The American Economy: Japan Redux?

by: Gerard Jackson

Quite a few economic commentators are hesitant about the direction of the US economy, uncertain about whether it will stagnate or recover. Some are making gloomy comparisons between the current state of the US and the Japanese economy of the 1990s: others are more optimistic. Overlooked by these commentators is the fact that the monetary policy that generated Japan's 1980s boom is basically the same one that generated the US boom of the 1990s and the subsequent bust. In fact, this policy has generated every boom-and-bust cycle I know of. It's called credit expansion.

What we need to know is whether Obama's economic policy will result in another boom or economic stagnation. Let us start with some economic history. In May 1989, the Bank of Japan started to raise interest rates, with very little response at first. The Tokyo market continued to roar ahead while many commentators spoke sagely of permanently rising share values, though others were realistic enough to know that shares were seriously overvalued. By the end of the year the Nikkei index stood at 38,915 and average price-earnings ratios were 70. It was January 1990 when stock prices first began to slide only to accelerate their decline with the Nikkei falling to 28,000 by March, a 30 per cent drop, triggering a panic. The end of the year saw the market about 40 percent lower.

The property market took a gigantic hit as inflated asset values dived, lumbering the banking system with massive non-performing loans. The situation created a crisis for the banks, seriously eroding their capital adequacy ratios. Property companies and security houses were savaged by the readjustment. These companies had borrowed huge amounts at very low interest rates only to find themselves faced with having to repay at real rates of interest and this with their own investment and share values slashed by as much as 66 percent. It was indeed a grim situation.

Instead of biting the bullet and taking its medicine by allowing the market to liquidate the country's unsound investments (what the Austrian school of economics calls malinvestments), Japan repeated the same mistake that pushed her economy into economic stagnation that prevailed from 1920-27. (Yes, folks, history had once again repeated itself.) This situation had also been preceded by a massive credit expansion. And despite the fact that wherever we look we always find credit expansion as the party that did the dirty deed, it is still invariably found not guilty by economic commentators. For this we can blame Lord Keynes. This is mainly why observers turn to consumption as the potential savior and the fallacious liquidity trap as the culprit, which is precisely what Paul Krugman did.

Keynesians ignore the economic reality that Japan's cheap money policy 'extended' investment beyond the country's pool of real savings. (This means that something had to give — and it did.) The situation was badly aggravated by consumption oriented policies that reduced the savings pool, when what the economy needed was the very reverse, notwithstanding Krugman's vulgar Keynesian prescription to the contrary. A number of stimulus plans were implemented, mainly consisting of public works programs and direct payments to the public.

In an attempt to loosen monetary policy, interest rates were driven down to zero. Yet the money supply remained moribund. Every first year economics student is taught that the banking system expands the money supply by multiplying the number of deposits until its excess reserves are exhausted. But in order to lend one must have borrowers. So where were they? The Keynesians' answer was the fallacious liquidity trap. People were not borrowing because they expected interest rates to rise.

Krugman's advice to the Japanese government was to flood the country with yen by buying any assets offered for sale. In simple English, just print the stuff and hand it out until inflation lifted the economy out of recession. That this policy might depress industry further never occurred to Krugman just as it never occurred to him that the reason why businesses were not borrowing is because they had — thanks to the Bank of Japan's Keynesian-inspired monetary policy — accumulated massive debts and an enormous amount of excess capacity.

Instead of allowing the necessary adjustments to take place, meaning that the production structure needed to be rearranged so that it accorded with the consumers' true ratio of savings to consumption, government policy aimed — unintentionally — at maintaining the existence of these malinvestments. Excess capacity was frozen and gigantic public works programs kept construction companies in business that should have gone into bankruptcy. Consequently a whole chain of unsound economic activities was kept afloat, drawing real capital away from investments that better reflected the demands of consumers.

To get a grip on why these interventionist policies failed, it needs to be understood that the boom-bust phenomenon follows a particular pattern. Most people believe that booms are driven by consumer spending and that when this slows down recession sets in. If this were so, then the consumption goods industries would be hit first and hardest. They are not. Manufacturing gets hit first and it is there that unemployment first begins to emerge, even as the aggregate demand for labor is increasing and the boom in consumer goods continues. This is exactly what happened at the end of the Clinton boom. Even after the boom ended, consumer spending continued to rise.

The effect of a policy directed at encouraging consumption is to aggravate conditions in manufacturing, particularly in the higher stages of production. Carried to its logical conclusion one could eventually end up with a decimated manufacturing sector and a lower wage level even though aggregate employment has been maintained.

Although pouring billions — much of which will end up as donations for the Democratic Party — into General Motors has no doubt caused ecstasy among the leadership of the United Auto Workers, it can do nothing but bring fiscal pain to American taxpayers. Obama is doing in Detroit what the Japanese did on a national scale. General Motors is now on a taxpayer-supported life system and its 'employees' are now in the process of becoming tax consumers. Yet the ample evidence that Japan has provided, that press-ganging taxpayers into subsidizing the consumption of masses of capital goods is a recipe for economic stagflation, completely eludes this administration.

Plenty of people are looking at the stock market as proof that recovery is on the way. But what I am seeing at the moment amounts to a monetary illusion. As a rule, a fall in the rate of interest usually results in a surge in stock prices whose continued rise is fueled by monetary expansion. Right now the market fits the pattern. Observers assume from this that the usual pattern of recovery will now develop. I am not so sure. The economic commentariat tend to overlook the fact that a sustained and genuine recovery would bring forth increased capital formation. I do not see this happening under the Obama administration for the same reasons it did not happen in the 1930s.

Now it is true that despite the depredations of its politicians, the US economy has remained remarkably flexible since WWII. However, Obama is the most interventionist president since Roosevelt and has already revealed a deep hostility to the free market. He will have been the only one since the 1930s to launch a barrage of taxes and regulations during a recession. His proposal to double the superannuation tax, for instance, amounts to a huge tax increase on investment and technical progress. (New technology is embodied in capital goods. Therefore anything that retards capital accumulation, such as a superannuation tax, hinders the application of productivity-enhancing technologies and the production of new products.) It ought to be clear — particularly to his economic advisors — that these policies carry a very heavy economic price.