Not so long ago, Japan was considered one of the world’s strongest economies, known for its globally recognized brands and rising productivity. However, over the past 30 years, the Japanese economy has stagnated, and the standard of living for the average citizen has declined compared to other strong economies like the United States, Canada, and Western European countries. What happened to Japan three decades ago? The causes, which go back much further, were analyzed by Jeffrey M. Herbener, professor of economics at Grove City College and editor of the Quarterly Journal of Austrian Economics, in a 1999 article for the Mises Institute:
In 1943, John Maynard Keynes claimed that central bank credit expansion was the “miracle of turning stones into bread.” In an attempt to recover from a long recession, the Japanese government and central bank gave the world the final Keynesian experiment of the 20th century. That experiment failed—catastrophically. Not only Japan’s history, but the entire economic history of the 20th century, showed that Keynes’s so-called miracle was a forgery that produced not higher living standards, but crises and depressions.
Economic growth requires genuine capital accumulation—the building of an extended capital structure through saving and investment. The counterfeit miracle of central bank monetary inflation produces only a cycle of boom and bust. Initially, it seems that credit expansion is driving economic growth: interest rates fall, capital values rise, and entrepreneurs profit by building capital structures. But this capital development cannot be completed because there is insufficient real saving and genuine investment. The boom is built on a lie—artificially low interest rates—and once the lie is exposed, the boom ends and bust inevitably follows.
Over the past 150 years, Japan has experienced both a true market miracle and a counterfeit state-created miracle.International trade with the West began seriously in the 1850s, and the Meiji Restoration government of 1868 replaced the old feudal system with private property rights, free trade, entrepreneurship, and freedom of movement. By the 1880s, Japan had sold most state enterprises to the private sector and quickly integrated into the international division of labor. Thrifty Japanese citizens provided ample savings for capital accumulation. However, the government countered these forces of real growth by subsidizing transport and communications, cartelizing banking and heavy industry, and establishing a central bank. In short, Japan emulated Britain’s mercantilist system—complete with empire, though on a regional scale. Like Britain’s, Japan’s empire was built on international trade, in this case with Asian neighbors such as Manchuria and Korea—but its debt-financing and monetary inflation powers were put in service of its war machine. Thus, Japan’s rise to industrial power before WWI was partly genuine economic growth, partly state construction, and partly a boom.
Japan’s economic development, like America’s, received a major boost from neutrality during World War I. Japan’s trade with Asia soared while former trading partners were at war. Like the U.S., Japan experienced wartime expansion fueled by massive gold reserves built from trade surpluses. The inflationary boom lasted until 1920, followed by a deflationary collapse. A massive 1923 earthquake triggered the next round of Bank of Japan monetary inflation to finance reconstruction spending. That boom ended with large gold outflows that led to another deflationary collapse in 1927, followed by a depression until 1931. Just as the Great Depression was about to hit the West, Japan launched another round of government spending, debt, and monetary inflation, this time focused on building up its military and navy.
For all belligerent nations in WWII, transitioning to a war economy meant centralized, political control of economic activity. In Japan, this was a natural continuation of the military buildup of the 1930s. Cartels aligned with the government led the war economy, as they already dominated heavy industry and banking. During the war, control over banking was further centralized in the Bank of Japan, while the Industrial Bank of Japan became the main financier of war production.
The economy had become so thoroughly transformed into a war machine that, when the fighting ended, its production capacity was nearly worthless and incapable of producing consumer goods. Tragically, the occupation authorities that governed Japan after the war stifled economic recovery. They introduced punitive taxation and labor unions, dissolved cartels, and confiscated land. More importantly, between 1945 and 1949, the U.S. poured $1.6 billion in foreign aid into Japan, which allowed the Bank of Japan to further inflate the money supply—already massively inflated at the war’s end. The result was hyperinflation, with wholesale prices increasing thirteenfold between April 1946 and March 1949. With large-scale economic reorganization impossible, industrial output in 1948 was only 40% of its 1937 level, and agricultural production was significantly below prewar levels.
In 1949, Japan was forced into a new international order dominated by the United States. The Bretton Woods monetary system fixed the yen-dollar exchange rate at 360:1 and required the Bank of Japan to match yen inflation to U.S. dollar inflation from the Fed, effectively integrating global credit expansion. The new military order—the Cold War—revived Japan’s dormant military production capabilities. American military procurement reactivated Japanese industry, which finally surpassed its prewar production levels in 1951. Having proven itself a reliable ally, Japan regained its sovereignty in the spring of 1952.
By 1953, occupation reforms were reversed. Labor unions were weakened, taxes were cut, cartels restructured, and state planning strengthened. Government control over credit was stronger than ever. Only the land reform survived. In short, Japan restored its prewar mercantilist economic system, minus the regional yen-based trading bloc. This was hardly a laissez-faire formula for a true economic miracle.
During the decades of the 1950s and 1960s, Japan served the American system in a similar way to how Indonesia did in the 1980s and 1990s. The inflow of U.S. dollars and the allocation of funds by the Japanese government from the postal savings system increased the average annual GDP growth to 9.6% in these two decades—more than double the rate of 4.6% from the 1925–1939 period.
However, this productive effort largely went toward meeting government demands rather than consumer needs. Military materials and infrastructure projects were financed at the expense of building capacity to serve consumers. International trade shifted away from prewar lines of comparative advantage, with the United States becoming Japan’s leading trading partner for both exports and imports. Deprived of its place in the interregional division of labor, Japan began a program of artificially expanding domestic production. The Japanese government subsidized the production of expensive synthetic substitutes for cheaper imported raw materials that had previously come from Manchuria. Imports of cheap food declined as an artificially built-up agricultural sector expanded costly production. Capacity in steel, electrical equipment, automobiles, and shipbuilding was heavily subsidized.
Also, part of the postwar economic miracle was artificially inflated. U.S. military procurements for the Korean War amounted to about $3.4 billion and triggered a domestic boom in the early 1950s. GDP rose at an annual rate of 12.1% during the war. However, the Bank of Japan overinflated the yen, leading to reserve outflows that, under the fixed exchange rates of the Bretton Woods system, could only be stopped by monetary deflation. A brief recession followed in 1954, and the next boom began in 1955, meeting the same fate in 1958. Driven by central bank monetary inflation, the 1959–1961 boom pushed GDP growth to 15% annually and ended with the exhaustion of gold reserves in 1961. A short recession followed in 1962, then another boom in 1963–1964, which ended in a 1965 recession. Over the next five years, GDP grew at more than 10% annually.
Although it required ups and downs, the central bank managed to match yen inflation closely enough with U.S. dollar inflation under Bretton Woods for the exchange rate of 360 yen per dollar to be maintained. However, this exchange rate stability required faster yen inflation than dollar inflation. With the Japanese economy growing output at three times the U.S. rate—19% annually versus 6.4%—during the latter half of the 1960s and early 1970s, the yen was inflated at 18.8% annually while still maintaining its exchange rate with the dollar, which was inflated only 5.4% annually.
When Bretton Woods collapsed, the Fed tripled the dollar inflation rate from 4.4% in 1970 to 12.1% in 1971. Japan’s central bank slavishly followed suit, as it had since World War II; but yen inflation did not accelerate enough. Although the yen money supply grew at 22.4% annually from 1971 to 1973, the yen appreciated 22% against the dollar between 1971 and 1974. Price inflation exploded in 1973 and 1974, with consumer prices rising by 11.7% and 23.1%, respectively. A severe recession followed the credit expansion boom.
After this debacle, Japan began to pursue a more independent monetary policy. The central bank gradually reduced yen inflation rates to the point that by 1977, it fell below the U.S. dollar inflation rate. But another credit expansion followed, with yen inflation at 11% annually over the next two years and the central bank lowering the discount rate from 4.25% in 1977 to 3.5% in 1978. Price inflation surged in 1980, with wholesale prices rising by 17.8%, forcing the central bank to more than double the discount rate to 7.25% by 1980. In response, interest rates surged, bringing the credit expansion to an end and pushing the economy into recession.
Whatever else might be said about Japan’s postwar miracle, it was over by 1970. The average annual GDP growth from 1971 to 1979 was 4.6%, and from 1980 to 1990 it was only 4.1%.
After freeing its monetary policy from the U.S. dollar, Japan in the 1980s attempted to reestablish its own yen-based trade bloc, although East and Southeast Asia had replaced the old North Asian alliance. In the first half of the 1980s, this goal could not be achieved because international demand for the dollar exceeded demand for the yen. Despite the central bank inflating the yen at lower rates than the Fed’s dollar inflation, the yen fell by 24% against the dollar, and consumer prices in Japan rose 2.7% annually from 1981 to 1984.
But in 1985, the strategy began to take shape. The Plaza Accord that year, in which leading industrial nations agreed to support a stronger yen and a weaker dollar, created space for interregional monetary inflation of the yen and credit expansion. The central bank increased the yen money supply by 10.5% annually from 1986 to 1990 and lowered the interest rate from 5% in 1985, where it had been since 1983, to 2.5% by 1987. Japan exported its credit expansion to Southeast Asia and South Korea in the form of direct investments. Massive Japanese investments in Asia were backed by credit guarantees issued by the Japan Export-Import Bank for investments in and trade with Asia. By the end of this debt cycle, Japan had become the world’s largest creditor nation, as evidenced by having the largest banks in the world and a stock market with the highest market capitalization.
Despite massive yen inflation, the yen strengthened by 50% against the dollar from early 1985 to the end of 1988, and consumer goods prices in Japan rose by only 0.5% annually, while wholesale prices fell by 4.6% annually—indicating that growing demand for the yen, both international and domestic, absorbed the monetary inflation. But the yen’s supremacy was short-lived. Demand for the yen fell in 1988–1989, causing a 16% devaluation against the dollar and a rise in domestic price inflation.
The central bank slammed the monetary brakes, drastically reducing yen inflation from 12.1% in 1990 to 4.1% in 1991, and then to 1.2% in 1992. The interest rate was raised from 2.5% in 1988 to 6% by 1990. The end of the credit expansion doubled interest rates, while the reduction in yen inflation helped raise the yen-to-dollar exchange rate by 22% from 1989 to 1993.
Japan experienced what America discovered after the collapse of Bretton Woods: creating international credit expansion works only as long as rising demand for money keeps price inflation under control. Japan’s attempt to reestablish a yen-based trade bloc in Asia was cut short when America reasserted dollar dominance—first in Canada, Mexico, Latin America, and South America, and then in Asia and Eastern and Central Europe. The yen stood little chance against the world’s reserve currency, and the yen-based credit expansion collapsed in 1990.
Although Keynes was the architect of economic destruction, Japan sought his advice for recovery.
Since 1990, Japan has tried nine stimulus packages totaling $888 billion. Although they differed in form and size, all shared the same three features: government spending and debt, bailouts, and reflation. To make matters worse, taxes have been raised several times since 1989, so the government now extracts over 30% of GDP, compared to 18% in 1965. The 1998 tax cut was too small to reverse this trend. But even a significant tax cut would have only minimal effect without a corresponding reduction in government spending. The depression will persist until the misuse of the boom is liquidated and the capital structure is reconstructed to best serve consumers. Fiscal spending delays liquidation and reconstruction since government expenditures always aim to rescue and subsidize the existing production structure.
Moreover, Japan’s public debt has grown to finance the overspending—a policy that further damaged already weakened credit markets. Japan’s public debt now stands well over 100% of its GDP, compared to 60% in 1993. In 1999, Japan would issue 90% of all net new bond issues among industrial nations—around $352 billion. Its total bond issuance in 1999 would amount to $517 billion, making Japan the world’s largest issuer of debt.
Despite Keynesian predictions, mountains of government debt did nothing to stimulate the economy—GDP fell by 2.8% in 1998—nor did it help ease private sector debt. Estimates from March that year placed the non-performing loans of private companies at $720 billion, a decrease of only 0.7% from the previous year despite write-offs. In August 1998, Japanese banks reported $600 billion in bad loans, with another $625 billion in loans at above-normal risk of default. As of July 19, 1998, banks still had $1.56 trillion in real estate loans on their books, most of it lent to developers with half-finished hotels, nonexistent golf courses, and crumbling rental properties—while real estate prices had fallen by 80% from 1991 to 1998. Banks were also still heavily invested in Japanese equities, even as the Nikkei had fallen 64% from 1990 to 1998.
The government’s response to the financial debacle was bailouts. At the end of 1998, a $514 billion rescue fund was established. The funds would go toward supporting the Deposit Insurance Corporation, purchasing shares of failing banks, and nationalizing, restructuring, and liquidating failed banks. In exchange for the government becoming a co-owner, banks were required to cut salaries, scale back foreign ventures, and write off bad loans. Nevertheless, fifteen of Japan’s leading banks lined up for aid. Their fate may or may not be better than that of the Long-Term Credit Bank and Nippon Credit Bank, which were nationalized at the end of 1998.
Bailouts were also extended to corporations. In November 1998, Nissan Motors requested a loan of $833 million from the government-run Japan Development Bank, while the Small Business Finance Corp. increased its lending to small businesses by 15% in 1997 and another 11% in 1998, bringing the total to $8.1 billion.
The government also tried to save its interests in Southeast Asia and South Korea that were built during the boom. Until 1997, Japanese banks held 38% of all outstanding foreign corporate loans in Indonesia, amounting to $58.4 billion. In Thailand, Japanese banks held $37.5 billion in debt. South Korean companies had borrowed $25 billion from Japanese banks. In response, Japan provided $20 billion in bailout funds to guarantee bank loans given to interests in Thailand, Indonesia, and South Korea.
The central bank attempted reflation throughout the 1990s. The interest rate was cut from 6% in 1991 to 0.5% by 1997. But banks refused to expand lending and instead simply absorbed the new money as reserves for bad debts. Blocked from domestic credit expansion, the central bank tried to expand Japanese bank lending abroad through the yen carry trade. Investors borrowed yen at low interest rates, converted them to dollars and other currencies, and bought higher-yielding foreign assets. This put downward pressure on the yen, which increased the profitability of the strategy. The yen carry trade was active from mid-1995 to mid-1998 when the yen fell 83% against the dollar, but in July 1998 the yen began to rise again, losses followed, and the trade dried up. This policy worsened the financial debacle in Asia by greatly expanding credit for three years and then suddenly cutting it off. The Asian financial debacle then burdened Japanese banks with even more foreign bad debts. In response, they cut foreign lending in the first quarter of 1998 by $244.3 billion, or 12%. This reduction was the latest in a downward trend that left once-dominant Japanese banks with the same global market share they had in the early 1980s.
In this morbid state, the banks were incapable of fulfilling their role as financial intermediaries. All additional reserves they acquired had to be used to cover bad loans rather than to increase lending. From 1995 to 1998, Japanese banks wrote off $300 billion in bad loans, while they reduced their lending by 2.7% from September 1997 to September 1998, and by another 5.4% from May 1998 to May 1999. As a result, massive increases in the monetary base—10% from mid-1997 to mid-1998—had little effect on broader monetary aggregates, which rose only 3.5%. Keynesians mistakenly interpreted the central bank’s impotence as a liquidity trap. But the failure of reflation to generate new credit expansion was not due to investors hoarding money out of expectations that interest rates would rise from their low levels. Rather, the huge burden of bad debts led banks to hold on to cash instead of expanding credit. Furthermore, what prevents entrepreneurs from investing is not a lack of “animal spirits,” but their debt burden, already excessive and misallocated capital capacity, and uncertainty about capital structure reconstruction.
In any case, by 1997 the central bank had already accepted the advice that Paul Krugman gave belatedly in mid-1998: to bypass the banks and use newly created yen to purchase bonds directly from private holders. From October 1997 to October 1998, the central bank’s holdings of commercial paper rose from zero to $117 billion. Today, the Bank of Japan is the largest single holder of commercial paper in Japan, owning one-third of the total. The Ministry of Finance and the central bank also bought government bonds directly from private holders. Together, they now account for 53% of Japan’s $2.22 trillion bond market. Yet the banks remain paralyzed, and the economy continues to decline.
Moreover, risk-averse savers are shifting their funds from banks to the postal savings system, giving the government even more scope to bypass the banks. In recent years, assets in the system have grown by 9% annually, so that today $2 trillion is under government control—more than the total savings in banks and one-third of all savings in Japan. Unsurprisingly, bureaucrats have squandered the funds. For example, in 1997, the government funneled $5.3 billion into building a high-tech bridge-tunnel over Tokyo Bay, which, according to official estimates, will operate at a loss until 2038. Building more loss-making projects is hardly a cure for depression.
While government spending, bailouts, and reflation only serve to prop up bad investments made during the boom and further delay the reconstruction of the capital structure, reconstruction is inevitable in a market economy since it functions to satisfy consumers. Bankruptcy, mergers, acquisitions, restructuring, and deflation are the means the market uses to liquidate bad investments and make room for new and better ones. Some of these forces are strengthening at that time. In 1998, bankruptcies averaged 1,600 per month, and mergers and acquisitions were on the rise in 1999. In April, holding companies—long suppressed by antitrust laws imposed by the Allies after World War II—were reborn. Alliances between foreign and Japanese banks began at the end of 1998.
Other restructuring plans will help reallocate the workforce. NEC Electric Co. announced the layoff of 11,600 workers, and overall in 1998, the number of jobs in Japan fell by 480,000. Moreover, workers across Japan were being asked to retire early or take pay cuts through the “tap on the shoulder” method—for example, elderly office workers being asked to chop wood.
Labor, like capital, is misallocated during a boom and must be reallocated during a bust. But unlike capital, which is relatively specific, labor is relatively non-specific and therefore more easily redirected to other productive purposes. In Japan, excess capacity had reached 30% and was especially acute in steel production, metal processing, construction, automobiles, and oil—sectors where the misallocation during the boom had been concentrated.
In contrast, unemployment rose to only 4.9% compared to an average rate of 2.5% in the 1980s. The resilience of the Japanese labor market stems from the flexibility of market-based compensation. Unions are too weak to maintain wages despite business losses, especially in medium and small enterprises. Although lifetime employment has little impact on unemployment, the government’s “employment adjustment subsidies” to companies that keep workers on the payroll as “window watchers” distort official unemployment figures downward, painting a rosier picture. But like the bailouts of banks and companies, these subsidies delay the reorganization of production and prolong the depression.
Regardless of whether the unemployment figure is distorted or not, Japan’s experience clearly demonstrates the fallacy of Keynesian explanations of depression. Krugman, for example, argued that a depression occurs when the stock market crashes, causing a drop in consumption, which reduces production, causing unemployment, which reduces income, which causes further drops in consumption, and so on. But Japanese workers did not experience an income reduction caused by unemployment.
Moreover, contrary to Keynesian concerns about insufficient consumption and excessive saving, savings rates in Japan have been falling for decades and continued to fall during the depression.
Although the Japanese government seems to allow some market forces to operate more freely, it persistently refuses to initiate deflation. The central bank’s desperate attempts to reintroduce inflation by bypassing banks illustrate the government’s determination. Yet even this policy relies on the dubious logic of Keynesian economics, according to which a drop in aggregate demand leads to falling prices which, since costs cannot adjust downward, generate losses, and thus reduce production and increase unemployment. But monetary deflation and credit contraction during a depression are the necessary financial aspect of the general liquidation of malinvestments caused by monetary inflation and credit expansion. The epicenter of the financial boom and bust is the banking system. Just as misallocations and distortions during the boom follow profitability patterns distorted by monetary inflation and credit expansion, reinvestment and reallocation during the bust follow a corrected pattern of profits and losses after monetary deflation and credit contraction. The central bank’s attempts to hide those losses through reflation delay their realization and paralyze the functioning of banks, working against the government’s relaxing pressure on other market forces of liquidation.
Losses during deflation are not caused by the Keynesian problem of falling aggregate demand, but by the mismatch between specific consumer demands for certain consumer goods and entrepreneurs’ demands for certain production factors, with the existing cost structure within a production system filled with malinvestments and misallocations. These bust losses are the reverse side of the abnormal profits made during the expansion phase and are concentrated on capital owners rather than labor, since the prices of capital goods — and to a lesser extent, land prices — fall relatively more than wages due to their specificity in each production process. This is how production costs fall in a market economy to restore or maintain profits even in the face of falling consumer goods prices. If the government props up prices of capital, land, and labor, losses will be crystallized, idle capacities and unemployment will appear, and liquidation and reallocation will be halted.
Despite the outcry over deflation, the central bank followed Milton Friedman’s advice and increased the money supply enough to prevent general price level changes. The money supply in yen increased by 2.8% annually from 1991 to 1998, and the consumer price index remained stable. The central bank had already followed Friedman’s delayed call in December 1997 for increased monetary inflation by raising the rate from 3% — where it had stood every year since 1994 — to 5% in 1997 and 4% in 1998. In response to this monetary stimulus, GDP fell 0.5% in 1997 and again fell 2.8% in 1998, while in 1996, with lower inflation rates, GDP had risen 5.4%, and in 1995 it rose 2.5%.
Moreover, the first reflation by the central bank in the 1990s caused consumer prices to rise 2.4% annually from early 1990 to the end of 1993. That’s three times the rate of price inflation during the boom, from early 1985 to late 1988. And while wholesale prices fell 0.8% annually in the early 1990s, they had dropped 3.75% annually in the late 1980s. If the U.S. experience of the 1920s wasn’t enough evidence, Japan’s experience in the 1980s again shows that stable price indexes are no remedy for the boom-bust cycle.
Hopefully, the legacy of Japan’s debacle will be the acceptance of the lesson Ludwig von Mises taught us in the early 1930s: that the Keynesian miracle of central bank monetary inflation and credit expansion is a false one — and must end in crises and depressions.
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