Many are wondering whether the US economy will follow the Japanese pattern and sink into economic stagnation, high levels of unemployment, massive debt¹ and huge deficits. What is annoying is that the economic commentariat are talking as if the Japanese experience is a new phenomenon for which there is no known explanation. Given Obama's tax, spend, borrow and regulatory policies I think it would be extremely foolish to deny the possibility of economic stagnation.

However, to gain a proper historical perspective I think it would be instructive to take a look at the Japanese economy, not the economy of the 1980s and 1990s but the economy of the 1920s. By doing so we shall learn that there is nothing new or inevitable about the current state of the Japanese economy. Like all economic crises, the problem is really one of lousy economic policies.

The same monetary policy that gave Japan a massive boom at the start of WWI followed by seven years of stagnation in the 1920s is basically the same one that brought her to the present sorry economic state. Understanding the events of the 1920s should, therefore, shed some light on the current situation.

World War I triggered a boom in Japan that was fuelled by cheap credit policies. In 1913 her wholesale price index stood at 100; by March 1920 it had risen to 322. This 222 per cent leap in prices was a sure sign that credit expansion had been out of control. It was also in March of 1920 that commodity prices broke. The boom came to an abrupt end and by April deflation had driven the price level down to 190. Even so, this steep and rapid drop of 132 points was insufficient to bring Japanese prices in to line with those of her trading partners, whose prices had fallen even further.

What is not generally understood (specially by some MIT economists) is that booms create malinvestments. 'Cheap money' policies mean that banks create excessive credit which is then loaned out at below market rates of interest. This in turn causes firms to undertake investments that will later prove to be unprofitable. The reason being that the artificially lowered rate of interest caused them to embark on projects that cannot be completed because there are insufficient capital goods available. Eventually these firms find themselves in a financial vice as returns fail to cover their rising costs. Unemployment begins to rise and idle capital appears as consumers reassert their savings consumption ratio. What usually happens, however, is that in an attempt to battle inflation government halts the boom before it plays itself out. Nevertheless, the result is still the same.

Unlike America after its 1920-21 depression (the sharpest in its history) Japan did not recover. So what happened? Basically the same thing that is happening in the US today. Government, the great banks and large industries came together to freeze the adjustment process. The zaibatsu, highly organised industrial groups who also controlled some of the banks, were determined to obstruct any policy of liquidation. Their success caused Japan seven years of economic stagnation and helped fuel Japanese militarism. By halting the deflation and paralysing the adjustment process, the Japanese locked-in boom-created malinvestments, freezing maladjusted costs and prices thus trapping capital in unprofitable lines of production, denying other lines of production the necessary capital for expansion.

As I have pointed out, 'cheap' money misdirects investment. In an economic sense, artificially lowering interest rates distorts time for investors. This not only means that savings will be invested in what will become unprofitable projects but that capital combinations throughout the economy, i.e., all stages of production will also be distorted to a lesser or greater degree, depending on their distance from the initial monetary injections.

So the inflation will have basically two effects during the course of the boom: (a) it will expand some stages of production at the expense of others and (b) it will cause firms to change their capital combinations in response to changing prices induced by the inflation. By halting the price decline and maintaining many unprofitable lines of production other companies were denied profitable opportunities for expansion. It should now be clear why halting the adjustment process results in economic stagnation. Therefore, blaming free market economics for this situation is both perverse and dangerous.

Thus for seven painful years Japan held its prices above the world level. Then in 1927 the internal contradictions of this policy were finally resolved by what was probably the severest financial crisis in Japanese history. (By now, much of this should be sounding all too familiar to the reader.) The crisis brought down industries and wiped out many branch bank systems. Thus ended Japan's first New Deal policy, all because she did not follow the American example of the time and allow market processes to fully liquidate her unsound investments and eliminate excess inventories.

As Ota Sik was said to have told Dubcek: "You ignore the market at your peril." Nevertheless, the 1927 crisis finally eliminated the war-time boom's malinvestments resulting in about 18 months of consolidation. Substitute the more recent boom for her war-time boom and we are back to the misbegotten policies of the 1920s.

No two economic-political situation are ever identical. Bearing that fact in mind I don't think it is likely that anyone can know for sure whether a crisis similar to that of 1927 is necessary to restore the Japanese economy. (The 1927 crisis was necessary because of the sheer scale of the malinvestments that needed to be liquidated.) Unfortunately the siren song of Keynesian economics has provided a plausible alternative explanation for Japan's economic plight, the very same song that the Fed and the likes of Krugman are merrily singing.

According to our unrepentant Keynesians Japan is still suffering from a liquidity trap and now the US finds itself in the same predicament. But the liquidity trap is just another Keynesian myth. These commentators are really asserting that Japanese interest rates have fallen so low that they have raised the demand for cash balances to the extent that additional monetary injections end up in hoards instead of spending streams. Accepting this nonsense is but a tiny step to recommending inflation as a cure for Japanese ills. And this is precisely what happened. Now the same argument is being made by the same people for the US.

The idea was that the government should print billions of yen with which to buy the banks' bad loans, over-valued assets and just about everything else in sight². This Weimarian policy of flooding the country with paper money was expected to create negative interest rates and raise prices (Krugman suggested an inflation rate target of 4 per cent a year for 15 years) hence stimulating production. But Japan's economic malaise is not due demand deficiency but to not liquidating her malinvestments that have become a huge burden on the economy.

It follows from this analysis that for inflation to stimulate output it must restore profitability to these unsound investments. For this to happen prices would have to rise high enough to cover the costs of production, meaning costs would have to fall relative to the monetary value of the output. But this means that the current malinvestments are only being temporarily rescued while new ones are being simultaneously created thus laying down the foundations for another recession. This explains why the demand for business loans can come to a grinding halt even when interest rates have been driven down to zero. No business will borrow in the absence of prospective profits.

The main aim of the Fed's inflationary package is to stimulate consumption. But Austrian analysis explains why a policy of stimulating consumption is incompatible with rescuing malinvestments. In fact, it will only worsen their condition. Production takes place in stages, with consumption being the lowest stage of production. Concentrating spending at this stage directs resources from the higher stages, which in turn will raise their costs of production and thus aggravate their financial situation, even endangering companies that would have other wise survived the crisis. Eventually the government would be forced to apply the monetary breaks, sending the economy into another recession. Moreover, these people forget that investment is forgone consumption: hence, promoting consumption can only reduce investment and retard growth.

The lesson from the American 1920-21 crisis is that Governments should follow the example of President Harding and do nothing instead of following in the interventionist footsteps of Hoover and Roosevelt.

That recessions are actually recovery processes during which maladjustments are purged from the economy is understood by very few economists. The emergence of economic dislocations are, in a sense, withdrawal symptoms. Trying to cure the business cycle with monetary injections is like trying to cure an addict by pumping more heroin into him. Therefore governments should ignore the Keynesian nostrums and cut taxes and allow the market to liquidate the malinvestments.

Inflation is the disease, not the cure. Using inflationary policies as counter recessionary-weapons will -- depending on the circumstance -- create stagflation or generate another boom followed by another crash.

1 It is being argued that Japan's huge debt doesn't matter because nearly all of it is owed to Japanese citizens and hence the country really owes it to itself. You cannot owe yourself money. What is happening is that masses of Japanese savings are being consumed by government instead of being ploughed into the capital structure. No wonder the economy is stagnating.

2 Japan followed the advice of Keynesians. And what did it get for its trouble? A rapidly expanding trade deficit. Needless to say, the economy is still stagnating.