Sun, Aug 05, 2001 - Page 9 News List

Faulty theories block economicgrowth in Japan

Movement toward improving Japan's economic performance is being held up by lack of action in investigating the misuse of investment funds in the past

By Christopher Lingle

For many, the inability of Japan's economy to recover remains a mystery. This inability to assess the situation arises from misjudgments concerning the nature of the malaise and can be traced to the application of faulty economic theory.

Besides the human suffering, one of the worst effects of Japanese economic stagnation is that it helped revive the discredited and forgotten concept of a "liquidity trap" that supposedly occurs when interest rates are very low. The English economist John Maynard Keynes envisioned this phenomenon in order to understand the Great Depression. However, Japan's economic misery is due neither to excessive savings nor to a liquidity trap as suggested by professor Paul Krugman, among others.

The fallacies of liquidity trap are blurred by some of the claims that seem otherwise to be logically intact. For example, the sort of low interest rates associated with Japan's "zero-interest policy" are thought to lead to expectations that interest rates can only rise. Since higher interest rates cause bond prices to fall, households and businesses will avoid capital losses that would occur from purchasing bonds by holding cash balances instead. Consequently, attempts to stimulate the economy by lowering interest rates will be ineffective. Keynes proposed that this situation could be remedied by boosting aggregate spending through inflating the money supply or more government spending through expanded public-sector budget deficits or both.

Part of the problem with this analysis resides in some underlying assumptions. There is no distinction between hoarded cash balances and savings, a difference that non-economists understand clearly, even if most supporters of Keynesian theory do not. But a more important logical inconsistency occurs by suggesting that the liquidity trap operates on the basis of preference for liquidity is largely determined by the uncertainty of bond prices and changing interest rates.

Such a relationship is inconsistent with Keynes' own theory of interest. Elsewhere, Keynes declares interest rates to be determined by liquidity preference and the supply of money. Depicting interest as both a cause and effect does not seem to bother acolytes of the liquidity trap model. (A more consistent assessment is that the demand for cash balances is determined by general uncertainty in the market instead of insecurity over bond prices.)

Another flaw in the conceptualization of a liquidity trap is that the increased demand for cash is a result and not a cause of Japan's deflation. A sudden and unwarranted increase in the demand for cash balances is without precedent. As suggested above, an increase in uncertainty about the future induces people to hold more money. Indeed, these cash balances are a productive economic activity because hoarding cash yields higher returns than are expected from spending.

If Japan is not stuck in a liquidity trap, then the remedies drawn from that conclusion are also wrong. Remember that Japan's bubble economy arose from cheap credit that caused distortions in the utilization of capital and led to misguided investments.

As seen in Japan, monetary policy that forces the rate of interest to deviate from a natural rate generated by the supply and demand for savings will cause the normal and unavoidable cycles in an economy to become booms and busts. When interest rates are lowered artificially, projects will be undertaken that cannot be completed successfully or profitably. As competition for producer goods drives up their prices and earnings fail to cover unanticipated rising costs, profits become squeezed or dry up altogether.

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