SYNOPSIS: Concise argument for Krugman's perscription for Japan: inflate, inflate, inflate.
When Japan's Kansai International Airport was being planned, there was considerable uncertainty over how much the artificial island on which it sits would sink. The officials in charge chose to accept the lowest, most favorable estimate; as it turned out, the reality has been worse than even the most pessimistic estimate, and despite expensive emergency measures -- and continual assurances from those officials that everything is under control -- the island is still sinking.
It's not a bad metaphor for the story of Japanese economic policy in recent years. Japan's government keeps on insisting that its economic strategy has put the nation on the road to sustained recovery, brushing aside both the doubts of outside economists and the growing evidence that the strategy is not, in fact, working. For most of the past year this unwarranted confidence has been supported by a strange consensus on the part of investment analysts, who somehow became committed as a group to the view that Japan's economy is on the mend.
And so it came as a shock last Sunday when a senior official admitted that the Japanese economy has almost certainly been shrinking for the last two quarters, which means that by the usual definition it has slipped back into recession.
Japan has the dubious distinction of being the first major nation since the 1930's to experience a "liquidity trap," in which even cutting the interest rate all the way to zero doesn't induce enough business investment to restore full employment. The result is an economy that has been depressed since the early 90's, and that in 1998 seemed to be on the verge of a catastrophic deflationary spiral.
The government's answer has been to prop up demand with deficit spending; over the past few years Japan has been frantically building bridges to nowhere and roads it doesn't need.
In the short run this policy works: in the first half of 1999, powered by a burst of public works spending, the Japanese economy grew fairly rapidly. But deficit spending on such a scale cannot go on much longer. Japan's government is already deeply in debt (about twice as deep, relative to national income, as the U.S. was before our own budget turned around). For the policy to do more than buy a little time, the recovery must become "self-sustaining": consumers and businesses have to start spending enough to allow the government to return to fiscal responsibility without provoking a new recession.
Carping critics (like me) warned that there was no good reason to think this would happen. Sure enough, it hasn't; as the big public works projects of early 1999 have wound down, so has the economy.
What can Japan do? One answer is "reform": deregulation and a breakup of the cozy collusion that still characterizes much Japanese business could open up new investment opportunities. But this is at best a long-term answer; in the short run, by making workers feel insecure, it could actually make things worse.
The other answer is "roll the printing presses." Although the Bank of Japan has already reduced the short-term interest rate to zero, Western economists have pointed out that there are other things it can and should do: buy longer-term bonds, announce a positive target for inflation to encourage businesses to borrow. Indeed, textbook economics tells us that to adhere to conventional monetary rules in the face of a liquidity trap is not prudent; it is irresponsible. (Full disclosure: I personally have been the most visible and vociferous advocate of inflation targeting).
But the current government has actually slowed the pace of reform, and the Bank of Japan -- which only recently acquired Federal Reserve-style autonomy -- has adamantly refused to do anything unconventional. (When I was in Japan in December, I witnessed an argument between former B.O.J. officials and current officials of the Ministry of Finance. The former declared that it would be wrong to do anything risky; the latter reminded them, to no avail, that the current policy of running up huge debts to finance public works is already very risky.)
Will the bad news make them reconsider? Don't count on it: since Sunday's awkward admission, Japanese officials have been out in force, insisting as usual that they have everything under control.
Originally published in The New York Times, 2.9.00