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Faulty theories block economicgrowth in Japan

By Christopher Lingle

Sunday, Aug 05, 2001, Page 9

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.

Just as the liquidity trap is not the problem, it is not the case that the Japanese are savings too large. Japan's suffers from distortions in other sectors of the economy caused by delays in liquidating unprofitable projects made during the bubble years. Loose credit led to the boom in asset prices during the 1980s whereby capital was misdirected into production schemes that were either unprofitable or untenable. Although the bubble burst, the projects were not readily liquidated. With funds locked in unsound investments, the economy began to stagnate.

Thus, Japan's ongoing economic hardships reflect inaction in resolving past decisions on the misuse of investment funds. The Japanese government connived with domestic banks and industrial conglomerates to block the adjustment process. Many keiretsu -- a group of closely associated Japanese business companies linked especially by cross-shareholding -- had extensive crossholding with banks and they collectively opposed liquidations. By paralyzing the necessary adjustments, capital and other resources were frozen in unprofitable activities and not available to use in other, more profitable activities.

Consequently, business investment remains weak and household spending in Japan continues to be low. This is not surprising, but a fictional liquidity trap does not cause it.

Businesses and investors worry about future profit margins. Since current policies lead to expectations that profit margins will be low or nonexistent, there will be little incentive to reallocate captive production capacity. Both households and businesses will hold relatively large cash balances due to insecurity about the future of profits and incomes.

Failed attempts to stimulate consumption through public-sector deficit spending show it was clearly not the right path. This is because public spending cannot cause capital that remains captive in unsound applications to be released.

Those who interpret Japan's plight as an economy caught in a liquidity trap believe that a burst of high inflation is necessary to spark a recovery are wrong for the wrong reasons. Adjustments to business cycles occur through the elimination of misguided investments that were provoked by inappropriate credit policies. Not only are employees reluctant to be entrenched, capital investors seem to cling to the fiction that their mistakes will be covered up by a recovery to the unsustainable levels that induced them to commit their funds in the first place.

Instead of protecting the distorted pattern of investments, banks should have been allowed to fail while forcing foreclosure on unsound investments. Domestic investment activity became and remains depressed because resources remain trapped in unprofitable applications so that savings continue to be misused while profit margins decline or disappear.

Japan's business and political leaders should set the conditions for readjustments where unsound investments are liquidated and labor released to be directed toward more economically sound activities. Rapid adjustments would have ended the economic distress more quickly but were blocked by an abject failure of corporate and political governance. Unfortunately, faulty economic analysis remains a co-conspirator in Japan's continuing economic woes.

Christopher Lingle is Global Strategist for eConoLytics.com.
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