In 1943, John Maynard Keynes claimed that central bank credit expansion performs the, quote,
miracle of turning a stone into bread, close quote.
History has revealed Keynes' miracle as a counterfeit,
producing not higher standards of living, but crises and depressions.
Economic growth requires genuine capital accumulation,
that is, the construction of an enlarged capital structure by saving and investing.
The counterfeit miracle of central bank monetary inflation generates only a boom bust.
At first, the credit expansion appears to be a stimulated process of economic growth.
Interest rates fall, capital values rise, and entrepreneurs profit by building up the capital structure.
The capital construction cannot be completed, however, since genuine saving is insufficient.
The boom rests on a lie, namely artificially low interest rates.
And once the lie is exposed, the boom must end and the bust must follow.
Japan has experienced both the genuine miracle of the market and the counterfeit miracle of the state for the past 150 years.
International trade with the West began in earnest in the 1850s
and the restoration government of 1868 supplanted the old feudal system
with private property rights, freedom of trade, enterprise and movement.
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.
The thrifty Japanese people provided ample saving for capital accumulation.
Countering these forces of genuine growth, the government subsidized transportation and communications,
cartelized the banking system and heavy industry, and established a central bank.
In short, Japan imitated the mercantilist system of Great Britain, complete with an empire, albeit on a regional scale.
The Japanese Empire, like the British one, was founded on the international division of labor,
in this case with its Asian neighbors, including Manchuria, Formosa and Korea.
But the financing power of Japan's debt and monetary inflation was put into the service of its warfare state.
Thus, the rise of Japan to a great industrial power prior to the First World War
was part genuine economic growth, part build-up for the state, and part boom-bust.
Japan's economic development, like America's, was given a tremendous boost by its policy of neutrality in the First World War.
Japan's trade with Asia increased enormously as former trading partners went to war with each other.
And like America, Japan inflated during the war on the base of huge gold reserves that were built up by burgeoning trade surpluses.
The inflationary boom lasted until 1920 and a deflationary collapse followed.
The massive earthquake of 1923 set up the next round of monetary inflation by the Bank of Japan to finance reconstruction spending.
That boom came to an end when heavy outflows of gold led to a deflationary collapse in 1927
and was followed by a depression until 1931.
Just as the Great Depression was gearing up in the West,
Japan was embarking on another round of government spending, debt and monetary inflation.
This time the expansion was devoted to building up the army and the navy.
For all the belligerence in the Second World War,
During the Second World War, the conversion to a war economy meant centralized political control of economic activity.
In Japan, it was a natural extension of the military build-up of the 1930s that the cartels, in league with the government,
would run the war economy since the cartels dominated heavy manufacturing and banking.
During the war, control over banking was further centralized in the Bank of Japan,
and the Industrial Bank of Japan became the financing agent for war production.
So completely was the economy transformed into a war machine that when the fighting ended,
the productive capacity of the economy was almost entirely worthless for consumer goods
production. Tragically, the occupation authority which ran Japan after the war prevented economic
reconversion. It imposed punitive taxation and labor unions, dissolved the cartels and
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
and Economic Reorganization. Industrial production in 1948 was merely 40% of its 1937 level and agricultural production well below its pre-war level.
In 1949, Japan was forced into the new American dominated international order.
The monetary order of Brenton Woods fixed the yen dollar exchange rate at 360 to 1 and required the Bank of Japan
to coordinate its yen inflation with the Fed's dollar inflation to integrate credit expansion internationally.
The new military order, that is the Cold War, brought Japan's existing military capacity into production again.
Its war machine revived by American military procurements, industrial production in Japan finally surpassed its pre-war level in 1951.
Having proved a reliable ally, the Japanese government had its sovereignty restored in the spring of 1952.
By 1953, the reforms of the occupation authority were reversed.
The unions were weakened, taxes were lowered, the cartels were reformed and government planning strengthened.
State control of credit was as strong as ever in the Japan Development Bank, the Export-Import Bank,
and the Trust Fund Bureau, which had oversight of the postal saving system.
Only land reform survived.
In short, Japan had restored its pre-war, mercantilist economic system,
save for its regional yen trading bloc.
This was hardly a laissez-faire recipe for performing the genuine miracle of economic growth.
For the decades of the 50s and 60s,
Japan served in the American system in a way similar to that of Indonesia in the 80s and 90s.
The inflow of American dollars in the Japanese government's allocation of funds from the postal saving system
boosted the average annual increase in GNP to 9.6% for these two decades,
more than double the 4.6% rate for the period 1925 to 1939.
This productive effort, however, went largely to satisfying government instead of consumer demands.
War materials and infrastructure projects were funded at the expense of building capacity to serve consumers.
International trade went counter to the pre-war lines of comparative advantage.
With America becoming Japan's leading trading partner in both exports and imports,
stripped of its place in the inter-regional division of labor,
Japan began a program of artificial expansion of domestic production.
The Japanese government subsidized production of costly synthetic substitutes
for cheaper imported raw materials, formerly obtained from Manchuria.
Imports of low-priced food declined, while the artificially built up agricultural sector
expanded high-priced output.
Capacity in steel production, electrical equipment, automobiles and shipbuilding
and shipbuilding was heavily subsidized.
Also, part of the post-war economic miracle was counterfeit.
American military procurements for the Korean War amounted to some $3.4 billion
and set off a domestic boom in the early 1950s.
GNP increased 12.1% per year during the war.
The Bank of Japan, however, overinflated the yen, leading to a drain of reserves,
which under the fixed exchange rates of Brenton Woods' system
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.
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.
A short recession followed in 62 and another boom in 63-64, which ended with a recession in 65.
For the next five years, GMP increased by more than 10% per year.
Although it required booms and busts, the Bank of Japan was able to coordinate yen inflation
with Fed dollar inflation sufficiently under Brenton Woods,
that the yen dollar exchange rate remained 360 to 1.
Exchange rate stability, however, required more rapid inflation of the yen than that of the dollar.
With the Japanese economy expanding production at three times the American rate,
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.
When Brenton Woods collapsed, the Fed tripled the rate of dollar inflation from 4.4% in 1970 to 12% in 1971.
The Bank of Japan slavishly followed suit as it had since the Second World War, but yen inflation was not accelerated sufficiently.
Even though the yen money stock grew 22% per year from 1971 to 1973, the yen appreciated against the dollar 22%.
price inflation exploded in 1973-1974 with consumer prices rising 11.7% and 23.1% respectively.
A severe recession followed the credit expansion boom.
After this debacle, Japan began to conduct a more independent monetary policy.
The Bank of Japan gradually decreased yen inflation rates to the point where in 1977
In 1977, the rate of yen inflation fell below the rate of dollar inflation, but another
credit expansion followed with the yen inflating at 11% per year for the next two years and
the Bank of Japan lowering the discount rate from 4.25% in 1977 to 3.5% in 1978.
Price inflation jumped in 1980 with wholesale prices up almost 18%, forcing the Bank of
in Japan to contract by more than doubling the discount rate to seven and a quarter percent by 1980.
Interest rates spiked upward in response, bringing the credit expansion to an end and driving the economy into another recession.
Whatever else can be said about the post-war Japanese miracle, it was over in 1970.
The average annual increase in GNP from 71 to 79 was 4.6 percent,
and from 1980 to 1990 it was an even more anemic 4.1 percent.
Having its monetary policy cut loose from the dollar, Japan attempted in the 1980s to reestablish its yen trading block,
albeit with East and Southeast Asia substituting for the old North Asian alliance.
In the first half of the 1980s this goal could not be attained,
Since the international demand for the dollar outstripped that for the yen.
Despite the Bank of Japan inflating the yen at rates lower than the Fed's inflation of the dollar,
the yen declined 24% against the dollar and consumer goods prices in Japan rose 2.7% per year from 81 to 84.
In 1985, however, the strategy began to be realized.
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.
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.
Japan exported its credit expansion to Southeast Asia and South Korea in the form of direct investment.
The massive Japanese investment in Asia was augmented by loan guarantees
made by the Export-Import Bank of Japan for investment and trade in Asia.
By the end of the debt binge, Japan was the world's largest creditor nation,
manifested by having the world's largest banks
and had the stock market with the world's largest capitalized value.
Despite the massive yen inflation, the yen appreciated 50% against the dollar
from the beginning of 85 to the end of 88,
and consumer goods prices in Japan rose only 0.5% per year,
while wholesale goods prices fell 4.6% per year,
indicating the growing yen money demand, international as well as domestic,
was absorbing the monetary inflation.
But supremacy of the yen was short-lived.
Yen demand collapsed in 1988-1989,
causing a 16% devaluation against the dollar
and a surge of domestic price inflation.
The Bank of Japan hit the monetary breaks,
drastically cutting yen inflation from 12% in 1990
to 4% in 1991 and then to 1.2% in 1992.
The discount rate was raised from 2.5% in 1988 to 6% in 1990.
The end of the credit expansion doubled interest rates
while the reduction in yen inflation helped push the yen dollar exchange rate up 22% from 1989 to 1993.
Japan had experienced what America discovered in the wake of the collapse of Brenton Woods.
Generating an international credit expansion succeeds so long as increases in money demand keep price inflation in check.
Japan's restoration of a yen trading bloc in Asia was cut short by America reasserting the dominance of the dollar,
first in Canada, Mexico, Latin America and South America, and then in Asia and Eastern and Central Europe.
The yen had little chance against the world's reserve currency and the yen-based credit expansion collapsed in 1990.
Although Keynes is the author of its economic destruction, Japan has looked to him for rebuilding advice.
Japan has tried nine stimulus packages since 1990 for a total value of $888 billion.
And although varied in shape and size, they have all had the same three features.
Government spending and debt, bailouts and reflation.
Making matters worse, taxes have been raised several times since 1989
so that the government now extracts over 30% of GDP up from 18% in 1965.
The tax cut of 1998 was too small to reverse this trend.
But even a sizable tax cut would have only a minimal effect
without a corresponding reduction in government spending.
A depression will persist until the malinvestments of the boom are liquidated
and the capital structure is reconstructed to best satisfy consumers.
Fiscal expenditures delay liquidation and reconstruction, since government spending always strives to bail out and subsidize the existing production structure.
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.
Japan's national debt now stands at well over 100% of GDP, up from 60% in 1993.
In 1999, Japan will issue 90% of all industrial countries net new bond issues, some $352 billion.
Its total bond issue in 1999 will be $517 billion and will give Japan the largest debt issue in the world.
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.
Despite Keynesian predictions, mountains of government debt have done nothing to stimulate the economy.
GDP fell 2.8% in 1998, or to alleviate private sector debt.
Estimates in March of this year put the bad debt of private businesses at $720 billion,
which was down only seven-tenths of one percent from a year earlier, despite write-offs.
In August of 1998, Japanese banks had an admitted $600 billion in bad loans,
with another $625 billion loans with higher than normal default risk.
The banks still had, in July of 1998, $1.56 trillion in real estate loans on their books.
Much of it lent to developers with half-finished hotels, defunct golf courses, and dilapidated rental properties,
while real estate prices have fallen 80% from 1991 to 1998.
Banks are also still heavily invested in Japanese stocks, while the Nikkei was down 64% from 1990 to 1998.
The government's answer to the financial debacle has been bailout funds.
Late in 1998, a $514 billion bailout fund was set up.
Funds will go to shore-up deposit insurance corporations to buy shares of stock in troubled banks
and to nationalize, restructure, and liquidate failed banks.
For the favor of having the government become part owner,
the banks must cut payrolls, slash overseas ventures, and write off bad loans.
Regardless, 15 of Japan's top banks lined up for the bailout money.
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.
Bailouts have also been extended to corporations.
In November of 1998, Nissan Motors requested an $833 million loan from the government-run Japan Development Bank,
While Small Business Finance Corp increased its lending to small business 15% in 1997 and another 11% in 1998.
The government has also attempted to bail out its interests in Southeast Asia and South Korea, which were built up during the boom.
As late as 1997, Japanese banks still held 38% of the total outstanding foreign corporate debt loans in Indonesia, amounting to some $58 billion.
In Thailand, Japanese banks held 38 billion in debt, while American banks held only five.
Enterprises in South Korea had borrowed 25 billion dollars from banks in Japan.
In response, the Japanese government provided 20 billion dollars in bailout money
to guarantee bank loans made to interests in Thailand, Indonesia and South Korea.
The Bank of Japan has tried reflation throughout the 1990s.
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.
Blocked from domestic credit expansion, the Bank of Japan tried to expand Japanese bank credit overseas with the yen carrying trade.
Investors would borrow yen at low interest rates, convert the yen to dollars and other currencies, and buy higher return assets overseas.
This put downward pressure on the yen which increased the profitability of the strategy.
The yen-dollar trade was active from mid-1995 to mid-1998 as the yen fell 83% against the dollar.
But in July of 1998, the yen began to appreciate again, losses ensued and the trade dried up.
This policy exacerbated the financial debacle in Asia by greatly expanding credit for three years
for three years and then suddenly shutting it off.
The financial debacle in Asia then saddled Japanese banks with more foreign bad debt.
In response, they cut foreign lending in the first quarter of 1998 by 12%.
This cut is the latest in a downward trend that has left the once dominant Japanese banks
with the same global market share that they had in the early 1980s.
In this morbid condition, banks are incapable of performing their function as financial
and financial intermediaries. Any added reserves they acquire must be used to pay down bad loans instead of expanding credit.
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.
This is why enormous increases in the monetary base, 10% from mid-97 to mid-98,
had little effect on broader monetary aggregates, which rose only three and a half percent.
Keynesians have mistakenly viewed the impotency of the Bank of Japan as a liquidity trap.
But the failure of reflation to generate another credit expansion is not the result of investors hoarding money
because they all expect interest rates must rise from their low levels.
It is the enormous burden of the bad debt that leads banks to hold cash instead of expanding credit.
Moreover, it is not the lack of animal spirits that keeps businessmen from investing.
Instead, it's their debt burden, their already excessive and malinvested capital capacity,
and the uncertainties of reconstructing the capital structure during a depression.
In any case, in 1997, the Bank of Japan had already taken the advice belatedly given in mid-1998 by Paul Krugman
To bypass the banks and use newly created yen to buy bonds directly from private holders.
From October of 1997 to October of 1998, the Bank of Japan's holding of commercial paper went from 0 to 117 billion dollars.
Today, the Bank of Japan is the single largest holder of commercial paper in Japan, owning one-third of the total.
The Ministry of Finance and the Bank of Japan have also been buying government bonds directly from private holders.
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.
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.
In recent years, funds in the system have been increasing at 9% per year,
so that today, $2 trillion, which is more than the total savings in banks,
and one-third of all savings in Japan, is under government control.
Not surprisingly, bureaucrats have squandered the funds.
In 1997, for example, the government channeled $5.3 billion into building a high-tech
bridge tunnel spanning Tokyo Bay that will, by the government's own estimates,
and suffer losses until the year 2038.
Constructing more loss-producing ventures is hardly the remedy for depression.
While government spending bailouts and reflation serve only to prop up malinvestments of the boom
and further delay the reconstruction of the capital structure,
that reconstruction is inevitable in a market economy since it functions to satisfy consumers.
Bankruptcy, mergers, acquisition, restructuring and deflation are the means the market uses to liquidate the malinvestments.
Some of these forces have been waning in the last two years.
Bankruptcies in 1998 averaged $1,600 per month, and mergers and acquisitions have been on the rise in 1999.
In April, holding companies, long suppressed by antitrust laws that the allies imposed after the Second World War, were reborn.
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,
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.
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.
Other restructuring plans will help reallocate labor.
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.
Moreover, workers across Japan are being asked to take early retirement or cuts in compensation by the method of shoulder tapping,
an example of which is asking an older office worker to chop wood.
Labor, like capital, is misallocated during the boom and must be reallocated during the bust.
But unlike capital, which is relatively specific, labor is relatively non-specific
and thus more easily transferred into other productive uses.
In Japan, excess capacity reached 30% and was particularly acute in steel production,
metalworking, construction, automobiles and petroleum, where the malinvestments of the boom were concentrated.
Concentrated. In contrast, unemployment has risen only to 4.9% from its average rate in the 1980s of 2.5%.
The resilience of the Japanese job market comes from the flexibility of market compensation in Japan.
Unions are too weak to maintain wages in the face of business losses, especially in medium to small size firms.
Although lifetime employment has little significance on unemployment,
government employment adjustment subsidies to companies who keep employees on the payroll as window-sitters
distort official unemployment figures downward, making the unemployment picture look brighter.
But like bank and business bailouts, these subsidies delay reorganization of production and prolonged depression.
But whether the unemployment figure is distorted or not,
Japan's experience clearly demonstrates the fallacy of Keynesian explanations for depression.
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.
But Japanese workers have not seen unemployment-driven reductions in their income.
Moreover, contrary to Keynesian concerns about under-consumption and over-saving,
saving rates have been falling for the last several decades in Japan
and have continued to drop during the Depression.
Net household saving was 13% in 1997, 12.2% in 1998, and this year stands at 11.5%.
Although the Japanese government appears to be permitting some market forces to operate more fully,
instead fastly refuses to unleash deflation.
The desperate attempts of the Bank of Japan to reinflate by circumventing the banks
illustrates the government's resolve.
Yet this policy, too, depends on the dubious logic of Keynesian economics,
according to which declines in aggregate demand cause prices to fall,
which, since costs cannot adjust downward, generate losses and thus production cutbacks and unemployment.
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.
The epicenter of the financial boom and bust is the banking system.
Just as the malinvestments and misallocations of the boom move along the lines of profitabilities distorted by monetary inflation and credit expansion,
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.
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.
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.
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.
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.
If the government props up the prices of capital, land and labor, then losses will be crystallized.
Unused capacity and unemployment will emerge, and liquidation and reallocation will be halted.
Despite lamentations about deflation, the Bank of Japan has followed Milton Friedman's advice
and increased the money stock sufficiently to keep prices in general from either rising or falling.
The end money stock has increased 2.8% per year from 91 to 98, and the consumer goods price index has been stable.
and the Bank of Japan had already heeded Friedman's call for increased monetary inflation
which he belatedly issued in December of 1997 by raising the rate of monetary inflation from 3%
where it had been every year since 1994 to 5% in 1997 and 4% in 1998.
In response to this monetary stimulus, GDP fell half a percent in 1997 and fell again 2.8% in 1998.
in 1998. Whereas in 1996, with slower rates of monetary inflation behind it, GDP increased 5.4% and in 1995 it increased 2.5%.
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.
This is three times the rate of price inflation during the boom from the beginning of 85 to 88.
And while wholesale goods prices fell 0.8% per year in the early 90s,
they fell 3.75% per year in the late 1980s.
If America's experience in the 1920s was not sufficient enough,
Japan's in the 1980s demonstrates once again that stable price indices are no panacea for the boom bus cycle.
Japan has given the world its last 20th century Keynesian experiment.
Let us hope that the legacy of Japan's debacle
is the acceptance of the lesson Ludwig von Mises taught us in 1912,
that the Keynesian miracle of central bank monetary inflation and credit expansion is counterfeit
and must end in crises and depressions. Thank you.
Thank you very much.