A Nation of Money Hoarders

When the general price level keeps falling in a depressed economy with high unemployment, firms and consumers might not invest or consume more no matter how low the interest rate is. Instead, they would rather hold on to the money they already have or convert other assets into money.

After more than a decade of economic slump, the Japanese have sunk into a deep pessimism that threatens to become self-perpetuating. The fear that profit and income will only decline over the long term has persuaded corporate executives and families alike to cut spending. Slack demand has led to falling prices for goods and land at 1.5% a year. Falling prices have bred deeper cost cuts by businessmen and more heroic efforts to save by individuals, which in turn lead to lower prices. And so on in a self-feeding downward spiral.

The Bank of Japan, its central bank, has not been able to use lower interest rates to arrest this downward spiral. Even with the key overnight call rate (what banks charge each other to borrow money overnight) lowered to around 0.001%, economic output and prices are still dropping. Bank deposits have risen about 2% during the past five years, even though banks are now paying only 0.02% on savings. Japanese banks are facing customer flight -- not by depositors but by healthy borrowers, who are paying down old debt or balking at new loans. Outstanding bank loans have fallen in Japan from year-earlier levels for 45 straight months. Total bank loans fell below deposits in early 1999 -- and now exceed them by about $300 billion. Under normal circumstances, firms and consumers would borrow more money to invest and consume when interest rates fall as money supply increases. But when the general price level keeps falling in a depressed economy with high unemployment, firms and consumers might not invest or consume more no matter how low the interest rate is. Instead, they would rather hold on to the money they already have or convert other assets into money.

Holding onto money is a winning strategy when the interest rate is already very low and the general price level is falling. Each dollar not spent today will buy more tomorrow when prices will be lower. If instead the money is used to buy bond to earn a very low fixed interest income, bond buyers might run the risk of capital loss as future interest rates are more likely to go up than down. When more money is simply held as liquid assets rather than spent to generate more output, a liquidity trap is said to have occurred.

In a liquidity trap, the central bank's ability to substantially expand money supply is quite limited. First, when commercial banks already heavily loaded with $600 billion of bad loans are reluctant to make new loans, the classic money creation mechanism is essentially disabled. Second, commercial banks return surplus cash on their books right back to the central bank by buying government bonds.

And whatever liquidity the central bank might have created is not sticking in Japan. Some fled overseas as Japanese investors snapped up higher-yielding foreign bonds, mostly U.S. Treasuries. More went to foreign hedge funds that made a killing borrowing yen cheap to buy up U.S. and European financial assets. If Japan has not accumulated such a large trade surplus, she could have depreciated its currency to export its way out of its anemic domestic demand. Instead, the expectation for higher not lower Japanese Yen might have encouraged the Japanese to hold on to their Yen in anticipation of better opportunity to buy more foreign currency bonds.