Let’s Delve a Little Deeper Into Krugman’s Newfound Respect for Liquidity Trap Economics in Japan
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.
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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.
He is unusually down on fiscal policy here (granted, Japan probably had a much bigger structural problem than we do, if you think about Japanese savings rates, growth prospects, and demographics vs. our savings rates, growth prospects, and demographics) – but overall the tone seems to be consistent with the bigger BPEA Japan paper, in which fiscal policy gave an assist to monetary policy.
Fiscal policy doesn’t work miracles. Monetary policy probably doesn’t either.
I doubt you’re going to be satisfied with that, but it seems like a bigger difference in tone than in argument. I think this only sounds damning if you think Keynesians argue that fiscal policy is a silver bullet. I’m not sure it’s that (particularly when paired with a banking crisis that needs to be painfully worked out), but that doesn’t mean it’s not a good idea.
Wasn’t there unemployment and idle resources in Japan 1999? Wasn’t there an “output gap”? Wasn’t there falling prices?
Aren’t all these reasons above the very Krugman relentlessly cites against “very serious people”, i.e. conservatives, to stop worrying about the deficit in the US?
Why wasn’t Japan 1999 a place and time when we were to say “Deficits are something to worry about…but now is not the time!”?
Isn’t the US having similar “democraphic restructuring”? Baby boomers and whatnot.
Fiscal policy doesn’t work. Monetary policy doesn’t either.
Yes they do Roddis, you demagogue.
They are incredibly effective at aggrandizing a particular group of people with state privilege, at the expense of those without state privilege.
Fiscal policy allows politicians to bribe voters with goodies at the expense of the bad guys, and monetary policy allows bankers to earn interest on money created out of nothing, also at the expense of the bad guys.
They work incredibly well, so stop trash talking them. Whole generations of people have benefited from it, and they died before there was any chance of the costs being redirected back at them where they clearly don’t belong.
Just reading his words I think his logic is that fiscal policy can only serve as ” a bridge over troubled water” and not as a solution to structural problems. He suggests that “Japan has a structural excess of saving over investment, even at a zero interest rate” which means that fiscal policy would have to last for ever and not be sustainable presumably (and ironically) because the debt burden would become too great
I assume he has either changed his mind since he wrote this article (and that he now thinks that fiscal policy would have worked in Japan back then) or he thinks that in the US today fiscal policy would just be a “bridge over troubled water” and would work since the problem is not structural.
(1) This was written before Krugman discovered the real problem in Japan in the 1990s: debt deflation and Richard’s Koo’s balance sheet recession analysis:
http://socialdemocracy21stcentury.blogspot.com/2012/10/richard-koo-on-macroeconomics-and.html
The strict “liquidity trap” idea in neoclassical synthesis Keynesian macro – the notion that there can be an infinitely elastic or a horizontal demand curve for money at some positive level of interest rates – was always false, nor did Keynes believe such a thing existed*:
http://socialdemocracy21stcentury.blogspot.com/2011/05/post-keynesians-reject-liquidity-trap.html
(2) “Japan is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP.”
Krugman was simply wrong about fiscal stimulus here. Austerity was imposed on the Japanese economy from 1996 to 1997 by Prime Minister Ryutaro Hashimoto. The result was nearly five quarters of negative growth in a recession from 1997–1999 and resulting banking crisis.
A major consequence of the recession induced by fiscal contraction was that the Japanese budget deficit soared by 68%, owing to the collapse of tax revenue. When fiscal expansion resumed in November 1998 the actual discretionary spending increases and stimulus weren’t the “largest peacetime fiscal stimulus in history”. The deficit was mostly the legacy of the tax revenue shortfall.
* “Liquidity trap” when used loosely or in a weak sense to mean that interest rates cannot fall below zero and that monetary policy can become impotent in some situations is perfectly true, however.
(1) This was written before Krugman discovered the real problem in Japan in the 1990s: debt deflation and Richard’s Koo’s balance sheet recession analysis
And apparently before he learned the causes of “debt deflation”.
Krugman was simply wrong about fiscal stimulus here. Austerity was imposed on the Japanese economy from 1996 to 1997 by Prime Minister Ryutaro Hashimoto. The result was nearly five quarters of negative growth in a recession from 1997–1999 and resulting banking crisis.
Epic cherry picking. Decades of stimulus and you pick the one time sanity was somewhat restored, and you can’t even see that the “negative growth” was the private economy restructuring to a more market oriented trajectory, which takes time.
You remind me of someone who accelerates his drinking the SECOND he starts to feel the slightest headache, and blames his headache on soberness.
Debt deflation. Isn’t that where people are misled by fiat funny money dilution and/or government spending into thinking that various lines of production are profitable so they take out loans to finance investment in those lines and only to later discover that their investments were unsustainable and they can’t pay their debts? And where, if you wish to be deemed a thoughtful and respectable person and hope to be invited to the right parties, you would never dare blame the situation ultimately on the price distortions that were induced by the various government interventions?
Did Krugman actually discover that?
Isn’t that where people are misled by fiat funny money dilution and/or government spending into thinking that various lines of production are profitable so they take out loans to finance investment in those lines and only to later discover that their investments were unsustainable and they can’t pay their debts? And where, if you wish to be deemed a thoughtful and respectable person and hope to be invited to the right parties, you would never dare blame the situation ultimately on the price distortions that were induced by the various government interventions?
No silly, because everyone knows that as long as the means of production are “overwhelmingly” owned by the private sector (define “overwhelmingly” any way you want, as long as the state is doing at least what you personally want it to do, every other statist can eat it), then market actors should be able to observe the single set of relative prices that only ever exists, and will exist, and then, somehow, magically, delineate those relative prices into two components:
1. That which was brought about by market actor voluntary preferences.
2. That which was brought about by non-market state intervention; and
LK’s beliefs imply that if market actors make decisions in accordance with prices determined by 1 + 2, then they are still making decisions in accordance with prices determined by 1 only.
There is no discoordination AMONG market actors, because heck, they should have those magical powers that can tell them which part of relative prices are coming from market actors and which are coming from the state.
You know, like when you take out a 30 year mortgage for 3.463% interest for 5 years, then you should use those magical powers to tell you which part of this is a function of market preferences, and which part is a function of government intervention. That way, you will never act NOT in accordance with other market actors. As long as “prices” exist, as long as “private ownership” exists, then the state simply cannot send out price signals that differ from one where the only participants are market actors.
a. Is LK really saying that or is he making a lot of noise trying to change the subject?
b. But, of course, funny money loans never provided the funds for the bidding up of $100,000 home prices to a temporary and artificial price of $500,000 and no one ever took out a mortgage loan to buy one of those homes at $500,000.
But if it ever did happen, it was only because people were afflicted with inexplicable “Minksy Moments” from which they never would have suffered but for the lack of proper government regulation.
You silly man. When I was looking to buy a home about 15 years ago in SoCal, I came across this great fixer upper.
Since I have magical powers, I knew exactly which part of the price and which part of the interest rate was due to government intervention and which was market driven, such that I was able to convince about a hundred other home applicants NOT to buy that home for the asking price.
Fortunately, I was able to teach every one of those hundred people about Austrian economics, and not only that, but I was also able to teach them the same magical powers of knowing which part of the price and interest rate was market driven.
But alas, a 101st buyer came along, and I was not able to convince him. He paid the asking price because his recently bailed out bank made him a lucrative offer. And he didn’t even have a job!
Actually I lied. That 101st person did not exist. Actually I made two lies. That bailed out bank also did not exist.
Krugman wrote:
A more likely scenario, however, is that the prolonged process of restructuring will keep consumers nervous
Did I read that right?
Yes. Krugman actually considered the concept of regime uncertainty, at least to some degree. But he would never call it that – the Austrians might be on to something if he did.
“Kill that snooping confidence fairy before she rats on us!”
This is all very informative, but how does it help get me rich ?
I know it’s off-topic but….
Thank you for the economic stimulus, Hurricane Sandy.
Krugman must be excited!
Hurricanes are only welcome when there are people not working, and resources are not being used, at the very most recent moment in time. Like, right now. If, right now, at this very moment, there are people and resources not “moving around”, then we should all welcome hurricanes.
Otherwise, regular boring economics reigns supreme, and nobody likes to read newspaper articles on regular boring economics.
I was being generally sarcastic about it being stimulus.
just so u know, Cap’n Freedom
I guess I have to work on my sarcasm.
Read my post carefully, and you’ll see that I implicitly argued that hurricanes are ALWAYS welcome. Hence the joke.
Ah well…
ha!
sarcasm is easily lost over the internet i suppose…