THE SUN WON'T COME OUT TOMORROW (OR THE NEXT DAY...)

Fear of a Quagmire? (PAUL KRUGMAN, May 24, 2003, NY Times)

The particular type of quagmire to worry about has a name: liquidity trap. As the I.M.F. report explains, the most important reason to fear deflation is that it can push an economy into a liquidity trap, or deepen the distress of an economy already caught in the trap.

Here's how it works, in theory. Ordinarily, deflation--a general fall in the level of prices--is easy to fight. All the central bank (in our case, the Federal Reserve) has to do is print more money, and put it in the hands of banks. With more cash in hand, banks make more loans, interest rates fall, the economy perks up and the price level stops falling.

But what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy--added liquidity--sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness.

Once an economy is caught in such a trap, it's likely to slide into deflation--and nasty things (what the I.M.F. report calls "adverse dynamics") begin to happen. Falling prices induce people to postpone their purchases in the expectation that prices will fall further, depressing demand today.

Also, deflation usually means falling incomes as well as falling prices. In a deflationary economy, a family that borrows money to buy a house may well find itself having to pay fixed mortgage payments out of a shrinking paycheck; a business that borrows to finance investment may well find itself having to pay a fixed interest bill out of a shrinking cash flow.

In other words, deflation discourages borrowing and spending, the very things a depressed economy needs to get going. And when an economy is in a liquidity trap, the authorities can't offset the depressing effects of deflation by cutting interest rates. So a vicious circle develops. Deflation leads to rising unemployment and falling capacity utilization, which puts more downward pressure on prices and wages, which accelerates deflation, which makes the economy even more depressed. The prospect of such a "deflationary spiral," rather than the mere prospect of deflation, is what scares the I.M.F.--and it should. [...]

Our own situation is strikingly similar in some ways to that of Japan a decade ago. Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble--the Nikkei and the Standard and Poor's 500 both tripled in the five years before their respective peaks.

Also like Japan, we face a problem not of sharp downturn but of persistent underperformance--an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.

What's different is that we have Japan as a cautionary example. Is forewarned forearmed?

Of course the differences between Japan and America are even greater than the similarities and Mr. Krugman has never demonstrated much understanding of those differences, so that in the late '90s, almost a decade after Bill Emmott's dispositive The Sun Also Sets, Mr. Krugman thought Japan had only short term problems. Even when he began to realize things went deeper, he was rather slow to comprehend how deep. For instance, he's argued innumerable times that Japan needs to inflate its currency, but, to the best of my knowledge, has not called on them to inflate their population. How can you ever create enough new money that fewer people will be paying more and more for less and less?

The Japanese stock market fell and then failed to rise because it was always a bad investment--the long term economic prospects of a country with a declining population; a lack of the kind of creation, innovation, and intiative that leads to new products and breakthroughs; and an economic model based on assembling things better and cheaper than the United States is damned bleak. (The last is important because there are dozens of other countries that can put stuff together as well as but cheaper than the Japanese--thereby driving wages down.) Combine all this with protectionism, over-regulation, the welfare state, and the way that the Japanese "invest" their supposedly wonderful savings--in actual savings accounts in banks that pay negligible interest--and you've got a recipe for a long slide into oblivion. Posted by Orrin Judd at May 25, 2003 6:50 PM