IT TAKES AN ECONOMIST . . .

A few posts down, Orrin demolishes a Paul Krugman piece from today's New York Times, in which Krugman writes about what he sees as the real chance of a liquidity trap developing in the US because our situation is so similar to Japan's. As Orrin shows, we are not Japan, most notably in our demographics. This is, in fact, a point to which Krugman should be more open. Before becoming a execrable opinion hack, Krugman was a good economist. One of his best pieces developed a simple and accessible but rigorous model of Japan's liquidity trap. The most notable part of that piece, for our purposes, follows:

Japan's Trap (Paul Krugman, May 1998)

If Japan is in a liquidity trap, however, why?

In the model of sections 1-3, a liquidity trap will arise only if future productive capacity is actually lower than current capacity. Before loosening that constraint, we can ask why one might expect Japan's future capacity to be relatively low compared with today's. And the obvious answer is demography: Japan's combination of declining birth rate and lack of immigration apparently means a shrinking rather than growing labor force over the next several decades. In the absence of productivity growth, potential output, say, 15 or 20 years out - y* in the model - could actually be below current capacity. Moreover, the labor force will drop faster than the population, because of shifting composition, so it is substantially easier to make the case that per capita productive capacity might actually be lower at some future date than it is today.

The case that a negative real interest rate is necessary can be strengthened if we allow for heterogeneity among individuals plus imperfect capital markets. Suppose that at any given time some people expect their future income to be higher than their current income, others expect it to be lower. In a perfect capital market those who expect their income to rise would tend to engage in dissaving. But suppose that this is difficult - that consumption loans are hard to come by. Then those who expect their income to rise will not contribute as much to the demand for funds as those who expect it to fall contribute to the supply, and the equilibrium real interest rate will be lower than it would have been in a more efficient capital market. Notice that we need not argue that Japanese capital markets are especially inefficient: this can be viewed simply as a reason why aggregate capacity need not actually be falling to require a negative real interest rate. But it is also true that at least some Japanese institutional pecularities - the relatively small use of credit cards, the high downpayments required on expensive houses (see Ito 1992) may contribute to the problem.

Moving outside the formal model, the prospects for a liquidity trap also depend on investment demand. Here demography again comes into play: the prospective decline in the labor force reduces the expected return on investments. And institutional problems, such as the troubles of the banking system, may also lead to some credit rationing that deters investment. And to the extent that firms are financially constrained by the debt run up in the past, they may be unable to invest as much as they otherwise would.

On the whole, while it is quite easy to make the case that Japan really is in a liquidity trap, it is much harder to give a convincing explanation of why. Demography seems to be the leading candidate; other "structural" reasons that are widely cited, while they do amount to an impressive litany of sins, do not necessarily explain why demand should be inadequate, as opposed to simply causing garden-variety microeconomic inefficiency. This lack of a clear link between the structural issues and the proximate problem has some important policy implications, as we will soon see.

Another way to think of this, though it boils down to the same analysis, is that in a time of expected deflation, the population will conclude that future yen will be more valuable than current yen. That is, even with near zero interest earned on savings, a yen tomorrow will be worth more (because of lower prices) than a yen today. Obviously, then, the rational response, caterus parebus, is to defer spending as long as possible. Lower spending reinforces the deflationary spiral, thus increasing the incentive to defer savings, etc., etc., etc. Consider that, if deflation is expected, a loan today bears a real interest rate higher than the nominal rate, because it will have to paid back with that more valuable yen. It becomes clear why, if deflation is expected, nobody buys nothin'.

Krugman's solution to this problem is to break the expectation of deflation. He suggests that, although structural reforms and fiscal policy can help, only a credible promise of permanent inflationary policies by the central bank will suffice to conquer deflation in the short term. Of course, all the major central banks have just spend the last thirty years making credible their promises to fight inflation. Even Krugman understands that this promise will have to be false -- the central banks will have to know that, once deflation has been turned around by the promise of inflation, they will have to once again fight inflation. If Krugman knows it, and the central banks know it, then the market will know it, meaning that the market won't believe the promise to reinflate as a permanent policy, which means that the promise won't work. This is part of why it's called a "trap." The only way around this, and this is me, not Krugman, is to convince people that, through increased productivity, GDP will grow faster than the population. If people expect to have more money in the future, they will spend money now, which will help insure that they will have more money in the future.

Now, can anyone name an industrialized economy in which the population is growing, productivity is growing, per capita GDP is growing, this growth is expected to continue and each member of the economy is convinced that he ought to be richer tomorrow than he is today. I can only think of one. Posted by David Cohen at May 25, 2003 11:39 PM