High savings by Japanese households of between 15 to 20 percent of their income is often blamed for the ongoing economic slump. In order to remedy the situation, much of the policy discussion is being directed towards increasing demand.
It would seem that the errors in this approach would be obvious after the vain efforts to boost the economy with a decade of large public-sector deficits. Just as in the case of the failure of deficit spending, more consumption by household will not halt recessionary pressures. Economies depend upon total spending, of which consumer spending is but a part. And it is less significant than the calculations of GDP indicate.
Japan's economy is not suffering from a deficiency in demand that can be eliminated by increased government spending or printing money. The problems are with supply.
There was a time when most economists understood this, but few of them get the analysis right these days. So it is not surprising that this confusion is passed on to their students who become citizens, journalist, analysts, politicians or bureaucrats. It is because conventional economic wisdom is wrong that matters have become worse.
The simple truth that is being forgotten is that economic growth requires an abstinence from consumption. Spending on capital goods means that resources are diverted away from consumption and vice versa.
When savings are funneled toward the purchase or creation of capital goods, it puts as much money into circulation and generates as much employment as if there were more consumption. But there is a big difference in the impact on the economy.
For there to be growth, there must be capital accumulation generated by a pool of savings (non-consumption). It turns out that household consumption is the result rather than the cause of economic growth. As investment increases, improvements in production allow real wages and future consumption to rise.
Stable growth requires a delicate balance between savings (as the basis of investment) and consumption. When the balance is maintained, living standards will continue to rise. When the balance is upset, it triggers responses that lead to business cycles. Usually, it is monetary policy that artificially changes credit conditions that causes imbalances. When monetary policy causes consumption to increase, a profit squeeze occurs in the higher stages of production and manufacturing will contracts. Loose monetary policy and deficit spending by Tokyo sent out false signals that created distortions and caused the destruction of savings and wealth. The enormous amount of savings has largely been dissipated by poor choices for investment.
In turn, households feel the need to save ever more to make up for the losses. In this case, high savings are the result of the contraction more than the cause of it. Lowering interest rates to zero continues this cycle of the destruction of real savings.
All the policy decisions to keep interest rates low and pump money into the system divert funds away from wealth-generating activities to make it available for consumers. Unfortunately, this continues to sap the potential for economic growth in Japan.
Lower interest rates allow the demand for consumption goods to increase and to be more satisfied more immediately. As financial resources are diverted from more lengthy, complex production processes, returns on these activities become less profitable. Raising the demand for consumption goods relative to producer goods increases the relative price of non-specific manufacturing inputs. As inputs are bid away for use in lower stages of production that are closer to the point of consumption, costs to manufacturers will rise and cause a profit squeeze that leads to a contraction in spending.
It does not end there. The non-specific inputs that are attracted away from more complex production at higher ends of the production process, more specific inputs that have but one function will be in excess supply and become idle. This excess capacity causes productivity to fall.
Although employment in manufacturing will fall, it is offset by increased demand for labor in the lower stages of production so that the overall level of employment remains stable. Eventually rising labor costs signal the end of the boom. Sound familiar?
When the conventional tools of monetary or fiscal policies are implemented to forestall the end of the boom, it shifts economic activity towards consumption at the expense of production. When savings diminishes, the structure of production begins to contract.
New money created by the central bank involves an exchange of nothing for money and then money for something. This exchange of nothing for something involves an act of consumption spending that is not supported by new production.
Such an increase in consumption without new production must involve a diversion of funds from wealth-generating activities. This is equivalent to a destruction of savings that eventually causes the production flow to contract.
Instead of running more public-sector deficits and loosening monetary policy, there should be a radical overhaul of taxes. At the same time, reducing the involvement of the government will allow markets to send signals to private enterprises so they can direct savings towards wealth-generating activities.
Perhaps the most important change in taxes would be to allow entrepreneurs and investors to keep more of their capital gains. Capital gains are real economic profits that can be invested to provide another round of economic growth and raise living standards.
When capital gains taxes are levied against the sale of assets, they reduce savings and also lead to a misallocation of scarce resources. This is because a tax on realized capital gains operates as both a transaction taxes and as a tax on investment. This encourages tax avoidance behavior to reduce the number and frequency of transactions and encourage savings to be shifted toward consumption activities.
Another distortion related to capital gains tax is that it can discourage the shift of funds toward more productive investment opportunities. By imposing such a tax, it discourages investors from making their funds available to what may prove to be new and better technologies. This benefits established enterprises while it disadvantages more innovative companies who may it harder to find sufficient venture capital.
Too much time has been wasted due to bad economic theorizing. Japan's leadership would be well advised to ignore conventional economic wisdom that brought about the current malaise and prolonged it.
Christopher Lingle is Global Strategist for eConoLytics.com.
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