So this is where we stand:
- Abenomics 101: Japan has a credit bubble, and it bursts because of high interest rates.
- Abenomics 102: Japan gets stuck in a liquidity trap – at least, if you’re a believer in Paul Krugman.
The Lost Decades
Even though I mentioned “the Lost Decades” in the last post – they really need a little more attention. After all, the real fear is that the missteps of the Fed and the American government will result in “The US Lost Decades”. And, I suppose, that the missteps of the ECB and the Eurozone governments will do the same in Europe. But realistically, Europe has a much grander set of structural issues. Also, we still look at Europe at an individual state level – and if Greece, or Italy, or even France, disappear from view for a while – the rest of the world probably won’t notice (no offence intended!).
I’ve talked about some of what was happening in the Lost Decades; so now I’d like to focus on the activities of the Japanese Government and the Japanese Central Bank (Bank of Japan – the BOJ). Because, surely, their steps should give some guidance on what-not-to-do-after-a-credit-crunch?
Let’s see. Here are some policies:
- Quantitative easing, courtesy of the BOJ;
- Low interest rates, courtesy of the BOJ;
- Fiscal expansion, courtesy of the Japanese Government
- Doing absolutely nothing about the banking sector – other than continuing to fund it.
And here’s the thinking behind those policies…
“Trouble is: we’re getting stuck in a rut. People are saving to pay back their debts instead of spending money, which means that they’re not consuming as much as they did before. Because of that, firms can’t sell the same volume of stuff that they used to, so the firms are cutting back on production. And you know what that means… Firing people. And people without jobs don’t get salaries, so now they literally can’t spend the way they spent before. Which means that firms will sell even less, which means even more firings – and where will it end?”
*pauses for thought*
“We ought to get involved before that happens too seriously and break the cycle. If the government creates the demand for products – by, say, hiring firms to build lots of public infrastructure – then at least the firms will have a reason to keep people employed. And hopefully, the security of having jobs will let people ease up with their spending – or at the very least, it’ll tide the economy over until they’re done clearing their debts.”
Quantitative Easing and Low Interest Rates:
“The reason that we’re not recovering must be because people are saving too much money. If we want the economy to recover, then they should be spending their money, not saving it! I mean – spending money means more demand, which means more jobs, which pay salaries, which make for more spending, and so on. We need to kickstart the spending. Only how? Hmmm. Well the real problem must be interest rates – those damned interest rates must be making people want to save money! What we need to do is lower those interest rates to the point where people start to say: let me rather spend the money than save it. And then firms will want to borrow money at those low interest rates in order to expand their businesses! Yes yes. Lower interest rates. Only how? Let’s, um…wait, hang on, it’ll come to me….”
“You know, when you think about it, interest rates are actually like the price of money, right? Because when a bank loans me money, then they expect me to pay them the interest rate in return for using their money – which is sort of a price. But then that means that money can work like anything else – because if you increase the supply of it, then its price will go down. So what we should do is print money in order to bring down interest rates!!”
*reduces interest rates to near zero*
The Banking Sector:
“If we let the banking sector fail, then everything will get even worse. So let’s just keep supporting them until the economy is back on its feet.”
Well the result tends to depend on how you look at it… Many people argue that the whole “Lost Decades” story is a bit of melodrama – because the general standard of living of the Japanese remained more or less the same. And if everyone continued to live as well as they did in the 1980s – then what’s the big deal? They were already living quite awesomely, after all.
Frankly – I think that argument is a bit myopic. The 1990s and the 2000s were the most spectacular years of global consumerism in the financial history of humankind. And Japan, the third largest economy in the world, the exporter of electronics and vehicles, continued to languish in almost the exact same economic spot while all that was happening? Uh no. That’s not success.
The other side of the argument is to say: those policies prevented everything from being worse! But much as I’m a fan of the glass being half-full, it does smack of half-measures. Or only half of them working. Or something.
That’s certainly the Krugmanite perspective…
The Krugman Interpretation
Paul Krugman was the outright proponent of Japan-not-recovering because of Japan-being-stuck-in-a-liquidity-trap (see Abenomics 102). And also – because everyone is looking at the wrong data-sets. Japan has a rapidly aging population, with low fertility rates and next-to-no immigration – which means that you have swathes of people leaving the work-force each year without equal numbers entering it. That fact alone would contribute to a lack of growth, as Japan is literally bleeding “resources”.
Basically, he argues that what is needed here is a “negative real interest rate” – where it costs people money to save, and where it saves businesses money to invest. I’ll explain that in a moment*…
But before I get there, my favourite quote from his “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap” paper (1998):
“The traditional view that monetary policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level.”
“…credibly promise to be irresponsible?”
If we go back to the Chocolate Cake analogy from yesterday – Krugman is saying that one of the reasons why the chocolate cake (monetary stimulus) doesn’t work in a liquidity trap is because you don’t believe that you’re going to get lots of it. You’re just going to get a taste, and as soon as you show any interest in eating again, the good doctor (being the Central Bank) is going to take away the cake and let you get on with eating something boring.
What he would like to see is the doctor credibly promising to give you as much chocolate cake as you would like – a “pedal to the metal” situation.
And how is that a negative real rate of interest?
If I’m to continue with the Chocolate Cake/binge-eating analogy – there is a taste-fat trade-off in food. The better something tastes, the more likely it is to make you fat.
And it works the same way here. The higher the interest rate, the less likely you are to consume – which means that the economy is less likely to experience, ah, inflation. And conversely, the lower the interest rate, the more likely you are to go out and spend money – which will certainly be inflationary.
In my mind, the Krugmanite viewpoint sees Japan’s liquidity-trap as a form of economic anorexia. The government spending (fiscal stimulus) was an intravenous drip of nutritive supplement, which at least meant that the economy was surviving. But in order for recovery really to take place, you needed to get Japan consuming on her own again. So the doctor (the BOJ) needed to commit to allowing a high-carb, high-sugar, taste-bud-tittilating diet (in the form of negative real rates of interest), and allow Japan to pick up some weight (inflation).
So what went wrong?
According to Paul Krugman – the problem was that the BOJ forays into quantitative easing (which would have caused the real interest rate to drop into negative territory) were always perceived to be short-lived by the Japanese. That is, at the first sign of growth and/or inflation, the BOJ was desperate to back-out.
This prevented inflation expectations from being formed, so no one had any reason to do anything other than save. Which is why Japan still hasn’t recovered.
What about America?
America is busily repeating all of the policies that Japan tried.
Just, like, harder…
*You can also read this post: the Drag(hi) of Negative Interest Rates.