Most of the following is from a comment in reference to an earlier post about the similarities between the U.S. policy response to the credit crunch ushering in the Great Recession and Japan's response to their downturn in the early 1990s. I think the issue so important, however, that it deserves its own post.
The author of the NYT piece about Japan's loss of vigor asserts:
For nearly a generation now, the nation has been trapped in low growth and a corrosive downward spiral of prices, known as deflation, in the process shriveling from an economic Godzilla to little more than an afterthought in the global economy.
Later the author writes:
The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the rational way to act when prices are falling is to hold onto cash, which gains in value. But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people instinctively reluctant to spend or invest, driving down demand — and prices — even further.
The misery and human costs however are not the result of deflation. They are the direct result of Japan's failure to allow the liquidation process to occur. The Japanese government has kept unprofitably invested capital in place with fiscal and monetary stimulus as well as central bank policy that continues to keep bad debt frozen on the books of zombie banks.
Recessions as the necessary consequence of capital consumption via malinvestment resulting from artificially low interest rates. In both Japan and the US, entrepreneurs were led astray by central bank credit expansion to undertake too much investment at higher stages of production and not enough investment at lower stages. The end result is that a large number of investment projects were begun at stages farther away from the consumption that were simply not sustainable. These projects must be liquidated if we do not want to continue to consume capital and make the situation even worse over time. Recession is the beginning of the necessary restructuring of capital toward its most highly valued uses.
Additionally, whatever the cause of the misery in Japan, it is not due to deflation. The claim that there has been a generation of deflation in Japan is simply wrong. As French notes, in 1989 the annual CPI in Japan was at 91.3. In 2009, it was 100.3. There have been ups and down along the way, but prices are higher now than they were in 1989. The monetary base of Japan is now more than 244 times what it was in July of 1991. M1 in Japan almost trippled from 1990 to 2002 and then increased every year after until 2009. In no way can this be construed as deflation.
We should also not forget that liquidation does not have to cause prolonged misery. That is the lesson of the recession of 1920-21 that followed the inflation of the war years. Historian Tom Woods documents that during 1920 unemployment increased from 4% to 12% and GDP fell by 17%. Warren Harding's response was to cut government spending, cut taxes, and reduce the national debt and the Federal Reserve did not act to inflate in an attempt to forestall deflation. Unemployment was back down to 6.7 by the end of 1922 and fell to 2.4% in 1923. The reason we did not have two decades of misery following the recession of 1920-21 is that the government by-and-large allowed the malinvestment to be liquidated and for the necessary capital restructuring to commence.
It's not inflation but NGDP growth that matters.
ReplyDeleteI would argue that the Fed should not have allowed NGDP and NGDP expectations to fall in 1920. From 1921-1929 it did a pretty good job of maintaining steady positive (3.7% average annual) NGDP growth and people had high expectations of NGDP growth until the Fed allowed those to fall in 1930. Hence people began hoarding cash and a recession turned in to a Depression as the Fed did nothing to stabilize nominal spending (as Hayek & Robbins had originally prescribed).
But Hayek and others believed that Fed policy was too loose in 1922 and 1923, and onward through 1929. You can't have it both ways-- either liquidation was successful because the Fed didn't inflate, or the Fed pursued too loose a policy during those years. Which is it?
In the Depression, countries that abandoned the gold standard experienced growth and inflation. Those who remained on the gold standard struggled. That experience is ingrained in the minds of mainstream economists today, IMO.
The data indicate that Japan's central bank shifted its policy toward NGDP growth right about 1989. They went from pursuing positive NGDP growth to 0% growth. Hence, the people in the NY Times don't have any expectations of positive NGDP growth. Anytime those expectations pick up, the bank has squashed them by raising the real interest rate.
Monetary base growth does not and never has been the same thing as inflation. If it was, Japan and the U.S. would have hyperinflation. The Fed's mistake in 2008 was to allow NGDP growth and expectations to fall dramatically-- just as in 1930.
The problems I have with the malinvestment argument are:
1. If interest rates are artificially low, who/what determines the magnitude of the artifice?
2. Likewise, how do you determine which goods/projects being produced are the "wrong kind?" How do we determine which ones should be "liquidated?"
3. If people are stupid/irrational enough to be led astray by those artificial rates (ie: they don't see the artifice) then how can they be expected to be rational in other areas of their economic behavior?
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ReplyDeleteI would also add that Japan has experienced actual CPI deflation in every year from 1999-2005, as well as 2009 to today. While not a "generation," this still has a dramatic impact on consumption & investment decisions. Japanese are expecting NGDP to fall and hence are holding money, as inflation gives them an incentive to do so rather to engage in any productive investment. The greater the deflation the greater real interest rates are.
ReplyDeleteI think you're arguing that the rate of deflation isn't large enough--liquidation isn't occurring rapidly enough.
About stabilizing nominal GDP and inflation:
ReplyDeleteThe problems associated with recession are due to capital being invested in the wrong parts of the production structure during a boom fueled by credit expansion not funded by voluntary savings. There are not enough capital goods to satisfy all of the projects begun. Therefore many of these projects are unsustainable and must be liquidated or end in failure. That is why business cycle data show more cyclical activity in capital-intensive industries than in consumer goods industries.
This is also why maintaining nominal GDP will not solve the problem. It is not nominal GDP that matters, but a sustainable well-balanced capital structure that matters. More spending is not helpful unless it is spent on goods at the stages of production that are compatible with social time preferences and hence the stock of voluntary savings. If it is not, then the spending will be poured into projects that are not sustainable with the given quantity of voluntary savings.
Additionally, the way nominal GDP is stabilized is by increasing the money supply. If the Fed attempts to prop up GDP to counteract people demanding to hold more cash (and I an not implying here that increased money demand is a necessary part, let alone cause, of the business cycle), the only way it can do so is to increase the money supply. This IS inflation. This inflation merely stimulates another round of malinvestment. We can't undo previous malinvestment with further inflation. We also cannot undo the effects of deflation with inflation.
About the 1920s:
ReplyDeleteThe data shows that the rate of growth in nominal GDP during the 1920s was not that stable. The annual rates of change were as follows:
Year %Change in Nominal GDP
1921 -23.9%
1922 6.5%
1923 14.8%
1924 -0.5%
1925 9.9%
1926 4.2%
1927 -2.2%
1928 2.2%
1929 6.3%
You are right that it was monetary inflation that created the inflationary boom of the late 1920s that led to the recession of 1929-30 that became the Great Depression, but the heavy inflation of the 1920s did not take off until 1924, well after recovery from the 1920-21 depression. Construction volume began to increase early in 1921 while overall production began to increase in August of 1921.
It's true that credit began to expand in 1922, but this was only marginally due to Fed action and it is not clear at all that it was the goal of Fed policy to expand credit so as to stabilize nominal GDP. The Fed did decrease the discount rate in 1921, but the volume of discount loans actually fell from $2.75 billion in the autumn of 1920 to $1 billion at the beginning of 1922. Beginning in early 1922 (note AFTER the recover began), the Fed made relatively large open market purchases, however this was an attempt to generate interest income for the Fed and not to promote bank credit expansion. Many member banks sold Treasure Bonds to the Fed and then used the reserves to pay off their discount loans. The total volume of discount loans decreased to $400 million by the summer of 1922. Therefore, I still would argue that the Fed was not trying to substantially expand credit in 1922-23. There was some inflation facilitated primarily from an inflow of gold and a decrease in the demand to hold cash, both of which worked to increase bank reserves and consequently fueled credit expansion. In any event, this all occurred after the recovery had already started. It was the monetary inflation that was begun in earnest in 1924 and continued with another great boost in 1927 that was specifically aimed at stabilizing prices and that generated the inflationary boom of the late 1920s that turned into the Great Depression.
About Japan:
ReplyDeleteIn the case of Japan, the data indicate that the Japanese didn't target a 0% growth rate in nominal GDP from 1989. If they did, they failed miserably. The data say otherwise:
Nom. GDP (in billions of Yen)
1989: 399,998
1990: 430,040
1991: 458,299
1992: 471,064
1993: 475,381
1994: 479,260
1995: 483,220
1996: 499,861
1997: 507,271
1998: 514,595
1999: 495,227
2000: 501,068
2001: 496,777
2002: 489,618
2003: 490,544
2004: 496,058
2005: 502,457
Japan's Nominal GDP rose 28.6% from 1989 through 1998. One cannot blame Japan's lost 1990s on falling nominal GDP spending.
I did not say that monetary base growth was the same as inflation, however, it IS an indicator of central bank policy. Inflation is an increase in the money supply. The tripling of M1 money supply from 1990 to 2002 was inflation.
As I said, Japan's CPI has had its ups and downs, but the fact remains that consumer prices are higher now than they were in 1989 and even from 1999 through 2005 prices never decreased even one percent per year. This is hardly a deflationary spiral.
About the Austrian/Manlivestment Theory of the Business Cycle:
ReplyDeleteThe magnitude by which interest rates are artificially low is determined by social time preferences and the central bank. By artificially low, I mean the extent to which market interest rates are lower than what they would be if credit was funded only by voluntary savings. Without inflation through credit expansion, interest rates would purely reflect social time preferences. We know that, when the Fed increases commercial bank reserves and banks respond by expanding credit, interest rates are pushed below what they would be if credit came only from voluntary savings. At any specific moment, however, I doubt we can determine just how much below they are. Therein lies the part of the problem.
Correct investments are those that are profitable without government intervention. This points to one of the most destructive elements of inflation via credit expansion and why it leads to malinvestment and recession. It falsifies the profit-loss calculation by giving the impression that certain, longer term, projects are profitable when in fact they are not. We know that the goods being produced with artificial credit expansion are the wrong kinds because the lower interest rates provide entrepreneurs incentives to invest in projects that are too long to be sustained with the available stock of capital goods.
Those who undertake malinvestment because of faulty profit-loss calculations resulting from monetary inflation are not necessarily stupid and are certainly not irrational. They undertake investment, after all, because they think that in so doing they will earn a profit. There are also not necessarily stupid. If they can borrow at 6% and turn a positive 7% rate of return, for example, that certainly seems like a wise thing to do. These entrepreneurs are in error, but we should not write them off as being merely stupid.
Interest rates are a key component of the profit-loss calculation. If interest rates fall, it is not easy to determine the precise cause. It could be due wholly to monetary inflation via credit expansion. It could also fully be due to an increase in savings. It could very well be due partially to both inflation and increased savings. The entrepreneur only really knows that the interest rate has fallen. He has to make a judgment as to why that is the case. Even those entrepreneurs that correctly sense that lower interest rates are primarily the result of monetary inflation in a given situation might think they can get in, make their profits, and get out of an investment before the bust hits. All of these decisions are entrepreneurial judgments, and those who make wrong judgments reap losses.
The virtue of Austrian Business Cycle theory (the malinvestment argument),is that explains the cluster of entrepreneurial error that constitutes recession. Not every entrepreneur undertakes malinvestment, however. Those who rightly forecast future market conditions based on their understanding that interest rates are artificially lower will reap profits. They are the ones who can come in at the bottom of the bust and buy assets from bankrupt or liquidating companies and put productive assets to the more valuable uses.