TCS Daily

Japan's Supply Problems

By Christopher Lingle - March 7, 2005 12:00 AM

Japan's economy has slipped, yet again, into recession. And once again, fingers are being pointed at low household consumption as the cause of the country's sluggish economic growth

In turn, the high savings by Japanese households (between 15 to 20 percent of disposable income) is targeted as an accomplice in this long saga of slow growth. In order to remedy the situation, the focus of policy discussions is directed towards boosting aggregate demand.


It would seem that the errors in this approach would be obvious after more than a decade of large public-sector deficits failed to boost the economy. Logic suggests that if such massive deficit spending failed to halt recessionary pressures that more household consumption will also fall short.


Japan's economy is not suffering from a deficiency in demand that can be eliminated by increased government spending or printing money. Its problems are with supply.


There was a time when most economists understood this, but few of them get the analysis right these days. So it is not surprising that this confusion is passed on to their students who become citizens, journalist, analysts, politicians or bureaucrats. It is because conventional economic wisdom is wrong that matters have become worse.


The simple truth that is being forgotten is that economic growth requires an abstinence from consumption. Spending on capital goods means that resources are diverted away from consumption and vice versa.


For there to be growth, there must be capital accumulation generated by a pool of savings (non-consumption). It turns out that household consumption is the result rather than the cause of economic growth. Stable growth requires a delicate balance between savings (as the basis of

investment) and consumption.


When savings are funneled toward the purchase or creation of capital goods, it puts as much money into circulation and generates as much employment as if there were more consumption. But there is a big difference in the impact on the economy.


Loose monetary policy and deficit spending by Tokyo sent out false signals that created distortions and caused the destruction of savings and wealth. The enormous amount of savings has largely been dissipated by poor choices for investment.


In turn, households feel the need to save ever more to make up for the losses. In this case, high savings are the result of the contraction more than the cause of it.


Lower interest rates allow the demand for consumption goods to increase and to be more satisfied sooner. As financial resources are diverted from more lengthy, complex production processes, returns on these activities become less profitable.


When the conventional tools of monetary or fiscal policies are implemented to forestall the end of the boom, it shifts economic activity towards consumption at the expense of production. When savings diminishes, the structure of production begins to contract.


New money created by the central bank involves an exchange of nothing for money and then money for something. This exchange of nothing for something involves an act of consumption spending that is not supported by new production. Such an increase in consumption without new production must involve a diversion of funds from wealth-generating activities. This is equivalent to a destruction of savings that eventually causes the production flow to contract.


Instead of running more public-sector deficits and loosening monetary policy, there should be a radical overhaul of taxes. At the same time, reducing the involvement of the government will allow markets to send signals to private enterprises so they can direct savings towards wealth-generating activities.


Perhaps the most important change in taxes would be to allow entrepreneurs and investors to keep more of their capital gains. Capital gains are real economic profits that can be invested to provide another round of economic growth and raise living standards.


When capital gains taxes are levied against the sale of assets, they reduce savings and also lead to a misallocation of scarce resources. This is because a tax on realized capital gains operates as both a transaction taxes and as a tax on investment. This encourages tax avoidance behavior to reduce the number and frequency of transactions and encourage savings to be shifted toward consumption activities.


Another distortion related to capital gains tax is that it can discourage the shift of funds toward more productive investment opportunities. By imposing such a tax, it discourages investors from making their funds available to what may prove to be new and better technologies. This benefits established enterprises while it disadvantages more innovative companies who may it harder to find sufficient venture capital.


Too much time has been wasted due to bad economic theorizing. Japan's leadership would be well advised to ignore conventional economic wisdom that brought about the current malaise and prolonged it.


Christopher Lingle is Global Strategist for eConoLytics.


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