Krugman Watch: Japan (again)

[Jim Devine <jdevine@xxxxxxxxxxxxxxx>]

>June 28, 2000 / New York TIMES

>RECKONINGS/ By PAUL KRUGMAN

>Japan's Memento Mori

>... Whenever I write about Japan, I get quizzical letters from Americans
who don't see why they should care. The world's second-largest economy is
neither doing well enough to provide villains for a Michael Crichton novel
nor badly enough to pose any clear and present danger to prosperity
elsewhere. So why should anyone without a direct financial stake be
interested in its troubles?

>The answer -- the reason professional macroeconomists are grimly
fascinated by Japan's economic malaise, and you should at least be
interested -- is that Japan's sad tale is a reminder that the roots of
prosperity may be shallower than we like to think. It's not just the
historical parallels, though Japan in the late 80's shared many of the
features of America in the early 00's: high growth without inflation,
technological dynamism, extremely high stock valuations that analysts
somehow managed to rationalize. What is really unsettling about Japan is
not so much the fact that it went wrong but the way it went wrong.

>If you had polled serious economists a decade ago, and asked whether it
was possible for a modern economy to experience a decade of "demand-side"
stagnation -- productive capacity going unused because consumers and
businesses could not be persuaded to spend enough -- I am sure that 99
percent of them would have answered "no." We had learned the lessons of the
Great Depression; never again would the leaders of a major economy make the
mistakes that allowed that slump to go on so long. Even now a fair number
of my colleagues seem to think that a slump that cannot be cured with a
sufficiently low interest rate is theoretically impossible. Yet that's the
reality in Japan, and if it can happen there, why not here? <

It's interesting that "a fair number" of the elite of the economics
profession see the possibility of a Great Depression-type slump or
stagnation in the US. However, have "we" really "learned the lessons of the
Great Depression"? A surprisingly large number of elite economists --
including PK sometimes -- seem to think that saving promotes real
investment, a naive return to pre-Keynesian economics (called Say's "Law").
That suggests that the lessons haven't been learned.

(A few years ago PK favored a "modern" version of Say's Law that saving
encourages investment. He assumed that the Federal Reserve could determine
the level of output, attaining the level of real GDP corresponding to the
non-accelerating inflation rate of unemployment, the NAIRU. With given real
GDP, a rise in saving indeed leads to a rise in investment. But not only is
the NAIRU totally unknown if not non-existent, but the Fed doesn't even try
to set the level of output. Instead, it fixes interest rates such as the
Fed Funds rate in hopes of preventing inflation. I believe that PK has
repudiated his modern Say's Law.)

>Admittedly, Japan does not look like a nation in the midst of depression,
mainly because we have learned something these past 70 years: instead of
trying to balance its budget in the face of a slump, the L.D.P. [Liberal
Democratic Party] has engaged in huge "pump-priming" deficit spending. Or
maybe that's a bad metaphor. Japan's fiscal efforts don't call to mind a
farmer getting his pump running so much as sailors frantically bailing out
a leaky boat. So far they have succeeded in keeping the boat from sinking,
giving themselves time -- but time to do what? Neither the L.D.P. nor the
opposition seems to have any idea. <

I think that there's been a failure of the imagination here, a failure
arising because there's not enough pressure on Japan's elite to break with
old ways of dealing with the problem. Awhile back, I suggested an idea to
PK that he seems to have ignored (as has the Japanese elite). Why couldn't
Japan do what the US did in a big way during the 1950s and 1960s, i.e.,
give "tied" foreign aid. Thus, they could give GigaYen to the poor folks
in, say, East St. Louis (Illinois), in a way that could only be spent on
buying Japanese goods and transported using Japanese ships, etc. Not only
does this stimulate economy of Japan, but it prevents the overbuilding of
infrastructure, something which seems to have happened. It would also make
Japan look like a philanthropist on a world scale, a global Bill Gates.
Then they could spend some of their moral capital they've earned by selling
arms to other countries (and by stirring up wars) ... Of course, all or
most of this might be unpopular with the US Treasury Secretary, who seems
to have a lot of input in deciding their policy.

Of course, there may also be infrastructure that needs to be built but
isn't because of domestic or foreign political opposition. Branching out
beyond the usual infrastructure, there may be some education or
basic-research investment that could be done. I don't know anything about
this in the case of Japan. But we can speculate: why can't Japan have its
own Supercolliding Superconductor, of the sort that was nixed in the US a
few years ago? If it was necessary to the progress of physics then, an even
better one is that much more necessary.

>The only Japanese policy makers who have a clear vision of what to do
next are its central bankers, who have been preparing the public for the
imminent end of their "zero interest rate" policy. Why insist on the need
to raise interest rates when the economy is still so depressed, when
independent economists are warning that Japan may well slip back into
recession later this year? To force structural change: the Bank of Japan
believes that it must raise interest rates to force the private sector to
become more efficient. This is just a modern version of "Liquidate labor,
liquidate stocks, liquidate the farmers, liquidate real estate. ... It will
purge the rottenness out of the system" -- the disastrous advice that
Herbert Hoover received from Andrew Mellon, his Treasury secretary. <

This, of course, has been the attitude of the IMF in most, if not all, of
its structural adjustment programs (and its good to see PK repudiating it,
though he should do so explicitly). The Japanese central bankers have
absorbed the "Washington Consensus" (of the US Treasury, the IMF, and the
World Bank) and are threatening to put it into action. This will of course
encourage world recession.

>And that is the other reminder from Japan. In the United States we have
come to rely on Alan Greenspan's knack for doing the right thing in an
emergency. After seeing the financial crises of both 1987 and 1998 turn out
to be manageable, we have come to take sensible, even heroic action on the
part of key economic officials for granted. But in reality a good Greenspan
is hard to find. So Japan's troubles are a reminder of the lack of wisdom
with which the world is usually governed. <

This assumes, of course, that Japan's problem was purely financial in
origin, so that a smart Central Banker could have solved the problem. I'll
leave that issue for another day or another economist.

It also assumes that the economic world is symmetrical, so that the smart
CB could fix the problem once it had happened. But PK's hoped-for solution
to the Japanese depression may not work, given the results of the popping
of the Bubble Economy about 10 years ago. That is, low interest rates
(negative real interest rates caused by rising inflation) won't work to
stimulate the economy if businesses don't want to invest in fixed capital
because there's already too much unused capacity, because their debts are
too high, and because they're pessimistic about the future. Given the last,
they might be spooked by expectations of inflation (perhaps irrationally).
A similar problem arises if the housing market is already overbuilt and
consumers have more than enough consumer durables. (Consumer debts don't
seem to be a problem in Japan, since consumers there are criticized for
saving too much.) And as I understand it, the US doesn't want Japan to
recover by pushing the Yen down in foreign exchange markets, increasing the
already-large Japanese trade surplus vis-a-vis the US (i.e., the US trade
deficit). So the obvious international effects of PK's chosen policy seem
to rule it out. Finally, would banks with holding all sorts of worthless
IOUs want to lend more, especially as they begin to expect inflation (which
would reduce these debt's real value)?

PK also exaggerates Greenspan's skill (participating in the popular cult of
St. Alan). Even if Greenspan had been able deal with financial crises _per
se_, it's important to remember that in the wrong situation, a central
banker can be "between a rock and a hard place" (to apply the late Hyman
Minsky's insight). Solving a financial crisis can involve the mass
injection of liquidity into the banking system that threatens to go against
the Central Banker's self-defined role in life, i.e., preventing inflation.
(It's not really, self-defined, of course, since the CBs typically
represent the interests of bankers, financiers, and rentiers, but that's
another issue.)

In 1987, unemployment stood at 6.2 percent, so that the Fed could deal with
the stock-market crash of that year with little fear of inflation. In the
last eight years or so, when Greenspan has faced a series of financial
crises, inflation hasn't been a problem. But this is a matter of luck:
Greenspan deserves little or no credit for the current US "Goldilocks
economy." He didn't cause the US economy's "high growth without inflation"
(i.e., the ability of the US economy to enjoy amazingly low official
unemployment without suffering from rising inflation). Nor is Greenspan
behind the "technological dynamism" that PK points to. Monetary policy has
little effect on the supply side, especially in the short run. In fact, all
else constant we'd expect that Greenspan's monetary policy would _hurt_ the
supply side: real interest rates have been rising since 1993 or so,
discouraging real investment, and thus the growth of industrial capacity --
and the supply side.

If monetary policy is to take any credit for supply-side growth in recent
years, I'd give the prize to Paul Volcker, who contributed to the one-sided
class war against labor by using back-to-back recessions in the early
1980s. (Of course, the Carter and Reagan administrations also did their
part, as did private businesses.) The high interest rates drove the dollar
exchange rate upward, which drove most of the old "industrial heartland" up
against the wall, destroying many unionized shops and weakening the US
working class. This also was a "shake-out," which destroyed a lot of
obsolete fixed capital, opening up the way for the building of new, more
technologically-progressive plant and equipment. All of this encouraged
wages to sink relative to labor productivity and allowed the profit rate
(the rate of return on fixed investment) to rise dramatically (though the
highs of the 1960s were not re-attained). The rising profit rate (up to
1997 or 1998) encouraged investment to rise despite the rising real
interest rates. Encouraging this has been a triumphalist rise in profit
expectations.

But none of this can be attributed to AG's fine touch. He's simply taking
advantage of his predecessors' policies.

On the demand side, AG's avoidance of recession is largely accidental. He's
been repeatedly raising interest rates to hold back an economy that mostly
resisted reacting to his reins, so he can't take credit for the galloping
stallion. It's impossible to see his policies as encouraging the rapid rise
in consumer indebtedness that has powered US growth, preventing recession.
If AG helped create the "extremely high stock valuations" that have
contributed to the buoying of consumer spending, it's in the wrong way: by
implicitly to save stock market speculators from crashes, he's encouraged
the stock market to rise that much further beyond levels justified by
fundamentals. Even if people see this as a good thing, it can't last
forever. To encourage consumer overspending to continue, to allow the boom
to persist, the stock market has to keep on rising. One thing that defines
a serious observer of the stock market is that he or she sees such a
continued rise in the stock market as impossible.

If anything, the increased uncertainty of stock prices and the shift toward
a "bear" market will discourage consumer overspending. Eventually, people
will realize that they have to do some saving for retirement and the like,
especially as interest rates on outstanding debts (and thus debt-service
payments) rises. This retrenching will induce a recession or at least a
slowdown. The accumulated indebtedness will imply barriers to expansionary
monetary policy in the future.

For those praising Greenspan's acumen and power, his ability to engineer a
"soft landing," we should remember the 1990 recession, which happened the
last time AG attempted this feat. He tried to reverse the slide into
recession by cutting interest rates, but it happened anyway. As Baily &
Friedman's MACROECONOMICS textbook (p. 249) points out, it is very hard to
create a "soft landing." This was seen in 1990.

First, even a slowdown in the economy encourages fixed investment to fall
(the oft-forgotten accelerator effect). Thus, a soft landing itself can
cause a recession.

Second, back in 1990, fiscal policy was slightly contractionary. Nowadays
it is strongly contractionary, a much more serious problem.

Third, back then, there had been "excessive borrowing and excessive
speculative building of offices and shopping centers," so that "high
vacancy rates discouraged further construction." There was also a problem
of corporate debt, which discouraged expansion. Nowadays, the problem is
more a matter of rising consumer debt, which would block further consumer
spending. But a slowdown of the economy could encourage a reversal of the
recent surge in property values, which would block further construction.

Fourth, back in 1990, a lot of banks owned doubtful or non-performing IOUs
because they had lent to the participants in the speculative boom. They
were thus loathe to lend. Though the banks are in much better shape these
days, a stock market decline and a fall in property values would undermine
the value of the borrowers' collateral, which would discourage both lending
and borrowing.

Fifth, high oil prices due to the Iraqi invasion of Kuwait made
expectations much more uncertain, especially hurting auto sales. These
days, though real oil prices are low by historical standards, the recent
spike might encourage pessimism and consumer retrenching.

In addition, any monetary policy might cause the high-flying dollar to fall
in foreign exchange markets (given the extremely large current-account
deficit), which would encourage inflation to come back. If AG follows his
instincts, he'd hike interest rates in a big way, which would encourage a
serious recession, one much deeper than that of 1990. That would broadcast
recession to the world, which would feed back to impact the US.

For a more complete analysis, see Tom Palley's article "End of the
Expansion: Soft Landing, Hard Landng, or Even Crash?" in CHALLENGE vol. 42,
no. 6, November-December 1999, pp. 6-25.

BTW, Martin Baily, the coauthor of the textbook cited above and a more
realistic macroeconomist than PK, is the chair of the President's Council
of Economic Advisors. So we can assume that someone in Washington DC is
aware of the recessionary or even depressionary possibilities on the
horizon. But the CEA is powerless, so that policy matters are dominated by
the optimistic laissez-faire economists at the Treasury and the Fed.

The complete version of PK's column is at
http://www.nytimes.com/library/opinion/#krugman.

For a useful article on PK, see Edward S. Herman, "Krugman On Economists as
Hacks," Z MAGAZINE June 2000, pp. 9-13.


Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine