I think everyone knows that for some years the Japanese economy has been very sluggish. In response to this situation a number of eminent economists suggested the usual Keynesian nostrum of spend, spend and spend. As expected, Krugman was one of them -- as was Milton Friedman. (Most economists do not know that Chicago was Keynesian before Keynes). Friedman claimed that Japan could climb out of recession by inflating the money supply. According to Friedman the answer lay with the central bank. All it needed to do was

[b]uy up government securities. It can keep on buying them. It doesn't matter whether the interest rate is 1.2 per cent, 1.1 per cent or 1 per cent. If it buys those securities it will increase the monetary base. It will do more in the short run to help Japan resolve its banking crisis than any short-term reforms. (Barron's, 24 August 1998).

The thinking behind Friedman's advice is very simple. When the central bank expands the money supply it raises nominal incomes which in turn increases spending. This additional spending will drive economic growth and hence bring about economic recovery. Moreover, the rise in nominal incomes will raise the demand for financial assets which will raise their prices and so lower their yields. This process, or so it is argued, will strengthen economic growth by raising the demand for capital goods. (If this thinking strikes you as being Keynesian, then you are absolutely right).

Thomas E. Nugent pointed out that in March 2001 the Bank of Japan (BOJ) implemented a policy of monetary expansion (NRO, Print More Money, Create Higher Inflation?, 7 September 2006). The result was a rapid increase in the monetary base (cash). This was followed by falling prices and collapsing interest rates, "with short-term interest rates moving to virtually zero".

Two years later the BOJ reported that the economy was still deteriorating. Keynesians responded by arguing that the monetary expansion had not been big enough. Yet in 2002 the monetary base, as Nugent pointed out, was up by 28 per cent. However, M2 (cash plus bank deposits) was up by only 1 to 2 per cent. So why didn't the economy boom and prices pick up?

Let's start with interest rates. If Keynes were right interest rates would be at their lowest at the peak of a boom and at their highest at the bottom of a bust. In fact we find the exact reverse. Sir Dennis Robertson, a far shrewder economist than Krugman or Galbraith Jr can ever hope to be, was keenly aware of the Keynesian confusion on interest rates, causing him to cleverly write:

Thus the [Keynesian] rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has become amputated. And yet it somehow still exists a grin without a cat.

Interest is the price of time. It is in this role that it brings into balance the supply of capital goods (future goods) with the demand for capital goods. In doing so it allocates these goods through time, so to speak. This is what gives capital its time structure.

By forcing the rate of interest below its market rate capitalists are deceived into thinking there are more real savings available than actually exist. This causes them to invest in projects for which the complementary factors of production will be available. This phenomenon will be particularly pronounced in the higher stages of production. In other words, manipulating the rate of interest generates malinvestments that have to be liquidated.

This brings us to the value of money. First and foremost money is a medium of exchange the value of which is determined by supply and demand, with demand consisting of two components: The exchange or pre-income demand. This is where people offer goods and services, including their labour, for money. The second component is the post-income demand or money balances.

The first component is what interests us here. An economy progresses by accumulating capital. (The Austrian School, which also stresses the role of the entrepreneur, describes this process as one in which the capital structure is lengthening). The effect of capital accumulation is increased productivity accompanied by falling prices. From about 1874 to 1896 Great Britain experienced falling prices even though the world's supply of gold was increasing by about 2 per cent per annum.

This secular price trend was clearly the result of increasing productivity. When productivity increases on a gold standard more and more goods are being offered for the same unit of gold. In other words, the purchasing power of gold, meaning money, is continually rising. On a paper standard, however, we usually find that many of the benefits of increased productivity are vitiated by slack monetary policies.

The above reasoning leads to the conclusion that falling prices brought about by increased productivity are really goods-induced changes in purchasing power. A situation like this has no effect on profit margins because these are being maintained by falling costs of production. This leads to the conclusion that the fall in the prices of Japanese manufactures is the result of increased productivity.

Real estate is a different matter. There is no doubt that Japan's inflationary policies of the 1980s raised real estate prices to preposterous levels, making a severe adjustment inevitable. This brings back to malinvestments (the result of misdirected production) and profit margins. If a government succeeds in preventing the necessary liquidations profit margins will continue to be squeezed and savings drained away from potentially profitable enterprises. When this happens one should expect the banks to accumulate excess reserves, even when the cash base has been significantly increased.

Japan has been here before. World War I triggered a boom in Japan that was fuelled by cheap credit policies. In 1913 the wholesale price index stood at 100: by March 1920 it had risen to 322. This leap in prices was a sure sign that credit expansion was out of control. It was also in March of 1920 that commodity prices broke.

The boom came to an abrupt end and by April 1920 a monetary contraction had driven the price level down to 190. Even so, this rapid and steep 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.

Then, as now, the Japanese authorities had arrested the adjustment process, causing Japan seven years of economic stagnation that helped fuel Japanese militarism. This locked-in the 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.

Something had to give -- and it did. In 1927 the internal contradictions of this economic policy were finally resolved by what was probably the severest financial crisis in Japanese history. 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. Nevertheless, the 1927 crisis finally eliminated the war-time boom's malinvestments resulting in about 18 months of consolidation.

The lesson for Japan is to follow the American example of allowing markets greater flexibility in eliminating malinvestments.

*I am referring to the 1920-21 financial crisis. Unfortunately, when the 1929 crisis broke Hoover's destructive meddling arrested recovery. His ad hoc interventionist policies were adopted by Roosevelt who was even more of an interventionist than Hoover.