Here PK recommends, working through – pretty uncontroversially – the logic of the standard New Keynesian model, that Japan should try another burst of expansionary fiscal policy to raise inflation. But that it should actually do it with enough force and persistence to get inflation to a higher target, so that this leaves room for a compensating monetary stimulus when, eventually, the necessary fiscal consolidation comes.
A few comments.
First, it may be that with debt/GDP ratios already so high the mechanism by which fiscal policy works to achieve this is not by raising demand, the output gap, and therefore inflation, but via the fiscal theory of the price level, or unpleasant monetarist arithmetic – creating the expectation that no politically acceptable plan for taxes and future spending would exist that could possible pay back the debt without either seigniorage or default.
That’s not to say that this should necessarily discourage the Japanese authorities from following PK’s prescription. Times may be sufficiently desperate that such desperate measures are called for. Sims warned that such may be the consequences of the Fed’s balance sheet expansion, and I am sure that there were those – looking over their shoulders at the Japanese situtation – who thought, privately, ‘so much the better’.
In that respect – given that things are so bad, in other words – it was odd not to hear PK’s views about alternatives. The two most prominent being to engage in helicopter drops, or to introduce reforms such that the zero bound to interest rates is lowered. Both of these measures I have warned against, but only in the context of the US/UK/EZ situations which don’t yet appear so dire.
Helicopter drops, implemented by the BoJ creating the necessary electronic money for cheques to be sent to Japanese households, may achieve the necessary stimulus without saddling the economy with the need for future fiscal consolidation. They would therefore not require that inflation was raised beyond 4 per cent for that purpose. Although there is reason enough to go to 4% anyway, to avoid a future recession tipping the Japanese economy back into the liquidity trap.
Cheques in the post would, as I have complained previously, risk that the expectation emerges that the authorities get a taste for winning elections this way. But, right now, that risk would almost seem to be a benefit, not a cost. And the authorities in Japan have plenty of institutional memory to draw on to prevent this expectation derailing monetary and fiscal affairs later on.
Likewise, the risk of a ‘wtf’ moment as citizens grappled with one of the means of reforming the institution of cash [either outright abolition, or something trickier] to allow for negative interest rates, is, in Japan, to be set against the more urgent need to escape what seems otherwise to become a permanent situation in which there is no monetary policy instrument with which to smooth the business cycle.
So, while PK’s prescription is fair enough, why not give something else a go? If not instead of a fiscal expansion, perhaps in combination.