The Lessons of Japan

Since Fed chairman Ben Bernanke announced his plan for the Federal Reserve to inflate (I’m sorry, “quantitatively ease”) commercial bank reserves by $600 billion, he has come under surprising, but understandable, criticism. So much so that he has felt compelled to defend his policy as necessary for continuing recovery. While defending his plan on CBS’ “60 Minutes” over the weekend, Bernanke revealed that he might expand his program and inflate even more.

Why the need for such monetary expansion? Conventional wisdom has it that unless the Fed is vigilant to protect us, we are in danger of falling into a bottomless pit of deflationary depression. Many think that deflation explains the 20-year “lost decade” in Japan, and the fear is, as the old World War II slogan goes, “It can happen here!”

Ben Bernanke is on record stating that prices are not rising fast enough for effective monetary expansion. His solution is to pour more money into the economy. Bernanke is no longer merely a deflation-phobe. He is a not-high-enough-inflation-phobe.

Japan is often pointed to as the quintessential recent example of the disastrous effects of deflation. Paul Krugman has been saying since the 1990s that Japan is caught in a liquidity trap, and the only solution is to manufacture inflationary expectations by creating money in earnest until the Japanese are convinced that prices are going up. Then they will stop holding money and start spending again, which is seen as the fount of economic rejuvenation. It is asserted that Japan’s once vibrant culture has been transformed into one of pessimistic risk aversion, due to a prolonged deflationary spiral following its boom of the 1980s.

But is this really the case? Sound economic theory and history instructs otherwise. Recessions are not the result of deflation but the necessary consequence of capital consumption via malinvestment resulting from artificially low interest rates. In both Japan in the 1980s and the United States in the 2000s, entrepreneurs were led astray by central bank credit expansion. This led them to undertake too much investment at capital-intensive stages of production and not enough investment at stages closer to consumption. Investors began a plethora of investment projects that were simply unsustainable. These projects must be liquidated if we do not want to make the situation even worse by continuing to consume even more capital. Recession is the beginning of the necessary restructuring of capital toward its most highly valued uses.

The misery that people continue to experience in Japan is the direct result of Japan’s failure to allow wasteful, losing enterprises to be liquidated. 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.

Additionally, the misery in Japan cannot be due to deflation, because there has not been any. In 1989, the annual consumer price index 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 1991. M1 in Japan almost tripled from 1990 to 2002 and then increased every year after until 2009. The claim that there has been a generation of deflation in Japan is simply wrong.

History also shows that liquidation of unwise investments does not necessarily cause prolonged misery. During the U.S. recession of 1920-21, President Warren Harding cut government spending, cut taxes, and reduced the national debt. The Fed did the unthinkable: It made no effort to reflate to forestall deflation. What happened was not (contrary to some interpretations) a short deflationary ride to the Great Depression; instead, unemployment quickly decreased to 2.4 percent in 1923. The government allowed unsound investments to be liquidated while the necessary capital restructuring commenced.

It is time to put the Japanese “deflationary depression” canard to rest. The true lesson to be learned is that after an inflationary boom turns into the inevitable bust, trying to fix the mess by fiscal stimulus, monetary inflation, and bank bailouts is a fool’s game. We should instead reduce the scope of government in the economy by cutting spending, lowering taxes, reducing regulation, and stop propping up profligate banks. Only this prescription will allow the necessary capital restructuring to take place and thereby place our economy on proper footing, setting the stage for future prosperity.