The Immutable Laws of the Business Cycle

0:00I don't have any jokes, in fact Bert stole those two jokes from me, but I will be dealing with some of the prescriptions for resolving the Japanese crisis from standard macroeconomists and these are jokes in themselves as you'll see. In 1949, just as Keynesian doctrines were achieving complete dominance in academic economics, Ludwig von Mises made a bold and startling declaration. He said that almost all economists now admitted the essential correctness of the Austrian theory of the business cycle. Even those economists opposed to the theory, according to Mises, quote, must admit and do admit that the upswing is invariably conditioned by credit expansion, that it could not come into being and continue without credit expansion and that it turns into depression when the further progress of credit expansion stops.

1:00As proof of his assertion, Mises pointed out that regardless of what specific factors these economists formally identify as the initiating cause of the boom, they all consider credit expansion as an indispensable requisite of the general boom. Now when I first read Mises' statement, I was a little dubious. Was it really true that in the heyday of radical Keynesianism, which explicitly downgraded the role of money in business cycles, most economists attributed the origination of the inflationary boom to credit expansion. But after reading some of the literature from the period, I discovered that Mises was indeed correct. In a book published in 1949, Alvin H. Hansen, the father of American Keynesianism, spent a chapter vehemently denying that the supply of money has any necessary causal role to play in precipitating booms. In a later chapter, Hansen, nonetheless, was forced to concede that, quote, any increase in the national income is likely to encounter restraining Mises points further, arguing that most economists of the early Keynesian era were profoundly

2:31Inconsistent, for while they grudgingly admitted the crucial role of bank credit in fueling the inflationary boom, at the same time, they bitterly disparaged proposals to suppress credit expansion as a recipe for perpetual depression. Once again, we find support for Mises' view in the writings of the extreme Keynesian, Alvin Hansen. And he says, indeed, the monetary weapon to curtail overall excess of effective demand has a peculiar characteristic that it is scarcely at all effective unless the brakes are applied so vigorously as to precipitate a collapse. It would be an easy matter to prevent a man from becoming excessively corpulent by strangling him to death. A sufficiently sharp curtailment of the money supply could indeed quickly end inflation. No one denies this. Yes, you were denying it a few chapters earlier. But a program to stop an inflationary development merely Supposedly by reducing the quantity of money is a dangerous device. Moderately used, it courts the failure of ineffectiveness. Pushed to the needed fanatical extreme, it courts

3:38disaster." So despite their reluctance, Hansen and the Keynesians in 1949 in effect recognized the immutable law of the business cycle as formulated by the Austrian theory of the business with one important reservation. Whereas Mises and other Austrian theorists always insisted that a policy of bank credit expansion once embarked upon could only end in either depression or hyperinflation, Keynesians and other opponents of the Austrian theory stubbornly and inconsistently clung to the belief that credit expansion, which was run by the central bank, Bank could extend the boom indefinitely and permanently postpone the depressionary day of reckoning. Today, the grip of rigid Keynesian orthodoxy on macroeconomics is happily long gone and economists are now openly and freely willing to grant money a central role in generating the inflationary boom.

4:37Nonetheless, most contemporary macroeconomists still believe that the The boom can be perpetuated by credit expansion, judiciously applied, of course, by a responsible central bank. Thus, monetarists, new Keynesians, new classicals, and supply-side economists and journalists all proclaim that stable growth of the real economy requires a positive rate of credit expansion, although they may disagree on the precise dose and the institutional conditions under which it is to be administered. Now the universal and immutable law of the business cycle states that the creation of unbacked bank deposits out of thin air by the banking system artificially lowers the available structure of interest rates below the level that would be determined exclusively by the available fund of voluntary savings.

5:30And this stimulates an unsustainable investment boom. The bitter but inescapable fruit of this inflationary boom is a misallocation of scarce resources which results in a financial crisis and an ensuing depression, which occurs when the credit inflation is finally brought to a halt and interest rates rise back to their natural level. It is during the depression that the capital malinvestments of the boom are revealed and purged and the economy is returned to health. Now what unites almost all contemporary macroeconomists, economic policy makers and financial journalists is their absolute, and the word that Murray Rothbard loves to use, per-blind rejection, complete blindness of the latter part of the law.

6:18To these groups, the proper aim of monetary policy is and should be to keep new money flowing through credit markets at a rate that is sufficient to maintain low interest rates and to keep stoking the boom while avoiding or minimizing price inflation. There thus exists today, for all practical purposes, only two schools of business cycle theorists, the same two schools that existed in 1949. The inflationist school comprises almost the complete range of modern macroeconomic schools, whose members believe that cheap money and a permanent boom is the royal road to economic growth and prosperity, and that the alternative to this is a grinding recession as exemplified by the current Japanese economy.

7:04The Misesian or sound money school, in contrast, maintains that the boom represents an inefficient and distortion of free market growth processes, which sooner or later must culminate in depression, if it is not to hive off into hyperinflationary breakdown. I must emphasize here that I am not using the term inflationist lightly or polemically when I apply it to all schools of macroeconomics. Mises has precisely defined inflationism as comprising three fallacious propositions. First, capital accumulation and the resulting rise in labor productivity and Living Standards, what we today call economic growth, require a progressive fall in the purchasing power of money, or at least a stabilizing of the price level. In other words, deflation is the enemy of economic growth and must be avoided at all costs.

7:55Second, continual bank credit expansion is a necessary means for fighting the ever-impending and ruinous deflation. And third, as a necessary corollary of the first two propositions, it is possible to permanently lower the rate of interest by credit expansion. That many contemporary macroeconomists do indeed subscribe to these three propositions is clearly evident in the proposals for resolving the Asian crisis that have been advanced by some of the more prominent among them in the last few years. Let me begin with Milton Friedman. In an article published in the Wall Street Journal at the end of 1997, Friedman wrote that quote, the surest road to healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden eighties, but without again overdoing it, unquote.

8:51Now Friedman's reference to the golden eighties is to the period from mid-1982 to mid-1987 and the Bank of Japan was inflating the Japanese money supply at the rate of over 8% per year. According to Friedman, this was a golden era because output was growing at a healthy clip of over 3% a year, while the price level rose at only a very modest 1.5% per year. Friedman proceeds to criticize the acceleration of monetary inflation to an annual rate of over Friedman says that the rate of monetary growth beginning in 1990 was too sudden and too sharp, as he says, too much of a good thing, and was responsible for precipitating the grinding Japanese recession of the 1990s. Furthermore, this recession has been prolonged by the relatively Friedman's proposed solution, therefore, is simply to ratchet the rate of monetary inflation back up to the magic number of 8 percent, but despite the moderate price inflation he admits would result from a relatively low rate of monetary growth.

10:21Friedman concludes that, quote, a return to the conditions of the late eighties would rejuvenate Japan and help sure up the rest of Asia, unquote. Clearly then, Friedman's proposal for the recovery of the Japanese economy rests on the principles of inflationism, as Mises has outlined them. Friedman blithely assumes that credit expansion, at just the proper rate, will ensure a golden era of perpetual prosperity. For Friedman, it is not even outright monetary deflation, but merely a low rate of credit expansion, which constitutes what he calls inept monetary policy and which is responsible for the intractable recession that afflicts Japan. But no matter how protracted and deeply entrenched in the real economy this recession appears to be, it can be magically made to disappear by a monetary sleight of hand.

11:11If not immediately, then after a year or so in Friedman's estimation. So once the money supply is ratcheted back up to this golden era rate, it will take maybe a year and the depression will magically disappear. Finally, Friedman correctly points out that as credit expansion increases, nominal interest rates will increase. But he utterly fails to recognize that as the inflation process unfolds, interest rates will continuously lag behind the rates that reflect the availability of voluntary savings in the Economy, and that this will interrupt the recovery and sow the seeds of another unsustainable investment boom. Friedman indeed assumes then that the interest rate can be indefinitely lowered by credit expansion. So he is an inflationist through and through.

12:01Let me turn to Martin Feldstein, a supply-side oriented economist who believes that a boom His 1998 diagnosis of the Korean crisis is simply that the high interest rate needed to restore confidence in the won, the Korean currency, and to arrest its depreciation on foreign exchange markets, quote, is killing many companies which would have flourished at the interest rates prevailing a year ago. Show. Feldstein points to the fact that between October 1997 and June 1998, the interest rate charged on business loans to the best borrowers in Korea jumped from 12% to 18% and that small and medium-sized companies in Korea were confronted with finance charges of 30% and higher. But Feldstein fails to note that in the 12 years prior to 1998, the Korean money supply grew through at an average annual rate of 18%. As an inflationist, he just doesn't comprehend that the interest rate formed under the influence of such rapid monetary expansion falsifies entrepreneurial calculations and induces investments that are inconsistent with the public's saving

13:14consumption preferences. They are also sustainable in the long run, whether monetary inflation is merely slowed or brought to an abrupt end. Feldstein's prescription for resolving the Korean crisis conforms to his inflationist diagnosis, quote, I believe he writes that the Korean government should require the commercial banks to limit the interest rates charged on existing business loans to rates that firms paid in the spring of 1997, just arbitrarily lowering interest rates, unquote. Of course, the wherewithal to make such cheap loans would be generously provided to the by the Korean Government from the large budget deficits Feldstein encourages it to incur. And although Feldstein does not specify this part of his proposal, no doubt he would expect these deficits to be monetized by the Bank of Korea in order to maintain the environment of low interest rates that he alleges to be so conducive to economic growth.

14:11For Feldstein then, the prevention of a rash of corporate bankruptcies and the return to to a healthy economy is simply a matter of rekindling the inflationary boom by, quote, removing the burden of artificially high interest costs and providing a stimulus to domestic demand, unquote. Note carefully that in this quotation, Feldstein uses the term artificially high interest rates to indicate the interest rate as it would be determined purely by voluntary consumption saving choices of the private economy. This bespeaks the mind of today's is modal macroeconomist, which has not been able to free itself from Keynes's central inflationist fallacy. This fallacy is that free market interest rates are almost always too high to permit full employment to be achieved. Now this brings me to Paul Krugman, perhaps the leading New Keynesian and perhaps the quintessential contemporary inflationist.

15:13In May 1998, Krugman published a now famous or infamous paper in which he argues that the Japanese short-term real interest rate, despite the fact that it hovers near zero now, is still too high to ensure full employment. So even at zero, it's too high. It needs to be negative in order to equate the abundance of Japanese savings with investment. But since the nominal interest rate can never be negative, you'd be crazy to loan at a negative interest Japan therefore needs expected inflation. Hence asserts Krugman, quote, the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy. That is, convince the private sector that it is the right thing to do.

16:11Sector, that it will not reverse its current monetary expansion when prices begin to rise." As recently as two weeks ago, Krugman declared that Japan needs inflation of 4% to reactivate demand because the government there had to change people's economic expectations, which are now based on deflation and zero interest rates. Now lest you think your ears are deceiving you, Krugman is not merely advocating that The Bank of Japan should inflate the money supply, which is an unremarkable position for a modern macroeconomist. He is actually contending that monetary inflation be deliberately carried to such an extent that it shocks the Japanese public into expecting a continuous and permanent decline in the purchasing power of the yen. How Krugman arrives at such an absurd and admittedly irresponsible conclusion reveals much about the shortcomings of modern macroeconomic theorizing.

17:07as quote, an extremely stylized model. Now, when economists refer to extremely stylized models, hold on to your hats, because it's going to involve gross and wallets, gross falsification of reality. Krugman himself admits that the purpose of his paper is to demonstrate possibilities and clarify thinking, not to be realistic. And so Krugman's model This is based on the following assumptions. One, people are identical and live forever. That's the first assumption. We're all clones of one another. Two, people's choices always involve an infinite time horizon. We always are trying to be aware of what we're going to do 3,000 years from now in order to choose today. We all live forever. Three, there is only one good in the economy.

17:55Four, this good is not produced but miraculously appears in every household at certain intervals. Maybe the garbage man brings the good when he picks up the garbage. Even though everyone periodically is endowed with the quantity of the exact same good, everyone has the same good that they eat and wear and live in, he is unable to consume his own endowment of the good, but must trade it for someone else's. So we all have the same goods, but we can't consume our own endowment. We have to buy our neighbors. Six, although there is absolutely no reason to hold cash in this one good economy, In the economy, everyone does so, because every purchase requires cash in advance. Why? Because every seller needs money. Why? Because every purchase requires cash in advance.

18:40In other words, people hold money because people hold money. Now, if you don't understand this, it doesn't matter, because it's Paul Krugman's highly stylized model and not yours. 7. People always expect the central bank to maintain the same fixed price level in the future, no matter how much money and price inflation it produces in the current period. This assumption implies that a higher rate of inflation in the short run intensifies the public's anticipation of deflation in the long run, right? Not right. In Crouben's own words, quote, since the future price level is assumed held fixed, any rise in the current price level creates expected deflation. Now, Crouben wishes to use this model to demonstrate that the current Japanese economy is mired in a liquidity trap.

19:25That is, a situation in which unemployment of labor and excess industrial capacity co-exists with essentially a zero short-term nominal interest rate. In order to obtain this result, Krugman makes several additional assumptions. First, he assumes that the current price level is mysteriously stuck at a predetermined level and will not respond to changes in the supply of or demand for money. Second, he relaxes the assumption that a quantity of the consumption good miraculously and regularly appears in the economy, and now he permits it to be produced each period by some productive capacity, labor, capital, and land. Furthermore, Krugman supposes that the amounts of labor, land, and capital goods that compose this productive capacity need not be fully employed.

20:12Finally, and just out of the blue, he assumes that people expect that their future real incomes will decline below their current levels. In other words, we all expect to get poorer and poorer in the future. That's another assumption of the model. Now, this model might be a little bit complicated in the next few minutes, but I will sum it up and show you how absurd it really is. Within the framework of this model, if people suddenly expect to be poorer in In the future, the value to them of the consumption good becomes higher in the future than in the present, because it is more scarce in the future than expected to be. They thus are induced to save more of their income and spend less on consumption in the current period. This brings about a reduction in demand for current output and a tendency for unemployment to emerge in labor and other resource markets.

21:02However, the economy would be spared depression if the interest rate could adjust downward, sufficiently to discourage the additional saving, thereby encouraging current consumption spending to remain at its full employment level. So you need the interest rate to fall to stop people from saving too much, and this will save the economy from a depression. But in Krugman's model, remember, the real rate of interest needed to bring this about may be negative, might be less than zero, while the nominal rate can fall no lower than zero, thus leaving excess saving and deficient consumption and therefore unemployment. Nonetheless, even in this case, the depression could still be avoided as long as prices were flexible. The reason is that the decline of current consumption spending causes a drop of the price level below its expected fixed future level.

21:50But this deflation is both necessary and beneficial because it will immediately stimulate inflationary expectations among market participants who, remember by assumption, will firmly expect the monetary authority to reinflate the price level back up to its long run target. In other words, according to Krugman, quote, what happens is that the economy deflates now in order to provide inflation later, unquote. This universally anticipated inflation causes a positive inflation premium to be added on to the real interest rate, causing the nominal rate to rise above zero because people now They now expect inflation, they expect the purchasing power of the dollars are getting paid back to be less in the future, so now they are charging an inflation premium. And thus providing room for the real interest rate to settle at its market clearing negative level.

22:38For example, if the expected annual inflation rate is 10%, then the nominal interest rate would rise to 7%, allowing the real rate to attain its equilibrium of, let's say, minus 3%. Okay, it's not crucial that you understand all the intricacies of the model, because I'm going to sum it up and show you how ridiculous it is. Now, the fly in the ointment, or rather in Krugman's highly stylized model, is the assumption of sticky prices which does not permit the economy to deflate now in order to obtain the inflationary expectations it needs to equilibrate the market for savings. The economy thus gets bogged down in a liquidity trap, with unemployment and a real interest rate stuck above the market clearing level. while the nominal interest rate language is at zero. Okay, now here's where he tries to make the connection to the real world.

23:27Krugman contends that this precisely describes the Japanese economy of the 1990s, which is characterized by, quote, essentially zero short-run nominal interest rates and also certainly seems to be operating well below capacity, unquote. So far, he's correct. Those two characteristics do exist. But if the Japanese economy is indeed in a liquidity trap, How did it get there? Remember, according to Krugman's model, a liquidity trap will arise only if future productive capacity is actually lower than current capacity. That is, if people expect to be poorer in the future. But how is this applicable to the modern Japanese economy? Krugman weakly suggests the following answer, quote, In the absence of productivity growth over the next several decades, potential output, say 15 or 20 years out, could actually be below current capacity.

24:30Moreover, the labor force will drop faster than the population because of shifting composition that is in the age makeup. So it is substantially easier to make the case that per capita productive capacity might be lower at some future day of the future. Perhaps sensing how astoundingly weak this explanation is, Krugman concedes that, quote, while it is easy, quite easy to make the case that Japan is in a liquidity trap, sure, you just make up a model, it is much harder to give a convincing explanation of why, unquote. So there we have it. According to one of the top pure theorists in modern economics, Japan, as a result of demographic factors, has suffered almost a decade of financial collapse and grinding recession because 15 to 20 years from now it faces the prospect of mildly reduced industrial capacity and real income. Maybe. Let me put this in even starker terms. Krugman is suggesting that the probability that Japan will have a smaller and older labor force a decade or two from now is the reason that it has been suffering

25:37from Economic Stagnation and Recession for the Past Decade. In the immortal words of Robin Leach, I am not making this up. Of course, Krugman's admitted inability to provide a robust explanation of just how the Japanese economy became ensnared in the so-called liquidity trap does not deter him from aggressively prescribing the means for extricating itself. Thus, in a follow-up note to his Japan's liquidity trap article, and I recommend that you read Kruggen writes, many people apparently read my previous note as saying simply that Japan should print money like crazy. I have indeed said this in the past and see no harm in such a policy. But I now believe that even a very large current monetary expansion will probably be ineffective. What is needed is a credible commitment to future monetary expansion, so as to generate expectations of inflation. But how might the Bank of Japan achieve such Such a commitment, you might ask. Krugman's response is that, quote, the natural way is to announce a target rate of price inflation over the long term, with the announce of intention of doing whatever is necessary to achieve that rate.

26:50But how high a rate would suffice, we again ask Krugman. Krugman's answer to this query is more modest. I don't know, he replies, but I am working on it, unquote. However, Krugman's admitted lack of knowledge does not restrain him from offering quote, a guess that the required inflation rate isn't very high, but that people must expect it for a long time. We might, for example, be talking, say, four percent inflation for fifteen years. Basically, Krugman's remedy is to destroy the purchasing power of the yen by raising the price level by sixty percent, uncompounded over fifteen years, which pretty much cuts The Value of Money in Half, not to mention the fact that once inflationary expectations are unleashed, they tend to be unpredictable and may culminate in a hyperinflation.

27:37Krugman's advocacy of such a profoundly foolish and destructive policy follows naturally from modern macroeconomic theory. The theory is based on what is called the classical dichotomy. Now this fancy term simply means that in the long run, a change in the quantity of money only affects the prices of goods and assets, and never the structure of the real economy or the relative earnings of different types of resources. Consequently, this leads macroeconomists like Friedman, Feldstein and Krugman to deny that credit expansion has any effect in artificially lowering interest rates and causing an inefficient and unsustainable alteration in the relative proportions of consumer goods and capital goods produced by the economy. Thus, while While they would all admit the existence of an asset price bubble in Japan, they are blinded by their theory to the second bubble that is right before their eyes.

28:32This second bubble was produced by the tremendous increase in real investment as a proportion of GDP, Gross Domestic Product, that occurred in the Japanese economy in the late 1980s. Between 1986 and 1990, the ratio of investment to GDP in Japan increased from 27.8 percent to 32.8% or by 5 percentage points. This massive reallocation of resources from the production of consumer goods to the production of capital goods coincided precisely with the massive credit expansion, declining interest rates and rapidly inflating asset prices of Japan's bubble era. However, while the first financial bubble abruptly popped in 1990, In 1990, its second real capital bubble is still in existence for reasons that Jeff Herbner specified yesterday.

29:21Basically, the enormous overinvestment in capital goods was prevented by mistaken policies of the Japanese government from being promptly liquidated. As late as 1998, the investment-GDP ratio still stood above 30 percent, more than two percentage points above its last pre-bubble year. So large and conspicuous was the second real bubble, the one that the macroeconomist has listed. One such journalist was Christopher Wood, who wrote a book in 1995 entitled The End of Japanese Japan Incorporated. In this book, he referred to Japan's other bubble and argued that this bubble was still Still in existence in 1995, Wood explained this bubble and its future prospects in the following terms, quote, This bubble was not the speculative boom in the stock market and property market, but a massive capital spending binge by Japanese business driven by the then availability of super cheap finance. For corporate Japan over-invested on a heroic scale. As a result, much of the investment undertaken by business in recent years will never earn and an adequate rate of return." I'm still quoting Wood here, okay? He sounds very, very

30:39close to an Austrian economist. Indeed, it is the unprofitability of all this domestic capital spending, rather than excess production capacity, per se, that is now the central problem facing Japan, Japanese industry, and the economy in general. Wood concludes that the post-war trend in the Japanese economy towards investment absorbing a progressively and a relatively larger share of GDP, quote, resulted in an increasingly lopsided form of economic activity. The bubble years marked this trend taken to its logical, though absurd, extreme, unquote. Wood labels the lopsided Japanese economy the Elephant Man economy. We can use Wood's vivid metaphor to distinguish between the various remedies prescribed for the ills affecting the Japanese economy.

31:27Recall that the Elephant Man was that unfortunate specimen of medical science, whose body was grotesquely disproportioned in its various parts, much like the current Japanese economy. Mainstream macroeconomists would cure the Japanese Elephant Man by injecting more money and credit into his system. But this quack panacea would only make him sicker, would only cause new distortions and disproportionalities, and aggravate the existing ones. Krugman, who was even more of a quack, would mainline inflationary expectations into the Elephant Man, a virulent intervention that risks killing him by inducing an inflationary breakdown of his entire system. Only the Austrian economists know how to cure the Japanese Elephant Man. In fact, according to the Austrians, the Elephant Man has the power to kill himself if he only will. All he needs to do is to reject the remedies of his quack macroeconomic physicians and in a short time his body will naturally return to its normal proportions.

32:30In other words, the cure for the Japanese economy is to permit the long delayed recession adjustment process to run its course without government meddling. This is the immutable law of the business cycle which is as true of Japan today as it was of the United States in the 1930s. Thank you.