forces tack back toward where they would have gone without
the fog of monetary intervention leading them astray. This requires
liquidation of projects and businesses that no longer appear profitable.
Workers and capital are redeployed to more profitable lines.

This is a painful
process, no doubt, but inevitable and salutary. The economy cannot grow again
on a firm sustainable base until the old bad investments, the malinvestments,
are liquidated. Each bust or recovery has its own unique features, but the
essential characteristic is that the bust is curative and necessary to get the
economy back on track.

The key, though, is
that the market must be allowed to correct itself and this takes time. Any
delay or prevention of the necessary spadework of the bust only promotes
further unsustainable circumstances and will aggravate the downturn. As we
will see below, the BOJ and the Japanese government did everything but let the
market self-correct.

<h1>The roots of the boom in Japan<a id="_ftnref1" title href="http://www.mises.org/fullstory.asp?control=1487#_ftn1" name="_ftnref1">[1]</a></h1>
The greatest boom in
Japanese history has its roots in the accommodative monetary policy pursued by
the Bank of Japan (BOJ) in the mid-1980s following the Plaza Accord. The BOJ
sought to stem the appreciation of the yen, which hurt its heavily export
dependent economy. Rather than allow market forces to rearrange the pattern of
production along more sustainable lines, the BOJ began its aggressive campaign
to bring down the yen.

Let us then sketch out
the outlines of what happened. The BOJ cut its discount rate from 5% to 2.5%
between January 1986 and February 1987, a 50% reduction in its key rate. The
result was a conflagration, as the stock market scorched its way upward. From
January 1985 to its peak in December of 1989 (based on month-end index prices),
the Nikkei nearly tripled. From 1986 through 1990, Japan's money stock grew by
an average of 10.5% per year.

Worried about the
bubble, the BOJ reversed course and began tightening. In 1989 and 1990, the
BOJ raised its discount rate five times to 6.0%. The bubble, having found its
pin, popped. >From a peak of 40,000 in December of 1989, the Nikkei tumbled
to a low (again, based on month-end prices) of 7,831 in April of last year—a
drop of 80%.

Japanese officials,
like the samurai of old, seemed intent on performing a seppuku-like
self-immolation, destroying the government's finances and crippling its
economy with repeated efforts to bail it out. The litany of rescue packages
attempted is absurd.

Japan spent 65.5
trillion yen between 1992 and 1995. In 1995, the BOJ dropped its discount rate
to 0.5%. In 1998, two spending packages worth 40.6 trillion yen were revealed.
In 1999, came yet another fiscal stimulus package, this one worth 18 trillion
yen. In 2000, another 11 trillion. Much of this deluge of money was put into
public works projects or funneled through to politically favored businessmen.
Japan's finances weakened as its debts grew.

The monstrous malaise
suffered by Japan was entirely of its own making. And consistent with Austrian
theory, these interventions have only slowed the recovery and hampered the
market's self-corrective process.

<h1>Do less, not more</h1>
After reading through
all that, it is quite surprising to find economists and others that say Japan
should have done more. Done more? Orphanides believes that central banks
should expand their interventionist efforts in environments with very low
interest rates to move into longer-dated debt securities. In other words, not
only should central banks fix the short-end of the yield curve, but if that
fails, Orphanides believes central banks can and should intervene further
along the yield curve as well.

Such prescriptions only
worsen the problem, as discussed above. The misdiagnoses on Japan are as bad
as the prescriptions.

Many are those who
believe Japan is or was in a"liquidity trap." The basic idea is
that people's"liquidity preference," or their demand for cash, is
so high that the interest rates cannot fall low enough to stimulate investment.
The basic Austrian criticism of the liquidity trap concept is that it has the
causation backwards. Interest rates do not drive investment.

As Murray Rothbard
points out in his book, America's Great Depression,"saving,
investment and the rate of interest are each and all simultaneously
determined by individual time preferences on the market. Liquidity preference
has nothing to do with it." In other words, the consumers' choices drive
the rate of interest—not vice versa.

Other analysts obsess
over the"deflation problem." The idea that deflation is the villain
of the piece misses an obvious fact: money supply continues to grow. However
you slice it, be it M-1, M-2 or"broadly-defined liquidity"—they
have all been growing every year since 1984, the earliest date provided by the
BOJ data bank on its website. M-1 grew 8.5% in 2001, 27.6% in 2002 and 8.2% in
2003. M-2, a broader index, grew 2.8%, 3.3% and 1.7% in each of these years.

Deflation proper—a
decline in the supply of money—clearly has not happened. Prices, as measured
by the current fashionable indices, have fallen, but that is not a deflation—no
more so than our current mild CPI readings measure low inflation. But even so,
the Japanese consumer price index decline has been quite mild. According to
the Japanese Statistic Bureau, the Japanese CPI stood at 98.1 at the end of
2003, a decline of 0.3% from the prior year (the base year, 2000 = 100).

It seems to defy common
sense to suggest that the problem with Japan is the small annual decreases in
its CPI. Surely, if a mild 1-3% increase in prices is acceptable to
mainstream economists, then a decrease of less than 2% ought to pose no dire
problems. Mainstream economists insist on treating price deflation as if it
were some unholy beast and inflation as some manna of prosperity.

The central problem of
Japan is not a liquidity trap and it is not deflation—the fundamental
problem is a pattern of production ill-suited and ill-fitted to meet the
realities of the marketplace.  

In general terms, the
Japanese wanted to protect their exporters, despite the fact that the
marketplace had changed and moved against them. They wanted to persist in the
belief that the blue chip debtors of yesteryear were still creditworthy. The
Japanese economy was like a shopkeeper in denial of what his customers were
telling him. Pretending not to hear it, he goes about his daily business as
before. only driving himself further into losses.

The madness of such an
approach is apparent when boiled down to the actions of individuals. Why it is
not so when thinking about many such individuals collectively is a mystery
beyond the scope of this small essay. 


 

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Christopher Mayer is the editor of
Capital & Crisis, a
financial newsletter. He is also a commercial lender in the suburbs of
Washington DC. cwmayer@provbank.com.
Comment on this article on the blog.

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<a id="_ftn1" title href="http://www.mises.org/fullstory.asp?control=1487#_ftnref1" name="_ftn1">[1]</a>
The sequence of events and data are
taken from Benjamin Powell's article"Explaining
Japan's Recession" published in The Quarterly Journal of Austrian
Economics Vol. 5, No. 2 (Summer 2002): 35-50 (article version here) and
from data at The Bank of Japan (www.boj.or.jp/en/index.htm).