There’s a lot of interest in the recent moves by the Abe administration to push for faster growth in Japan. Paul Krugman’s comments:
As far as I can tell, Posen is going with the notion that unconventional monetary policy, by working both on asset demand and on expectations, can do the job. Maybe, but most of us have taken the limited payoff to quantitative easing as a cautionary tale. There’s a lot to say for the notion of using temporary fiscal stimulus to push the output gap down, ideally even causing some economic overheating, to jump-start the transition to an inflationary regime.
And beyond that, the credibility of a higher inflation target in the face of the deflationary bias of central bankers may well be best established by (a) reducing the central bank’s autonomy and (b) getting the central bank in the business of supporting — indeed, monetizing — government deficits, at least for a while.
I don’t have any big problems with the technical framework used by Krugman, but I interpret the situation quite differently. Let’s start where we agree. I think neither of us are 100% convinced that Abe plans to carry through with aggressive stimulus. But suppose he does, what will that tell us?
1. Krugman see a coordinated fiscal-monetary push, whereas I see markets reacting mostly to the monetary side. In my view the Japanese have already tried something like what Krugman discusses, and it failed. They combined aggressive fiscal stimulus, lots of big government construction projects, and aggressive QE. Been there, done that.
2. One reason it failed was that the QE was partly temporary. Krugman’s expectations trap model shows that temporary monetary injections are not effective. I would add that temporary monetary injections combined with fiscal stimulus are also not effective, or at least they weren’t in Japan.
3. The huge plunge in the yen began in mid-November, the day Abe announced he’d ask the BOJ to set a 2% inflation target. I did a post that day, talking about the story. I’ve followed it very closely ever since. Lots of Keynesians seem to have jumped on the bandwagon much later, when talk of fiscal stimulus also seemed to impact the stock market. However it seems to me that the big plunge in the yen has been very closely linked to reports that Abe would push a higher inflation target on the BOJ. One wouldn’t even expect fiscal stimulus to depreciate the exchange rate at all. So while we can’t be certain, I think the evidence strongly supports the view that expectations of easier money are depreciating the yen. And the rise in stocks is very closely correlated with the fall in the yen. Given that fiscal stimulus didn’t work in the late 1990s and early 2000s, I see little reason to believe that a modest fiscal stimulus would be a game changer today.
Having said that, I don’t dispute that a modest portion of the gain in the stock market, and more importantly the fall in the yen, was linked to a fiscal stimulus announcement, supporting Krugman’s argument that fiscal stimulus might help push the BOJ toward a higher inflation target. That’s obviously a psychological argument that can never be precisely modelled.
4. I’ll be focusing more on the BOJ, not fiscal policy. What sort of target does the BOJ set? Is it precise or vague? Do they do level targeting? When they fall short, how do they respond? Unlike Krugman, I don’t think expectations traps are a real problem. I see central banks as being like small children. Markets can read their moods better than they can read their own mood. (That’s why despite the fact that they have the technical ability to do “insider trading,” they often lose to people like George Soros.) So if the BOJ sincerely wants 2% trend inflation, the markets will recognize that fact, and they’ll get 2% trend inflation. But will they want it? I’m still a bit dubious, although the odds have obviously improved in recent weeks.
Some commenters ask what sort of outcome would show that I am wrong. So far it’s been easy to show that no fiat money central bank has ever tried to inflate and failed. But I could envision it being much harder in the future, which would make my claim more dubious. What if the BOJ had not raised interest rates in 2000 and 2006? What if they hadn’t reduced the monetary base sharply in 2006? What if they had set a symmetrical 2% inflation target in 2000, and consistently failed to hit it? Yes, I could envision a situation where it’s hard to tell whether they were really trying and failing, or not trying at all.
I suppose I could always point to more things that haven’t been tried. Why not push the yen to 120/$, and do a Swiss style policy? If someone responds that the US won’t let them, then I’d respond; “Fine, then it’s not a liquidity trap it’s a US trap. The US is declaring economic war on Japan and forcing them into perma-deflation.” But like most sweet, innocent, naive Americans, I could never imagine us doing anything so evil.
PS. Remember, they attacked us in 1941! We are the good guys. Oh wait, wasn’t there something about an oil embargo . . .
PPS. Lars Christensen reminds us that Japan did a bit better in the 2000s than the 1990s. But that wasn’t because of growing AD—NGDP is lower than 20 years ago. More likely the labor market partially adjusted. However the Japanese natural rate of unemployment used to be about 2% to 3%, so it’s still quite possible that a bit more AD would help. (I’m told that Japanese unemployment data is misleading.) That’s not to deny that structural problems are the number one concern in Japan.
HT: Travis V