Paul Krugman examines former Bank of England Monetary Policy Committee member Adam Posen’s attempts to square the circle between his support for expansionary fiscal stimulus in Britain — where it hasn’t happened — and opposition to the same in Japan — where it is apparently about to begin.
Mr Abe’s new fiscal stimulus initiative is therefore questionable. Not because another 2 per cent of GDP will be the proverbial tipping point on Japanese debt sustainability, for the factors protecting Japan from overt fiscal crisis remain. Nor because it will be ineffective; if anything, when combined with monetary expansion and a likely consumption tax rise in the near future, I expect its multiplier and thus short-run impact to be high.
The additional stimulus in Japan is counterproductive because it adds to the long-term costs without addressing Japan’s real problem: a return to deflation and an overvalued exchange rate.
Krugman is “a bit puzzled”. He agrees that deflation is Japan’s problem, because deflation forces short-term interest rates to bump against the lower bound. Since interest rates can’t go below zero, that is, they are forced to remain slightly positive. That means that real interest rates — the nominal interest rate plus inflation — are forced to be significantly higher under deflation than they would be with mildly positive inflation, reducing the effectiveness of monetary policy.
So far, so macroeconomics 101. Where Krugman disagrees with Posen is how to break out of the deflation trap. Posen argues that unconventional monetary policy — quantitative easing and the like — can be enough. It’s a monetary problem, so it ought to have monetary solutions. But Krugman argues that there may be a better way:
The credibility of a higher inflation target in the face of the deflationary bias of central bankers may well be best established by (a) reducing the central bank’s autonomy and (b) getting the central bank in the business of supporting — indeed, monetizing — government deficits, at least for a while. Gauti Eggertsson made this point long ago (pdf), pointing to Japan’s successful polices in the first half of the 30s as a clear example. Indeed, Gauti argued that having a large government debt can be a real advantage in such circumstances: efforts to raise expected inflation gain extra credibility if the government would clearly benefit in fiscal terms, and the central bank is sufficiently subordinated to elected officials that investors believe that it will take these fiscal benefits into account.
In other words, it all comes back to the question of central bank independence. If the government destroys that independence (even if it does it for paleo-conservative, nationalistic, reasons), and engineers a situation where inflation would make it better-off, then inflation expectations can be raised far higher than an independent central bank could ever do alone. Especially one which has so consistently failed to reverse the trend as the national bank of Japan.