Macro-Economic Analysis

Kel Kelly

It’s not the Economy, Stupid, it’s the Money

East Asia

What has looked like recession in Japan is really steady growth in the presence of a stable money supply


The Japanese economy is, it has been reported, in its longest period of recession-free economic growth since 1989. Business conditions and confidence indexes are the highest in decades. Most strikingly, the Japanese stock market is up 200% from its recession lows, though still far from its 1989s highs. By many accounts, Japan is roaring back to life from its 28-year economic slump.

However, all is not quite how it seems. Data other than those usually cited show that Japan has not, in fact, been in a recession, nor can it be said to be in a period of dramatic improvement. The reason for the disparity between appearance and reality is that the main economic gauges used to assess Japan's (and other countries') economy are imprecise and, therefore, often misleading to a greater or lesser degree.

The Problem

The main economic gauge is GDP, the single indicator almost universally relied upon to represent the wealth and the level of economic growth of a country's entire economy. Economic growth is defined as the increased production of material goods and services, which is measured in number of units produced (e.g., ten units this year, two more than last year, etc.). Since GDP, on the other hand, is expressed in money, it must convert or attempt to convert the units produced to monetary values (i.e., total dollars spent on goods produced).

The prices that determine monetary value, however, can be artificially raised or lowered by inflation, which itself is predominantly caused by changes in the quantity of money in the economy. If prices rise, GDP can rise even if there has been no growth, i.e. no actual increase in units produced. Falling prices can reflect the opposite situation.

Economists have formulas to adjust GDP according to the rate of inflation to arrive at so-called real GDP. But correctly measuring the rate of price inflation is extremely difficult, and there is no way to know if it is done correctly. Numerous statistical techniques are employed, and there is ongoing debate about re-adjustments of those techniques.  

As but one example of the problem of measuring price increases, consider the study by economist William Nordhaus that showed an increase of 300-500% in the price of light over the last two centuries using GDP. However, innovations in lighting over time changed its real cost, so that, in fact, the cost of light in cents per lumen-hour had actually plummeted more than a hundredfold in the same period.

Thus, while real GDP is not supposed to be affected by price changes, it often is. This is likely the case with Japan’s real GDP: it appears to have permanently declined with the permanent fall in price inflation in 1990 when it should not have.  Japan’s central bank decided that year to cease its currency management practice of printing new yen to match each dollar it acquired from its trade surplus.

The cessation dramatically reduced the rate of money growth in the country. Since increasing volumes of money are the sole source of rising prices in a stable economy, the reduced money growth reduced GDP growth and popped Japan’s real estate and asset bubbles that had been caused by the prior infusions of money from the central bank.

The large drop in inflation and real GDP made it appear that there had been a large drop in production, when almost certainly there had not been. Japanese industry was not suddenly less capable of producing goods, and citizens did not suddenly desire fewer goods.

The monetary shock did lead to a real economic bust, but only transiently, not for several decades. GDP, as well as real GDP to a lesser degree, remained low, but did so only because the rate of money growth was low. By contrast, the actual physical Japanese economy picked back up as its citizens kept producing goods and services. It looked like a recession on paper, but did not necessarily on the ground.

The Evidence

Instead of reducing Japan’s economic growth to a single statistic in order to gauge the amount of production and wealth generation in the country, let us consider some other statistics and observational data: city skylines the last several decades have been dotted with building cranes putting up shopping malls, condos and entire forests of office buildings; new single family housing has been popping up every day for two decades (Japan adds new housing per capita at a much faster rate than does the United States); the number of physicians for every 1,000 people has consistently risen; life expectancy has increased by more than four years; Japan’s ranking in country quality of life indexes—which is often near the top—has not fallen.

 When we stick to formal economic statistics other than standard GDP, we find a brighter picture. Japan’s industrial production, though still influenced by price changes, has continued rising the last three decades.

To be sure, the growth rate has been lower since 1990, but since Japan’s working age population has fallen since the mid-1990s, less production is expected with fewer people producing. The country’s official real GDP has averaged 1% growth per year (it averaged 4.4% in the 10 years prior to its 1991 recession). That is still positive economic growth. Viewing GDP in dollars and having the currency markets adjust for prices by using Purchasing Power Parity, and, adjusting for population changes, reveals that Japan’s real GDP per capita has risen impressively, more than doubling since 1990 by growing at 3.2% per year. Notice that the main difference in these measurements is the impact of and adjustment for money and prices.

Perhaps the most convincing data comes from comparing Japan’s GDP per capita to that of other OECD countries. It shows that in 2016 Japan’s OECD ranking had slipped only one notch since its supposed 1986 heyday, such that it is still the 17th wealthiest OECD country—as it was in 2012 when the most recent government stimulation of the economy began. Most countries ranked above Japan also fell, because they were all leapfrogged by Ireland. So if Japan has been in a several decade recession, so have virtually all OECD countries.

What’s more, the OECD’s productivity data confirms Japan’s relative economic position through time, showing that Japan’s productivity relative to the U.S. is exactly the same as in 1990, at 64%.

This is not to say that Japan is doing perfectly and is without economic problems. Like all countries, it could be doing much better, and there are many unresolved challenges. But the observational and economic evidence suggests that Japan is not only doing as well as its peers, but also is not mired in a multi-decade economic malaise as is commonly asserted.


The Deflation

What about Japan’s terrible deflation problem so often mentioned? It does not really exist. Commentators assign the word deflation to Japanese prices that temporarily fall 1-2%. But that’s not really deflation, which is traditionally seen as a downward spiral of prices as a result of a collapse of the money supply, as occurred during the Great Depression. Prices can fall because the money supply falls, or, because the supply of goods increases faster than the government adds new money to the economy. The former is a fall in demand, the latter is an increase in supply. The former is a negative consequence of manipulating the money supply while the latter is a positive consequence of economic growth. People conflate the two and treat them as equivalent, whereas they are complete opposites.

Nominal prices (but not wages) would always fall with economic growth—as is historically the case—if the government did not add new money, because the same quantity of money would have to buy a greater quantity of goods. In fact, with or without additional money and price inflation economic growth always results in falling prices in real terms because it results in greater purchasing power, as prices fall relative to wages.

Japan did not experience a collapse in the money supply, i.e., a fall in demand. Thus, it had no deflation. Instead, it had an increase in supply resulting in relative flat prices due to the fact that the Bank of Japan (BOJ) printed money at about the same rate that the economy produced goods, with slight variations in certain periods resulting in prices that oscillated slightly higher and slightly lower (Figure 4). Prices still rose overall: they are 12.6% higher now than they were in 1990.

The Unemployment

If Japan hasn’t really been in a recession all this time, how do we explain its higher unemployment rate? In general, the unemployment rate is separate from the economic growth rate. For example, China has had the same or higher unemployment rate as Japan and Thailand over the last 20 years while growing at least twice as fast. Similarly, Spain has grown at about the same rate as Chile, while having almost double the unemployment rate.

Unemployment is an unnatural phenomenon, as every economy has more work to be done than there are people to do it, since human needs of goods and services are unlimited. It stems from government-mandated artificially high wages such that the existing stock of company payroll funds is too small to be able to pay all workers the mandated amount. Additionally, these wages, such as minimum wages and union wages force the pay of low-productivity workers higher than the value the workers can produce.  Thus, some workers will go unutilized, and companies instead invest in relatively cheaper automation.

The evidence suggests this happened to some significant degree in Japan. Though it’s not clear what the situation was the first 10 years of Japan’s recent “recession,” over the last 20 years minimum wages in Japan have risen at least 1% faster than hourly earnings.

Why does unemployment fall during recessions and rise during expansions? Certainly, an economy diving into recession will see unemployment as a result. But just as monetary policy is almost always the cause of recessions, it also dictates the long-term monetary value of the economy, which affects employment. When the central bank prints money, business revenues rise faster than costs; this increases profits. With additional revenues and higher profits, companies have more money with which to pay workers; therefore, previously unprofitable workers become profitable, and hired. So changes in money drive changes in employment in multiple ways.


The Current State

What are we to make of the current economy of Japan given this economic retrospective? Is the country suddenly producing substantially more goods? No, instead Japan’s Prime Minister Shinzo Abe’s administration began a deliberate money-printing campaign in late 2012, increasing the monetary base—the “high-powered” money the BOJ creates that enables banks to lend new money—by a whopping historical 283%. The new bank loans, in turn, grew the last two years at the fastest pace since 1990. Borrowers then spend the money, and receivers re-spend it. As the new and additional money filters though the economy, it pushes up prices in the process. This pumps up GDP and other monetary indicators in the economy.  

Thus, the economic boom we now see  just reflects the largest monetary pumping the country has engaged in for a generation.  Economist Paul Krugman has been instructing Japan to “PRINT LOTS OF MONEY” for decades. It finally has.

While the boom is technically only a monetary one that does not affect real production, it might conceivably affect it indirectly. The new money redistributes purchasing power from savers to borrowers, because it allows borrowers to spend the money before prices rise, while savers’ fixed stock of money buys less, once prices do rise. It is theoretically possible that this redistribution could serve to enable more real capital to be invested than otherwise would be, and thus eventually grow the economy faster.


The Stock Market

What about the rising stock market? Isn’t it forecasting stronger economic growth? No, it’s just asset price inflation: stocks can go higher only by way of more money being spent on them—assuming the number of shares outstanding is not shrinking. Much of the new money being created by the central bank is flowing into the stock market. In fact, the BOJ is directly buying Japanese stocks, injecting $27 billion into the stock market last year. It is a top-10 shareholder in 90% of the Nikkei 225. Doesn’t the stock market instead rise because the economy is growing and companies are making more money?

No, companies do not produce more money; they produce goods and services that push prices lower, not higher. Additional money comes only from the central bank and manifests as price inflation. Thus, the increased corporate revenues and earnings as well as the increased share prices are both just price inflation. Starting to get the picture about how we confuse money and real things? Much of what we see in the economy is a monetary illusion.

The growth in money, credit and lending leading to higher prices for the longest period in decades explains why Japan’s GDP has expanded for the longest period in decades. But what about the strong business confidence? Both business and consumer confidence always rise when an economy is being pumped up with money, and revenues, profits and wages rise—though Japan has not yet seen wage growth (but surely will if the money keeps flowing). And, business confidence has been this high in Japan many times over the recent decades.

The Future

What does this all mean for Japan’s future? If the money printing continues, Japan will continue to have high GDP growth and a rising stock market. But regardless of the changes in money supply, Japan’s true economic growth will likely continue as it has been, i.e., at only moderate rates.

The money creation will also help with the government’s obsession with a supposedly strong yen, as additional yen on the market will help lower the exchange rate.

The other main strategy of the Abe administration is fiscal policy. Japan has engaged in many years of strong government spending over the last three decades in hopes of pumping up the economy. Just as it failed to increase growth then, so it will fail in the future, since taking monetary capital away from producing goods in order to spend money consuming goods does not help to produce more goods. If money printing and spending were an economic panacea, Argentina and Zimbabwe would wealthy countries. However, if the money printing continues it will help sustain the impression that the spending actually helped produced growth.

Is Japan’s debt burden a problem? Yes and no. It does reallocate capital from production to debt payments, thus sacrificing growth. But as long as the debt doesn’t continue growing, the amount of capital left for the production of goods can continue creating still more physical capital and more goods. It’s not different from the United States' continuing to grow even though a massive amount of capital is taken away from production and used on military spending: the capital that is not consumed is still used to produce goods.

Either way, Japan cannot grow its way out of debt as is commonly assumed, since economic growth does not create new money. It can only inflate away the value of the debt, forcing citizens to pay it via the redistributive inflation tax.

Is Japan’s dwindling population a problem? Technically no, because with a lower population fewer goods are needed. What counts is not the amount of goods in total, but the amount available per person. The problem is that the social support system in place requires current workers to support retirees. Since the ratio of workers to retirees is shrinking and workers have to give increasing amounts of their production to retirees even as less is being produced per retiree, there is less wealth left for all citizens. Future productivity gains could offset this problem, but it is still an absolute negative.

What’s holding Japan back from significantly increasing production, i.e., growing at a much faster rate, is that it is, as financier Steven Rattner put it, “straitjacketed by bureaucracy, tradition and overregulation.” Before Japan can transform into a Singapore or Hong Kong, it needs the relative economic freedom that Singapore and Hong Kong have. Thus, Japan needs less control and manipulation of its economy by the government.

The Abe administration, however, continues policies of government management of the economy yet presents them as new and innovative pro-growth policies. Since money-printing does artificially boost an economy and looks and feels like real growth, people are already "buying it," and the administration might just get away with it on perception alone. But regardless of monetary illusions, with these policies, we won’t see Japanese citizens with the living standards of those in Singapore and Hong Kong any time soon.