Why Japan should not fight deflation

On January 22, 2013 policy makers of the Bank of Japan (BOJ) voted for a 2% inflation target, to be achieved “at the earliest possible time”, with a planned 13 trillion yen a month ($145 billion) in extra securities buying. The action came after months of intense pressure on the BOJ from the country’s new Prime Minister, Shinzo Abe, to take more aggressive action to boost the economy.

Mr. Abe maintains that deflation will undermine any efforts to grow the economy and the government and the central bank must act together to get prices rising again.

The yearly rate of growth of the consumer price index (CPI) stood at minus 0.1% in December against minus 0.2% in the previous month. This was the 7th consecutive monthly decline.

Furthermore, the yearly rate of growth of industrial production fell to minus 5.5% in November from minus 4.5% in the previous month.

Most economists are in agreement with Prime Minister Abe that falling prices, labeled as deflation, are a major threat to Japanese economy. They are in agreement with Prime Minister Abe that the way out of the economic slump is for the central Bank of Japan (BOJ) to aggressively increase the money supply. This, it is held, will raise inflationary expectations and lift people’s willingness to spend, which in turn will set an economic recovery in motion. In short, the key to economic recovery is lifting the demand for goods and services by arresting the fall in prices.

However, many experts were disappointed by the BOJ’s latest plans because the planned expanded asset purchases will not begin until 2014.

Also, many of the securities the Bank of Japan will be purchasing are in the form of short-term debt that will quickly mature hence experts hold that  the yearly additional purchase of assets will equal less than $150 billion per year. By contrast, experts argue, the Fed’s balance sheet is expected to expand by a trillion dollars in 2013.

Is a fall in prices bad news?

Contrary to conventional wisdom, there is nothing wrong with declining prices. In fact, it is the essential characteristic of a free-market economy to select as money those commodities the purchasing power of which is growing over time. What signifies an industrial market economy under commodity money such as gold is that the prices of goods follow a declining trend. According to Salerno,

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75 percent per year, while real income rose by about 85 percent, or around 5 percent per year.[1]

In a free market, the rising purchasing power of money, i.e., declining prices, is the mechanism that makes the great variety of goods produced accessible to many people.

On this, Murray Rothbard wrote,

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[2]

It is argued by most experts, however, that a general fall in prices could be “bad news,” for it slows down people’s propensity to spend, which in turn undermines investment in plant and machinery. All this sets in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline. But does it all make sense?

According to Salerno,

Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. Note that the substantial price deflation in the high-tech industries did not impair and, in fact, facilitated the enormous expansion of profits, productivity and outputs in these industries. This reflected in the fact that in 1980 computer firms shipped a total of 490,000 PCs while in 1999 their shipments exceeded 43 million units despite that fact that quality-adjusted prices had declined by over 90 percent in the meantime[3]

Moreover, it does not make any sense to argue that a fall in prices as a result of real wealth expansion causes consumers to postpone purchases of goods and services. To suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present. Without the maintenance of life in the present, however, no future life is conceivable.

Should “bad” price deflation be fought against?

Even if we were to accept that declines in prices in response to an increase in the production of goods promotes the well-being of individuals, what about the case when a fall in prices is associated with a decline in economic activity? Surely this type of deflation is bad news and must be fought against.

Whenever a central bank pumps money into the economy this benefits various individuals engaged in activities that sprang up on the back of loose monetary policy, and it occurs at the expense of wealth generators.

Through loose monetary policy, the central bank gives rise to a class of people who unwittingly become consumers without the prerequisite of making any contribution to the pool of real wealth. Their consumption is made possible through the diversion of real wealth from wealth producers.

Not only does the easy monetary policy push the prices of existing goods higher, but the monetary pumping also gives rise to the production of goods which are only demanded by non-wealth producers.

Now, goods that are consumed by wealth producers are never wasted, for these goods sustain wealth generators in the production of goods and services. This is not so, however, with regard to non-wealth producers who only consume and produce nothing in return.

As long as the pool of wealth is growing, various goods and services that are patronized by non-wealth producers appear to be profitable. However, once the central bank reverses its loose monetary stance, the diversion of real income from wealth producers to non-wealth producers is arrested. This in turn undermines the demand of non-wealth producers for various goods and services, thereby exerting downward pressure on their prices. The fall in the prices of various goods and services signifies that there was never a genuine demand for these goods.

The tighter monetary stance that undermines various activities which sprang up on the back of previous loose monetary policy arrests the bleeding of wealth generators. The fall in the prices of various goods and services comes simply in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. To reverse the monetary stance in order to prevent a fall in prices, amounts to the renewal of impoverishment of wealth generators. As Mises said,

Prices of the factors of production–both material and human–have reached an excessive height in the boom period. They must come down before business can become profitable again. . . .  Thus any attempt of the government or the labor unions to prevent or delay this adjustment merely prolongs the stagnation. [4]

As a rule, what the central bank tries to stabilize is the so-called price index. The “success” of this policy, however, hinges on the state of the pool of real wealth. As long as the pool is expanding, the reversal of the tighter stance creates the illusion that the loose monetary policy is the right remedy. This is because the loose monetary stance, which renews the flow of real wealth to non-wealth producers, props up their demand for goods and services, thereby arresting or even reversing price deflation. Furthermore, since the pool of real wealth is still growing, the pace of economic growth stays positive–hence, the mistaken belief that a loose monetary stance that reverses a fall in prices is the key in reviving economic activity.

The illusion that, through monetary pumping, it is possible to keep the economy going is shattered once the pool of wealth begins to decline. Once this happens, the economy begins its downward plunge. The most aggressive loosening of monetary policy will not reverse the plunge. Any attempt to boost the demand for goods cannot be effective. The means to support this demand are not there. Moreover, the reversal of the tight monetary stance will eat further into the pool of real wealth, thereby deepening the economic slump.

Even if loose monetary policies were to succeed in lifting prices and inflationary expectations, they cannot revive the economy while the pool of real wealth is declining. (Real wealth is required to fund various activities). Since the key to an economic recovery in Japan is the state of the pool of real wealth, how can we ascertain its status? How does one know whether it is growing, stagnating, or declining?

If the pool had been growing, then the underlying growth trend of economic activity would have been following suit. This, in turn, would have made loose monetary and fiscal policies appear to be successful.

From the level of 8.56% in March 1991, the BOJ has lowered the interbank call interest rate to almost nil. Moreover, despite the accusation that the BOJ was not aggressive enough, on average since 1990 the pace of monetary pumping by the central bank stood at 14% per annum. Despite all that, the growth momentum of bank lending remains subdued. The yearly rate of growth of lending stood at 1.4% in December against 1.3% in November. The yearly rate of growth of Japanese AMS stood at 1.9% in December against 2.3% in the month before.

Notwithstanding the BOJ’s stimulatory policies, economic activity has continued to deteriorate. This therefore raises the likelihood that the pool of real wealth is either stagnant, or, worse, declining. Consequently, the only way left to revive the economy – which is also the only way authorities are reluctant to pursue – is to allow wealth producers to take over. However, this means that various activities that cannot support themselves must be allowed to disappear. The worst thing that the central Bank of Japan could do is to further intensify monetary injections.

Summary and conclusion

Contrary to the popular view, price deflation as a rule is always good news for the economy. When prices are falling in response to the expansion of real wealth, this means that people’s living standards are rising. When prices are falling as a result of the burst of the financial bubble, it is also good news for the economy, for it indicates that the impoverishment of wealth producers was arrested. The latest proposed Japanese policy to raise the pace of the monetary pumping in order to counter deflation amounts to furthering the economic impoverishment of wealth producers, thereby delaying any meaningful economic recovery from taking place.

[1] Joseph T. Salerno “An Austrian Taxonomy of Deflation” presented at “Boom, Bust, and the Future,” January 19,2002, The Mises Institute, Auburn, Alabama p 8.

[2] Murray N. Rothbard What Has Government Done to Our Money?  p 17.

[3] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at “Boom, Bust, and the Future,” January 19,2002, p 8

[4] Ludwig von Mises Human Action p 568-569.