04-07-2013, 12:37 PM
The Paper that set Krugman 15 years ahead in macroeconomics
Paul Krugman
May 1998
Japan's economic malaise is first and foremost a problem for Japan itself. But it also poses problems for others: for troubled Asian economies desperately in need of a locomotive, for Western advocates of free trade whose job is made more difficult by Japanese trade surpluses. Last and surely least - but not negligibly - Japan poses a problem for economists, because this sort of thing isn't supposed to happen. Like most macroeconomists who sometimes step outside the ivory tower, I believe that actual business cycles aren't always real business cycles, that some (most) recessions happen because of a shortfall in aggregate demand. I and most others have tended to assume that such shortfalls can be cured simply by printing more money. Yet Japan now has near-zero short-term interest rates, and the Bank of Japan has lately been expanding its balance sheet at the rate of about 50% per annum-and the economy is still slumping. What's going on?
There have, of course, been many attempts to explain how Japan has found itself in this depressed and depressing situation, and the government of Japan has been given a lot of free advice on what to do about it. (A useful summary of the discussion may be
found in a set of notes by Nouriel Roubini. An essay by John Makin seems to be heading for the same conclusion as this paper, but sheers off at the last minute). The great majority of these explanations and recommendations, however, are based on loose analysis at best, purely implicit theorizing at worst. Japan is depressed, we are told, because of too much corporate debt, or the refusal of banks to face up to their losses, or the overregulation of the service sector, or the aging of its population; recovery requires tax cuts, or a massive bank reform, or maybe cannot be achieved at all until the economy has painfully purged itself of excess capacity. Some or all of these propositions may be true; but it is hard to know unless we have some clear framework for understanding the current predicament.
Economists of a certain age - basically my age and up - do have a theoretical framework of sorts for analyzing the situation: Japan is in the dreaded "liquidity trap", in which monetary policy becomes ineffective because you can't push interest rates below zero. The celebrated paper by Hicks (1937) that introduced the IS-LM model also showed, in the context of that model, how monetary policy might become ineffective under depression conditions. And for a long time macroeconomists kept the liquidity trap in mind as an important theoretical possibility, if not something one was likely to encounter in practice. But the IS-LM model, while it continues to be the workhorse of practical policy analysis in macroeconomics, has increasingly been treated by the profession as a sort of embarrassing relative, not fit to be seen in polite intellectual company. After all, even aside from the dependence of IS-LM analysis on the ad hoc assumption of price inflexibility, that analysis is at best a very rough attempt to squeeze fundamentally intertemporal issues like saving and investment into a static framework (a point which, incidentally, Hicks noted right at the beginning). As a result, IS-LM has been hidden away in the back pages of macroeconomic textbooks, given as little space as possible; and curiosa like the liquidity trap have been all but forgotten.
But here we are with what surely looks a lot like a liquidity trap in the world's second- largest economy. How could that have happened? What does it say about policy? For in a way the criticisms of IS-LM are right: it is too ad hoc, too close to assuming its conclusions to give us the kind of guidance we want. Indeed, many economists probably have doubts about whether anything like a liquidity trap is actually possible in a model with better microfoundations.
The purpose of this paper is to show that the liquidity trap is a real issue - that in a model that dots its microeconomic i's and crosses its intertemporal t's something that is very much like the Hicksian liquidity trap can indeed arise. Moreover, the conditions under which that trap emerges correspond, in at least a rough way, to some features of the real Japanese economy. To preview the conclusions briefly: in a country with poor long-run growth prospects - for example, because of unfavorable demographic trends-the short-term real interest rate that would be needed to match saving and investment may well be negative; since nominal interest rates cannot be negative, the country therefore "needs" expected inflation. If prices were perfectly flexible, the economy would get the inflation it needs, regardless of monetary policy-if necessary by deflating now so that prices can rise in the future. But if current prices are not downwardly flexible, and the public expects price stability in the long run, the economy cannot get the expected inflation it needs; and in that situation the economy finds itself in a slump against which short-run monetary expansion,no matter how large, is ineffective.
If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit- financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy-that is, convince the private sector that it will
not reverse its current monetary expansion when prices begin to rise!
[You can click the article (title) link if macroeconomic modelling is your thing SHU]
Krugman brought the liquidity trap back from the dead, and now, 15 years later, much of the Western world is mired in one, and Japan is the first who takes his policy advice to heart. Better late than never, although the risks have greatly increased over those 15 years.