The Bank of Japan has embarked on one of the most inflationary policies ever undertaken. Pledging to inject $1.4 trillion dollars into the economy over the next two years, the policy is aimed at generating price inflation of 2% and further depreciating the Yen. The idea is to fight “deflation” and increase exports.
The end result of this policy will be an assuredly larger balance sheet at the Bank of Japan (projected to nearly double to $2.9 trillion). Despite being lower than it was 25 years ago, the Japanese Stock Index has increased by 70% since November of last year. However happy people have been about higher stock prices, eventually the economic effects will be harmful; indeed the recent stock price crashes foreshadow still more troubles to come.
In my own contribution to Guido Hülsmann’s recent edited book The Theory of Money and Fiduciary Media, I take a critical look at these exact policies — expansions of the money supply aimed at stimulating output by way of manipulating the exchange rate. At the 100-year anniversary of the publication of Ludwig von Mises’s The Theory of Money and Credit, we can see that Mises had already grappled with the issues of currency depreciation in a manner superior to modern monetary economics. Furthermore, with the refinement of his business cycle theory in his book Human Action, we find that Mises also outlined the detrimental effects of such expansionary monetary policies.
The exchange rate determines the price a foreigner will have to pay for a domestically produced good. Increases in the money supply will generate inflationary price pressures that will in turn increase prices. This leads to a higher exchange rate, which means it takes more domestic currency to purchase a unit of foreign currency. This makes it cheaper for foreigners to buy our goods so exports increase. Conclusion: countries can stimulate exports and increase the number of jobs in export industries by inflating their money supply.
Unfortunately, this is not the end of the story.
Depreciating your currency does make your export goods cheaper for foreigners to buy. However, it also makes it more expensive for you to buy imported goods. This helps to close a trade deficit and reduces foreign investment in your economy. However, if the goods you sell to foreigners are composed of many inputs that you have to purchase from foreigners the effect will be to drive up your cost of production.
Therefore, Japanese exporters will pay more for the inputs that they will need to import to construct the same goods they intend to sell to foreigners. This effect is especially noticeable in countries with large export markets, but only a small ability to supply the inputs for goods destined for export. No other large economy fits this description better than Japan.
Mises’ key insight was in looking at the long-term effects of such a policy, and in the process he examined the logic behind the short-term results as well.
The ineffectiveness of the policy in the long run is apparent when one understands how prices – both domestic and foreign – interact to determine exchange rates. Exports will be promoted in the short run, though the effect will be cancelled in the long run once prices adjust.
If the policy is ineffective in the long run, Mises demonstrated that the short-run gains are illusory. The same monetary policy aimed at depreciating the currency to promote international trade will reap domestic chaos.
Higher monetary inflation will reduce interest rates. One result of this policy will be greater consumption expenditures – what Mises coined “overconsumption” – as consumers save less and spend more. The other result of reduced real rates is what Mises referred to as malinvestment. Production plans must supply not only the amount of goods consumers want in the present, but also orient these production plans to produce goods in the future. The interest rate is what coordinates all these plans over time and is what entrepreneurs use to determine when to produce goods, and how long a production process should be employed. The negative effects of distorting the interest will only be revealed much later.
Upsetting the natural rate of interest through an inflationary monetary policy unbalances both consumption and production plans. The economy eventually succumbs to an Austrian business cycle as it tries to regain footing, and move to a more sustainable pattern.
The more things change, the more they stay the same. Ludwig von Mises was able to correctly identify the pitfalls of expansionary monetary policies over 100 years ago. Policy makers have yet to learn these important lessons, and consequently continue to plague their countries with the results of these failed measures.
This article was previously published at Mises.org.
The monetary and fiscal position in Japan is hopeless – but we should not gloat, as the British monetary and fiscal position is also hopeless.
We also (just like Japan) have a financial system (and a housing market and stock market that are state supported bubbles)and, on the fiscal side, the British deficit is almost as big as the Japanese one – and government spending in Britain is actually higher than in Japan (some 49% of GDP – basically half the entire economy is taken by government spending).
Yet, if one turns to the media, the out of control government spending in Britain is not even mentioned – on the contrary according to (for example) the Economist magazine last week (and endless other reports) Mr Osborne has vastly “cut” government spending, greatly reduced the role of the state (and on and on – in a report that was false figures and so on).
It is fashionable to blame the people for the “failure of democracy” – but when the people are fed a diet of lies (told that the government has rolled back the state, with “cuts in the increase” presented as a “cut in government spending”, – when it has NOT) are they really to blame?
Every time some country implements some QE, Austrians start hyperventilating and forecasting hyperinflation by this time next month. Trouble is that the hyperinflation never arrives.
In fact Austrians have been forecasting hyperinflation by this time next month for decades. But the hyperinflation never arrives. Doesn’t it ever occur to them that they might have got something wrong?
I’ve already explained on this site why QE has very little effect: money and government debt aren’t much different. So swapping one for the other has little effect (on inflation or anything else). Japanese government debt is a promise to pay someone X Yen a six months or whatever, and that debt pays interest of 0.5% approximately. What’s the big different between that and X Yen (which pays zero interest)?
The Japanese have (for decades) being trying to maintain (not to expand) the banking credit-bubble (“broad money”).
What the Peronist Ralph Musgrave does not understand is that Austrians do not claim that simply propping up an existing credit bubble will produce “hyper inflation” – it will, in fact, leave the economy in a “zombie” state (as Japan was in the 1920s – as well as since 1989, for they tried to keep their banks and so going in the 1920s also).
The economy can not really recover till the agony of the liquidation of the malinvestments (the credit bubble – “broad money”) is undergone (as it was in the United States in 1921 – but which the Japanese government refused to allow when their own World War One credit bubble looked set to burst – thus dragging things out till 1927).
The propping up of the financial system (not just by the Japanese government, but by the Obama Administration and Mr George O. as well) delays (and makes worse) the inevitable liquidation.
As for Mr Musgrave’s own Peronist solution (that the government should directly print money and spent it) this does not have the positive consequences he thinks it does -as the decline of Argentina since World War II (i.e. since the rise of Peronism) shows.
I’ve never taken any interest in “Peronism” – in fact I didn’t have the faintest idea what it consisted of till three minutes ago when I looked it up on Wiki. They define it as a combination of “social justice, economic independence, and political sovereignty”. Sounds a bit vague, but pretty harmless, so I plead guilty to being a bit Peronist.
What on earth that has to with matters monetary, I’ve no idea.
Mr Musgrave your memory is letting you down (no insult meant by that – my memory lets me sometimes also). We have been through this before.
Your position is that banks should not be allowed to play credit expansion games – but that the government should itself, directly, print money and spend it.
That was the position of General Peron – that was what he did.
It did not work out well.
Forgive my ignorance but, when the banks expand the broad money supply through lending, don’t they choose where the money goes (mostly secured lending mortgages etc.), charge interest and then demand it back? Does this then create the cycle of boom and bust and a shortage of liquidity?
If the state spends into the economy directly do they receive seniorage, not charge interest, and not demand it back?
Once again forgive my ignorance but this sounds simple to me. Are banks are just middle men?
Turblue72 – it is true that banks can create a boom-bust event on their own (without Central Bank intervention). However, Central Bank intervention (to actively promote monetary expansion) then the damage is far greater.
As for the idea that government should just print money and spend it (without charging interest and so on) – that is the principle of Peronism, and it was not a wonderful success in Argentina.
Lending should be 100% from REAL SAVINGS (i.e. money that people have earned but chosen NOT to consume – to lend out instead, they make a SACRIFICE by not consuming). This is something that both credit bubble bankers, governments, and mainstream academia (and media) ignore.
Hello Paul and thanks for your reply but I don’t agree. When private banks expand the money supply through lending at interest it is worse than central bank intervention. The Money supply has to be expanded to keep up with production (see wealth of nations) and Peronism is just a new name for an age old system. The problem with private banks creating the broad money supply is that they will at some time demand it back ie. right now with basle III, therefore creating the bust whilst expanding their capital position. We do not need private banks, the moey supply should be non political central bank that prints money in line with GDP. Simples
PS The money supply in Argentina far outstripped the GDP therefore hyperinflation was inevitable, this doesn’t mean it is always a bad idea.
Banks do not expand the money supply by lending “at interest” (why would anyone lend without the hope of getting interest? they expand the money supply by lending out money that DOES NOT EXIST (“money”, credit, that no one really saved).
As for the government printing money and spending it – that is always a bad idea.
It is the idea of a “free lunch” – the idea that the government can buy stuff (or help other people buy stuff) with no one picking up the bill.
Kipling’s “Gods of the Copybook Headings” always make themselves felt in the end. There is no prosperity with out seat – hard, backbreaking work.
Neither the credit bubble book keeping tricks of bankers, or the government printing press, are any good.
Paul, I think you misunderstand my point but we are very much on the same page in regards to banks creating lines of credit from thin air. The broad money supply ie. bank credit, creates, in the end, more for the banks and has to be repaid. Money spent into the economy means the government can use this for state projects without borrowing from private banks and the credit remains in circulation. This lending is always at interest and the banks will create the money out of thin air anyway.
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