Part 2: The Deflationists' Myth of Japan
by Gary North
by Gary North
Recently by Gary North: Keynes and Bernanke on Bubbles and Manias: Blame the Free Market
In my previous report in this series, I contrasted the monetary views of the Austrian School of economics with the standard views of Keynesian and Chicago School economists. Despite their deep-seated differences, all of them oppose the views of the handful of forecasters who predict inevitable price deflation. I wrote:
Austrian School economists insist that hyperinflation is always an option, leading to the destruction of capital markets, the breakdown of the division of labor, and a switch to a new currency unit when money dies. They also say that if the Federal Reserve System ceases to inflate and also refuses to intervene to save the banks, there will be a banking collapse leading to monetary deflation and price deflation. Most of them think this is politically unlikely. . . .
Non-Austrian School economists insist that the government and the central bank can always get the economy out of any crisis that previous laws and central bank policies have created. All that it will take to avoid the crisis will be "prudent" economic policies — "prudent" being defined as "what I would recommend if anyone ever asked me." They say that there need not be price deflation. The price of avoidance is mild monetary inflation — a small price to pay, they all insist.
The deflationists have had only one representative economist with experience as a mega-banker and a central banker: John Exter. I devoted my previous report to an explanation of his major error. It was this: he confused rising and falling prices of investment assets with rising and falling prices of consumer goods. He said that the debt load associated with investment assets will someday cause a collapse of asset prices. This will create a collapse of prices in the economy.
I demonstrated that the rise or fall of asset prices do not affect the rise and fall (rare) in consumer prices, except when the fall in asset prices bankrupts commercial banks, and the central bank and the government fail to bail out these banks. Then the money supply shrinks, as it did, 1930—33.
The government and the FED will not sit idly in the sidelines, allowing banks to fail. That was the lesson of September and October, 2008.
To put this in terms anyone can understand, the collapse of Lehman Brothers in 2008 had no effect on the price of toilet paper or any other consumer good. Exter's intellectual disciples have confused Lehman Brothers with Charmin. They have confused Richard Fuld with Mr. Whipple.
For as long as the money supply remains constant, consumer prices will fall slightly, due to increased productivity. So teach the Austrians and Chicago School monetarists. This is price deflation, and it is a benefit to consumers, Austrians teach. Consumers' real wealth increases with falling consumer prices, if their wages stay constant, and if they did not have their money invested in bubble assets.
This brings me to the topic of this report: consumer prices in Japan.
WHAT ARE THE FACTS?
First, let me begin with the facts of central bank monetary policy. The Bank of Japan controls the supply of the monetary base. It does so by buying or selling income-producing assets, mainly government debt.
I offer two charts. One is a chart of the Bank's monetary policies since 1992. The second is a chart of the Federal Reserve's monetary policies since 1992. These charts are published by the Federal Reserve Bank of St. Louis in its quarterly publication, "International Economic Trends."
The charts may amaze you. What they show is simple to state: the two nations had similar central bank policies until late 2008, when the Federal Reserve went berserk.
Second, consider the year-to-tear rates of change in the money supplies in both nations. For Japan, M1 and M2 are on the same chart. The chart for the money supply for the U.S. in this publication compares MZM, which is a useless predictor of consumer prices, and M2, which isn't much better than MZM. Both of them overestimate future consumer prices. (Is there an editor for "International Economic Trends"? Or is it an uncoordinated effort?) So, I have used the similar chart of M1 and MZM that is published in another St. Louis FED publication, "Monetary Trends." Ignore MZM.
The results of the respective central bank policies (adjusted monetary base) were similar. If we compare Japan's M2, which was mildly inflationary (usually under 3%, 1992—2002; about 1%, 2003—2009), with America's M1, which was also mildly inflationary — actually deflationary, 1996—98 — we see little difference. These two monetary aggregates are the best indicators of future consumer prices in their respective nations.
Let us now look at charts comparing rates of change in the consumer price indexes of both nations. The rate of annual change in Japan has been slightly deflationary, but no greater than 1% in any 12-month period, and rarely that low. In two years, prices rose by 2%: 1997 and 2008.
Conclusion: there has been no systemic price deflation in Japan.
As the earlier chart indicated, M2 rose by very little in Japan, especially 2003—2009. This means that prices declined slightly in response to a mild monetary expansion. This is consistent with the monetary theories of both the Austrian School and the Chicago School of economics. Increased output, when coupled with very low increases in the money supply, will produce falling prices.
Here is the ideal scenario: no monetary inflation and output increasing by 2% to 3% per annum. Consumer prices fall by 2% to 3% per annum. Japan has been close to this ideal for two decades — closer than any other industrial nation.
The Austrian School favors slowly falling prices in response to zero monetary inflation. The Chicago School favors stable prices and a slowly but steadily rising money supply. Japan is more Chicago School than Austrian, but it has been closer to Austrianism than any other nation for two decades with respect to money and prices.
Here is my fundamental point. Japan's central bank has systematically adopted monetary policies that have produced a Chicago School outcome: nearly stable prices. This indicates that Japan's central bank has had a goal, and it has achieved this goal. It has not been fighting systemic price deflation. It has produced deliberate price deflation on a minute scale.
With this as background, I will survey some statements from deflationists regarding Japan.
CONFUSION AMONG DEFLATIONISTS
I searched Google for "systemic deflation" and "Japan."
The good news is that there are not many examples of this: fewer than 400 links. I found no examples of the more famous deflationists using this phrase with respect to Japan.
If you search for "systemic deflation" and leave out "Japan," you still do not find a lot of examples, and numerous links are to statements by analysts who oppose the idea that deflation will be systemic. I found fewer than 1,000 links.
Some of my readers have been concerned that the United States may be facing a systemic deflation comparable to what Japan has experienced. They did not get this idea from the more famous deflationists' explicit warnings about systemic deflation. Whatever the warnings have been, the better-known deflationists have avoided the use of that terminology.
They have used the term "deflation." They have used it often enough so that some readers have gotten the impression that the deflationists have used the stronger term: "systemic deflation."
If you search Google for "deflation" and "Japan," you will get over a million hits. There is no doubt that Japan is associated with deflation. Some of these articles are Keynesian hand-wringing. Here are two examples.
The BoJ can start by being more assertive. It is almost as if it is so exasperated by the flaky achievements of its previous anti-deflationary efforts that it would rather sit back and wait for a recovery. But that is a defeatist attitude. If nothing else, it should publicly revive discussion of alternative plans to reflate the economy. That could include increasing government-bond purchases, or setting itself a monetary target not just based on a positive inflation rate, but on robust growth of nominal GDP.
To the man on the street, deflation does not seem like a bad thing — prices are falling, so what can be so bad?
However Japan has been through the experience of deflation, in the late 1990s, and has a different tale to tell.
It came after the country had first gone through a banking crisis meltdown, when the government had to take unprecedented measures in what was then "the field of the unknown."
Then, just when it seemed the worst was over, at the end of the decade deflation gripped the economy — and its effect filtered through all sectors of society affecting all parts of life.
This is the standard Keynesian Party Line: the evils of falling consumer prices.
Then there is a statement from a hard-core deflationist: a follower of Elliot wave theory.
One argument inflationists make is that the U.S. can't have deflation because it will simply print enough money to counteract it. But the Japanese tried that and failed, but interestingly, it did succeed in holding up one economic statistic — the GDP number. Even as Japan's stock and real estate bubbles imploded (commercial properties fell by 87%!), Japan's GDP continued to press higher, as seen in the chart.
Note: this example has to do with falling asset prices, not falling consumer prices. This was John Exter's mistake: he focused on the bubbles and busts of asset markets, not the effects of these events on the price of consumer goods. There were no effects on the price of consumer goods.
Furthermore, this article provides a chart of the increase in Japan's GDP during these two decades It rose from about 500 to 800 in real terms — factoring in output and prices. That is an increase of 60%. That is an increase of 2.5% per annum. This is quite respectable. It is consistent with the growth rate over the last two centuries in the West.
Then why the hand-wringing over Japan's price deflation? It makes no sense.
People who lack background in economic theory, money and banking theory, and economic history are easily manipulated by journalists who are not much better informed, but who have an axe to grind or a hobby horse to ride. I wish they would take their sharpened axes and hack the hobby horses into kindling.
Let me list what is demonstrably true from the available statistics.
- Consumer prices in Japan fell little, 1992—2009: no more than 1% per annum in most years, if at all.
- In some years, they rose by 2%.
- Output increased at respectable rates.
- Per capita output increased.
- The M2 money supply barely rose.
- The Bank of Japan did not inflate the currency in order to overcome systemic price deflation, which did not exist.
- The Bank of Japan pursued a policy that kept prices close to stable.
- The collapse of real estate prices did not lower consumer prices.
- The collapse of the stock market did not affect consumer prices.
Let me list what is true, based on Austrian School economics.
- Rising prices are a monetary phenomenon.
- Stable money and increased output produce slowly falling consumer prices.
- Stable prices indicate a mildly rising money supply.
- Central banks control the money supply through the loan markets.
- Central bankers do not need to worry about price deflation that might become systemic, as long as the governments and fiat money bail out fractional reserve banks.
- Any future price deflation will be the result of central bank policy: refusing to bail out busted banks and refusing to buy Treasury debt.
- As long as the FDIC bails out depositors, there will be no decrease in the money supply due to busted banks, as there was in 1930—33.
- Central banks control the lending practices of commercial banks through (1) the monetary base; (2) the legal reserve ratio; (3) by not imposing an excess reserves fee on commercial banks holding excess reserves rather than lending them in the form of fiat money.
- The FED is not powerless to prevent price deflation.
- The FED can increase the total money supply at any time by imposing a fee on excess reserves.
If you keep in mind the facts of Japan's experience and the facts of Austrian economic theory, you will not be deceived by journalists who predict inevitable price deflation based on some variant of John Exter's mistake.
January 11, 2010
Copyright © 2010 Gary North