DismalTrader

Yet, in assessing the Japanese experience and its relevance today, it is important to recognize that Japan’s fall to earth was due not only to its financial crisis. Japan also suffered a number of severe productivity shocks, which had much to do with its longer-term problems. Even if Japan had never experienced a real-estate and stock-market bubble, the meteoric rise of its giant neighbor China would have been a huge challenge.

The US today seems to be moving towards a gentler and more European-style state, with higher taxes and possibly greater regulation. Supporters of the US administration might fairly argue that it is undertaking long-deferred maintenance on issues such as income inequality. But if the US does experience slow growth over the next decade, can it all be blamed on the financial crisis?

Last but not least, however, it is important to try to preserve dynamism in the US and European economies through productivity-enhancing measures – for example, by being vigilant about anti-trust policy, and by streamlining and simplifying tax systems.

For better or for worse, productivity trends are very difficult to extrapolate, depending as they do on hugely complex interactions of social, economic, and political forces. Nobel Prize winners Robert Solow and Paul Krugman famously once questioned whether the proliferation of computers and technology would lead to bottom-line growth. (This theme underlies the title of Krugman’s classic 1990 book “The Age of Diminished Expectations.”)

In the end, policymakers must remember that whether or not the US and Europe avoid a lost decade depends on their ability to retain productive vitality in their economies, not simply on short-term demand-stimulation measures.

So let's get something absolutely clear. The fiscal policy intervention that Krugman, DeLong, and others have been advocating can be analyzed and supported using the New Keynesian model. See Woodford and Eggertsson's work in particular, or see this work by my colleague George Evans along with his coauthors. For the most part, these models support the types of policies the administration has put into place. (Generally, demand side policies are the solution when the economy is stuck at the zero bound. Supply side polices such as a capital gains tax cut actually make things worse. The reason is that an increase in supply when demand as already insufficient causes prices to fall, and the fall in the price level raises the real interest rate. At the zero bound, the rise in the real interest rate cannot be offset by the Fed. Away from the zero bound, the Fed can stabilize the real rate and the policy has positive effects, but it depends critically on the Fed's ability to offset increases in the real rate and the nature of the reaction).

Yet the biggest stunner was the whopping collapse in Yen net short positions, which moved from +10,161 to -30,866: the biggest net short in the Japanese currency since 2007. This is happening just in time for the Yen to hit fresh 7 month lows against the dollar, as the Yen is back to being the funding currency for all carry trades.

Bloomberg report:

Japan’s export growth accelerated to 45.3 percent in February, led by Asian demand that increased the likelihood the economic recovery will be sustained.

The year-on-year increase was faster than January’s 40.8 percent, the Finance Ministry said today in Tokyo. The median estimate of 17 economists surveyed by Bloomberg News was for a 45.7 percent gain.

Imports climbed 29.5 percent in February from a year earlier, resulting in a trade surplus of 651 billion yen ($7.2 billion). The median estimate of 22 analysts surveyed was for 560.6 billion yen.

The strong export growth was driven by a large jump in exports to the United States (as well as the above mentioned Asian demand), but unlike Asian (including China below), trade did not flow both ways with the United States. The below chart shows the collapse in trade (imports and exports) between the United States and Japan during the crisis and the lack of a full rebound in exports to the United States and absolutely no budge in imports from the United States.

Source: Customs.GO

First, contrary to a widely-held view that the Bank of Japan made extraordinary policy errors in the early 1990s, the model estimates suggest that the Bank of Japan followed a conventional Taylor-type reaction function with a strong emphasis on inflation stabilisation, and an implicit inflation target of about 1%. There was thus nothing unorthodox about Japan’s interest-rate policy. Figure 1 plots the actual policy rate along with the estimated Taylor-type reaction function, showing that the actual rate followed the rate prescribed by the model in the early 1990s.

Figure 1. Japan: Estimated policy-rate target and actual policy rate

Note: Fine dashes indicate 95-percent confidence bands.

Second, counterfactual simulations suggest that an inflation target of 4% would have allowed the Bank of Japan to avoid the zero lower bound on nominal interest rates. But merely having more room for rate cuts would not have yielded much improvement in output performance. Without a strong output-stabilisation objective, the additional margin for interest rate cuts would not have been fully used. The higher inflation target raises inflation expectations in this model, but the associated improvement in output is short-lived (Figure 2).

Figure 2. Japan: 4% inflation target (actual and counterfactual performance)

Note: Figure reports actual path (solid line) of output gap, inflation, and interest rate, and simulated counterfactual path (dashes).

Finally, there is evidence that a policy that combines a higher inflation target with a vigorous response to output would have substantially improved the economy’s performance. In particular, the simulation results suggest that such a policy would have reduced Japan’s output losses during the “Lost Decade” by half (Figure 3).

Figure 3. Japan: 4% inflation target and stronger output response (actual and counterfactual performance)

Note: Figure reports actual path (solid line) of output gap, inflation, and interest rate, and simulated counterfactual path (dashes).