Japan Steps in It

What do you know? Japan now is out of Paul Krugman's doghouse, and all it took was some inflation. Writes Krugman:

For three years economic policy throughout the advanced world has been paralyzed, despite high unemployment, by a dismal orthodoxy. Every suggestion of action to create jobs has been shot down with warnings of dire consequences. If we spend more, the Very Serious People say, the bond markets will punish us. If we print more money, inflation will soar. Nothing should be done because nothing can be done, except ever harsher austerity, which will someday, somehow, be rewarded.

But now it seems that one major nation is breaking ranks — and that nation is, of all places, Japan.  

Even though Japan's massive Keynesian spending plan in the 1990s did not prevent the "lost decade," nonetheless it seems that the Japanese are ready for their own version of Phase II. (True to form, Krugman claims that Japan's trouble was that it did not build enough roads and bridges to nowhere to have a sustained recovery.)

I'll let Krugman go on with his newest version of the magic of inflation, but I would like to share a great article on the Japanese experience, written by Doug French. Japan, says French, engaged in massive amounts of malinvestment during the 1980s, but the government did everything it could to keep the necessary liquidations from happening:

Between 1992 and 1995, the Japanese government tried six stimulus plans totaling 65.5 trillion yen and they even cut tax rates in 1994. They tried cutting taxes again in 1998, but government spending was never cut. Also in 1998, another stimulus package of 16.7 trillion yen was rolled out nearly half of which was for public-works projects. Later in the same year, another stimulus package was announced, totaling 23.9 trillion yen. The very next year an ¥18 trillion stimulus was tried, and, in October of 2000, another stimulus for 11 trillion was announced. As economist Ben Powell points out, "Overall during the 1990s, Japan tried 10 fiscal stimulus packages totaling more than 100 trillion yen, and each failed to cure the recession," with Japan's nominal GDP growth rate below zero for most of the five years after 1997.

 That, folks, means a lot of bridges to nowhere. Unfortunately for Japan, when this latest experiment with inflation and new government spending provides results similar to what happened before, Krugman will claim that the problems was a lack of spending and inflation. I doubt seriously that the Inflation Fairy will grant Japan or Krugman their wishes: a booming economy.

Krugman joins the "Broken Window Fallacy" crowd

I am in New York for a conference, but I will share this gem from Paul Krugman's recent blog post in which he claims that the tragedy and recovery in Japan likely will be "expansionary." Yes, we see yet another "economist" become a caricature of the people who claimed that the hoodlum who broke the baker's window described in Henry Hazlitt's classic Economics in One Lesson.

As Hazlitt explains in the first chapter, the "Broken Window Fallacy" is the central fallacy that we see in one form or another, and from what I see, Krugman is the biggest advocate of this fallacy. Hey, I know. We're in a "liquidity trap," so the world is turned upside down. Right?

Krugman: Government is not a burden; It creates wealth!

[NOTE]: In answer to a comment from AP Lerner regarding the behavior of interest rates and government bonds, I will be answering that question via an article I will send to the Mises Institute page. That will give me more space to deal with this question, the same one that Paul Krugman has been asking in his columns: If the "bond vigilantes" were right, why have interest rates fallen instead of going up? I'll post the column when it is put up on the Mises page. That means the answer will be coming in a few weeks.

On another point, I know that some of you have seen your comments disappear. I am NOT deleting any of them. Yesterday, I was having problems of my own dealing with Blogger, and so I believe that what we are seeing is a technical issue at work that is beyond my own blog. I'm sorry that you have experienced those problems, but I also want you to know that I don't delete things just because I disagree with them. [END NOTE]

In his missive today on Japan and the state of its economy, as well as the state of our own economy, Paul Krugman decides that being a partisan hack is good economics. While I hold no love for the Republican Party and fully agree that the Bush administration was irresponsible and profligate, nonetheless, when the Democrats took power, they did not put the brakes on runaway spending, but, instead, stepped on the accelerator.

Here is the problem. While Krugman and the Democrats rightly accuse the Republicans of "running the economy into a ditch," they don't say how it was done. After all, with the explosion in government spending during the Bush years, they cannot accuse the Republicans of not spending enough "to give the economy traction."

Yes, the purposeful diversion of huge amounts of money into the housing market created a destructive bubble, but even there, the Democrats and Krugman have a problem. First, if all that is needed is more spending, then why did the attempts to continue to prop up the housing market fail miserably?

If recessions are caused simply by a drop in private spending (both consumption and investment spending), then fixing it should be easy: Ben Bernanke can just fly lots of helicopters over the country and drop money. Since government is not "revenue constrained," as the Chartalists are fond of reminding us, the solution is easy. As Robert Murphy noted in this article, since government monetary creation "abolishes scarcity," fixing the current problem is a helicopter drop away.

Furthermore, spending is spending, and since the Bushies launched wars on the other side of the world and spent, spent, spent, it would seem to me that they were increasing the "aggregate demand" that Krugman claims is the key to prosperity. Yet, why did the boom turn into a bust? The Austrians have the answer, but Krugman and his followers (the entire U.S. Government apparatus) certainly are not going to listen.

I also wish to address one more issue, and that is Krugman's claim that ObamaCare is a cost-cutting measure. He says:

(The Republicans) also surely (will) try to repeal health reform, which would be another twofer, reducing economic security even as it increases long-term deficits.

What is Krugman's proof that this initiative will lower the future federal deficits? He cites studies from the Congressional Budget Office, studies that were made by Democrats to benefit Democrats. Now, I like to see empirical evidence as much as the next guy, but I am NOT going to accept partisan political speculation of something that supposedly will happen in the future as "empirical evidence" of something that is GOING to happen. That is not economic analysis; it is simply partisan hackery. Furthermore, name me one "cost-saving" government spending program that has cut the federal deficit. These "programs" are nonexistent.

As some of the people commenting on this blog have noted, Krugman was calling for a $1.2 trillion "stimulus," but we got "only" $800 billion. Now, we are supposed to assume that for want of just $400 billion more, the economy would have been close to "full employment." That seems absolutely ludicrous on its face. Furthermore, he demonstrates no causal mechanism on how that extra "stimulus" would have translated into longer-term economic benefits. By claiming that all of this is the fault of Goldstein the Republicans, Krugman further moves away from economic analysis into the world of pure partisan politics.

Liquidity Trap or Malinvestments?

One of the standard Krugman-Keynesian beliefs is that assets are homogeneous, and that the only thing that matters in an economy is spending. (This is separate from real-live purposeful consumption, which is the end of all productive activity.)

In this line of thinking, a "liquidity trap" view of things makes perfect sense, and Krugman is fond of claiming that the U.S. economy, like Japan 20 years ago, suffers from such a condition. In his post on inflation and Japan, he repeats the old canard that deflation is the enemy and that inflation means nothing, at least at the present time.

(I find it interesting that in yesterday's post, he claims that "inflation did have to be brought down," although he does not specify what that was so, given that at the time, the nation's rate of unemployment was unacceptably high. There is no real consistency here, except to throw out partisan political barbs of "Democrats good, Republicans bad," which is acceptable at DNC headquarters, but I do not think is such when coming from a supposed Nobel Prize winner in economics.)

According to Krugman-Keynesian doctrine, an economy is in a "liquidity trap" if interest rates have a lower bound of zero or near-zero, yet businesses are not borrowing at a rate necessary to keep the economy going at the boom rates. That is why Krugman is fond of repeating his contention that current government borrowing only is replacing lost business borrowing, as though all borrowing has its use ONLY in the money spent.

When the economy is in such a "liquidity trap," according to Keynesians, then the only thing that can "stimulate" an economy is more government spending. That is because, according to Keynesians, there is no mechanism within a market economy that will allow economic activity to be generated, as though it were a dead battery that needs to be "jump-started" from the outside.

In a recent post on the Freeman Online, I take issue with the Keynesian approach, pointing out that the real issue we face -- as did Japan two decades ago -- is that government intervention has generated massive amounts of malinvestment. Our current situation is not a "liquidity trap," but rather is one in which the government has kept the malinvestments alive through the intervention via the Federal Reserve System.

For example, the huge amounts of resources poured into propping up the banks and other financial houses, along with keeping General Motors and Chrysler alive, drain the economy of productive capacity. Furthermore, the Obama administration clearly has shown itself to be hostile to real productivity and profitability, labeling profitable firms as being the cause of our problems and calling for higher taxes and other measures to cut the healthy firms down to the level of the unhealthy ones.

The real problem that Japan faced was that its economy had generated malinvestments during its previous boom, and those malinvestments needed to be liquidated, not propped up. Instead, the government tried to keep everything afloat and the result was the "lost decade." Likewise, we are seeing the same thing here.

Krugman, as a True Believer, does not see that. Instead, he really seems to hold that all assets are homogeneous, profits are a drain on the economy, and high taxes and the iron hand of the state will guide us to prosperity. This will not be the case, but I doubt seriously that he will change his tune, given the public worship that intellectuals and the political classes have bestowed upon him.

Japan's "Lost" Decade: Deflation or Malinvestments?

There are two reasons why I believe Keynesian economic analysis is popular not only in academe but also in government circles. The first is obvious: any kind of analysis that claims only government can create prosperity is going to be the ideology of choice by those in government, and those who believe that they should be empowered to tell others what to do.

The second reason is that Keynesian analysis is pretty easy to understand and to teach. (I always wait until the end of the semester to teach the "aggregate demand -- aggregate supply lessons, but students have no problem understanding how the graphs work and the Keynesian claims.) According to the Keynesians, the entire economy is moved by aggregate spending on consumption goods and services. There is no concern at all about the factors of production, no messy "structure of production" to analyze, nor should one worry about inflation, as inflation is good for the economy. Just spend, spend, spend, and everything is fine.

Thus, Krugman's column today in which he foresees a "lost decade" for the United States, does not surprise me. His prediction might be true, but perhaps it is ironic that Krugman's very policy prescriptions that the government is following will be the reason for that "lost decade."

First, he writes:

Recent data don’t suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged era of high unemployment and slow growth.

Let’s talk first about those interest rates. On several occasions over the past year, we’ve been told, after some modest rise in rates, that the bond vigilantes had arrived, that America had better slash its deficit right away or else. Each time, rates soon slid back down. Most recently, in March, there was much ado about the interest rate on U.S. 10-year bonds, which had risen from 3.6 percent to almost 4 percent. “Debt fears send rates up” was the headline at The Wall Street Journal, although there wasn’t actually any evidence that debt fears were responsible.

Since then, however, rates have retraced that rise and then some. As of Thursday, the 10-year rate was below 3.3 percent. I wish I could say that falling interest rates reflect a surge of optimism about U.S. federal finances. What they actually reflect, however, is a surge of pessimism about the prospects for economic recovery, pessimism that has sent investors fleeing out of anything that looks risky — hence, the plunge in the stock market — into the perceived safety of U.S. government debt.

What’s behind this new pessimism? It partly reflects the troubles in Europe, which have less to do with government debt than you’ve heard; the real problem is that by creating the euro, Europe’s leaders imposed a single currency on economies that weren’t ready for such a move. But there are also warning signs at home, most recently Wednesday’s report on consumer prices, which showed a key measure of inflation falling below 1 percent, bringing it to a 44-year low.

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.

So what we should really be asking right now isn’t whether we’re about to turn into Greece. We should, instead, be asking what we’re doing to avoid turning Japanese. And the answer is, nothing.

It’s not that nobody understands the risk. I strongly suspect that some officials at the Fed see the Japan parallels all too clearly and wish they could do more to support the economy. But in practice it’s all they can do to contain the tightening impulses of their colleagues, who (like central bankers in the 1930s) remain desperately afraid of inflation despite the absence of any evidence of rising prices. I also suspect that Obama administration economists would very much like to see another stimulus plan. But they know that such a plan would have no chance of getting through a Congress that has been spooked by the deficit hawks.

In short, fear of imaginary threats has prevented any effective response to the real danger facing our economy.

Will the worst happen? Not necessarily. Maybe the economic measures already taken will end up doing the trick, jump-starting a self-sustaining recovery. Certainly, that’s what we’re all hoping. But hope is not a plan.

In other words, the problem is that we don't have enough inflation. However, there is something that Krugman misses, and that is the fact that there are massive malinvestments in our economy that the government continues to try to prop up. Furthermore, the government is forcing billions of dollars to be spent on resources that cannot be sustained in our economy without draining the healthy industries. That is the meaning of "malinvestments."

Is there an alternative view? Doug French, in a recent article, points out that the Japanese economy in the late 1980s had a both real estate and stock market bubbles (Sound familiar?) and the government did exactly what Krugman has said needs to be done. French writes:

After the bubble popped in Japan, that government pursued a relentless Keynesian course of fiscal pump priming and loose fiscal policy with the result being a Japan that went from having the healthiest fiscal position of any OECD country in 1990 to annual deficits of 6 to 7 percent of GDP and a gross public debt that is now 227 percent of GDP. "The Japanese tried to cure an alcoholic with heroin," writes Bonner. "Now, they're addicted to it."

Japan's monetary policy was to aggressively lower rates to .5 percent between 1991 and 1995 and has operated a zero-interest policy virtually ever since.

Between 1992 and 1995, the Japanese government tried six stimulus plans totaling 65.5 trillion yen and they even cut tax rates in 1994. They tried cutting taxes again in 1998, but government spending was never cut. Also in 1998, another stimulus package of 16.7 trillion yen was rolled out nearly half of which was for public-works projects. Later in the same year, another stimulus package was announced, totaling 23.9 trillion yen. The very next year an ¥18 trillion stimulus was tried, and, in October of 2000, another stimulus for 11 trillion was announced. As economist Ben Powell points out, "Overall during the 1990s, Japan tried 10 fiscal stimulus packages totaling more than 100 trillion yen, and each failed to cure the recession," with Japan's nominal GDP growth rate below zero for most of the five years after 1997.

The simply question, then, is this: Why didn't this "stimulus" work in Japan and why won't it work here? The answer can be given in one word: malinvestments.

In the Keynesian world, all assets are homogeneous, and all that needs to be done is to stimulate consumer spending. If consumers spend, then the factors of production automatically adjust and the economy is fine. However, Austrians point out that the real activity is in the factors themselves, and when government "stimulus" programs encourage people to spend now, their spending patterns will change the very structures of production.

The recessions begin when the production structures develop problems, which then leads to less spending by consumers. In other words, Keynesians get it backwards. They believe that the recessions begins with a fall in consumer spending when then moves to the production side.

In other words, the gulf between Keynesians and Austrians is huge and cannot be bridged. That people in power are listening to Krugman and the Keynesians means that we are in for a long, harsh, and ruinous recession. Unfortunately, the government and its allies will blame private enterprise, and the Congress will pass news laws that will make us even poorer. Like it or not, that is our future.

Krugman, Japan and the Keynesian Cult

One of my pet peeves with Paul Krugman's writings has been his constant rewriting of history, a rewriting that just happens to coincide with left-wing political talking points. For example, we hear that the Great Depression occurred because Herbert Hoover was a staunch believer in laissez-faire and took the advice of Treasury Secretary Andrew Mellon, who called for liquidation of bad assets to "purge" the economy of whatever was "rotten" in the system.

However, even a cursory reading of the history demonstrates Hoover openly rejected Mellon's advice and tried stimulus after stimulus, only to see the economy crumble. (Krugman's response always is the same: Hoover tried "too little, too late." So, whenever ANY so-called stimulus does not work, the standard Krugman-Keynesian response is that the "stimulus" was "too small.")

Thus, he takes issue with a paper by Alberto F. Alesina and Silvia Ardagna in which the authors claim that tax cuts, as opposed to increases in government spending, provide a better "stimulus" for a moribund economy. Not having read the paper, I cannot make any "expert" or otherwise comments except to say that the issue at hand ultimately is not "stimulus" at all; it is the presence of malinvestments that must be liquidated in order for the economy to recover.

Once a boom has collapsed, the boom-era malinvestments begin to act like cancer cells, sucking the life out of what is left of the economy. It is better to let the market salvage any malinvested assets that it can while permitting the others to liquidate rather than to have these sick "assets" bring down the entire economy. (Government Motors and Chrysler, anyone?)

Krugman, however, goes on to criticize the paper on two points: (1) the presence of a "liquidity trap" in which monetary expansion by the central bank no longer can "stimulate" anything, and (2) the record of so-called expansionary policy of the Japanese government during Japan's decade-long recession of the 1990s. Let me begin with the "liquidity trap" arguments.

Murray Rothbard in his classic America's Great Depression devastates the Keynesian "liquidity trap" in the following passage:

...the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the "profit spread" on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers' goods prices falling faster than do consumer goods' prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned "classical" speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from "speculative" hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.

Keep in mind that Keynesians hold that "real rates" don't mean much, just as Keynes advocated inflation to cut real wages as a means to increase employment. His response was to declare that workers are only interested "in their money wage." History tells us something different, does it not?

On the Japanese recession, Krugman differs with Alesina and Ardagna on the timing and the forcefulness of the government's "stimulus" actions, yet his response is more technical than it should be:

First, the whole stimulus debate is supposed to be about what happens when interest rates are up against the zero bound. Everything is different if the central bank is busy adjusting rates in response to conditions, and may well raise rates to offset the effects of any fiscal expansion. Yet the Alesina-Ardagna analysis doesn’t make that distinction; Japan in the 90s, which was up against the zero bound, is treated the same as a batch of countries in the 70s and 80s, when interest rates were quite high.

Second, they use a statistical method to identify fiscal expansions — trying to identify large changes in the structural balance. But how well does that technique work? When I want to think about Japan, I go to the work of Adam Posen, who tells me that Japan’s only really serious stimulus plan came in 1995. So I turn to the appendix table in Alesina/Ardagna, and find that 1995 isn’t there — whereas 2005 and 2007, which I’ve never heard of as stimulus years, are.

However, as Doug French recently wrote, the Japanese government enacted a number of spending and interest-rate cutting actions during the 1990s, none of which worked. (True to form, Krugman several years ago claimed that had Japan's government not engaged in such actions, the Japanese economy would have fallen into depression, another "Heads, I win, Tails, you lose" proposition we often see from Krugman.)

Interestingly, Krugman always has approached the Japanese recession as having come out of nowhere, or he has linked it to Japan's high savings rate. French, however, notes that Japan had a huge and unsustainable boom that turned into a combination of stock and real estate bubble which popped:

For a brief moment in 1990, the Japanese stock market was bigger than the US market. The Nikkei-225 reached a peak of 38,916 in December of 1989 with a price-earnings ratio of around 80 times. At the bubble's height, the capitalized value of the Tokyo Stock Exchange stood at 42 percent of the entire world's stock-market value and Japanese real estate accounted for half the value of all land on earth, while only representing less than 3 percent of the total area. In 1989 all of Japan's real estate was valued at US$24 trillion which was four times the value of all real estate in the United States, despite Japan having just half the population and 60 percent of US GDP.

Bubbles, as we have seen, result from deliberate "expansionary" policies by government authorities, yet Krugman always seems to treat them as being solely the product of private enterprise. It never occurs to him that the policies of high leverage and betting on inflated asset values would not happen systematically if government were not acting behind the scenes. Instead, he tells us that the only thing that can rescue a financial system is a new round of government regulations.

Japan did not go into recession because of laissez-faire or because its citizens saved too much money, just as the Chinese did not cause our financial bubbles with their own savings. Krugman's response to the boom and bust cycle reminds me of something I saw written about a friend of mine: "The trouble with the world is wine, women, and song. We must stop singing."