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<font face="Verdana" size="1" color="#002864">http://www.mises.org/fullstory.asp?control=889</font>
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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>A
Japanese Lesson</strong></font>
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<font size="4">by Hans F. Sennholz</font>




[Posted February 12, 2002]




<img align="right" border="0" src="http://www.mises.org/images/japanese.gif" width="217" height="158">The
Japanese economy, the world's second largest, apparently is unable to recover
from a lingering recession that descended on the country in 1991. Industrial
output has been erratic and lackluster ever since, meandering between
expansion and contraction. Unemployment has been rising steadily and now
exceeds 5 percent of workforce.




All along, the Japanese yen has fluctuated wildly between 124 yen to the
U.S. dollar in 1991, 99 in 1994, and 132 today. In the face of so much
instability and adversity, Japanese authorities have sought guidance from the
universal full-employment prescript which is Keynesian economics. They have
wholeheartedly embraced the most influential formulation of the economic
thought of the twentieth century and have deliberately pursued a policy of
spectacular deficit spending in order to revive the economy.




In 1992, facing a stagnating economy and plummeting stock prices, the
government adopted a comprehensive package of measures totaling 10.7 trillion
yen, the equivalent of 2.3 percent of GDP. One year later, to offset the
worsening economic slump, it unveiled another stimulus package, the largest in
history. In 1994 a new administration added its own huge pump-priming package.&nbsp;
When the Japanese yen nevertheless rose sharply in world money markets,
distressing and depressing important export industries, the government
launched new public works projects and adopted the largest stimulus package
ever.




At the same time, the Bank of Japan lowered its discount rate to a record
low of 0.5 percent. For a moment the economy seemed to recover, but
unemployment continued to rise steadily. A few months later, the Japanese
economy suffered the biggest drop in 23 years, shrinking at an 11.2-percent
rate. It caused Japan to be buffeted by a stream of investigations,
indictments, arrests, and resignations, involving many politicians and the
most prestigious financial houses.




When hope changes to despair, politicians are tempted to accelerate public
spending. In 1998 the Japanese government adopted another comprehensive
stimulus package--the largest ever--increasing public expenditures for social
infrastructure. After months of political wrangling, the Diet appropriated
some $500 billion to rescue the nation's top 19 banks.&nbsp; With unemployment
at 5.4 percent, another supplementary stimulus package of some $195 billion
was to create 700,000 jobs.&nbsp; The Bank of Japan revealed that it had spent
some $580 billion to clean up bad loans and vowed to keep its discount rate
"near zero."




When in 2000 the economy contracted anyway, the government once again
mapped out record budget expenditures.&nbsp; Instead of marketing its
obligations in the capital market, it borrowed massive funds directly from
commercial banks, thereby saving some interest costs. In 2001 the Japanese
economy is estimated to have contracted 1 percent; it is expected to continue
to stagnate in the foreseeable future.




It is difficult to imagine how the Japanese can ever return to a
market-adjusted economic order, that is, to one shaped by the people's choices
and preferences. With a government debt of more than 135 percent of GDP and
still rising, and with government bonds presently yielding 1.08 percent, the
debt consumes some 23 percent of government expenditures. If interest rates
were allowed to rise to market rates of 5 to 6 percent, the interest costs
would soon exceed total present revenue. Taxes would have to be raised
significantly, which would prevent any recovery. Or, government expenditures
other than debt service would have to be slashed drastically, which would
cause unforeseeable social and political problems.&nbsp; Of course, there
always is the proven method of drastic debt reduction: rampant inflation which
depreciates all debt and defrauds all creditors.




Economic considerations point in the same direction. Even if we assume that
the blunders of the past will be corrected eventually, the present monetary
policy of extreme ease with the discount rate near zero and the prime rate at
1.375 percent undoubtedly is leading the Japanese economy into a new state of
horrendous maladjustment.&nbsp; Countless businesses will face new
difficulties if and when interest rates are allowed to return to market levels.
Of course, inflation flushes all monetary debt away, but it also tends to
raise the market rates of interest by the anticipated rate of money
depreciation.




As the history of the Great Depression is one long regret of political
follies and blunders that aggravated the suffering, so is the story of the
Japanese recession from the 1990s to the present. The Japanese government
tried to spend its way out of the recession, but instead merely prolonged it
and created a mountain of debt. It probably improved the Japanese
infrastructure but simultaneously propped up a badly misguided economy;
sustained insolvent banks and insurance companies, always preventing the
needed readjustment and thereby prolonging and aggravating the recession; and,
last but not least, consumed the people's savings of a decade.&nbsp; It is a
hard world of politics, where every mistake must be paid for in full by the
people.




The Japanese people are the latest victims of a spurious economic ideology.
Their political leaders who shape economic policies are possessed by the
notions and theories of Keynesianism, which is akin to basic statist
philosophy. Unfortunately, Keynesian thought misinterprets the very nature of
the business cycle. Contrary to its contentions, a recession does not signal a
failure of the market order that government needs to correct; rather, it is
the inevitable consequence of a misguided economy. False interest rates tend
to cause maladjustments by misleading businessmen in their investment
decisions.




The primary function of the market rate of interest is to guide
entrepreneurial activity. It leads businessmen to satisfy the most urgent
needs of consumers in the best possible way and shows them what they may
invest in the production of present goods and what they may allocate to future
production. When a central bank substitutes its rates for that of the market,
it falsifies economic calculation and accounting. It misguides the process of
production and causes costly maladjustments which sooner or later necessitate
readjustments, that is, recessions.&nbsp; Recessions last until the mistakes
are corrected. In an effort to&nbsp;shorten the recession, central banks
usually falsify the rates again, which may prevent the corrections and create
new imbalances.




The seeds to the Japanese economic predicament were sown between 1985 and
1990 when, in response to both economic sluggishness and a rising exchange
value of the yen, the government conducted a deliberate policy of expanding
domestic demand.&nbsp; It adopted several packages of incentives, including
lower interest on government loans, and added a supplementary budget for
public works, housing, and assistance to small business. And in order to make
the economy less dependent on exports and more amenable to domestic spending,
the Bank of Japan did its part by cutting its base rate from 5 percent to 3.5
percent.




When the yen nevertheless appreciated some 30 percent toward the U.S.
dollar, the bank lowered its rate to 2.5 percent while the government
announced emergency measures in order to stimulate domestic demand. And while
the Japanese gross national product continued to expand at some 5 percent
annually, government outlays for public works increased by some 20 percent.
Japanese stock prices soared to unprecedented levels.


<center><img border="0" src="http://www.mises.org/images/Dollars-to-Yen.gif" width="412" height="192"></center>


In 1990, the Japanese government and the Bank of Japan finally parted ways.
With the economy expanding at record rates and stock prices at wondrous levels,
and with consumer prices rising at an annual rate of 3.5 percent, the highest
in eight years, the Bank of Japan raised its basic rate, first to 5.25 percent
and finally to 6 percent. The boosts were meant especially to"dampen
volatility" at the Tokyo Stock Exchange. The government, however,
preferred to continue in its spendthrift ways. It adopted a supplementary
budget with an additional 4.4-percent increase over the 1991 budget. The sharp
increase was to help finance additional public works of some 430 trillion yen
($2.9 trillion) over a ten-year period. The government was determined to
sustain the bubble, the biggest in modern times.&nbsp;




All economic bubbles must burst sooner or later because they consist of
countless business errors that finally yield painful losses. As financial
institutions and capital goods industries are most prone to fall prey to false
interest rates, they are the primary victims of the inevitable readjustment.
The Japanese bubble finally burst when the Bank of Japan raised its rates. The
Nikkei 225-stock average soon plunged to a 15-month low, below the
30,000-point level and down some 26 percent from the peak reached in December
1989. And once the bubble had burst, it was well-nigh impossible to restore it
despite prompt discount rate deductions to 3.25 percent and massive deficit
spending. This merely propped up the ill-fated system and encouraged banks and
businessmen to hold on to their poor investments. Even consumers became rather
defensive, saving their cash and bracing for uncertain times ahead. In terms
of popular econometrics, the velocity of money fell, which tended to depress
prices and aggravate the plight of business. The Japanese people have been in
this predicament for over a decade.




The Japanese economic malaise provides ample material for serious
reflection about popular economic thought.&nbsp; No one can deny that both the
boom and the bust are characterized by feverish deficit spending and active
government intervention that visibly are unable to facilitate a recovery.
Mainstream economists may want to reconsider the Keynesian notion that
capitalistic economic systems are plagued by equilibria short of full
employment and that they lack forces that automatically lead to recovery. They
may even heed the advice of a few economists who, ever mindful of numerous
money and banking reforms throughout history, point at the monetary policies
of the Bank of Japan as the ultimate cause of the malaise and the pivotal
object of reform. They would immediately inactivate the bank and allow all
interest rates to find their market levels.&nbsp; And lest the government
obstruct the readjustment, it would have to balance its budgets forthwith.




To inactivate a central bank is to stabilize a given volume of its currency
and credit on the day of reform.&nbsp; Henceforth the bank would be barred
from expanding or contracting its stock of money and from setting rates. Bank
of Japan inactivity undoubtedly would trigger a financial crisis that would
reveal the full magnitude of the maladjustment. The crisis probably would be
rather severe, but the readjustment would be swift and efficient in today's
vast global capital market, which is swamped with U.S. dollars. Japanese
financial institutions have ready access to the world capital markets which
stand ever ready to serve and support a return to the market order.




A stabilization through Bank of Japan inactivity undoubtedly would draw a
furious censure and condemnation, not only from mainstream economists but also
from all agents of government and their beneficiaries. And it would be
rejected summarily by many individuals who would have to bear the pains of
readjustment. Of all the evils, they probably will choose the worst: inflation,
which defrauds all creditors and rewards the debtors caught in the net.


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Hans F. Sennholz, emeritus professor of economics at Grove City College, is
an adjunct scholar of the Mises Institute. Send him MAIL.
See also his Mises.org Articles
Archive and his Personal
Website.


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