WEBVTT NOTE The Rise and Fall of the Japanese Miracle 1 00:00:00.000 --> 00:00:06.800 In 1943, John Maynard Keynes claimed that central bank credit expansion performs the, quote, 2 00:00:06.800 --> 00:00:10.960 miracle of turning a stone into bread, close quote. 3 00:00:10.960 --> 00:00:14.040 History has revealed Keynes' miracle as a counterfeit, 4 00:00:14.040 --> 00:00:18.280 producing not higher standards of living, but crises and depressions. 5 00:00:18.280 --> 00:00:22.200 Economic growth requires genuine capital accumulation, 6 00:00:22.200 --> 00:00:26.640 that is, the construction of an enlarged capital structure by saving and investing. 7 00:00:26.640 --> 00:00:32.640 The counterfeit miracle of central bank monetary inflation generates only a boom bust. 8 00:00:32.640 --> 00:00:37.140 At first, the credit expansion appears to be a stimulated process of economic growth. 9 00:00:37.140 --> 00:00:43.640 Interest rates fall, capital values rise, and entrepreneurs profit by building up the capital structure. 10 00:00:43.640 --> 00:00:49.640 The capital construction cannot be completed, however, since genuine saving is insufficient. 11 00:00:49.640 --> 00:00:54.640 The boom rests on a lie, namely artificially low interest rates. 12 00:00:54.640 --> 00:00:59.240 And once the lie is exposed, the boom must end and the bust must follow. 13 00:00:59.240 --> 00:01:07.140 Japan has experienced both the genuine miracle of the market and the counterfeit miracle of the state for the past 150 years. 14 00:01:07.140 --> 00:01:11.040 International trade with the West began in earnest in the 1850s 15 00:01:11.040 --> 00:01:15.740 and the restoration government of 1868 supplanted the old feudal system 16 00:01:15.740 --> 00:01:20.640 with private property rights, freedom of trade, enterprise and movement. 17 00:01:20.640 --> 00:01:30.640 In the 1880s, Japan sold most state-run enterprises to the private sector and its economy was rapidly integrated into the international division of labor. 18 00:01:30.640 --> 00:01:36.240 The thrifty Japanese people provided ample saving for capital accumulation. 19 00:01:36.240 --> 00:01:42.440 Countering these forces of genuine growth, the government subsidized transportation and communications, 20 00:01:42.440 --> 00:01:48.140 cartelized the banking system and heavy industry, and established a central bank. 21 00:01:48.140 --> 00:01:56.740 In short, Japan imitated the mercantilist system of Great Britain, complete with an empire, albeit on a regional scale. 22 00:01:56.740 --> 00:02:02.140 The Japanese Empire, like the British one, was founded on the international division of labor, 23 00:02:02.140 --> 00:02:07.740 in this case with its Asian neighbors, including Manchuria, Formosa and Korea. 24 00:02:07.740 --> 00:02:14.740 But the financing power of Japan's debt and monetary inflation was put into the service of its warfare state. 25 00:02:14.740 --> 00:02:19.740 Thus, the rise of Japan to a great industrial power prior to the First World War 26 00:02:19.740 --> 00:02:25.740 was part genuine economic growth, part build-up for the state, and part boom-bust. 27 00:02:25.740 --> 00:02:33.740 Japan's economic development, like America's, was given a tremendous boost by its policy of neutrality in the First World War. 28 00:02:33.740 --> 00:02:39.740 Japan's trade with Asia increased enormously as former trading partners went to war with each other. 29 00:02:39.740 --> 00:02:47.740 And like America, Japan inflated during the war on the base of huge gold reserves that were built up by burgeoning trade surpluses. 30 00:02:47.740 --> 00:02:53.740 The inflationary boom lasted until 1920 and a deflationary collapse followed. 31 00:02:53.740 --> 00:03:03.740 The massive earthquake of 1923 set up the next round of monetary inflation by the Bank of Japan to finance reconstruction spending. 32 00:03:03.740 --> 00:03:10.740 That boom came to an end when heavy outflows of gold led to a deflationary collapse in 1927 33 00:03:10.740 --> 00:03:13.740 and was followed by a depression until 1931. 34 00:03:13.740 --> 00:03:16.740 Just as the Great Depression was gearing up in the West, 35 00:03:16.740 --> 00:03:22.740 Japan was embarking on another round of government spending, debt and monetary inflation. 36 00:03:22.740 --> 00:03:27.740 This time the expansion was devoted to building up the army and the navy. 37 00:03:27.740 --> 00:03:29.740 For all the belligerence in the Second World War, 38 00:03:29.740 --> 00:03:35.740 During the Second World War, the conversion to a war economy meant centralized political control of economic activity. 39 00:03:35.740 --> 00:03:43.740 In Japan, it was a natural extension of the military build-up of the 1930s that the cartels, in league with the government, 40 00:03:43.740 --> 00:03:49.740 would run the war economy since the cartels dominated heavy manufacturing and banking. 41 00:03:49.740 --> 00:03:53.740 During the war, control over banking was further centralized in the Bank of Japan, 42 00:03:53.740 --> 00:03:58.740 and the Industrial Bank of Japan became the financing agent for war production. 43 00:03:58.740 --> 00:04:03.300 So completely was the economy transformed into a war machine that when the fighting ended, 44 00:04:03.300 --> 00:04:07.740 the productive capacity of the economy was almost entirely worthless for consumer goods 45 00:04:07.740 --> 00:04:14.500 production. Tragically, the occupation authority which ran Japan after the war prevented economic 46 00:04:14.500 --> 00:04:21.620 reconversion. It imposed punitive taxation and labor unions, dissolved the cartels and 47 00:04:21.620 --> 00:04:51.620 and Confiscated Land. More importantly, America poured $1.6 billion of foreign aid into Japan between 1945 and 1949, which permitted the Bank of Japan to further inflate the money stock already tremendously inflated at the close of the war. Hyperinflation ensued, with wholesale prices increasing 13-fold from April of 1946 to March of 1949. Unable to proceed with any large-scale 48 00:04:51.620 --> 00:05:02.620 and Economic Reorganization. Industrial production in 1948 was merely 40% of its 1937 level and agricultural production well below its pre-war level. 49 00:05:02.620 --> 00:05:09.620 In 1949, Japan was forced into the new American dominated international order. 50 00:05:09.620 --> 00:05:18.620 The monetary order of Brenton Woods fixed the yen dollar exchange rate at 360 to 1 and required the Bank of Japan 51 00:05:18.620 --> 00:05:25.620 to coordinate its yen inflation with the Fed's dollar inflation to integrate credit expansion internationally. 52 00:05:25.620 --> 00:05:33.620 The new military order, that is the Cold War, brought Japan's existing military capacity into production again. 53 00:05:33.620 --> 00:05:42.620 Its war machine revived by American military procurements, industrial production in Japan finally surpassed its pre-war level in 1951. 54 00:05:42.620 --> 00:05:49.620 Having proved a reliable ally, the Japanese government had its sovereignty restored in the spring of 1952. 55 00:05:49.620 --> 00:05:54.620 By 1953, the reforms of the occupation authority were reversed. 56 00:05:54.620 --> 00:06:01.620 The unions were weakened, taxes were lowered, the cartels were reformed and government planning strengthened. 57 00:06:01.620 --> 00:06:08.620 State control of credit was as strong as ever in the Japan Development Bank, the Export-Import Bank, 58 00:06:08.620 --> 00:06:13.620 and the Trust Fund Bureau, which had oversight of the postal saving system. 59 00:06:13.620 --> 00:06:16.620 Only land reform survived. 60 00:06:16.620 --> 00:06:21.620 In short, Japan had restored its pre-war, mercantilist economic system, 61 00:06:21.620 --> 00:06:24.620 save for its regional yen trading bloc. 62 00:06:24.620 --> 00:06:31.620 This was hardly a laissez-faire recipe for performing the genuine miracle of economic growth. 63 00:06:31.620 --> 00:06:35.620 For the decades of the 50s and 60s, 64 00:06:35.620 --> 00:06:42.620 Japan served in the American system in a way similar to that of Indonesia in the 80s and 90s. 65 00:06:42.620 --> 00:06:48.620 The inflow of American dollars in the Japanese government's allocation of funds from the postal saving system 66 00:06:48.620 --> 00:06:55.620 boosted the average annual increase in GNP to 9.6% for these two decades, 67 00:06:55.620 --> 00:07:03.620 more than double the 4.6% rate for the period 1925 to 1939. 68 00:07:03.620 --> 00:07:08.620 This productive effort, however, went largely to satisfying government instead of consumer demands. 69 00:07:08.620 --> 00:07:15.620 War materials and infrastructure projects were funded at the expense of building capacity to serve consumers. 70 00:07:15.620 --> 00:07:20.620 International trade went counter to the pre-war lines of comparative advantage. 71 00:07:20.620 --> 00:07:25.620 With America becoming Japan's leading trading partner in both exports and imports, 72 00:07:25.620 --> 00:07:29.620 stripped of its place in the inter-regional division of labor, 73 00:07:29.620 --> 00:07:34.620 Japan began a program of artificial expansion of domestic production. 74 00:07:34.620 --> 00:07:39.620 The Japanese government subsidized production of costly synthetic substitutes 75 00:07:39.620 --> 00:07:44.620 for cheaper imported raw materials, formerly obtained from Manchuria. 76 00:07:44.620 --> 00:07:49.620 Imports of low-priced food declined, while the artificially built up agricultural sector 77 00:07:49.620 --> 00:07:52.620 expanded high-priced output. 78 00:07:52.620 --> 00:07:57.620 Capacity in steel production, electrical equipment, automobiles and shipbuilding 79 00:07:57.620 --> 00:08:00.620 and shipbuilding was heavily subsidized. 80 00:08:00.620 --> 00:08:04.620 Also, part of the post-war economic miracle was counterfeit. 81 00:08:04.620 --> 00:08:10.620 American military procurements for the Korean War amounted to some $3.4 billion 82 00:08:10.620 --> 00:08:14.620 and set off a domestic boom in the early 1950s. 83 00:08:14.620 --> 00:08:18.620 GNP increased 12.1% per year during the war. 84 00:08:18.620 --> 00:08:23.620 The Bank of Japan, however, overinflated the yen, leading to a drain of reserves, 85 00:08:23.620 --> 00:08:26.620 which under the fixed exchange rates of Brenton Woods' system 86 00:08:26.620 --> 00:08:37.620 were ultimately halted by monetary deflation. A short recession followed in 54 and the next boom was underway in 55 and suffered the same fate in 58. 87 00:08:37.620 --> 00:08:48.620 Fueled by Bank of Japan monetary inflation, the boom of 59-61 saw GMP increasing 15% per year and ended with a drain of gold reserves in 61. 88 00:08:48.620 --> 00:08:55.620 A short recession followed in 62 and another boom in 63-64, which ended with a recession in 65. 89 00:08:55.620 --> 00:09:00.620 For the next five years, GMP increased by more than 10% per year. 90 00:09:00.620 --> 00:09:06.620 Although it required booms and busts, the Bank of Japan was able to coordinate yen inflation 91 00:09:06.620 --> 00:09:09.620 with Fed dollar inflation sufficiently under Brenton Woods, 92 00:09:09.620 --> 00:09:13.620 that the yen dollar exchange rate remained 360 to 1. 93 00:09:13.620 --> 00:09:19.620 Exchange rate stability, however, required more rapid inflation of the yen than that of the dollar. 94 00:09:19.620 --> 00:09:24.620 With the Japanese economy expanding production at three times the American rate, 95 00:09:24.620 --> 00:09:43.620 19% per year versus 16.4%. During the second half of the 60s and 70s, the yen was inflated at 18.8% per year and still maintained its exchange rate against the dollar, which is being inflated at only 5.4% per year. 96 00:09:43.620 --> 00:09:53.620 When Brenton Woods collapsed, the Fed tripled the rate of dollar inflation from 4.4% in 1970 to 12% in 1971. 97 00:09:53.620 --> 00:10:02.620 The Bank of Japan slavishly followed suit as it had since the Second World War, but yen inflation was not accelerated sufficiently. 98 00:10:02.620 --> 00:10:12.620 Even though the yen money stock grew 22% per year from 1971 to 1973, the yen appreciated against the dollar 22%. 99 00:10:12.620 --> 00:10:24.620 price inflation exploded in 1973-1974 with consumer prices rising 11.7% and 23.1% respectively. 100 00:10:24.620 --> 00:10:27.620 A severe recession followed the credit expansion boom. 101 00:10:27.620 --> 00:10:32.620 After this debacle, Japan began to conduct a more independent monetary policy. 102 00:10:32.620 --> 00:10:38.620 The Bank of Japan gradually decreased yen inflation rates to the point where in 1977 103 00:10:38.620 --> 00:10:44.100 In 1977, the rate of yen inflation fell below the rate of dollar inflation, but another 104 00:10:44.100 --> 00:10:49.660 credit expansion followed with the yen inflating at 11% per year for the next two years and 105 00:10:49.660 --> 00:10:57.980 the Bank of Japan lowering the discount rate from 4.25% in 1977 to 3.5% in 1978. 106 00:10:57.980 --> 00:11:04.500 Price inflation jumped in 1980 with wholesale prices up almost 18%, forcing the Bank of 107 00:11:04.500 --> 00:11:10.500 in Japan to contract by more than doubling the discount rate to seven and a quarter percent by 1980. 108 00:11:11.500 --> 00:11:17.500 Interest rates spiked upward in response, bringing the credit expansion to an end and driving the economy into another recession. 109 00:11:19.500 --> 00:11:24.500 Whatever else can be said about the post-war Japanese miracle, it was over in 1970. 110 00:11:25.500 --> 00:11:30.500 The average annual increase in GNP from 71 to 79 was 4.6 percent, 111 00:11:30.500 --> 00:11:36.500 and from 1980 to 1990 it was an even more anemic 4.1 percent. 112 00:11:36.500 --> 00:11:45.500 Having its monetary policy cut loose from the dollar, Japan attempted in the 1980s to reestablish its yen trading block, 113 00:11:45.500 --> 00:11:52.500 albeit with East and Southeast Asia substituting for the old North Asian alliance. 114 00:11:52.500 --> 00:11:56.500 In the first half of the 1980s this goal could not be attained, 115 00:11:56.500 --> 00:12:00.500 Since the international demand for the dollar outstripped that for the yen. 116 00:12:00.500 --> 00:12:06.500 Despite the Bank of Japan inflating the yen at rates lower than the Fed's inflation of the dollar, 117 00:12:06.500 --> 00:12:16.500 the yen declined 24% against the dollar and consumer goods prices in Japan rose 2.7% per year from 81 to 84. 118 00:12:16.500 --> 00:12:21.500 In 1985, however, the strategy began to be realized. 119 00:12:21.500 --> 00:12:33.500 The Plaza Accord that year in which the leading industrial nations agreed to support a stronger yen and a weaker dollar gave room for an inter-regional yen monetary inflation and credit expansion. 120 00:12:33.500 --> 00:12:49.500 The Bank of Japan inflated the yen money stock by 10.5% per year from 1986 to 1990 and lowered the discount rate from 5% in 1985 where it had been since 1983 to 2.5% in 1987. 121 00:12:49.500 --> 00:12:57.500 Japan exported its credit expansion to Southeast Asia and South Korea in the form of direct investment. 122 00:12:57.500 --> 00:13:02.500 The massive Japanese investment in Asia was augmented by loan guarantees 123 00:13:02.500 --> 00:13:07.500 made by the Export-Import Bank of Japan for investment and trade in Asia. 124 00:13:07.500 --> 00:13:12.500 By the end of the debt binge, Japan was the world's largest creditor nation, 125 00:13:12.500 --> 00:13:15.500 manifested by having the world's largest banks 126 00:13:15.500 --> 00:13:19.500 and had the stock market with the world's largest capitalized value. 127 00:13:19.500 --> 00:13:25.500 Despite the massive yen inflation, the yen appreciated 50% against the dollar 128 00:13:25.500 --> 00:13:28.500 from the beginning of 85 to the end of 88, 129 00:13:28.500 --> 00:13:32.500 and consumer goods prices in Japan rose only 0.5% per year, 130 00:13:32.500 --> 00:13:36.500 while wholesale goods prices fell 4.6% per year, 131 00:13:36.500 --> 00:13:41.500 indicating the growing yen money demand, international as well as domestic, 132 00:13:41.500 --> 00:13:44.500 was absorbing the monetary inflation. 133 00:13:44.500 --> 00:13:47.300 But supremacy of the yen was short-lived. 134 00:13:47.300 --> 00:13:50.100 Yen demand collapsed in 1988-1989, 135 00:13:50.100 --> 00:13:53.300 causing a 16% devaluation against the dollar 136 00:13:53.300 --> 00:13:56.200 and a surge of domestic price inflation. 137 00:13:56.200 --> 00:13:58.500 The Bank of Japan hit the monetary breaks, 138 00:13:58.500 --> 00:14:02.300 drastically cutting yen inflation from 12% in 1990 139 00:14:02.300 --> 00:14:08.000 to 4% in 1991 and then to 1.2% in 1992. 140 00:14:08.000 --> 00:14:13.600 The discount rate was raised from 2.5% in 1988 to 6% in 1990. 141 00:14:13.600 --> 00:14:16.400 The end of the credit expansion doubled interest rates 142 00:14:16.400 --> 00:14:26.400 while the reduction in yen inflation helped push the yen dollar exchange rate up 22% from 1989 to 1993. 143 00:14:26.400 --> 00:14:31.600 Japan had experienced what America discovered in the wake of the collapse of Brenton Woods. 144 00:14:31.600 --> 00:14:39.600 Generating an international credit expansion succeeds so long as increases in money demand keep price inflation in check. 145 00:14:39.600 --> 00:14:46.600 Japan's restoration of a yen trading bloc in Asia was cut short by America reasserting the dominance of the dollar, 146 00:14:46.600 --> 00:14:53.600 first in Canada, Mexico, Latin America and South America, and then in Asia and Eastern and Central Europe. 147 00:14:53.600 --> 00:15:01.600 The yen had little chance against the world's reserve currency and the yen-based credit expansion collapsed in 1990. 148 00:15:01.600 --> 00:15:08.600 Although Keynes is the author of its economic destruction, Japan has looked to him for rebuilding advice. 149 00:15:08.600 --> 00:15:15.600 Japan has tried nine stimulus packages since 1990 for a total value of $888 billion. 150 00:15:15.600 --> 00:15:21.600 And although varied in shape and size, they have all had the same three features. 151 00:15:21.600 --> 00:15:25.600 Government spending and debt, bailouts and reflation. 152 00:15:25.600 --> 00:15:30.600 Making matters worse, taxes have been raised several times since 1989 153 00:15:30.600 --> 00:15:39.600 so that the government now extracts over 30% of GDP up from 18% in 1965. 154 00:15:39.600 --> 00:15:43.600 The tax cut of 1998 was too small to reverse this trend. 155 00:15:43.600 --> 00:15:47.600 But even a sizable tax cut would have only a minimal effect 156 00:15:47.600 --> 00:15:50.600 without a corresponding reduction in government spending. 157 00:15:50.600 --> 00:15:54.600 A depression will persist until the malinvestments of the boom are liquidated 158 00:15:54.600 --> 00:15:58.600 and the capital structure is reconstructed to best satisfy consumers. 159 00:15:58.600 --> 00:16:08.600 Fiscal expenditures delay liquidation and reconstruction, since government spending always strives to bail out and subsidize the existing production structure. 160 00:16:08.600 --> 00:16:18.600 Moreover, the national debt in Japan was run up to pay for the spending binge, a policy that has further impaired already injured credit markets. 161 00:16:18.600 --> 00:16:26.600 Japan's national debt now stands at well over 100% of GDP, up from 60% in 1993. 162 00:16:26.600 --> 00:16:37.600 In 1999, Japan will issue 90% of all industrial countries net new bond issues, some $352 billion. 163 00:16:37.600 --> 00:16:46.600 Its total bond issue in 1999 will be $517 billion and will give Japan the largest debt issue in the world. 164 00:16:46.600 --> 00:16:58.600 The burgeoning debt load led Moody's Investors Service to downgrade Japan's sovereign credit rating in April of this year as it had topped Japanese banks and corporations last year. 165 00:16:58.600 --> 00:17:05.600 Despite Keynesian predictions, mountains of government debt have done nothing to stimulate the economy. 166 00:17:05.600 --> 00:17:12.600 GDP fell 2.8% in 1998, or to alleviate private sector debt. 167 00:17:12.600 --> 00:17:18.600 Estimates in March of this year put the bad debt of private businesses at $720 billion, 168 00:17:18.600 --> 00:17:24.600 which was down only seven-tenths of one percent from a year earlier, despite write-offs. 169 00:17:24.600 --> 00:17:30.600 In August of 1998, Japanese banks had an admitted $600 billion in bad loans, 170 00:17:30.600 --> 00:17:35.600 with another $625 billion loans with higher than normal default risk. 171 00:17:35.600 --> 00:17:42.600 The banks still had, in July of 1998, $1.56 trillion in real estate loans on their books. 172 00:17:42.600 --> 00:17:49.600 Much of it lent to developers with half-finished hotels, defunct golf courses, and dilapidated rental properties, 173 00:17:49.600 --> 00:17:54.600 while real estate prices have fallen 80% from 1991 to 1998. 174 00:17:54.600 --> 00:18:02.600 Banks are also still heavily invested in Japanese stocks, while the Nikkei was down 64% from 1990 to 1998. 175 00:18:02.600 --> 00:18:07.600 The government's answer to the financial debacle has been bailout funds. 176 00:18:07.600 --> 00:18:13.600 Late in 1998, a $514 billion bailout fund was set up. 177 00:18:13.600 --> 00:18:18.600 Funds will go to shore-up deposit insurance corporations to buy shares of stock in troubled banks 178 00:18:18.600 --> 00:18:22.600 and to nationalize, restructure, and liquidate failed banks. 179 00:18:22.600 --> 00:18:25.600 For the favor of having the government become part owner, 180 00:18:25.600 --> 00:18:30.600 the banks must cut payrolls, slash overseas ventures, and write off bad loans. 181 00:18:30.600 --> 00:18:35.600 Regardless, 15 of Japan's top banks lined up for the bailout money. 182 00:18:35.600 --> 00:18:43.600 Their fate may or may not be better than that suffered by Long-Term Credit Bank and Nippon Credit Bank, which were nationalized in 1998. 183 00:18:43.600 --> 00:18:46.600 Bailouts have also been extended to corporations. 184 00:18:46.600 --> 00:18:56.600 In November of 1998, Nissan Motors requested an $833 million loan from the government-run Japan Development Bank, 185 00:18:56.600 --> 00:19:06.600 While Small Business Finance Corp increased its lending to small business 15% in 1997 and another 11% in 1998. 186 00:19:06.600 --> 00:19:13.600 The government has also attempted to bail out its interests in Southeast Asia and South Korea, which were built up during the boom. 187 00:19:13.600 --> 00:19:25.600 As late as 1997, Japanese banks still held 38% of the total outstanding foreign corporate debt loans in Indonesia, amounting to some $58 billion. 188 00:19:25.600 --> 00:19:32.600 In Thailand, Japanese banks held 38 billion in debt, while American banks held only five. 189 00:19:32.600 --> 00:19:38.600 Enterprises in South Korea had borrowed 25 billion dollars from banks in Japan. 190 00:19:38.600 --> 00:19:43.600 In response, the Japanese government provided 20 billion dollars in bailout money 191 00:19:43.600 --> 00:19:48.600 to guarantee bank loans made to interests in Thailand, Indonesia and South Korea. 192 00:19:48.600 --> 00:19:52.600 The Bank of Japan has tried reflation throughout the 1990s. 193 00:19:52.600 --> 00:20:04.600 The discount rate was lowered from 6% in 1991 to 0.5% in 1997, but the banks refused to expand credit and instead simply absorbed the new money to hold as reserves against bad loans. 194 00:20:04.600 --> 00:20:12.600 Blocked from domestic credit expansion, the Bank of Japan tried to expand Japanese bank credit overseas with the yen carrying trade. 195 00:20:12.600 --> 00:20:21.600 Investors would borrow yen at low interest rates, convert the yen to dollars and other currencies, and buy higher return assets overseas. 196 00:20:21.600 --> 00:20:27.600 This put downward pressure on the yen which increased the profitability of the strategy. 197 00:20:27.600 --> 00:20:36.600 The yen-dollar trade was active from mid-1995 to mid-1998 as the yen fell 83% against the dollar. 198 00:20:36.600 --> 00:20:44.600 But in July of 1998, the yen began to appreciate again, losses ensued and the trade dried up. 199 00:20:44.600 --> 00:20:50.600 This policy exacerbated the financial debacle in Asia by greatly expanding credit for three years 200 00:20:50.600 --> 00:20:53.880 for three years and then suddenly shutting it off. 201 00:20:53.880 --> 00:21:00.480 The financial debacle in Asia then saddled Japanese banks with more foreign bad debt. 202 00:21:00.480 --> 00:21:05.560 In response, they cut foreign lending in the first quarter of 1998 by 12%. 203 00:21:05.560 --> 00:21:10.960 This cut is the latest in a downward trend that has left the once dominant Japanese banks 204 00:21:10.960 --> 00:21:16.020 with the same global market share that they had in the early 1980s. 205 00:21:16.020 --> 00:21:19.880 In this morbid condition, banks are incapable of performing their function as financial 206 00:21:19.880 --> 00:21:26.880 and financial intermediaries. Any added reserves they acquire must be used to pay down bad loans instead of expanding credit. 207 00:21:26.880 --> 00:21:40.880 From 95 to 98, banks' bad loan write-offs were $300 billion, while banks reduced their loans 2.7% in 97 and another 5.4% in 98. 208 00:21:40.880 --> 00:21:48.880 This is why enormous increases in the monetary base, 10% from mid-97 to mid-98, 209 00:21:48.880 --> 00:21:54.880 had little effect on broader monetary aggregates, which rose only three and a half percent. 210 00:21:54.880 --> 00:21:59.880 Keynesians have mistakenly viewed the impotency of the Bank of Japan as a liquidity trap. 211 00:21:59.880 --> 00:22:05.880 But the failure of reflation to generate another credit expansion is not the result of investors hoarding money 212 00:22:05.880 --> 00:22:09.880 because they all expect interest rates must rise from their low levels. 213 00:22:09.880 --> 00:22:16.880 It is the enormous burden of the bad debt that leads banks to hold cash instead of expanding credit. 214 00:22:16.880 --> 00:22:23.180 Moreover, it is not the lack of animal spirits that keeps businessmen from investing. 215 00:22:23.180 --> 00:22:29.080 Instead, it's their debt burden, their already excessive and malinvested capital capacity, 216 00:22:29.080 --> 00:22:34.780 and the uncertainties of reconstructing the capital structure during a depression. 217 00:22:34.780 --> 00:22:44.380 In any case, in 1997, the Bank of Japan had already taken the advice belatedly given in mid-1998 by Paul Krugman 218 00:22:44.380 --> 00:22:50.380 To bypass the banks and use newly created yen to buy bonds directly from private holders. 219 00:22:50.380 --> 00:22:59.380 From October of 1997 to October of 1998, the Bank of Japan's holding of commercial paper went from 0 to 117 billion dollars. 220 00:22:59.380 --> 00:23:06.380 Today, the Bank of Japan is the single largest holder of commercial paper in Japan, owning one-third of the total. 221 00:23:06.380 --> 00:23:12.380 The Ministry of Finance and the Bank of Japan have also been buying government bonds directly from private holders. 222 00:23:12.380 --> 00:23:23.380 Together, they now make up 53% of the $2 trillion market for Japanese bonds, and yet the banks are still paralyzed and the economy still slumping. 223 00:23:23.380 --> 00:23:33.380 Moreover, risk-averse savers have been shifting their funds away from banks and into the postal saving system, giving the government even more scope to circumvent the banks. 224 00:23:33.380 --> 00:23:37.540 In recent years, funds in the system have been increasing at 9% per year, 225 00:23:37.540 --> 00:23:42.340 so that today, $2 trillion, which is more than the total savings in banks, 226 00:23:42.340 --> 00:23:46.980 and one-third of all savings in Japan, is under government control. 227 00:23:46.980 --> 00:23:50.580 Not surprisingly, bureaucrats have squandered the funds. 228 00:23:50.580 --> 00:23:56.740 In 1997, for example, the government channeled $5.3 billion into building a high-tech 229 00:23:56.740 --> 00:24:01.380 bridge tunnel spanning Tokyo Bay that will, by the government's own estimates, 230 00:24:01.380 --> 00:24:04.380 and suffer losses until the year 2038. 231 00:24:05.380 --> 00:24:09.380 Constructing more loss-producing ventures is hardly the remedy for depression. 232 00:24:10.380 --> 00:24:16.380 While government spending bailouts and reflation serve only to prop up malinvestments of the boom 233 00:24:16.380 --> 00:24:19.380 and further delay the reconstruction of the capital structure, 234 00:24:20.380 --> 00:24:25.380 that reconstruction is inevitable in a market economy since it functions to satisfy consumers. 235 00:24:25.380 --> 00:24:33.380 Bankruptcy, mergers, acquisition, restructuring and deflation are the means the market uses to liquidate the malinvestments. 236 00:24:33.380 --> 00:24:37.380 Some of these forces have been waning in the last two years. 237 00:24:37.380 --> 00:24:44.380 Bankruptcies in 1998 averaged $1,600 per month, and mergers and acquisitions have been on the rise in 1999. 238 00:24:44.380 --> 00:24:52.380 In April, holding companies, long suppressed by antitrust laws that the allies imposed after the Second World War, were reborn. 239 00:24:52.380 --> 00:25:04.380 Alliances between foreign and Japanese banks began late in 1998, and although most bank mergers have occurred among smaller regional banks that have not had access to bailout funds, 240 00:25:04.380 --> 00:25:15.380 a mega merger was announced last month which will combine three of the large Japanese banks into a world-class size concern with $1.3 trillion in assets. 241 00:25:15.380 --> 00:25:29.380 Even though the government has subsidized the merger, the new bank will restructure by cutting 17% of its workforce in the process of eliminating its 8.7 billion dollar losses. 242 00:25:29.380 --> 00:25:33.380 Other restructuring plans will help reallocate labor. 243 00:25:33.380 --> 00:25:46.380 Neck Electric announced an 11,600 worker lay-off in February of this year and overall in 1998 the number of jobs in Japan fell by 480,000. 244 00:25:46.380 --> 00:25:55.380 Moreover, workers across Japan are being asked to take early retirement or cuts in compensation by the method of shoulder tapping, 245 00:25:55.380 --> 00:26:00.380 an example of which is asking an older office worker to chop wood. 246 00:26:00.380 --> 00:26:05.380 Labor, like capital, is misallocated during the boom and must be reallocated during the bust. 247 00:26:05.380 --> 00:26:11.380 But unlike capital, which is relatively specific, labor is relatively non-specific 248 00:26:11.380 --> 00:26:15.380 and thus more easily transferred into other productive uses. 249 00:26:15.380 --> 00:26:21.380 In Japan, excess capacity reached 30% and was particularly acute in steel production, 250 00:26:21.380 --> 00:26:27.380 metalworking, construction, automobiles and petroleum, where the malinvestments of the boom were concentrated. 251 00:26:27.380 --> 00:26:36.380 Concentrated. In contrast, unemployment has risen only to 4.9% from its average rate in the 1980s of 2.5%. 252 00:26:36.380 --> 00:26:42.380 The resilience of the Japanese job market comes from the flexibility of market compensation in Japan. 253 00:26:42.380 --> 00:26:49.380 Unions are too weak to maintain wages in the face of business losses, especially in medium to small size firms. 254 00:26:49.380 --> 00:26:54.380 Although lifetime employment has little significance on unemployment, 255 00:26:54.380 --> 00:27:00.380 government employment adjustment subsidies to companies who keep employees on the payroll as window-sitters 256 00:27:00.380 --> 00:27:06.380 distort official unemployment figures downward, making the unemployment picture look brighter. 257 00:27:06.380 --> 00:27:14.380 But like bank and business bailouts, these subsidies delay reorganization of production and prolonged depression. 258 00:27:14.380 --> 00:27:17.380 But whether the unemployment figure is distorted or not, 259 00:27:17.380 --> 00:27:23.380 Japan's experience clearly demonstrates the fallacy of Keynesian explanations for depression. 260 00:27:23.380 --> 00:27:38.380 Krugman, for example, has argued that a depression occurs when the stock market crashes, causing consumption to fall, which reduces production, causing unemployment, which reduces income, which causes consumption to fall further, etc., etc. 261 00:27:38.380 --> 00:27:43.380 But Japanese workers have not seen unemployment-driven reductions in their income. 262 00:27:43.380 --> 00:27:47.880 Moreover, contrary to Keynesian concerns about under-consumption and over-saving, 263 00:27:47.880 --> 00:27:51.880 saving rates have been falling for the last several decades in Japan 264 00:27:51.880 --> 00:27:54.880 and have continued to drop during the Depression. 265 00:27:54.880 --> 00:28:05.380 Net household saving was 13% in 1997, 12.2% in 1998, and this year stands at 11.5%. 266 00:28:05.380 --> 00:28:10.380 Although the Japanese government appears to be permitting some market forces to operate more fully, 267 00:28:10.380 --> 00:28:14.380 instead fastly refuses to unleash deflation. 268 00:28:14.380 --> 00:28:18.380 The desperate attempts of the Bank of Japan to reinflate by circumventing the banks 269 00:28:18.380 --> 00:28:21.380 illustrates the government's resolve. 270 00:28:21.380 --> 00:28:25.380 Yet this policy, too, depends on the dubious logic of Keynesian economics, 271 00:28:25.380 --> 00:28:29.380 according to which declines in aggregate demand cause prices to fall, 272 00:28:29.380 --> 00:28:36.380 which, since costs cannot adjust downward, generate losses and thus production cutbacks and unemployment. 273 00:28:36.380 --> 00:28:48.380 The monetary deflation and credit contraction during the Depression are the necessary financial aspects of the general liquidation of the boom's malinvestments which were caused by monetary inflation and credit expansion. 274 00:28:48.380 --> 00:28:52.380 The epicenter of the financial boom and bust is the banking system. 275 00:28:52.380 --> 00:29:00.380 Just as the malinvestments and misallocations of the boom move along the lines of profitabilities distorted by monetary inflation and credit expansion, 276 00:29:00.380 --> 00:29:10.380 expansion, the reinvestments and reallocations of the bust follow the corrected pattern of profits and losses in the wake of monetary deflation and credit contraction. 277 00:29:10.380 --> 00:29:24.380 Efforts by the central bank to paper over these losses with reflation delay the realization and paralyze the functioning of the banks and work at cross purposes with the government's relaxing grip on other market forces of liquidation. 278 00:29:24.380 --> 00:29:54.380 Losses during a deflation are not caused by the Keynesian bugbearer of falling aggregate demand but by the mismatch of particular demands by consumers for particular consumer goods and by entrepreneurs for particular factors of production with existing array of costs of production within a production structure filled with malinvestments and misallocations. These losses of the bust are the reverse of the abnormal profits earned during the build-up of the boom and are concentrated on the owner. 279 00:29:54.380 --> 00:30:06.380 Consumers of capital, not labor, since being more specific to each production process, prices of capital goods and to a lesser degree prices of land decline relatively more than wages. 280 00:30:06.380 --> 00:30:14.380 This is how costs of production fall in a market economy to restore or maintain profit even in the face of declining prices of consumer goods. 281 00:30:14.380 --> 00:30:20.380 If the government props up the prices of capital, land and labor, then losses will be crystallized. 282 00:30:20.380 --> 00:30:26.380 Unused capacity and unemployment will emerge, and liquidation and reallocation will be halted. 283 00:30:26.380 --> 00:30:32.380 Despite lamentations about deflation, the Bank of Japan has followed Milton Friedman's advice 284 00:30:32.380 --> 00:30:38.380 and increased the money stock sufficiently to keep prices in general from either rising or falling. 285 00:30:38.380 --> 00:30:47.380 The end money stock has increased 2.8% per year from 91 to 98, and the consumer goods price index has been stable. 286 00:30:47.380 --> 00:30:54.380 and the Bank of Japan had already heeded Friedman's call for increased monetary inflation 287 00:30:54.380 --> 00:31:00.380 which he belatedly issued in December of 1997 by raising the rate of monetary inflation from 3% 288 00:31:00.380 --> 00:31:08.380 where it had been every year since 1994 to 5% in 1997 and 4% in 1998. 289 00:31:08.380 --> 00:31:16.380 In response to this monetary stimulus, GDP fell half a percent in 1997 and fell again 2.8% in 1998. 290 00:31:16.380 --> 00:31:28.380 in 1998. Whereas in 1996, with slower rates of monetary inflation behind it, GDP increased 5.4% and in 1995 it increased 2.5%. 291 00:31:28.380 --> 00:31:40.380 Moreover, the Bank of Japan's first reflation of the 1990s caused consumer goods prices to rise 2.4% per year, from the beginning of 1990 to the end of 1993. 292 00:31:40.380 --> 00:31:46.380 This is three times the rate of price inflation during the boom from the beginning of 85 to 88. 293 00:31:46.380 --> 00:31:51.380 And while wholesale goods prices fell 0.8% per year in the early 90s, 294 00:31:51.380 --> 00:31:56.380 they fell 3.75% per year in the late 1980s. 295 00:31:56.380 --> 00:32:00.380 If America's experience in the 1920s was not sufficient enough, 296 00:32:00.380 --> 00:32:08.380 Japan's in the 1980s demonstrates once again that stable price indices are no panacea for the boom bus cycle. 297 00:32:08.380 --> 00:32:13.380 Japan has given the world its last 20th century Keynesian experiment. 298 00:32:13.380 --> 00:32:18.380 Let us hope that the legacy of Japan's debacle 299 00:32:18.380 --> 00:32:23.380 is the acceptance of the lesson Ludwig von Mises taught us in 1912, 300 00:32:23.380 --> 00:32:28.380 that the Keynesian miracle of central bank monetary inflation and credit expansion is counterfeit 301 00:32:28.380 --> 00:32:32.380 and must end in crises and depressions. Thank you. 302 00:32:38.380 --> 00:32:40.380 Thank you very much.