Sunday, June 3, 2012

Japan, Anti-Liquidity-Trap Edition

A quick post today, which can more or less be summarized in one sentence: I don't buy the idea that Japan  has suffered from a liquidity trap.

The concept of the liquidity trap, in short, is that when the short-term interest rate goes to zero, monetary policy becomes ineffective as stimulus because it is unable to further depress interest rates; therefore to get out of a liquidity trap, you need to employ fiscal policy. And I agree with that statement insofar as the only monetary policy channel is interest rates, which in Japan have been near zero for decades.

However, the statement I just made is incorrect. Saying that interest rates are the only monetary policy channel is a little like, well, saying that ketchup is the only topping for hot dogs. It's simply not true. It's untrue even though, in many situations, ketchup may very well be a sufficient topping for hot dogs. Similarly, interest rate policy may be a sufficient or adequate tool for monetary policy in most economic conditions. But when the situation calls for mustard, and all you know how to put on hot dogs is ketchup, then even if you are standing in front of a selection of condiments, you're in trouble. Just like when the situation calls for the expectations channel, and all the Bank of Japan knows how to do is interest rates and short-term interventions, then if even if they could have changed expectations, they remained in a position of apparent monetary policy inefficacy -- a "liquidity trap." (For the record, I prefer both mustard and NGDP targeting.)

I find the Japanese liquidity trap story all the more strained by the fact that the fiscal policy channel was very aggressively exercised, and to little effect. As a result of a decade of fiscal expansion, the Japanese government is today in a position of 215 percent debt-to-GDP -- see the graph below. Moreover, its commitment to fiscal stimulus has been enduring since the 1990s, running budget deficits in the several percentage points of GDP. I don't think you could ask for a better test of fiscal policy in the "liquidity trap."The problem with fiscal policy is that its almost irrelevant when monetary policy controls, or is at least not indifferent, to the level and growth of nominal GDP.

And now we are in a very awkward position for the liquidity trap story in Japan. It seems that the only thing not tried is the sort of monetary policy which really makes a difference: the expectations channel.Here I contend that the Bank of Japan hasn't even tried. While the Diet, Japan's parliament, has spent trillions of yen seeking to induce growth, the Bank of Japan has silenced nominal growth. Consumer prices have not changed since the mid-90s. Monetary growth has been in the single percentage points since the early 90s. And the yen has gained value against other currencies since 1990, roughly doubling against the U.S. dollar.

It is time to reclaim Japan's story, believers in monetary policy. I'm not a subscriber to the Japan declinism club -- see here, from Noah Smith, for good reasons why -- but the Japanese liquidity trap story is almost unworkable today. In fact, if anything, Japan is now the strongest argument for why monetary policy is effective, and why fiscal policy isn't except when monetary policy cooperates.


  1. I don't understand the idea that expectations can work when all other channels are exhausted. Expectations rely on a credible commitment through other channels; hence, if they are the only feasible channel left, the credibility is automatically undermined.

    I also object to the more general idea that expectations are something that can be majorly manipulated by CB policy, especially expectations of something like NGDP. The average person doesn't even know what a CB does; they are unlikely to be concerned with its mandate.

  2. Unlearningecon: Are you really claiming that the Bank of Japan could not create hyperinflation if it wanted to? Or any other level of inflation? Or deflation, for that matter? Interest rates are not remotely the only channel for transmission of monetary policy. As the Swiss Central Bank recently proved.

  3. UnlearningEcon:

    The way this would work in practice is the fed would say, "we commit to keep inflation on a growth path of 2% per year, and as long as we are under that path, we will keep interest rates low."

    No one really doubts that if the fed keeps interest rates at 0% for 50 years, it will eventually cause inflation. What they doubt is that they can create inflation in the short term. But the growth path approach changes expectations for the price level 2,5,10 years down the road, which causes behavior changes today, which (perhaps counter-intuitively) can increase inflation in the short term.

  4. Lorenzo,

    Actually I doubt the ability of the BoJ to create hyperinflation simply by conducting what are ordinarily considered 'monetary' measures - I guess they could create hyperinflation with something like helicopter drops but that blurs the line between monetary and fiscal policy. Furthermore, historically hyperinflation is associated with wider economic and political instability.


    It really depends on how long termist expectations are, and how much they are influenced by CB targets (rather than recent experience). Chris Dillow offered some good evidence that they aren't particularly reliable: