May 12, 2003

Paul Krugman's "Thinking About the Liquidity Trap"

Paul Krugman's "Thinking About the Liquidity Trap":

Thinking about the liquidity trap: We live in the Age of the Central Banker - an era in which Greenspan, Duisenberg, and Hayami are household words, in which monetary policy is generally believed to be so effective that it cannot safely be left in the hands of politicians who might use it to their advantage. Through much of the world, quasi-independent central banks are now entrusted with the job of steering economies between the rocks of inflation and the whirlpool of deflation. Their judgement is often questioned, but their power is not.

It is therefore ironic as well as unnerving that precisely at this moment, when we have all become sort-of monetarists, the long-scorned Keynesian challenge to monetary policy - the claim that it is ineffective at recession-fighting, because you can?t push on a string - has reemerged as a real issue. So far only Japan has actually found itself in liquidity-trap conditions, but if it has happened once it can happen again, and if it can happen here it presumably can happen elsewhere. So even if Japan does eventually emerge from its slump, the question of how it became trapped and what to do about it remains a pressing one.

In the spring of 1998 I made an effort to apply some modern, intertemporal macroeconomic thinking to the issue of the liquidity trap. The papers I have written since have been controversial, to say the least; and while they have helped stir debate within and outside Japan, have not at time of writing shifted actual policy. Moreover, too much of that debate has been confused, both about what the real issues are and about what I personally have been saying.

The purpose of this paper is twofold. First, it is a restatement of what I believe to be the essential logic of liquidity-trap economics, with an emphasis in particular on how the "modern" macro I initially used to approach the problem links up with more traditional (and still very useful) IS-LM-type thinking. Second, it attempts to examine in a more or less coherent way the various alternative policies that either are in place or have been proposed to deal with Japan?s liquidity trap, ranging from fiscal stimulus to unconventional open-market operations (and it tries in particular to make clear the difference between the latter and the expectations-focused inflation targeting I have proposed)...

Posted by DeLong at May 12, 2003 07:28 AM | TrackBack

Comments

One way to jump start inflation would be to increase real wages. Wouldn't substantial increases in the minimum wage increase demand if it did not lead to more job loss? PK does not discuss this in his article.

Posted by: bakho on May 12, 2003 08:48 AM

Japan is a male dominated society, which makes the money supply inherently unstable.

Posted by: nkirsch on May 12, 2003 09:29 AM

>One way to jump start inflation would be to increase real
>wages. Wouldn't substantial increases in the minimum
>wage increase demand if it did not lead to more job loss?
>PK does not discuss this in his article.

OK, so I'm not sure how your suggestion would work in a presumed liquidity trap economy. Isn't the essence of the problem that nobody is spending money? If you increased the minimum wage *AND* nobody lost their job, then presumably there would be more money in the economy. But the reason why this is such a trap is that we've seen that the mere presence of more money hasn't done much to stimulate demand.

So with the recent history of interest rates, everybody could refinance their houses and/or take out home equity loans. The result was more money floating around. This has led to some increase in demand for a few select things (cars, for example, last year, and real estate), but not enough to actually cause any real inflation.

So what if we raised the minimum wage? Well, think first about what has been happening to payrolls recently without any increase in the minimum wage (so that real minimum wage has been going down due to what meager inflation we do have). They have not been going up. If the minimum wage goes up, there would be two scenarios. In the first scenario, let's pretend nobody is fired. Then either
firms invest less (definitely bad) or they try to raise prices (which is what we perversely want). Then either people but the same amount at the new improved prices, *or they don't*. In the latter case, nothing was achieved, and its not silly to think that firms might start to lay off more workers. In the first case, inflation would go up the way we want. But only in the short run. The problem is that we don't really need a bump up in inflation, what we need (if Krugman is right) is a bump up in inflationary *expectations*, and a one-time rise in the minimum wage is unlikely to do that. Furthermore, you do run the risk in our new high-productivity growth economy that attempts to raise wages like this will just lead to more increases in productivity, and increase the output gap we already have.

So I could well be wrong here (I'd *LOVE* to be wrong here), but the problem with a liquidity trap is that the easy and obvious stuff doesn't work anymore. I'm guessing that the only thing that might work in the "increase the minimum wage" category would be to enact a program stipulating that the minimum wage would be indexed to the CPI + 2% for the next 10 years, or something equally long-lived and basically nutty sounding. If something like that didn't increase inflationary expectations, I'm not sure what would.

But then I get this really nagging feeling about the current federal budget fiasco. With red ink as far as the eye can see, and an increasing extent to which foreigners are underwriting the debt, everybody can tell that there will have to be higher interest rates being offered down the road, or a truly impressive devaluation of the dollar, or both. And I'm not sure that any of these things would be positive for people in the US.

Posted by: Jonathan King on May 12, 2003 09:32 AM

When I took my one and only economics course almost 30 years ago, the "you can't push on a string" argument was alive and well. While tossing out old papers, I found notes from that class explaining the effects of:
(a) Tight money and tight fiscal policy (recession and dis-inflation);
(b) Loose money and loose fiscal policy (expansion and inflation);
(c) Loose money and tight fiscal policy (inflation);
and my own question: "What about loose fiscal and tight monetary policy?" (This was pre-Reagan, and, apparently, no one had tried it yet)
I even have a scrawled Phillips curve in my notes.
Did all of that go out of style at some point? If so, when and how? Is there a cheaper way of catching up than spending close to $100 on a more recent edition of some Economics 101 warhorse text?

Posted by: C.J. Colucci on May 12, 2003 09:51 AM

What if the government (States and Federal, Bush is against but that is another question) contracted people to do things? Would not that kickstart the economy on a large scale? I am thinking along the lines of the New Deal of FDR, unless I misunderstood the texts I've read on those times.

DSW

Posted by: Antoni Jaume on May 12, 2003 09:59 AM

Brad,

Textbook macroeconomic models based on the IS/LM paradigm are all well and good, but is there any empirical evidence that the U.S. or any other advanced industrial country has ever been in a liquidity trap? Consider these three historical situations:

1. U.S. in the 1930s. Short-term interest rates were extraordinarily low, often less than ½% percent, but when Keynes spoke of “the interest rate” as relevant to the rate of investment, he was speaking of long-term interest rates, was he not? In the 1933-1937 expansion, there was rapid money supply growth and interest rates on AAA bonds declined from about 5 ¼% to 3 ¼%. Not much evidence of a liquidity trap here. Then again, Keynes explicitly stated he regarded the liquidity trap as a theoretical possibility, not something that had ever actually happened.

2. Japan today. As far as I can tell, there’s a widespread consensus that Japan’s problems are essentially structural. An interesting book on the subject is Japan, the System that Soured, by Richard Katz. Keynes concern was that in a slump, monetary policy could not push interest rates low enough to stimulate private investment. Katz argues that Japan failed to make the transition to mass-consumption economy, that it invests too much and too inefficiently. Another view of Japan’s problems points to its insolvent banks that aren’t allowed to fail, that continue to lend to insolvent “zombie” companies, while other businesses are starved of credit. I can’t see how Krugman’s policy of planned inflation would solve either kind of problem. By the way, Keynesian deficit-financed public works spending hasn’t worked for Japan either.

I know Krugman doesn’t buy the “structural” explanantion of Japan’s problems. What is your opinion Brad?

3. The U.S. today. Many people have compared the stock market boom of the 1990’s to the 1920’s. The Greenspan Fed responded to the ensuing recession the way the 1930’s Fed did not, with massive monetary stimulus. And while you wouldn’t know it from all the gloom and doom, the policy (with the help of some fiscal stimulus) was quite successful. The recession was one of the shallowest in history. Of course, no one is happy with the present phase of slow growth and 6% unemployment. But didn’t we learn in the 1970s that there are limits to government’s ability to push the economy to full employment, unless you solve the problem semantically by adding 2 percentage points and renaming it the “natural rate”? Remember when the natural rate used to be 6%? It wasn’t that long ago.

I’m reminded here of your interesting unfinished paper on “Liquidation Cycles”. I don’t know how valid the “over-investment” theory of business cycles is generally, but the 1990’s boom must provide the best case it’ll ever have. The Liquidation theorists of the 1930s were wrong that government policy is impotent in a recession, but they maybe weren’t altogether wrong that for business investment to revive sometimes requires that certain time-consuming structural adjustments take place. The investment boom of the late 1990’s continued long after corporate profits peaked (in 1997) while personal savings fell to unsustainably low levels. Before the “good old days” come back (if they ever do) there are going to have to be adjustments in corporate and individual balance sheets that may take another year or two. Maybe a still lower Fed Funds rate can still help; if not, don’t blame the “liquidity trap”.

Phil

Posted by: Philip Pam on May 12, 2003 10:29 AM

>What if the government (States and Federal, Bush is
>against but that is another question) contracted people to
>do things? Would not that kickstart the economy on a l
>large scale? I am thinking along the lines of the New Deal
>of FDR, unless I misunderstood the texts I've read on
>those times.

I believe Keynes would think this would be a good idea. :-)

But I think Krugman would point out a possible flaw in your analogy: what you need isn't really a "kickstart", since that implies a one-time push. What you might need is a sustained push that signals the intention to be inflationary for as long as it takes *and then some*. So the problem with the idea that FDR's New Deal programs saved us from the Depression was that things were still fairly bleak up to the eve of World War II. I'm assuming there is a big discussion about why this didn't work (or that it really did work in part) but I'm not an economist. In any case, I'm guessing that Krugman would argue that something like World War II was just the ticket because it was so big and so unavoidable and so obviously inflationary for an unkown amount of time...so inflationary expectations had to come back.

Posted by: Jonathan King on May 12, 2003 10:37 AM

Phillip Pam writes:
> 3. The U.S. today. Many people have compared the stock
> market boom of the 1990?s to the 1920?s. The
> Greenspan Fed responded to the ensuing recession the
> way the 1930?s Fed did not, with massive monetary
> stimulus. And while you wouldn?t know it from all the
> gloom and doom, the policy (with the help of some fiscal
> stimulus) was quite successful. The recession was one of
> the shallowest in history. Of course, no one is happy with
> the present phase of slow growth and 6% unemployment.

I'm not Brad, but I think there are two important points to note here. The first one is that, however you want to view the current state of growth in the US economy, the state we are currently in was *unexpected* by everybody, including the Fed. In other words, if I told you back in 1998 that, five years from now, the Fed would be looking at a rate cut to 1% (or less) while inflation was in control and while there was a positive GDP, I would hope you would have laughed at me. Now, you can fill in lots of details to make the current situation make more sense, but the Fed is now publicly concerned with the fact that the response to their stimulus has been atypical, and that our state of disinflation might be a real problem. As far as arguments about the "natural rate" or unemployment goes, I think it is worth pointing out that, again, we're in a very unusual situation now where *employment* peaked over 2 years ago, and labor force participation has declined in what is supposed to be a recovery. Again, this can probably be explained, but it is an atypical kind of situation we are in. Jobs are still apparently being lost; that's neither good nor really expected. If any of this ever translates into reduced spending by consumers, then the recovery will be gone, too. And if that happens when the Fed is still stuck around 1%...well, that's just the problem.

I have no idea how this will all turn out. If I had to guess, I'd go for grindingly slow increases in employment for as long as productivity increases keep up their current rate.


Posted by: Jonathan King on May 12, 2003 11:05 AM

Philip Pam's comments on the liquidity trap (or its non-existence) do apply to today's economy. As far as short-term interest rates have fallen, real long-term rates have not fallen that much. The FED has engaged in expansionary monetary policy which has done what it could do to lower long-term rates but this is being offset by a lack of credibility as far as our long-term fiscal responsibility. Which is why the bipartisan moderates in the Senate had the right idea in October 2001 - short-term fiscal stimulus and long-term fiscal restraint. If Bush really were interested in the twin goals of full employment and long-term growth - why is his fiscal policy just the opposite?

Posted by: Hal McClure on May 12, 2003 11:38 AM

WWI took millions of workers out of the workforce. Government provided much demand for everything. Why did we not slide back after WWII? After WWII, soldiers were not just returned to the farm economy to be surplus workers. Soldiers were educated and trained for new jobs in an era that saw rapid expansion of US universities.

Is part of the trap having an excess of workers trained to make products/services that are already in excess capacity and a need to train workers to go to another level and produce products/services that previously were not available?

Kevin Phillips in his book Wealth and Democracy found that after bubble collapses, it was not the overbuilt technology (railroads or whatever) that led the recovery, but expansion of other sectors that were responsible for recovery. I guess that means we should not look for the telecoms to lead the way in the near future. Does this mean that we have too many trained for jobs in the telecom sector and not enough for the next big area?

Posted by: bakho on May 12, 2003 11:49 AM

"Katz argues that Japan failed to make the transition to mass-consumption economy, that it invests too much and too inefficiently."

I don't see how it is possible to blame the Japanese for their personal demand curves for saving and spending. This is the whole point of interest rates and convincing a population to do one vs. the other is very much the job of the central bank. If rates in the US were raised to 10% the very same mess would occur, so how can this be a structural issue as opposed to monetary?

The central bankers are the ones who need to measure the propensity of the population to spend--they need to take everything into account such as demographics as they relate to retirement, the cultural values of the nation, and how consumers would respond to economic hardship. They must take into account that luxury cars, playstations and huge TVs have become a part of any relatively successful economy and so consumers must feel as if they can continue to afford luxuries.

This isn't what central bankers did in Japan. They saw prosperity and decided they didn't like it. If one wants to encourage mass consumption anywhere, all that is needed are some nicely low or negative real rates (which the central bankers there hesitated to do for so long that it's not even possible anymore). When this is done, there would be no illusion that one could save for the future by investing, and especially not by investing in cash. Anybody who wants stuff had better buy now or wave bye-bye to the money. But the Japanese central bankers continue to insist that investing should be rewarded, and so the population plugs in the real interest rate into their demand curve and this is what you get.

Blaming the personal preference instead of the policy response here reminds me of the 'family values' campaign. As obvious as it might be that bad parenting causes poor grades, poverty, and criminal activity, it doesn't excuse the government from responsibility for these failures because human behavior is the way it is and responds or fails to respond rather predictably to various attempts to change it.

Posted by: snsterling on May 12, 2003 12:18 PM

>Philip Pam's comments on the liquidity trap (or its non-
>existence) do apply to today's economy. As far as short-
>term interest rates have fallen, real long-term rates have
>not fallen that much.

I do know that, but I have to say that I'm inclined to put the word "yet" after your sentence. So looking that the Fed's stat, I can look at constant 10-year maturity data and see
we were down to 3.92% on May 2, from 6.5% in May 2000.
And Yahoo's latest quote was for 3.6% or so. In the last 6 months, they are also down, albeit not by very much.

As far as corporate bonds go, the Fed says:

http://www.federalreserve.gov/releases/h15/data/m/aaa.txt

So corporate Aaa bonds peaked around 8% in May 2000 (but were more consistently at 7.7% or so that year), and were at 5.74% in April 2003. The last time they were that low was in 1967. Those rates have gone down 11 out of the past 12 months, and have fallen about 0.5% in the last 6 months. The reading from May 2 was actually 5.56%, and the weekly data tell you that rates have gone down 43 basis points since the beginning of the last war, which was 7 weeks ago. None of this has apparently led to a rebound in corporate investment.

Conventional 30-year mortgage rates have gone from 8.5% in April 2000 to 5.70% on May 2, and dropped 41 basis points in the last 6 months.

So, sure, long-term rates aren't yet near zero, but and aren't even in the "not since the 50s" range that the short-term Fed rates are, but they are dropping, many are dropping fairly quickly, and could continue to drop. It's true that the Fed doesn't control them, so I guess you could argue that the market still has a lot of room to reduce rates, but on the other hand, the fed has almost no room, which is not where I'd prefer to be.

Posted by: Jonathan King on May 12, 2003 12:28 PM

Bakho notes the post WWII period. It is true that real government purchases (1996 $) fell from $1041 billion in 1945 to $307 billion in 1947. The folklore is that economists expected a recession that never came and the saving grace was pent-up consumption demand. Actually real GDP did fall from $1693 billion in 1945 to $1495 billion in 1947 before it started rising over the rest of the decade. My read of the BEA data suggests that part of the recesion why real GDP got back on a growth track has to do with rising investment demand and higher net exports relative to 1945 levels. Could that higher government purchases of 1945 led to some crowding-out which was reversed as soon as we got back to fiscal restraint?

Jonathan King correctly notes that lately long-term interest rates have been coming down. Maybe Dr. Greenspan's optimism over an investment-led recovery in 2003 is not so crazy after all. But then doesn't that lessen the need for a large dose of fiscal stimulus? In other words, I have not yet given up on the power of monetary policy.

Posted by: Hal McClure on May 12, 2003 12:48 PM

"Jonathan King correctly notes that lately long-term interest rates have been coming down. Maybe Dr. Greenspan's optimism over an investment-led recovery in 2003 is not so crazy after all."

Why should there be an investment-led recovery when demand does not warrant more investment? There never has been an investment-led recovery in a post-WWII cycle. I am doubtful. There must be a consumer demand led recovery. That would seem to mean fiscal stimulus.

Posted by: anne on May 12, 2003 12:52 PM

Anne

Dr. Greenspan had testified in Feb. and he has repeated his view that the rising corporate profits should lead to more investment demand. I'm not saying he is right and many economists have expressed similar concerns as you. My only point is that the cost of capital (as in long-term real interest rates) has something to do with this. And for a while, it had not declined that much. JK is right that it has recently declined, which would add to Greenspan's optimism if one accepts his view. But then not all do. My main concern, however, is that we let the investment community know we intend to have any fiscal stimulus as a short-term dose and not a long-term dose. In my view (which is not inconsistent with Glenn Hubbard's faith in the life cycle model of consumption), this is easier done using government spending than tax rates, but that is not the politician's current choice of action these days.

Posted by: Hal McClure on May 12, 2003 01:00 PM

Hal McClure

Agreed completely. Nicely argued!

Anne

Posted by: anne on May 12, 2003 01:27 PM

Hal and Bakho

Remember the massive effect of the GI Bill after WWII. I will take a look at when there began to be an effect of returning service men and women and the beginning of the GI Bill spending. There was a successful welfare program!

Posted by: anne on May 12, 2003 01:39 PM

OK, so in terms of where you would like to increase demand and what the stakes are, that's actually not hard to see. So let's look at some recent GDP breakdowns:

http://www.bea.doc.gov/bea/newsrel/gdp103a.htm

In Table 2, it's easy to find the weaknesses after the bubble burst. Interestingly, personal consumption really isn't an area of relative weakness; as a GDP category it *never* went negative for any quarter. Now, there are some (sub)areas of concern. Personal consumption of durable goods did not grow strongly in 2002, and has been negative over the last two quarters. But it has been private fixed non-residential investment that has really been the problem. This has been frankly negative every quarter since Q4 of 2000 except for Q4 of 2002. Some of that is investments in structures (think office buildings...ouch), and that is probably an unstimulatable sector at the moment. Which leaves us with investments in equipment, which was growing in Q2-Q4 of 2002 but went negative again last quarter. If you could target that plus demand for durable goods among consumers, you'd be doing something useful.

Now, another point is that the Q1 2003 number was as "good" as it was in large part because residential fixed investment was strong and because the exports/imports category was helping for a change. I'm not sure I'd depend much on either of these in the future.

Posted by: Jonathan King on May 12, 2003 02:21 PM

"Keynes explicitly stated he regarded the liquidity trap as a theoretical possibility, not something that had ever actually happened."

Yes, and Keynes wrote that well after watching the early-1930s collapse. If he didn't think a liquidity trap happened then...

"I don't see how it is possible to blame the Japanese for their personal demand curves for saving and spending."

One can certainly blame the Japanese gov't for structurally distorting the capital markets -- and thus forcing consumers to positions out on the extreme end of their personal demand curves. E.g, by forcing trillions of dollars of consumer savings into postal savings accounts that pay almost no interest in the best of times, to have funds that the one-party government can direct at below-market rates to favored industries (which then go bust and are propped up with a great deal more such savings).

What percentage of income does someone in Japan need to save to meet a given savings target over 30 years or so, compared to the percentage of income that must be saved by an American, when the American can get a market rate of return that is maybe 4 or 5 points higher all that time?

"This is the whole point of interest rates and convincing a population to do one vs. the other is very much the job of the central bank."

Don't the other parts of government have an effect here too? Say the US had a one-party gov't that didn't let Enron, Global Crossing or any other major company ever fail in an economic bust, but propped them all up with loans politically directed from major banks, keeping people like Skilling et.al. in charge of their companies (and supporting the gov't). Say this forced a chain reaction where the lending banks' that made the such loans had to be supported by others, creating hundreds of billions if not trillions of dollars worth of bad debts and insolvent companies in the economy that were being carried forward indefinitely -- with everybody knowing about them but nobody accounting for them and all fearing that a day of reckoning may be awaiting in the unknown future.

Say that at the same time the gov't itself was running up the biggest debts in the world -- building bridges to nowhere, building floating airports without any airplanes, color tiling the roads, etc., all of which will have to be paid off over time out of real income -- and having its credit standing steadily downgraded.

Add the conumdrum that if general price level ever does start rising again -- as must necessarily happen to get out of this mess -- the value of all that massive outstanding debt will plunge and take all the big debt holders down with it (so "planned inflation" could be extremely costly and structurally damaging).

What would the effect be on consumer confidence and saving?

"If one wants to encourage mass consumption anywhere, all that is needed are some nicely low or negative real rates..."

Real prices matter too. To boost spending one could reduce them by knocking down the gross protections for producers and sellers that reduce consumer welfare in Japan by about 30% relative to income compared to the other developed nations. Having nicely low interest rates with very high real prices might not be nearly as effective.

Letting consumers earn market rates on their savings so they wouldn't have had to save near as much to reach their savings targets might have been useful as well.

We could also remember the statement found in near every macro textbook: "monetary policy is neutral in the long run". It's been 13 years now in Japan, and counting, which is getting to be a pretty long run. So it looks like either a lot of textbooks need revision or maybe there are other things going on over there.

Posted by: Jim Glass on May 12, 2003 03:43 PM

Anne

My characterization of the GI bill is not welfare - rather it was government investment in the formation of human capital (more simply put -education). One problem with how many (including me) measure national savings is the treatment of all government purchases as public consumption. I'll bet when we look at the some of private and government investment with the proper accounting, the 50's, 60's, and 70's would look even better as compared to the low commitment to investment in the 80's and now.

Posted by: Hal McClure on May 12, 2003 04:52 PM

Jim, I agree that Japan does have structural problems, but the thing I never understand is why their inefficiencies in directing investment, retailing, rice gowing, & bizarre gov't projects don't lead just as likely to inflation. There are many 3rd world countries with much worse structural problems than Japan but they have inflation instead. I think it is pretty natural for a structurally screwed up economy to experience inflation because increasing economic activity brushes up against the inability to produce. To me the deflation is the red flag that should draw attention to monetary policy. If there is a continuous disinflation then how is it possible that the upper limit of production has been tested? As opposed to a liquidationist which would claim that inefficiencies are driven out at the bottom of the cycle, I would claim that inefficiencies are driven out at the top, because there is a pressure to do more with less..... for instance, much of the wasteful gov't projects came into being to take the place of useful endeavors which were eliminated due to tight money. If the gov't would stop "wasting" this production the unemployment and deflation would only get worse. But if the consumers were given the right monetary/fiscal incentives (maybe even a negative sales tax???) the companies would stop nagging the government to send projects their way. They'd have enough work fulfilling the needs of the consumers.

"monetary policy is neutral in the long run"

Well, this relates to what I was just saying about how dysfunction can actually be a response to an economy with spare capacity, so I've already disagreed with the textbook statement. If monetary policy is run reasonably well then it won't effect productive capacity in the long run, but if it is allowed to get too far off path in the short run then you start changing people's perspectives and this leads to government interventions or redirection of productive behavior into non-productive or even destructive (like crime or drugs, for instance). 60 years after the great depression my grandfather was keeping a good sum of cash hidden in his house, and the way he talked about banks or the economy you could tell he was scarred by the experience, so severe monetary trauma doesn't just get cancelled out by the next upturn.


Posted by: snsterling on May 12, 2003 10:03 PM

"Real prices matter too. To boost spending one could reduce them by knocking down the gross protections for producers and sellers that reduce consumer welfare in Japan by about 30% relative to income compared to the other developed nations. Having nicely low interest rates with very high real prices might not be nearly as effective"

I have heard this before, but I only see how reducing protections increases standard of living, not how it has anything to do with deflation. Even at first glance, I would think that reducing prices to cure deflation sounds kind of odd, even if it is offset by spending.

But if one were to plot the standard of living of present day and historical economies of various countries againt the inflation rate or against the rate of change of inflation, couldn't that be tested? At least the way I read it, that reasoning suggests such a graph. Considering how inflation has fluctuated in the USA as standard of living has increased, I'm pretty sure there is no correlation.

Most countries have much lower purchasing power per capita than the US, and most are much lower than Japan, but it's not particularly associated with "lack of demand" any more than it is with inflation or with economic balance.

Posted by: snsterling on May 12, 2003 10:42 PM

No time to explain this in detail but note that the version of the "liquidity trap" Brad and PK are dealing with is Hicks-Keynes, and there are plenty of us PostKeynesians who would very much disagree with the statement that Keynes only regarded the liquidity trap as a "theoretical possibility".

Posted by: dsquared on May 13, 2003 07:21 AM

Does anyone have a reference for Jim's claim that there is forced saving in Japan? I'm not sure that there is.

Posted by: dsquared on May 13, 2003 09:36 AM

DD

I can find NO evidence that there is forced saving in Japan. Spoke also with a Japanese business woman about this last night.

Hal

I should have put welfare in quotes "welfare" to refer to the GI Bill. I was for welfare as is Social Security and Medicare and Medicaid, and that is terrific.

Posted by: anne on May 13, 2003 09:54 AM

"...the thing I never understand is why their inefficiencies ... don't lead just as likely to inflation. There are many 3rd world countries with much worse structural problems than Japan but they have inflation instead. I think it is pretty natural for a structurally screwed up economy to experience inflation...".

Having a structurally screwed up economy is bad for real incomes and welfare but would seem to me to be neutral for the price level by itself. "Inflation is always and everywhere a monetary phenomena" Friedman purportedly said. (He denies saying it but accepts it as true at least for serious inflation.) But nations with such screwed up economies tend to have fiscally and politically screwed up governments, which makes them a natural for inflation because, as Keynes pointed out long ago, inflation acts as a tax that helps the government fiscally and also helps certain interest groups that are likely to have influence within it.

But back to Japan. Start with a neutral price level and reasonable growth. Then pile on a growing mountain of bad debts and unacknowledged insolvencies the private sector -- unrecognized but ever worrying -- plus another mountain in the public sector, so people reasonably worry about their jobs and future. What happens to demand? Which way do prices move?

Now it is a truism that a lot of this debt could be wiped out with a nice dose of inflation -- but then there's the structural problem that a *lot* of major institutions that are borderline as-is (if not really already broke) are being propped up by counting this debt in their capital, and many also reportedly are highly leveraging it to arbitrage gains from investing to earn higher foreign rates. What happens to all these institutions when inflation causes their capital value to plunge into a hole? (And when people who think they need so much in savings see them going away in this scenario, will they save less or be scared into saving more? )

The late great Rudy Dornbusch used to have a "nightmare scenario" for Japan posted on his web site where the someday inevitably necessary inflation causes everybody in Japan to realize how little all the vast debt they hold could really be worth so they stampede to dump it and cause the next Great Depression. He and the BofJ have pointed out about "targeted inflation" what few of its fans do -- you may not be able to target it. When pressure is gradually added to systems under stress they sometimes do not move gradually but instead go "snap, bang, *boom*".

There's no obvious, easy, low-risk way out for Japan due to the structural problems -- especially when you include in the structure the constraints imposed by the political system, which doesn't want to make any hard decisions at all. (Or they'd have taken care of their bad debt 10 years ago like we did with the S&Ls). Dornbusch was not optimistic about Japan.

"'Real prices matter too. To boost spending one could reduce them by knocking down the gross protections..'"

"'I have heard this before, but I only see how reducing protections increases standard of living ... I would think that reducing prices to cure deflation sounds kind of odd, even if it is offset by spending."

Lower prices, more spending. Freeing currently wasted goods to move to profitable new uses would seem to increase demand (somebody buys the Tokyo real estate now saved for rice growing, etc.) An improving standard of living would seem to be good for optimism and maybe demand. Freed-up markets improve. (Not that this is a quick-and-easy fix now.)

Deflation per se is not so bad. It can result from increasing supply with stable money and strong demand driving continued growth. The US averaged over 5% deflation annually during the last third of the 19th century with strong average growth. Deflation was anticipated and factored into market transactions so it didn't exaggerate debt, etc. To the extent deflation in Japan resulted from increasing supply it wouldn't be bad -- it would just mean real prices got cheaper so people could buy more things.

Deflation is bad when it results from weak demand and underused resources. Once weak demand drops the economy into deflation territory the weakness is compounded a host of ways -- including the fact that since it wasn't expected it drives the real debt level up even higher, and Japan had way to much debt to start.

I'm with Dornbusch in not seeing any easy way out for Japan. He was a lot smarter than me.

Posted by: Jim Glass on May 13, 2003 04:44 PM

"'Does anyone have a reference for Jim's claim that there is forced saving in Japan?'"

Nobody puts a gun to the family dog's head and says "save or we shoot!".

But if you grow up and the only place you have to put your savings is the postal savings account, because gov't policy has kept anything else from being available to you as an average citizen, are you "free" to save as you might have wished? And if the interest rate is way below what you'd get in a free market, how much more of your income are you going to be forc^H^H^H need to save to wind up with the same amount at the end, say when you retire, compared to if you could have saved at the higher rate?

Now imagine a generation or two or three of such vast savings at non-market rates being politically directed by a one-party government -- what's the effect on the structure of the nation's political-economics? (Politics and economics being joined at the hip here). Here's a brief description from the Economist...
~~~

With ¥240 trillion ($2 trillion) of deposits and another ¥125 trillion in insurance policies, the post office is the world's biggest financial institution, controlling a quarter of Japan's household financial assets. It has enormous political clout ...

Postal savings and insurance also provide a shadow budget for the government by buying wads of zaito bonds, which fund the finance ministry's fiscal investment and loan programme, used to build empty roads and bridges.

Between 1990 and 2001 the assets of private financial institutions increased by ¥84 trillion. By contrast, the combined assets of the postal savings and insurance system and public pensions grew by ¥315 trillion (thanks largely to the post office), of which 80% was invested in government bonds, regional bonds and zaito bonds.

These investments skew the markets...

Posted by: Jim Glass on May 13, 2003 05:04 PM

I'm still not sure of this. I think that normal bank deposits are available to the Japanese public and, furthermore, that Japan has never even had an equivalent of the USA's Regulation Q (which did, for a very long time, prevent the US public from saving at market rates). I think that the postal system is part of the deposit market and that therefore its rates are market rates. I'd be grateful if we could clear this up.

Posted by: dsquared on May 13, 2003 11:15 PM

""No time to explain this in detail but note that the version of the "liquidity trap" Brad and PK are dealing with is Hicks-Keynes, and there are plenty of us PostKeynesians who would very much disagree with the statement that Keynes only regarded the liquidity trap as a "theoretical possibility""

General Theory p.207:

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the
rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed,
owing to the unwillingness of most monetary authorities to deal boldy in debts of long term, there has not been much opportunity for a test.


Posted by: Philip Pam on May 15, 2003 06:10 AM
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