Krugman's lessons from Japan

With the usual caveat that I'm not a macroeconomist, I find what Paul Krugman wrote about Japan 10 years ago to be especially, perhaps uniquely, relevant to the current situation.

Here is his page that collects his writings on the subject.

Given our current situation is remarkably similar, except worldwide and thus likely worse, it seems like an especially salient perspective.

Here are a couple selected quotes from those writings:


Japan is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; Japan now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.

Is this likely? The phrase "self-sustaining recovery" trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea....

When, then, can fiscal stimulus work as a long-run solution? There seem to be two possible answers. The first is that deficit spending can serve as a bridge over troubled waters.....

It's actually hard to come up with good examples of this kind of fiscal program - maybe Sweden's efforts to ride out the first oil shock in the mid-70s. In the case of Japan, a starry-eyed optimist might argue that restructuring of Japanese banks and corporations will eventually create a "new economy" that generates a lot of investment. A more likely scenario, however, is that the prolonged process of restructuring will keep consumers nervous and if anything depress demand. That cavalry may be a long time in coming.

What continues to amaze me is this: Japan's current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy. (My emphasis)

Now our budget deficit isn't close to 10% of GDP yet. But the way things are going it easily could be within a couple years. And according to Krugman (and many others), output will almost surely remain below GDP potential for many years. "What comes after the stimulus?" he asked in November:
For the coming year, and probably well beyond, the economy will be on life support — sustained by massive fiscal stimulus. (Either that, or we’ll be in a very deep slump.) But eventually the economy will have to come off life support. What will take the place of the stimulus?

I don’t really know the answer...

Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.

But that’s going to be hard if the rest of the world is also in a slump, and in particular if emerging markets are facing currency crises.
Sound similar? What was Krugman's proposed solution for Japan? Inflation targeting.

Rumors suggest that the Bank of Japan may actually be considering adopting some form of inflation targeting, with a positive upper bound. This is good news, because it means that the Japanese are finally starting to understand the nature of their situation. But do they still get it? I am not sure, because the numbers being floated are almost surely too low. And in that case perhaps they still don't get it - because the basic logic of a liquidity trap says that the choice facing a country in such a trap is between a significant positive rate of inflation and grinding deflation. There is no middle ground.

The point is simple, but apparently hard to grasp. Suppose that the equilibrium real interest rate - the rate at which savings and investment, including net foreign investment, would be equal at full employment - is negative. (As I have tried to explain, in Japan: still trapped , that is what a liquidity trap is all about). And suppose also that prices do not fall quickly in the face of unemployment. Then if the expected inflation rate is too small to allow a low enough real interest rate - if, for example, the economy "needs" a minus 3 real interest rate, and expected inflation is only 1 percent - the actual result will be an underemployed economy, and hence continuing slow deflation. This will soon mean that the inflation target loses credibility, and you are back where you started.

So an inflation target can work only if it is high enough that, if believed, it would produce a strong enough economy to actually generate inflation. A target that is set too low is doomed to failure.

This is why people who want to water down proposals for "managed inflation" - why can't we just aim for price stability, or 1 percent inflation, instead? - are missing the point. As I tried to say in my original piece on Japan's trap , the deflationary pressures we actually see in Japan represent an economy that is "trying" to achieve the inflation it needs, by reducing current prices compared with expected future levels; the reason the economy is depressed is that such deflation does not come quickly and painlessly.

I know that all of this is painful to think about; policymakers are certainly not used to dealing with such paradoxical-sounding problems, and their instinct is always to go for some sort of middle ground. But the law of the excluded middle here is not some abstract professorial quibble. It is the unavoidable conclusion of any reasonable analysis.

So let me say it in capitals:


Okay. So I read this and look at the situation now and I wonder why there isn't as much or more talk about inflation targeting as there is about fiscal stimulus. Granted, our budget situation and the size of the stimulus, placed in proper perspective, are not at quite the levels of Japan in the nineties. But it's hard to see how we won't be there soon.

I'm not anti-stimulus. But when I look at graphs like this and this, I cannot believe that this stimulus package, no matter how massive it may seem, will do the trick.

So I google news "inflation targeting" and I get 126 hits. Most are about South Africa. This statement from Charles Plosser is about all I can find about the U.S. Fed. Pretty cautious, no? I thought Ben Bernanke was Mr. Inflation Targeting? Google news "fiscal stimulus" and there are 13,397 hits.

And not a word from Krugman about inflation targeting. Even though he's seriously worried about deflation (here and here).

Can someone please tell me what I'm missing here?


  1. Isn't Bernanke's "printing money" essentially implicit inflation targetting?

  2. Rogoff has actually written about inflation targetting to avoid deflation, recently.


    Bernanke has not yet pursued quantitative easing which if it were anchored on inflation would be essentially inflation targetting.

    Instead they are seeking to selectively buy into particular asset markets to try to unfreeze credit markets. They may be forced to pursue quant easing soon...

  3. Krugman has written on inflation targeting, arguing that the Fed should act "irresponsibly" to convince the markets that quantitative easing will not be taken back prematurely.

    I think the reason why he's quiet on it now is that he's trying to argue for stimulus, and the more the debate focuses on the Fed, the less argument for stimulus.

  4. The lesson of the 70s is that prolonged high inflation leads to a wage/price spiral, followed by stagflation. To be effective at stimulating the economy, inflation must be short and unexpected.

    If people believe that inflation will be fairly high and prolonged, this will just set up a repeat of the 70s, followed by a Volker type severe recession to wring inflationary expectations out of the economy.

    IOW, long run high inflation targeting just doesn't work.

  5. David Pearson: Yes, it would seem Krugman wants expansion of government for more than stimulus reasons. I think he sees other benefits of increased spending, not just stimulus. I wish he would say that rather than ignore inflation targeting.

    Anonymous #1: Yes and no. I think an important part of inflation targeting is saying clearly what the target is and what they plan to do to achieve that. Expanding the Fed's balance sheet by printing money and buying long-term or risky assets is a way to achieve this.

    lerxst: Yes, it seems this is just a matter of time... I guess would have thought that they would announce these things, given Bernanke's emphasis on targeting and transparency. It seems this must be part of the thinking but I see little coverage of it and that confuses me.

    Anonymous #4: I think stagflation in the 70s had a lot to do with oil prices--it was a real price change, not just due to monetary policy.

    Yes, the Fed induced a recession to kill inflation, and that hurt. The current situation looks much different and much worse. Deflation is worse than inflation.

    The art of getting timing of monetary policy right is tough. Friedman wrote about the 'idiot in the shower.' Right now I'd guess there is too little too late for the extreme circumstances, just like Greenspan probably kept rates too low too long leading into the bubble.

  6. Well late to the tthread. Everytime someone brings up Japan I point out they have 4 years in personal savings. If most of these are Yen denominated it is political suicide to inflate this away. How many Americans have saved up enough to live for 4 years unemployed? Not symmetrical apart from both being flight-to-safety currencies and able to profit from panic with stimulus.

  7. By calling for significantly higher inflation targets, you may be thinking about somethin akin to Martin Uribe and Stephanie Schmitt-Grohe's ideas for exiting liquidity traps. They argue that once nominal rates hit the zero lower bound, certain monetary policy rules may trigger dyamics that keep the economy stuck with deflation. The solution, they argue, is to increase (!) nominal interest rates, which would then push up inflationary expectations.

  8. Javier H:
    That idea by Uribe and Schmitt-Grohe looks silly to me.


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