WEBVTT NOTE The Immutable Laws of the Business Cycle 1 00:00:00.000 --> 00:00:07.420 I don't have any jokes, in fact Bert stole those two jokes from me, but I will be dealing 2 00:00:07.420 --> 00:00:17.120 with some of the prescriptions for resolving the Japanese crisis from standard macroeconomists 3 00:00:17.120 --> 00:00:23.960 and these are jokes in themselves as you'll see. 4 00:00:23.960 --> 00:00:29.960 In 1949, just as Keynesian doctrines were achieving complete dominance in academic economics, 5 00:00:29.960 --> 00:00:33.960 Ludwig von Mises made a bold and startling declaration. 6 00:00:33.960 --> 00:00:40.960 He said that almost all economists now admitted the essential correctness of the Austrian theory of the business cycle. 7 00:00:40.960 --> 00:00:44.960 Even those economists opposed to the theory, according to Mises, 8 00:00:44.960 --> 00:00:51.960 quote, must admit and do admit that the upswing is invariably conditioned by credit expansion, 9 00:00:51.960 --> 00:01:00.960 that it could not come into being and continue without credit expansion and that it turns into depression when the further progress of credit expansion stops. 10 00:01:00.960 --> 00:01:10.960 As proof of his assertion, Mises pointed out that regardless of what specific factors these economists formally identify as the initiating cause of the boom, 11 00:01:10.960 --> 00:01:16.960 they all consider credit expansion as an indispensable requisite of the general boom. 12 00:01:16.960 --> 00:01:35.960 Now when I first read Mises' statement, I was a little dubious. Was it really true that in the heyday of radical Keynesianism, which explicitly downgraded the role of money in business cycles, most economists attributed the origination of the inflationary boom to credit expansion. 13 00:01:35.960 --> 00:01:40.960 But after reading some of the literature from the period, I discovered that Mises was indeed correct. 14 00:01:40.960 --> 00:01:48.360 In a book published in 1949, Alvin H. Hansen, the father of American Keynesianism, spent 15 00:01:48.360 --> 00:01:53.440 a chapter vehemently denying that the supply of money has any necessary causal role to 16 00:01:53.440 --> 00:02:00.320 play in precipitating booms. In a later chapter, Hansen, nonetheless, was forced to concede 17 00:02:00.320 --> 00:02:05.520 that, quote, any increase in the national income is likely to encounter restraining 18 00:02:05.520 --> 00:02:31.040 Mises points further, arguing that most economists of the early Keynesian era were profoundly 19 00:02:31.040 --> 00:02:37.320 Inconsistent, for while they grudgingly admitted the crucial role of bank credit in fueling 20 00:02:37.320 --> 00:02:42.640 the inflationary boom, at the same time, they bitterly disparaged proposals to suppress 21 00:02:42.640 --> 00:02:46.880 credit expansion as a recipe for perpetual depression. 22 00:02:46.880 --> 00:02:51.080 Once again, we find support for Mises' view in the writings of the extreme Keynesian, 23 00:02:51.080 --> 00:02:52.080 Alvin Hansen. 24 00:02:52.080 --> 00:02:58.600 And he says, indeed, the monetary weapon to curtail overall excess of effective demand 25 00:02:58.600 --> 00:03:04.200 has a peculiar characteristic that it is scarcely at all effective unless the brakes are applied 26 00:03:04.200 --> 00:03:09.400 so vigorously as to precipitate a collapse. It would be an easy matter to prevent a man 27 00:03:09.400 --> 00:03:15.540 from becoming excessively corpulent by strangling him to death. A sufficiently sharp curtailment 28 00:03:15.540 --> 00:03:21.600 of the money supply could indeed quickly end inflation. No one denies this. Yes, you were 29 00:03:21.600 --> 00:03:26.720 denying it a few chapters earlier. But a program to stop an inflationary development merely 30 00:03:26.720 --> 00:03:31.880 Supposedly by reducing the quantity of money is a dangerous device. Moderately used, it 31 00:03:31.880 --> 00:03:38.160 courts the failure of ineffectiveness. Pushed to the needed fanatical extreme, it courts 32 00:03:38.160 --> 00:03:45.160 disaster." So despite their reluctance, Hansen and the Keynesians in 1949 in effect recognized 33 00:03:46.880 --> 00:03:50.680 the immutable law of the business cycle as formulated by the Austrian theory of the business 34 00:03:50.680 --> 00:03:53.680 with one important reservation. 35 00:03:53.680 --> 00:03:59.680 Whereas Mises and other Austrian theorists always insisted that a policy of bank credit expansion 36 00:03:59.680 --> 00:04:05.680 once embarked upon could only end in either depression or hyperinflation, 37 00:04:05.680 --> 00:04:12.680 Keynesians and other opponents of the Austrian theory stubbornly and inconsistently clung to the belief 38 00:04:12.680 --> 00:04:16.680 that credit expansion, which was run by the central bank, 39 00:04:16.680 --> 00:04:21.880 Bank could extend the boom indefinitely and permanently postpone the 40 00:04:21.880 --> 00:04:28.720 depressionary day of reckoning. Today, the grip of rigid Keynesian orthodoxy on 41 00:04:28.720 --> 00:04:33.640 macroeconomics is happily long gone and economists are now openly and freely 42 00:04:33.640 --> 00:04:37.880 willing to grant money a central role in generating the inflationary boom. 43 00:04:37.880 --> 00:04:43.320 Nonetheless, most contemporary macroeconomists still believe that the 44 00:04:43.320 --> 00:04:49.200 The boom can be perpetuated by credit expansion, judiciously applied, of course, by a responsible 45 00:04:49.200 --> 00:04:56.000 central bank. Thus, monetarists, new Keynesians, new classicals, and supply-side economists 46 00:04:56.000 --> 00:05:01.640 and journalists all proclaim that stable growth of the real economy requires a positive rate 47 00:05:01.640 --> 00:05:07.160 of credit expansion, although they may disagree on the precise dose and the institutional 48 00:05:07.160 --> 00:05:11.400 conditions under which it is to be administered. 49 00:05:11.400 --> 00:05:16.040 Now the universal and immutable law of the business cycle states that the creation of 50 00:05:16.040 --> 00:05:21.920 unbacked bank deposits out of thin air by the banking system artificially lowers the 51 00:05:21.920 --> 00:05:27.300 available structure of interest rates below the level that would be determined exclusively 52 00:05:27.300 --> 00:05:30.800 by the available fund of voluntary savings. 53 00:05:30.800 --> 00:05:34.600 And this stimulates an unsustainable investment boom. 54 00:05:34.600 --> 00:05:41.360 The bitter but inescapable fruit of this inflationary boom is a misallocation of scarce resources 55 00:05:41.360 --> 00:05:53.360 which results in a financial crisis and an ensuing depression, which occurs when the credit inflation is finally brought to a halt and interest rates rise back to their natural level. 56 00:05:53.360 --> 00:06:03.360 It is during the depression that the capital malinvestments of the boom are revealed and purged and the economy is returned to health. 57 00:06:03.360 --> 00:06:18.360 Now what unites almost all contemporary macroeconomists, economic policy makers and financial journalists is their absolute, and the word that Murray Rothbard loves to use, per-blind rejection, complete blindness of the latter part of the law. 58 00:06:18.360 --> 00:06:24.280 To these groups, the proper aim of monetary policy is and should be to keep new money 59 00:06:24.280 --> 00:06:30.040 flowing through credit markets at a rate that is sufficient to maintain low interest rates 60 00:06:30.040 --> 00:06:36.000 and to keep stoking the boom while avoiding or minimizing price inflation. 61 00:06:36.000 --> 00:06:40.880 There thus exists today, for all practical purposes, only two schools of business cycle 62 00:06:40.880 --> 00:06:44.680 theorists, the same two schools that existed in 1949. 63 00:06:44.680 --> 00:06:50.480 The inflationist school comprises almost the complete range of modern macroeconomic schools, 64 00:06:50.480 --> 00:06:55.680 whose members believe that cheap money and a permanent boom is the royal road to economic 65 00:06:55.680 --> 00:07:02.280 growth and prosperity, and that the alternative to this is a grinding recession as exemplified 66 00:07:02.280 --> 00:07:04.480 by the current Japanese economy. 67 00:07:04.480 --> 00:07:10.120 The Misesian or sound money school, in contrast, maintains that the boom represents an inefficient 68 00:07:10.120 --> 00:07:16.400 and distortion of free market growth processes, which sooner or later must culminate in depression, 69 00:07:16.400 --> 00:07:21.640 if it is not to hive off into hyperinflationary breakdown. I must emphasize here that I am 70 00:07:21.640 --> 00:07:26.520 not using the term inflationist lightly or polemically when I apply it to all schools 71 00:07:26.520 --> 00:07:32.600 of macroeconomics. Mises has precisely defined inflationism as comprising three fallacious 72 00:07:32.600 --> 00:07:38.320 propositions. First, capital accumulation and the resulting rise in labor productivity 73 00:07:38.320 --> 00:07:48.320 and Living Standards, what we today call economic growth, require a progressive fall in the purchasing power of money, or at least a stabilizing of the price level. 74 00:07:48.320 --> 00:07:55.320 In other words, deflation is the enemy of economic growth and must be avoided at all costs. 75 00:07:55.320 --> 00:08:03.320 Second, continual bank credit expansion is a necessary means for fighting the ever-impending and ruinous deflation. 76 00:08:03.320 --> 00:08:08.720 And third, as a necessary corollary of the first two propositions, it is possible to 77 00:08:08.720 --> 00:08:14.000 permanently lower the rate of interest by credit expansion. 78 00:08:14.000 --> 00:08:19.780 That many contemporary macroeconomists do indeed subscribe to these three propositions 79 00:08:19.780 --> 00:08:24.880 is clearly evident in the proposals for resolving the Asian crisis that have been advanced by 80 00:08:24.880 --> 00:08:28.480 some of the more prominent among them in the last few years. 81 00:08:28.480 --> 00:08:30.600 Let me begin with Milton Friedman. 82 00:08:30.600 --> 00:08:35.280 In an article published in the Wall Street Journal at the end of 1997, Friedman wrote 83 00:08:35.280 --> 00:08:40.480 that quote, the surest road to healthy economic recovery is to increase the rate of monetary 84 00:08:40.480 --> 00:08:46.360 growth, to shift from tight money to easier money, to a rate of monetary growth closer 85 00:08:46.360 --> 00:08:51.680 to that which prevailed in the golden eighties, but without again overdoing it, unquote. 86 00:08:51.680 --> 00:08:58.400 Now Friedman's reference to the golden eighties is to the period from mid-1982 to mid-1987 87 00:08:58.400 --> 00:09:04.640 and the Bank of Japan was inflating the Japanese money supply at the rate of over 8% per year. 88 00:09:04.640 --> 00:09:09.880 According to Friedman, this was a golden era because output was growing at a healthy clip 89 00:09:09.880 --> 00:09:16.880 of over 3% a year, while the price level rose at only a very modest 1.5% per year. Friedman 90 00:09:16.880 --> 00:09:21.960 proceeds to criticize the acceleration of monetary inflation to an annual rate of over 91 00:09:21.960 --> 00:09:38.960 Friedman says that the rate of monetary growth beginning in 1990 was too sudden and too sharp, 92 00:09:38.960 --> 00:09:45.320 as he says, too much of a good thing, and was responsible for precipitating the grinding 93 00:09:45.320 --> 00:09:51.600 Japanese recession of the 1990s. Furthermore, this recession has been prolonged by the relatively 94 00:09:51.600 --> 00:09:58.600 Friedman's proposed solution, therefore, is simply to ratchet the rate of monetary inflation back up to the magic number of 8 percent, but despite the moderate price inflation he admits would result from a relatively low rate of monetary growth. 95 00:10:21.600 --> 00:10:23.920 Friedman concludes that, quote, 96 00:10:23.920 --> 00:10:29.960 a return to the conditions of the late eighties would rejuvenate Japan and help sure up the rest of Asia, unquote. 97 00:10:29.960 --> 00:10:37.680 Clearly then, Friedman's proposal for the recovery of the Japanese economy rests on the principles of inflationism, as Mises has outlined them. 98 00:10:37.680 --> 00:10:42.080 Friedman blithely assumes that credit expansion, at just the proper rate, 99 00:10:42.080 --> 00:10:45.600 will ensure a golden era of perpetual prosperity. 100 00:10:45.600 --> 00:10:49.120 For Friedman, it is not even outright monetary deflation, 101 00:10:49.120 --> 00:10:54.320 but merely a low rate of credit expansion, which constitutes what he calls inept monetary 102 00:10:54.320 --> 00:11:02.440 policy and which is responsible for the intractable recession that afflicts Japan. 103 00:11:02.440 --> 00:11:07.000 But no matter how protracted and deeply entrenched in the real economy this recession appears 104 00:11:07.000 --> 00:11:11.960 to be, it can be magically made to disappear by a monetary sleight of hand. 105 00:11:11.960 --> 00:11:16.880 If not immediately, then after a year or so in Friedman's estimation. 106 00:11:16.880 --> 00:11:22.600 So once the money supply is ratcheted back up to this golden era rate, it will take maybe 107 00:11:22.600 --> 00:11:27.360 a year and the depression will magically disappear. 108 00:11:27.360 --> 00:11:33.100 Finally, Friedman correctly points out that as credit expansion increases, nominal interest 109 00:11:33.100 --> 00:11:34.800 rates will increase. 110 00:11:34.800 --> 00:11:41.080 But he utterly fails to recognize that as the inflation process unfolds, interest rates 111 00:11:41.080 --> 00:11:45.620 will continuously lag behind the rates that reflect the availability of voluntary savings 112 00:11:45.620 --> 00:11:50.060 in the Economy, and that this will interrupt the recovery and sow the seeds of another 113 00:11:50.060 --> 00:11:54.980 unsustainable investment boom. Friedman indeed assumes then that the interest rate can be 114 00:11:54.980 --> 00:12:01.740 indefinitely lowered by credit expansion. So he is an inflationist through and through. 115 00:12:01.740 --> 00:12:08.740 Let me turn to Martin Feldstein, a supply-side oriented economist who believes that a boom 116 00:12:08.740 --> 00:12:29.740 His 1998 diagnosis of the Korean crisis is simply that the high interest rate needed to restore confidence in the won, the Korean currency, and to arrest its depreciation on foreign exchange markets, quote, is killing many companies which would have flourished at the interest rates prevailing a year ago. 117 00:12:29.740 --> 00:12:36.620 Show. Feldstein points to the fact that between October 1997 and June 1998, the interest rate 118 00:12:36.620 --> 00:12:42.980 charged on business loans to the best borrowers in Korea jumped from 12% to 18% and that small 119 00:12:42.980 --> 00:12:49.660 and medium-sized companies in Korea were confronted with finance charges of 30% and higher. But 120 00:12:49.660 --> 00:12:55.740 Feldstein fails to note that in the 12 years prior to 1998, the Korean money supply grew 121 00:12:55.740 --> 00:13:01.700 through at an average annual rate of 18%. As an inflationist, he just doesn't comprehend 122 00:13:01.700 --> 00:13:07.840 that the interest rate formed under the influence of such rapid monetary expansion falsifies 123 00:13:07.840 --> 00:13:14.360 entrepreneurial calculations and induces investments that are inconsistent with the public's saving 124 00:13:14.360 --> 00:13:20.420 consumption preferences. They are also sustainable in the long run, whether monetary inflation 125 00:13:20.420 --> 00:13:24.820 is merely slowed or brought to an abrupt end. 126 00:13:24.820 --> 00:13:28.860 Feldstein's prescription for resolving the Korean crisis conforms to his inflationist 127 00:13:28.860 --> 00:13:33.740 diagnosis, quote, I believe he writes that the Korean government should require the commercial 128 00:13:33.740 --> 00:13:39.900 banks to limit the interest rates charged on existing business loans to rates that firms 129 00:13:39.900 --> 00:13:45.400 paid in the spring of 1997, just arbitrarily lowering interest rates, unquote. 130 00:13:45.400 --> 00:13:49.580 Of course, the wherewithal to make such cheap loans would be generously provided to the 131 00:13:49.580 --> 00:13:55.420 by the Korean Government from the large budget deficits Feldstein encourages it to incur. 132 00:13:55.420 --> 00:14:00.740 And although Feldstein does not specify this part of his proposal, no doubt he would expect 133 00:14:00.740 --> 00:14:05.660 these deficits to be monetized by the Bank of Korea in order to maintain the environment 134 00:14:05.660 --> 00:14:11.780 of low interest rates that he alleges to be so conducive to economic growth. 135 00:14:11.780 --> 00:14:16.980 For Feldstein then, the prevention of a rash of corporate bankruptcies and the return to 136 00:14:16.980 --> 00:14:22.180 to a healthy economy is simply a matter of rekindling the inflationary boom by, quote, 137 00:14:22.180 --> 00:14:27.420 removing the burden of artificially high interest costs and providing a stimulus to domestic 138 00:14:27.420 --> 00:14:34.820 demand, unquote. Note carefully that in this quotation, Feldstein uses the term artificially 139 00:14:34.820 --> 00:14:40.220 high interest rates to indicate the interest rate as it would be determined purely by voluntary 140 00:14:40.220 --> 00:14:45.700 consumption saving choices of the private economy. This bespeaks the mind of today's 141 00:14:45.700 --> 00:14:50.300 is modal macroeconomist, which has not been able to free itself from Keynes's central 142 00:14:50.300 --> 00:14:56.540 inflationist fallacy. This fallacy is that free market interest rates are almost always 143 00:14:56.540 --> 00:15:07.540 too high to permit full employment to be achieved. Now this brings me to Paul Krugman, perhaps 144 00:15:07.540 --> 00:15:13.300 the leading New Keynesian and perhaps the quintessential contemporary inflationist. 145 00:15:13.300 --> 00:15:18.260 In May 1998, Krugman published a now famous or infamous paper in which he argues that 146 00:15:18.260 --> 00:15:23.580 the Japanese short-term real interest rate, despite the fact that it hovers near zero 147 00:15:23.580 --> 00:15:30.680 now, is still too high to ensure full employment. So even at zero, it's too high. It needs to 148 00:15:30.680 --> 00:15:37.740 be negative in order to equate the abundance of Japanese savings with investment. But since 149 00:15:37.740 --> 00:15:41.500 the nominal interest rate can never be negative, you'd be crazy to loan at a negative interest 150 00:15:41.500 --> 00:16:11.500 Japan therefore needs expected inflation. Hence asserts Krugman, quote, the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy. That is, convince the private sector that it is the right thing to do. 151 00:16:11.500 --> 00:16:18.540 Sector, that it will not reverse its current monetary expansion when prices begin to rise." 152 00:16:18.540 --> 00:16:24.960 As recently as two weeks ago, Krugman declared that Japan needs inflation of 4% to reactivate 153 00:16:24.960 --> 00:16:30.060 demand because the government there had to change people's economic expectations, which 154 00:16:30.060 --> 00:16:33.120 are now based on deflation and zero interest rates. 155 00:16:33.120 --> 00:16:37.100 Now lest you think your ears are deceiving you, Krugman is not merely advocating that 156 00:16:37.100 --> 00:17:07.100 The Bank of Japan should inflate the money supply, which is an unremarkable position for a modern macroeconomist. He is actually contending that monetary inflation be deliberately carried to such an extent that it shocks the Japanese public into expecting a continuous and permanent decline in the purchasing power of the yen. How Krugman arrives at such an absurd and admittedly irresponsible conclusion reveals much about the shortcomings of modern macroeconomic theorizing. 157 00:17:07.100 --> 00:17:13.940 as quote, an extremely stylized model. Now, when economists refer to extremely stylized 158 00:17:13.940 --> 00:17:20.180 models, hold on to your hats, because it's going to involve gross and wallets, gross 159 00:17:20.180 --> 00:17:25.300 falsification of reality. Krugman himself admits that the purpose of his paper is to 160 00:17:25.300 --> 00:17:33.300 demonstrate possibilities and clarify thinking, not to be realistic. And so Krugman's model 161 00:17:33.300 --> 00:17:37.300 This is based on the following assumptions. One, people are identical and live forever. 162 00:17:37.300 --> 00:17:41.300 That's the first assumption. We're all clones of one another. 163 00:17:41.300 --> 00:17:46.300 Two, people's choices always involve an infinite time horizon. 164 00:17:46.300 --> 00:17:51.300 We always are trying to be aware of what we're going to do 3,000 years from now in order to choose today. 165 00:17:51.300 --> 00:17:55.300 We all live forever. Three, there is only one good in the economy. 166 00:17:55.300 --> 00:18:02.300 Four, this good is not produced but miraculously appears in every household at certain intervals. 167 00:18:02.300 --> 00:18:06.300 Maybe the garbage man brings the good when he picks up the garbage. 168 00:18:06.300 --> 00:18:11.300 Even though everyone periodically is endowed with the quantity of the exact same good, 169 00:18:11.300 --> 00:18:15.300 everyone has the same good that they eat and wear and live in, 170 00:18:15.300 --> 00:18:20.300 he is unable to consume his own endowment of the good, but must trade it for someone else's. 171 00:18:20.300 --> 00:18:24.300 So we all have the same goods, but we can't consume our own endowment. 172 00:18:24.300 --> 00:18:26.300 We have to buy our neighbors. 173 00:18:26.300 --> 00:18:30.300 Six, although there is absolutely no reason to hold cash in this one good economy, 174 00:18:30.300 --> 00:18:40.300 In the economy, everyone does so, because every purchase requires cash in advance. Why? Because every seller needs money. Why? Because every purchase requires cash in advance. 175 00:18:40.300 --> 00:18:49.300 In other words, people hold money because people hold money. Now, if you don't understand this, it doesn't matter, because it's Paul Krugman's highly stylized model and not yours. 176 00:18:49.300 --> 00:18:59.300 7. People always expect the central bank to maintain the same fixed price level in the future, no matter how much money and price inflation it produces in the current period. 177 00:18:59.300 --> 00:19:08.300 This assumption implies that a higher rate of inflation in the short run intensifies the public's anticipation of deflation in the long run, right? 178 00:19:08.300 --> 00:19:19.300 Not right. In Crouben's own words, quote, since the future price level is assumed held fixed, any rise in the current price level creates expected deflation. 179 00:19:19.300 --> 00:19:25.300 Now, Crouben wishes to use this model to demonstrate that the current Japanese economy is mired in a liquidity trap. 180 00:19:25.300 --> 00:19:35.300 That is, a situation in which unemployment of labor and excess industrial capacity co-exists with essentially a zero short-term nominal interest rate. 181 00:19:35.300 --> 00:19:40.300 In order to obtain this result, Krugman makes several additional assumptions. 182 00:19:40.300 --> 00:19:50.300 First, he assumes that the current price level is mysteriously stuck at a predetermined level and will not respond to changes in the supply of or demand for money. 183 00:19:50.300 --> 00:20:03.300 Second, he relaxes the assumption that a quantity of the consumption good miraculously and regularly appears in the economy, and now he permits it to be produced each period by some productive capacity, labor, capital, and land. 184 00:20:03.300 --> 00:20:12.300 Furthermore, Krugman supposes that the amounts of labor, land, and capital goods that compose this productive capacity need not be fully employed. 185 00:20:12.300 --> 00:20:17.300 Finally, and just out of the blue, he assumes that people expect that their future real 186 00:20:17.300 --> 00:20:22.300 incomes will decline below their current levels. In other words, we all expect to get poorer 187 00:20:22.300 --> 00:20:29.300 and poorer in the future. That's another assumption of the model. Now, this model might be a little 188 00:20:29.300 --> 00:20:33.740 bit complicated in the next few minutes, but I will sum it up and show you how absurd it 189 00:20:33.740 --> 00:20:38.820 really is. Within the framework of this model, if people suddenly expect to be poorer in 190 00:20:38.820 --> 00:20:45.780 In the future, the value to them of the consumption good becomes higher in the future than in 191 00:20:45.780 --> 00:20:49.620 the present, because it is more scarce in the future than expected to be. 192 00:20:49.620 --> 00:20:53.220 They thus are induced to save more of their income and spend less on consumption in the 193 00:20:53.220 --> 00:20:55.380 current period. 194 00:20:55.380 --> 00:20:59.380 This brings about a reduction in demand for current output and a tendency for unemployment 195 00:20:59.380 --> 00:21:02.380 to emerge in labor and other resource markets. 196 00:21:02.380 --> 00:21:08.180 However, the economy would be spared depression if the interest rate could adjust downward, 197 00:21:08.180 --> 00:21:13.100 sufficiently to discourage the additional saving, thereby encouraging current consumption 198 00:21:13.100 --> 00:21:17.860 spending to remain at its full employment level. So you need the interest rate to fall 199 00:21:17.860 --> 00:21:22.620 to stop people from saving too much, and this will save the economy from a depression. But 200 00:21:22.620 --> 00:21:26.020 in Krugman's model, remember, the real rate of interest needed to bring this about may 201 00:21:26.020 --> 00:21:32.380 be negative, might be less than zero, while the nominal rate can fall no lower than zero, 202 00:21:32.380 --> 00:21:37.580 thus leaving excess saving and deficient consumption and therefore unemployment. 203 00:21:37.580 --> 00:21:42.780 Nonetheless, even in this case, the depression could still be avoided as long as prices were flexible. 204 00:21:42.780 --> 00:21:50.280 The reason is that the decline of current consumption spending causes a drop of the price level below its expected fixed future level. 205 00:21:50.280 --> 00:21:58.580 But this deflation is both necessary and beneficial because it will immediately stimulate inflationary expectations among market participants 206 00:21:58.580 --> 00:22:04.020 who, remember by assumption, will firmly expect the monetary authority to reinflate the price 207 00:22:04.020 --> 00:22:08.420 level back up to its long run target. 208 00:22:08.420 --> 00:22:12.100 In other words, according to Krugman, quote, what happens is that the economy deflates 209 00:22:12.100 --> 00:22:16.020 now in order to provide inflation later, unquote. 210 00:22:16.020 --> 00:22:21.180 This universally anticipated inflation causes a positive inflation premium to be added on 211 00:22:21.180 --> 00:22:26.500 to the real interest rate, causing the nominal rate to rise above zero because people now 212 00:22:26.500 --> 00:22:33.500 They now expect inflation, they expect the purchasing power of the dollars are getting paid back to be less in the future, so now they are charging an inflation premium. 213 00:22:33.500 --> 00:22:38.500 And thus providing room for the real interest rate to settle at its market clearing negative level. 214 00:22:38.500 --> 00:22:50.500 For example, if the expected annual inflation rate is 10%, then the nominal interest rate would rise to 7%, allowing the real rate to attain its equilibrium of, let's say, minus 3%. 215 00:22:50.500 --> 00:22:56.500 Okay, it's not crucial that you understand all the intricacies of the model, because I'm going to sum it up and show you how ridiculous it is. 216 00:22:56.500 --> 00:23:11.500 Now, the fly in the ointment, or rather in Krugman's highly stylized model, is the assumption of sticky prices which does not permit the economy to deflate now in order to obtain the inflationary expectations it needs to equilibrate the market for savings. 217 00:23:11.500 --> 00:23:19.500 The economy thus gets bogged down in a liquidity trap, with unemployment and a real interest rate stuck above the market clearing level. 218 00:23:19.500 --> 00:23:23.340 while the nominal interest rate language is at zero. 219 00:23:23.340 --> 00:23:27.840 Okay, now here's where he tries to make the connection to the real world. 220 00:23:27.840 --> 00:23:31.340 Krugman contends that this precisely describes the Japanese economy of the 221 00:23:31.340 --> 00:23:36.420 1990s, which is characterized by, quote, essentially zero short-run nominal 222 00:23:36.420 --> 00:23:40.740 interest rates and also certainly seems to be operating well below capacity, 223 00:23:40.740 --> 00:23:41.660 unquote. 224 00:23:41.660 --> 00:23:43.540 So far, he's correct. 225 00:23:43.540 --> 00:23:45.740 Those two characteristics do exist. 226 00:23:45.740 --> 00:23:48.940 But if the Japanese economy is indeed in a liquidity trap, 227 00:23:48.940 --> 00:24:18.940 How did it get there? Remember, according to Krugman's model, a liquidity trap will arise only if future productive capacity is actually lower than current capacity. That is, if people expect to be poorer in the future. But how is this applicable to the modern Japanese economy? Krugman weakly suggests the following answer, quote, 228 00:24:18.940 --> 00:24:30.940 In the absence of productivity growth over the next several decades, potential output, say 15 or 20 years out, could actually be below current capacity. 229 00:24:30.940 --> 00:24:38.940 Moreover, the labor force will drop faster than the population because of shifting composition that is in the age makeup. 230 00:24:38.940 --> 00:24:47.940 So it is substantially easier to make the case that per capita productive capacity might be lower at some future day of the future. 231 00:24:47.940 --> 00:24:53.940 Perhaps sensing how astoundingly weak this explanation is, Krugman concedes that, quote, 232 00:24:53.940 --> 00:24:59.940 while it is easy, quite easy to make the case that Japan is in a liquidity trap, sure, you just make up a model, 233 00:24:59.940 --> 00:25:04.940 it is much harder to give a convincing explanation of why, unquote. 234 00:25:04.940 --> 00:25:10.940 So there we have it. According to one of the top pure theorists in modern economics, 235 00:25:10.940 --> 00:25:17.580 Japan, as a result of demographic factors, has suffered almost a decade of financial 236 00:25:17.580 --> 00:25:23.360 collapse and grinding recession because 15 to 20 years from now it faces the prospect 237 00:25:23.360 --> 00:25:29.700 of mildly reduced industrial capacity and real income. Maybe. Let me put this in even 238 00:25:29.700 --> 00:25:33.980 starker terms. Krugman is suggesting that the probability that Japan will have a smaller 239 00:25:33.980 --> 00:25:37.840 and older labor force a decade or two from now is the reason that it has been suffering 240 00:25:37.840 --> 00:25:41.680 from Economic Stagnation and Recession for the Past Decade. 241 00:25:41.680 --> 00:25:48.200 In the immortal words of Robin Leach, I am not making this up. 242 00:25:48.200 --> 00:25:52.760 Of course, Krugman's admitted inability to provide a robust explanation of just how the 243 00:25:52.760 --> 00:25:59.680 Japanese economy became ensnared in the so-called liquidity trap does not deter him from aggressively 244 00:25:59.680 --> 00:26:02.840 prescribing the means for extricating itself. 245 00:26:02.840 --> 00:26:07.440 Thus, in a follow-up note to his Japan's liquidity trap article, and I recommend that you read 246 00:26:07.440 --> 00:26:15.200 Kruggen writes, many people apparently read my previous note as saying simply that Japan 247 00:26:15.200 --> 00:26:19.880 should print money like crazy. I have indeed said this in the past and see no harm in such 248 00:26:19.880 --> 00:26:26.040 a policy. But I now believe that even a very large current monetary expansion will probably 249 00:26:26.040 --> 00:26:31.640 be ineffective. What is needed is a credible commitment to future monetary expansion, so 250 00:26:31.640 --> 00:26:37.200 as to generate expectations of inflation. But how might the Bank of Japan achieve such 251 00:26:37.200 --> 00:26:50.200 Such a commitment, you might ask. Krugman's response is that, quote, the natural way is to announce a target rate of price inflation over the long term, with the announce of intention of doing whatever is necessary to achieve that rate. 252 00:26:50.200 --> 00:26:59.200 But how high a rate would suffice, we again ask Krugman. Krugman's answer to this query is more modest. I don't know, he replies, but I am working on it, unquote. 253 00:26:59.200 --> 00:27:03.640 However, Krugman's admitted lack of knowledge does not restrain him from offering quote, 254 00:27:03.640 --> 00:27:08.720 a guess that the required inflation rate isn't very high, but that people must expect it 255 00:27:08.720 --> 00:27:13.840 for a long time. We might, for example, be talking, say, four percent inflation for fifteen 256 00:27:13.840 --> 00:27:19.000 years. Basically, Krugman's remedy is to destroy the purchasing power of the yen by raising 257 00:27:19.000 --> 00:27:25.840 the price level by sixty percent, uncompounded over fifteen years, which pretty much cuts 258 00:27:25.840 --> 00:27:29.880 The Value of Money in Half, not to mention the fact that once inflationary expectations 259 00:27:29.880 --> 00:27:37.080 are unleashed, they tend to be unpredictable and may culminate in a hyperinflation. 260 00:27:37.080 --> 00:27:42.520 Krugman's advocacy of such a profoundly foolish and destructive policy follows naturally from 261 00:27:42.520 --> 00:27:45.400 modern macroeconomic theory. 262 00:27:45.400 --> 00:27:48.480 The theory is based on what is called the classical dichotomy. 263 00:27:48.480 --> 00:27:53.280 Now this fancy term simply means that in the long run, a change in the quantity of money 264 00:27:53.280 --> 00:27:58.320 only affects the prices of goods and assets, and never the structure of the real economy 265 00:27:58.320 --> 00:28:04.360 or the relative earnings of different types of resources. Consequently, this leads macroeconomists 266 00:28:04.360 --> 00:28:10.440 like Friedman, Feldstein and Krugman to deny that credit expansion has any effect in artificially 267 00:28:10.440 --> 00:28:16.600 lowering interest rates and causing an inefficient and unsustainable alteration in the relative 268 00:28:16.600 --> 00:28:22.200 proportions of consumer goods and capital goods produced by the economy. Thus, while 269 00:28:22.200 --> 00:28:27.120 While they would all admit the existence of an asset price bubble in Japan, they are blinded 270 00:28:27.120 --> 00:28:32.200 by their theory to the second bubble that is right before their eyes. 271 00:28:32.200 --> 00:28:37.280 This second bubble was produced by the tremendous increase in real investment as a proportion 272 00:28:37.280 --> 00:28:43.520 of GDP, Gross Domestic Product, that occurred in the Japanese economy in the late 1980s. 273 00:28:43.520 --> 00:28:50.400 Between 1986 and 1990, the ratio of investment to GDP in Japan increased from 27.8 percent 274 00:28:50.400 --> 00:28:56.800 to 32.8% or by 5 percentage points. This massive reallocation of resources from the 275 00:28:56.800 --> 00:29:01.680 production of consumer goods to the production of capital goods coincided precisely with 276 00:29:01.680 --> 00:29:07.120 the massive credit expansion, declining interest rates and rapidly inflating asset prices of 277 00:29:07.120 --> 00:29:14.120 Japan's bubble era. However, while the first financial bubble abruptly popped in 1990, 278 00:29:14.120 --> 00:29:21.120 In 1990, its second real capital bubble is still in existence for reasons that Jeff Herbner specified yesterday. 279 00:29:21.120 --> 00:29:38.120 Basically, the enormous overinvestment in capital goods was prevented by mistaken policies of the Japanese government from being promptly liquidated. 280 00:29:38.120 --> 00:29:45.200 As late as 1998, the investment-GDP ratio still stood above 30 percent, more than two 281 00:29:45.200 --> 00:29:48.760 percentage points above its last pre-bubble year. 282 00:29:48.760 --> 00:29:55.000 So large and conspicuous was the second real bubble, the one that the macroeconomist has 283 00:29:55.000 --> 00:29:56.000 listed. 284 00:29:56.000 --> 00:30:00.460 One such journalist was Christopher Wood, who wrote a book in 1995 entitled The End 285 00:30:00.460 --> 00:30:03.040 of Japanese Japan Incorporated. 286 00:30:03.040 --> 00:30:07.480 In this book, he referred to Japan's other bubble and argued that this bubble was still 287 00:30:07.480 --> 00:30:12.720 Still in existence in 1995, Wood explained this bubble and its future prospects in the 288 00:30:12.720 --> 00:30:17.920 following terms, quote, This bubble was not the speculative boom in the stock market and 289 00:30:17.920 --> 00:30:23.520 property market, but a massive capital spending binge by Japanese business driven by the then 290 00:30:23.520 --> 00:30:30.520 availability of super cheap finance. For corporate Japan over-invested on a heroic scale. As 291 00:30:30.960 --> 00:30:35.000 a result, much of the investment undertaken by business in recent years will never earn 292 00:30:35.000 --> 00:30:39.200 and an adequate rate of return." I'm still quoting Wood here, okay? He sounds very, very 293 00:30:39.200 --> 00:30:44.880 close to an Austrian economist. Indeed, it is the unprofitability of all this domestic 294 00:30:44.880 --> 00:30:50.880 capital spending, rather than excess production capacity, per se, that is now the central 295 00:30:50.880 --> 00:30:56.920 problem facing Japan, Japanese industry, and the economy in general. Wood concludes that 296 00:30:56.920 --> 00:31:01.400 the post-war trend in the Japanese economy towards investment absorbing a progressively 297 00:31:01.400 --> 00:31:08.400 and a relatively larger share of GDP, quote, resulted in an increasingly lopsided form of economic activity. 298 00:31:08.400 --> 00:31:14.400 The bubble years marked this trend taken to its logical, though absurd, extreme, unquote. 299 00:31:14.400 --> 00:31:19.400 Wood labels the lopsided Japanese economy the Elephant Man economy. 300 00:31:19.400 --> 00:31:27.400 We can use Wood's vivid metaphor to distinguish between the various remedies prescribed for the ills affecting the Japanese economy. 301 00:31:27.400 --> 00:31:38.400 Recall that the Elephant Man was that unfortunate specimen of medical science, whose body was grotesquely disproportioned in its various parts, much like the current Japanese economy. 302 00:31:38.400 --> 00:31:45.400 Mainstream macroeconomists would cure the Japanese Elephant Man by injecting more money and credit into his system. 303 00:31:45.400 --> 00:31:54.400 But this quack panacea would only make him sicker, would only cause new distortions and disproportionalities, and aggravate the existing ones. 304 00:31:54.400 --> 00:31:59.240 Krugman, who was even more of a quack, would mainline inflationary expectations into the 305 00:31:59.240 --> 00:32:04.900 Elephant Man, a virulent intervention that risks killing him by inducing an inflationary 306 00:32:04.900 --> 00:32:14.700 breakdown of his entire system. Only the Austrian economists know how to cure the Japanese Elephant 307 00:32:14.700 --> 00:32:19.960 Man. In fact, according to the Austrians, the Elephant Man has the power to kill himself 308 00:32:19.960 --> 00:32:24.920 if he only will. All he needs to do is to reject the remedies of his quack macroeconomic 309 00:32:24.920 --> 00:32:30.480 physicians and in a short time his body will naturally return to its normal proportions. 310 00:32:30.480 --> 00:32:35.280 In other words, the cure for the Japanese economy is to permit the long delayed recession 311 00:32:35.280 --> 00:32:39.900 adjustment process to run its course without government meddling. This is the immutable 312 00:32:39.900 --> 00:32:45.240 law of the business cycle which is as true of Japan today as it was of the United States 313 00:32:45.240 --> 00:32:52.240 in the 1930s. Thank you.