Krugman often tells of how he is a true scientist because he didn’t believe in the liquidity trap, until faced with the problem of Japan in the 1990s. Then he realized that unconventional monetary policy–the promise to be irresponsible in the future–was something the Bank of Japan could do. All of this serves as a model for us in our present crisis.
(I heard Krugman talk of his eureka moment regarding Japan in person at a talk he gave at NYU’s Stern School of Business in the early 2000s, and he hints at this narrative in his response to my diabolical question in this video.)
From these assurances, one would have thought that Krugman writing about Japan in the late 1990s would sound pretty much like Krugman writing about the Great Recession in the 2010s. And yet, here is a selection from 1999 (HT2 “Blackadder” and Lars Christensen):
Japan is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; Japan now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.
Is this likely? The phrase “self-sustaining recovery” trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea. The purpose of this note is to expose this hidden exoticism – to show that anyone who believes that temporary fiscal stimulus will produce sustained recovery is implicitly endorsing a rather fancy economic model, the sort of model that finance ministries would under normal circumstances regard as implausible and disreputable.
When, then, can fiscal stimulus work as a long-run solution? There seem to be two possible answers. The first is that deficit spending can serve as a bridge over troubled waters. Suppose that the factors depressing private spending are clearly temporary – for example, there is a clearly temporary financial crisis underway, or investment is on hold pending some sort of financial cleanup, etc.. That is, there are good reasons to think that EE will shift up in the not-too-distant future in any case; so propping it up artificially with fiscal stimulus is simply a holding action until the cavalry arrives.
It’s actually hard to come up with good examples of this kind of fiscal program – maybe Sweden’s efforts to ride out the first oil shock in the mid-70s. In the case of Japan, a starry-eyed optimist might argue that restructuring of Japanese banks and corporations will eventually create a “new economy” that generates a lot of investment. A more likely scenario, however, is that the prolonged process of restructuring will keep consumers nervous and if anything depress demand. That cavalry may be a long time in coming.
Anyway, Japanese officials seem to have something more in mind than waiting for good news to arrive. Their idea is that the massive stimulus now underway will not need to be continued, because it will generate that “self-sustaining recovery”. What would the Keynesian cross have to look like for that view to be justified?
The answer is that it would have to look like Figure 2…
Do you believe this picture? There is nothing wrong with multiple equilibrium stories in macroeconomics….The point is that multiple equilibria are too easy – they are a device that can justify practically any policy, and should therefore not be proposed unless you have some compelling reason to think they must be there.
Now you could argue that the experience of the Depression and after provides just such evidence. Many economists thought that with the end of World War II spending the United States would revert to Depression-type conditions; a whole school of thought, the “secular stagnation” hypothesis, was built around that idea. In fact, once jolted out of depression, the U.S. did not fall back; one explanation is a story something like that in Figure 2.
But it is quite a stretch to argue that Japan in the 90s is a parallel case. It might be; but an at least equally, if not more, plausible story is that Japan has a structural excess of saving over investment, even at a zero interest rate; in that case a temporary fiscal stimulus will produce only temporary results.
What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.
Will somebody please explain this to me?
Yes, someone please explain this.