Three things that I learned from watching Japan

There was a time in my life when I thought and read a lot about Japan. I was just starting to get interested in economics when Japan was at the height of its boom and everyone was talking about how they were going to take over the world. Then came the crash and Japan became the sick man of the first world. This turnaround fascinated me.

Time constraints and other interests have prevented me from following the subject as I would like. So I can’t say that I have anything really profound or informative to say about Japan. (If you want more up to date thoughts on Japan I recommend checking out Claus Vistesen and Edward Hugh’s Japan Economy Watch site.) But I can’t watch the current crisis unfold in America without comparing and contrasting it to what has been happening in Japan. So I thought that I would lay out some of the things that I learned from watching Japan so as to provide a basis for explaining some of my thoughts on America’s current situation.

1. People save at a rate determined by anticipated needs, not on expected rate of return.

At one time I thought that expected rate of return had a lot to do with the rate at which people saved. So I was inclined to be dismissive when I first came across the idea that lowering the interest rate could actually increase the rate of savings (I don’t remember where I first came across this idea, but it was in the context of somebody arguing that lowering interest rates could actually be counterproductive for Japan). But watching Japan and the people around me in America convinced me that individual savings rate had little to do with expected return.

Given my interest in history, you would have thought that I would have realized this from the get-go. After all, when people saved up food and other supplies in pre-industrial times they were not dissuaded by the fact that their savings had a negative real return. The fact that the rats are going to eat a portion of grain is not going to stop you from stockpiling grain when you know that you are going to have to eat come winter. That is so obvious that it is hardly worth mentioning.

Yet it should also be obvious that an aging population with little in the way of safety nets (either in the form of extended families or governmental entitlements) are going to have a high savings rate no matter what. If people anticipate needs in the future they will save even if the real return is negative.

This is why all the people clamoring for Japan’s central bank to inflate the currency and “force” people to spend more were wrong. Even if Japan had managed to force all savers to pay for the privilege of saving through a drop in buying power (which they never quite managed although they came close), I don’t think they would have accomplished their goal of lowering the savings rate. Japan’s people just have too many good reasons to anticipate future needs for them to stop saving just because returns go negative.

Since the early 90’s up until the present, America has demonstrated the other side the coin. Even though Americans have had a rate of return on their savings that has been high compared to the rest of the world, Americans have not seen fit to increase their savings rate. If anything, the American savings rate has been dropping as the rate of return went up. Instead of taking their outsized returns on their savings as encouragement to save more, Americans seem to have taken it as a sign that they could save less.

I suspect that we will see the savings rate in America go up as the expected rate of return falls (which it likely will as a result of the current economic problems).

2. It is aggregate real expected rates of return that determines how much people will borrow. Not real interest rates.

I am going to have trouble explaining this one so bear with me.

At one point in my life, I would have thought that mentioning real expected rates of return and real interest rates in the same breath would have been a tautology. I always assumed that real expected rates of return and real interest rates could be charted as a kind of supply/demand chart.

That statement is probably meaningless blather to a lot of you so let me try a more detailed explanation. Real interest rate is the interest rate minus the rate of inflation (or plus the rate of deflation) right? So what does this imply?

To my mind it implies that there is a finite amount of “real” money available to be lent out. Otherwise you could change the real interest rate by printing money. But printing money only changes nominal interest rates. Real rates are not affected.
So what cause real interest rates to rise and fall? Demand for the money. What determines the demand for money? Expectations of future returns. People are not going to want to contract to repay money in the future if they think they will have less money in future relative to what they owe, than they have in the present.

In other words, if a company thinks it will make 10 percent on its capital, it will be willing to borrow at 9% to get that capital. Or if consumers think that their incomes are going to go up in the future, they will be more willing to borrow money now. In both cases it is the expected rate of future returns that governs the price they will be willing to pay to borrow money. (Although in the case of consumers, it is the future returns of their labor instead of the future return of their capital that govern their willingness to borrow.)

If this is true, interest rates should be higher when people expect to make a lot of money in the future and lower when people don’t expect to make a lot money. In other words, real interest rates should reflect the expected rate of return.

So far, so good. But there is one big question left unanswered by the above theory. Is the “real money” available to be lent out a relatively fixed sum or is it a variable number? And if it is a variable number can central banks affect that number?

Watching Japan has led me to believe that “real money” is not all that variable in the short term. I think “real money” is a reflection of the production possibilities of a society. Thus, I think the only way a central bank can lower real interest rates is to lower the expected rate of return.

This is what the Bank of Japan did when it tried to lower real interest rates. In the process of trying to lower real interest rates they kept banks with lots of bad loans on the books, construction companies with no work to speak of, and various regional government bodies from going bust. In my opinion, this lowered the expected rate of return faster than the bank was able to lower the real interest rates. And that caused people’s desire to invest or spend in Japan to fall in an equally dramatic fashion. The net result was that Japan as a nation exported more and more capital overseas rather than spend it in their own country.

To understand why this is so, imagine that you want to start a business. Now imagine that your potential employees have a choice between taking an uncertain job with your startup or a certain government job turning Japan into a giant parking lot (common Japanese make work scheme). Or imagine that your start up is going to try to compete with a company that the government has decided is too big to fail. What do you think the impact of these scenarios would be on your expected rate of return?

This is why I say aggregate real expected rates of return are more important than real interest rates. The goal of policy makers should be to insure that real expected rates of return are as high as possible. That will encourage people to borrow and spend in their own country instead of overseas. It will also encourage foreign investors to invest in the country. But if they focus on lowering real interest rates, they will simply lower demand for real money by lowering the expected rate of return. And that is in no one’s interest.

3. The impact of monetary policy on a nation’s economic health is vastly overstated.

To a certain extent, this lesson was implicit in the other two. But it struck me how much the central bank of Japan was being blamed for things it had no control over. I accepted that the Bank of Japan had not acted perfectly. But I came to believe that most of the criticism that was directed against the BOJ stemmed from the fact that most economists attach too much importance to monetary policy.

For example, I remember one paper by a couple of economists who worked for the Fed. They admitted that according to most standard economic theories, the BOJ had done everything right based on the data they had at the time. However, they went on to argue that the data available to BOJ was slightly flawed. They argued that if the BOJ had had better data available to it, Japan’s depression could have been avoided. They essentially argued that minuscule differences in policy would have had massive differences in outcomes.

Needless to say, I did buy their conclusion. But their demonstration of how closely the BOJ had followed standard advice for how central banks should behave was a real eye opener to me. The more I learned about Japan’s problems and the more I read about economics, the more I came to suspect that the importance placed on central banks was a result of confusing correlation with causation.

A good example of what I mean by that is the accusation that central banks are the cause of investment bubbles. I have never seen a good theoretical or empirical argument that even comes close to demonstrating that this is true. I can’t think of anything that would prevent mob behavior from creating over-investment in certain sectors even if monetary policy was “perfect.” It seems to me that in the absence of mob behavior, overly loose monetary policy would cause across the board price rises. Not a more narrowly based investment bubble.

In fact, rather than bubbles being caused by overly loose monetary policy, I suspect that bubbles cause overly loose monetary policy. If mob behavior causes an overinvestment in a particular area (usually because of new technology whose benefits are not yet fully known and thus make it difficult to accurately assess future return) it makes it more difficult to accurately measure inflation. On one hand the bubble could hide an undesirable increase in the money supply because everyone would be rushing to invest in narrow segment of the economy. On the other hand, an overzealous bubble picker could actually cause deflation by trying to end a bubble that was caused by an overly enthusiastic mob as opposed to easy money.

Don’t get me wrong. I fully accept that central banks can cause inflation and deflation. I fully accept that inflation and deflation are bad things. Therefore, I don’t dispute central banks have an important role to play in any national economy. But so do electrical grid operators. Yet nobody blames them for every recession.

Economies have grown in real terms even as they were experiencing deflation. Economies have grown in real terms even as they experienced high rates of inflation. Yet if an economy experiences a contraction with only mild accompanying deflation (as happened to Japan) people have a tendency to place a huge share of blame on the central bank for the contraction. Ditto if an economy is experiencing slightly elevated rates of inflation as it goes into a contraction (say, like what is happening in the US right now).

I don’t believe that perfect monetary policy can prevent contractions. I don’t even believe that perfect monetary policy can prevent long periods of economic contraction. I don’t believe that perfect monetary policy can prevent overinvestment in certain sectors. I don’t believe that perfect monetary policy can prevent government actions that make things much worse. (The tariff bill that Hoover signed into law, for example.)

In Japan’s case, the central bank was faced with a bursting bubble along with an ageing demographic, and a government determined to prevent any kind of readjustment that might threaten social stability (which in practice meant no readjustment whatsoever). It is difficult for me to imagine a policy that the BOJ could have followed that would have prevented the mess that followed.

Monetary policy is only a small part of the sum total of economic behavior. And those who look to monetary policy to solve all their economic problems are going to be sadly disappointed.

3 Responses to “Three things that I learned from watching Japan”

  1. […] _uacct = “UA-1202685-1”; urchinTracker(); Map of the Ethereal Land The Ethereal Voice Front Page – Politics – Money – Knowledge – Art – Food – Fun Masthead About Three things that I learned from watching Japan By Ape Man | January 19, 2008 – 6:24 pm Posted in Category: Money There was a time in my life when I thought and read a lot about Japan. I was just starting to get interested in economics when Japan was at the height of its boom and everyone was talking about how they were going to take over the world. Then came the crash and Japan became Click Here to continue reading. […]

  2. […] I explained some of the reasons why this is so here. […]

  3. […] Still, this demonstrates the costs of trying to lower interest rates in order to stimulate the economy. This is one of the reasons why lowering the interest rates can actually increase the savings rate as I explained in this post. […]

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