Can More Yen Save Japan?

September 30, 2002

In the latest move to revive Japan's financial system, the governor of the Bank of Japan (BOJ) announced that the central bank would buy stocks directly from lending institutions in order to help them reduce the impact of falling share prices. According to the plan, the BOJ will hold the purchased stocks for at least 10 years.

The persistent fall in stock prices has severely eroded banks' capital accounts. (In Japan, banks' holdings of equities could be counted as capital.) Every time stocks plunge, banks are subject to valuation losses that are deducted from their capital accounts. Many analysts have expressed concern that if stocks were to fall further, some large banks may experience sharp declines in capital. This, in turn, may precipitate bank runs and failures. By helping the banks, the BOJ authorities are hoping that bank capital-to-assets ratios will be lifted, kick-starting bank lending and thereby providing a boost to consumer spending and reviving the economy.

Many experts treat the purchasing of stocks by the BOJ with skepticism. It is held that the BOJ purchase of equities would stifle the pricing process of this class of assets. Also, experts point out that the BOJ's recent program of government bond purchasing by means of monetary base expansion while lifting liquidity in the financial system had no effect on the real economy.

According to many high-profile economists and financial experts, the failure of the BOJ's aggressive lowering of interest rates and monetary pumping to revive the economy points to the possibility of a "liquidity trap." The only way out of this predicament, so the experts say, is by means of much more aggressive monetary pumping.

A consensus is starting to emerge that the most effective monetary solution to Japan's problems would be for the central bank to finance private-sector debt repayment. If the BOJ, it is suggested, repaid 30 percent of all household and corporate debts outstanding, financed by monetary base expansion, there would be a recovery in domestic demand. Alternatively, the experts argue, the BOJ could simply post a check for the yen equivalent of $10,000 to every household. If this has little impact, they could send another one.[1]

What is a liquidity trap?

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Thus, spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual's earnings. Recessions, according to Keynes, are a response to the fact that consumers--for some psychological reasons--have decided to cut down on their expenditure and raise their savings.

If for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts on his spending. Consequently, a vicious circle sets in: the decline in people's confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further. This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. Consequently, people's demand for money will become very high, implying that people would hoard money and refuse to spend it, no matter how much the central bank tries to expand the money supply.

Keynes wrote,

"There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest."[2]

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects--what matters here is that a lot of money must be pumped, which is expected to boost consumers' confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby reestablishing the circular flow of money.

Contrary to the Keynesian framework, saving doesn't shrink, but rather expands, economic activity. According to Mises,

"The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well being and toward every further progress on this way."[3]

When a baker produces 10 loaves of bread and consumes one loaf, his saving is nine loaves of bread. Once he exchanges his bread for shoes or shirts, he enhances his well-being and also enhances the well-being of the shoemaker and the shirt producer. In short, his saved bread sustains the shoemaker and the shirt producer, enabling them to continue in their production of shoes and shirts.

Furthermore, by exchanging his bread for various parts that improve his oven, the baker's productivity increases and his production of bread follows suit. This, in turn, enables the baker to save more and acquire a greater variety of goods and services.

Moreover, the real saving of one producer that is sold to another producer buys time for another producer. By buying the baker's saved bread, the shoemaker is buying time. Instead of producing the bread, he has bought ready-for-consumption bread that sustains him and thus enables him to proceed immediately in the production of shoes. Likewise, the unconsumed production of any other producers that is sold buys time for the buying producers.

On this Rothbard wrote,

"Crusoe without the axe is two hundred fifty hours away from his desired house; Crusoe with the axe is only two hundred hours away. If the logs of wood had been poled up ready-made on his arrival, he would be that much closer to his objective; and if the house were there to begin with, he would achieve his desire immediately. He would be further advanced toward his goal without the necessity of further restriction of consumption."[4]

Also, individuals don't save money as such; they save real goods. The chief role of money is that of the medium of exchange: it helps to facilitate the flow of saved real goods among trading producers. Consequently, to suggest that people could have an unlimited demand for money would imply that no one would be exchanging goods. Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being.

The fact that an economy doesn't respond to a low-interest-rate policy has nothing to do with peoples' sudden unwillingness to spend money and the mythical "liquidity trap." The lack of response is due to the shrinking pool of real funding. The shrinking pool exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.

What is the pool of real funding?

The driving force of economic activity is not consumers' demand as such, but the production of real goods and services. It is through the production of goods and services that producers exercise their demand for the products of other producers. In a free-market economy, there is no such thing as an independent entity called the consumer. One must produce something useful before one can exercise his demand for goods and services. The production of every producer is his means of payments, or his means of funding. In short, the produce of one producer is exchanged for the produce of another producer.

When a baker produces bread, he doesn't produce everything for his own personal consumption. Part of the produced bread he exchanges for other goods that he requires to sustain his life and well-being. Note that the baker exercises his demand for goods and services by means of his produced bread. Likewise, a potato farmer exercises his demand by means of the production of potatoes. And so other producers too also exercise their demand by means of the goods and services they have produced.

While producers exchange among themselves the various products they have produced it is, however, final goods that are ready for human consumption that dominate the scene. To undertake the production of various tools and machinery there must be a sufficient stock of final goods to sustain the life and well being of all the individuals that are engaged in the production of those tools and machinery. The stock of the final goods constitutes the pool of real funding.[5]

The size of this pool is determined by past savings and the present flow of the production of final goods. The size of the pool sets the limit on the type of projects that can be undertaken at any point in time. If the size of the pool is only sufficient to support 100 days of work, then a project that requires 200 working days cannot be undertaken. It is the state of the pool of real funding that is the key to any economic growth. The faster the growth of the pool, the faster the economy can grow.

As long as a particular piece of equipment or machine is in the process of being built, it adds nothing to peoples' well-being. On the contrary, it drains the pool of real funding for the duration of its production. Only once the making of the equipment or the machine is accomplished and once it is employed in the production of final goods can that equipment and machine make a contribution to peoples' well-being.

In other words, while the machine is being built, a part of the pool of consumer goods is tied up in supporting the well-being of the workers that are engaged in the building of the machine. The "release" of these goods tied up in supporting the production process, so to speak, occurs only once the built tools and machinery are employed in the production of final consumer goods.

There are, of course, difficulties in saving various perishable goods, so this is where money steps in and solves the problem of storing perishables. Instead of storing his bread, the baker can now exchange his bread for money. In other words, his unconsumed production is now "stored," so to speak, in the form of money. Note that money here fulfills the role of the medium of savings. Observe also that the money is fully backed up by the goods that the producer has produced. There is, however, one proviso in all of this: that the flow of the production of goods and services continues unabated. This means that whenever a holder of money decides to exchange some money for goods, these goods are there for him. So whenever a producer who has exchanged his production for money decides to exchange his money for the goods that he requires he can always do so.

Problems emerge, however, whenever the central bank embarks on loose monetary policy and creates money out of 'thin air'. Since this type of money was never earned, it is therefore not 'backed up," so to speak, by goods and services. When such money is exchanged for goods and services, it in fact results in consumption that is not supported by production. Consequently, a holder of "honest" money that wants to exercise his claim over goods discovers that he cannot get back all the goods he previously produced and exchanged for money. In short, he discovers that the purchasing power of his money has fallen.

Money that is created out of "thin air" always sets in motion consumption that is not supported by production. That is, money out of "thin air" always undermines the pool of real funding. Likewise, various government projects drain the pool of funding, since the quantity of real goods that are tied up in these projects tends to far exceed the quantity of goods and services released once these projects are accomplished.

As long as the rate of growth of the pool of real funding stays positive, this can continue to sustain genuine wealth producers, the holders of newly created out-of-thin-air money and various government projects.

Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. The excessive consumption relative to the production of consumer goods leads to a decline in the pool of real funding. This in turn provides weakening support for economic activities, resulting in the economy plunging into a severe economic slump. Needless to say that once the economy plunges into a recession on account of a decline in the pool of real funding any government or central bank attempts to revive the economy must fail. Not only will these attempts not revive the economy, but they will deplete the pool of real funding further thereby prolonging the economic slump.

Strong possibility that Japan's pool of real funding is declining

What is currently observed in Japan is symptomatic of a declining pool of real funding and has nothing to do with the mythical liquidity trap. For years, the Japanese economy has been subjected to tight government controls of businesses via the ministry of trade and industry (MITI). The deliberate emphasis on exports means that Japan has been shipping its final goods overseas in return for American T-Bonds and dollars. To put it bluntly, for years the Japanese have been depriving themselves of real funding in return for American government promises to repay the debt. The relentless government interference is presently manifest in massive government debt. In Q2, the debt-to-GDP ratio jumped to 1.25 from 1.20 in the previous quarter (see chart). Note that this ratio has been on an accelerating trajectory since 1992 --indicative of an aggressive government fiscal policy to revive the economy.

The explosive ratio also indicates that various government projects to lift the economy have been a large destroyer of the pool of real funding. For if it had been otherwise, i.e., if the projects would had been generating real wealth, then the government wouldn't have required so much borrowing.

In addition to this, the central bank has been engaged for years in reckless monetary policy that weakened further the pool of real funding. The aggressive nature of the monetary pumping by the BOJ is depicted by the money base-to-trend ratio. After reaching 1.0 by March 1987, the ratio climbed to 1.83 by April of this year (see chart). In short, the money base stood 83 percent above its historical average in April this year.

This aggressive monetary pumping has been accompanied by a massive lowering of interest rates. From 6 percent in June 1991 the discount rate was lowered to 0.1 percent (see chart). Needless to say, this lowering has severely stifled the structure of production.

It seems to us that the present production structure is so distorted that it is almost like a "black hole" that only sucks in the real funding with little hope of its release.

But what about the fact that the Japanese are great savers? Why is this not helping the economy? One needs to distinguish between the saving of money and real saving. When a person places his money with a post office savings bank (the traditional outlet for Japanese savers), he transfers his claims over real savings to the post office. Now, when the post office buys government bonds with this money, it transfers the claim over real savings to the government. In short, real savings, rather than being employed in generating wealth, will now be consumed. This is what has been going on in Japan for years. (A product of tight government control of businesses that amounts to prescribing to financial institutions the type of assets they can invest in.)

Moreover, it is important to emphasize here that some of the money that is saved, i.e., stored, in the postal savings accounts has also been created out of "thin air," implying that this money doesn't represent any real savings. Again it must be reiterated that only real-wealth generators can save,and neither government activities nor the outcome of loose monetary policy falls under the category of real-wealth generation.

Against this background, the latest proposal to revive the economy through massive monetary pumping can only make things much worse. All that is now needed in order to save the economy from further collapse is a cessation of monetary pumping and cutting government involvement with the economy back to the bone. The removal of the government from the economy will put an end to the endless support for various activities which sprang up on the back of loose fiscal and monetary policies and thereby will allow sound, wealth-producing structures of production to emerge.

Summary and conclusion

Most experts are of the view that the latest Bank of Japan plan to revive the financial system by direct purchases of stock held by lending financial institutions can only further stifle an already severely battered financial system. According to most experts, what Japan is currently experiencing is a classical "liquidity trap." The only way out of this trap, it is argued, is through extremely aggressive monetary pumping by the BOJ that would lift consumers spending and revive the economy.

We find this way of thinking extraordinary, considering the fact that the BOJ has been pursuing an aggressive monetary policy for many years. Moreover, during the past year and a half, the BOJ has intensified its monetary injections, and yet the economy has continued to stagnate. The main reason for this stagnation is not the mythical "liquidity trap," but the collapse of the pool of real funding as a result of aggressive monetary and fiscal policies. All that is now required to revive the economy is not more of the same, which weakens the economy further, but a drastic reduction of the government and central bank involvement with the economy.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

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