Krugman’s blog, 10/20/15

There were two posts yesterday.  The first was “Rethinking Japan:”

The IMF held a small roundtable discussion on Japan yesterday, and in preparation for the event I thought it was a good idea to update my discussion of Japan – not so much about the question of whether Abenomics is working / will work (unclear, don’t know) as about the current nature of the Japanese problem.

It’s a bit self-centered, but I find it useful to approach this subject by asking how I would change what I said in my 1998 paper on the liquidity trap. Hey, it was one of my best papers; and it has held up pretty well in many respects. But Japan and the world look different now, and trying to pin down that difference may help clarify matters.

It seems to me that there are two crucial differences between then and now. First, the immediate economic problem is no longer one of boosting a depressed economy, but instead one of weaning the economy off fiscal support. Second, the problem confronting monetary policy is harder than it seemed, because demand weakness looks like an essentially permanent condition.

The weaning issue

Back in 1998 Japan was in the midst of its lost decade: while it hadn’t suffered a severe slump, it had stagnated long enough that there was good reason to believe that it was operating far below potential output.

This is, however, no longer the case. Japan has grown slowly for the past quarter century, but a lot of that is demography. Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar (and Japan has done better than Europe):

You can even make a pretty good case that Japan is closer to potential output than we are. So if Japan isn’t deeply depressed at this point, why is low inflation/deflation a problem?

The answer, I would suggest, is largely fiscal. Japan’s relatively healthy output and employment levels depend on continuing fiscal support. Japan is still, after all these years, running large budget deficits, which in a slow-growth economy means an ever-rising debt/GDP ratio:

So far this hasn’t caused any problems, and Japan has clearly been much better off than it would have been if it tried to balance its budget. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point.

And here’s the thing: under current conditions, with policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion.

The big reason to raise inflation, then, is to make it possible to cut real interest rates further than is possible at low or negative inflation, allowing monetary policy to take over from fiscal policy.

I’d also add a secondary consideration: the fact that real interest rates are in effect being kept too high by insufficient inflation at the zero lower bound also means that debt dynamics for any given budget deficit are worse than they should be. So raising inflation would both make it possible to do fiscal adjustment and reduce the size of the adjustment needed.

But what would it take to raise inflation?

Secular stagnation and self-fulfilling prophecies

Back in 1998, when I tried to think through the logic of the liquidity trap, I used a strategic simplification: I envisaged an economy in which the current level of the Wicksellian natural rate of interest was negative, but that rate would return to a normal, positive level at some future date. This assumption provided a neat way to deal with the intuition that increasing the money supply must eventually raise prices by the same proportional amount; it was easy to show that this proposition applied only if the money increase was perceived as permanent, so that the liquidity trap became an expectations problem.

The approach also suggested that monetary policy would be effective if it had the right kind of credibility – that if the central bank could “credibly promise to be irresponsible,” it could gain traction even in a liquidity trap.

But what is this future period of Wicksellian normality of which we speak? Japan has awesomely unfavorable demographics:

Which makes it a prime candidate for secular stagnation. And bear in mind that rates have been very low for two decades, fiscal deficits have been high that whole period, and at no point has there been a hint of overheating. Japan looks like a country in which a negative Wicksellian rate is a more or less permanent condition.

If that’s the reality, even a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t. The only way to be at all sure of raising inflation is to accompany a changed monetary regime with a burst of fiscal stimulus.

And this in turn suggests something counterintuitive: while the goal of raising inflation is, in large part, to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion. This isn’t at all a paradox, but it’s unconventional enough that one despairs of turning the argument into policy (a despair reinforced by yesterday’s meeting …)

Escape velocity

Suppose, bad instincts aside, that we really can go down this road. How high should Japan set its inflation target? The answer is, high enough so that when it does engage in fiscal consolidation it can cut real interest rates far enough to maintain full utilization of capacity. And it’s really, really hard to believe that 2 percent inflation would be high enough.

This observation suggests that even in the best case Japan may face a version of the timidity trap. Suppose it convinces the public that it will really achieve 2 percent inflation; then it engages in fiscal consolidation, the economy slumps, and inflation falls well below 2 percent. At that point the whole project unravels – and the damage to credibility makes it much harder to try again.

What Japan needs (and the rest of us may well be following the same path) is really aggressive policy, using fiscal and monetary policy to boost inflation, and setting the target high enough that it’s sustainable. It needs to hit escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

Yesterday’s second post was “More Artificial Unintelligence:”

David Beckworth pleads with fellow free-marketeers to stop claiming that low interest rates are “artificial” and comparing them to price controls. No, the Fed isn’t imposing a price ceiling on interest rates, he says; in fact, the zero lower bound is acting like a price floor.

He’s completely right about the economics. Monetary policy, in which the central bank buys and sells securities to change the monetary base, is nothing at all like price controls. Furthermore, we have a very clear model that tells us what interest rates would be in the absence of distortions and rigidities, the Wicksellian natural rate — the rate of interest consistent with an economy subject neither to inflationary overheating nor deflationary excess supply. And with inflation consistently below the generally accepted 2 percent target, this model says that the actual interest rate, at zero, is above the natural rate, not below.

But the question Beckworth should be asking himself is why almost nobody on the right is willing to think clearly about this issue.

It’s important to realize that we’re not just talking about monetary ignoramuses like Rand Paul and George Will. The “low interest rates = price controls” meme is bang-your-head-on-the-table stupid — but it has been made by none other than John Taylor. Clearly, this is a line of argument that people on the right really, really like for reasons that have nothing to do with intellectual coherence, so much so that famous monetary experts who have to know better fall meekly in line.

My take is that someone like Beckworth is trying to take the monetarist, Milton Friedman position, which is basically one of trusting markets to get it right except when it comes to the business cycle, where it becomes necessary to have expansionary monetary policies in slumps. This is a slightly problematic position on logical grounds: you need some kind of market failure to give monetary policy large real effects, and in that case why imagine that this is the only important failure? But more important, at this point, is the fact that this position turns out to be politically unsustainable. “Government is always the problem, not the solution, except when it comes to monetary policy” just doesn’t cut it for modern conservatives.

Nor did it cut it for traditional conservatives. Remember, during the 1930s people like Hayek were liquidationists, with Hayek specifically denouncing expansionary monetary policy during a slump as “the creation of artificial demand.” The era of Friedmanism, of free-market views paired with tolerance for monetary stimulus, was a temporary and unsustainable interlude, and no amount of sensible argumentation will bring it back.



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