SYNOPSIS: Finds that Japan's too cautious Monetary Policy has led to all the bad problems predicted.
I have been wrong about a lot of things lately. Most notably, I underestimated the strength of Asia's recovery, including that of Japan. Well, short-term forecasting is a black art, and I should know better than to try. But when it comes to conceptual issues - which is, after all, what academic economists are supposed to focus on - I feel rather vindicated by recent events in Japan.
Here is the issue: beginning about a year and a half ago, I began arguing that if we took the normal logic of macroeconomics seriously, Japan's persistent slump - its persistent excess of desired savings over desired investment - implied that the Japanese real interest rate was too high, even though the nominal rate was near zero. The only way to get the "right" real interest rate would therefore be to create expectations of inflation.
The big objection to this proposal was that it would weaken the yen. But it was or at least should have been clear from the logic of liquidity-trap economics (see Japan: still trapped ) that Japan's fundamental tendency is to have a yen that is too strong, that is, a yen that does not generate a current account surplus large enough to close the savings-investment gap. Or to put it differently: an excessive real interest rate leads to too little investment of all kinds, net foreign investment included.
And sure enough, the Japanese problem now is a yen that wants to be too strong. Indeed, hopes of recovery are starting to look like a self-denying prophecy: as soon as investors start to think that maybe the worst is over, the yen pops up and undermines the expansion. Intervention has not worked: well, that is no surprise. Sterilized intervention is never effective when it tries to oppose the fundamentals; and in Japan the fundamentals are a real interest rate that is still too high, and a central bank that has made it clear that it is not yet in any mood to go beyond conventional policies.
Of course, Japan could surprise us all. Perhaps this time massive fiscal deficits will not only keep the economy afloat, but provide the long-awaited, never-delivered jump-start: the self-sustaining expansion in private demand that continues even as the public works programs wind down. But to believe in that jump-start you must believe in a very exotic model of the macroeconomy, one in which there are multiple equilibria and a temporary fiscal expansion can jolt the economy out of a low-level trap. Well, maybe. But isn't it funny that the orthodox policy now being followed can be justified only by invoking highly speculative, dubious models with little empirical backing; whereas the radical, unorthodox policy I have advocated flows naturally from textbook economics?
Meanwhile, as the BOJ wonders what to do about that rising yen, let me say: I told you so.