It's Baaack: Japan's Slump and the Return of the Liquidity Trap

Krugman defines a liquidity trap as “a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes” (p. 141). He argues the concept had “virtually disappeared from economic discourse in the past twenty years” because postwar inflation kept nominal rates comfortably above zero and because Friedman and Schwartz’s reinterpretation of the Depression suggested sufficiently aggressive monetary policy could always have prevented or reversed a slump; Japan’s experience in the 1990s, he argues, shows “it has happened… to the world’s second-largest economy” and therefore needs to be taken seriously again (pp. 137-138).

The author’s central new conclusion is that “the answer lies in a little-noticed escape clause in the standard argument for monetary neutrality: an increase in the money supply in the current and all future periods will raise prices in the same proportion. There is no corresponding argument that a rise in the money supply that is not expected to be sustained will raise prices equiproportionally – or indeed at all” (p. 143). From this he concludes that “a liquidity trap fundamentally involves a credibility problem – but it is the inverse of the usual one, in which central bankers have difficulty convincing private agents of their commitment to price stability. In a liquidity trap, the problem is that the markets believe that the central bank will target price stability, given the chance, and hence that any current monetary expansion is merely transitory” (p. 139). The policy implication is stated directly: “monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level” (p. 139).

Krugman builds a cash-in-advance, representative-agent endowment economy with rational expectations and shows that once an open-market expansion of the money supply is large enough to push the nominal interest rate to zero, “it must be that any increase in the money supply beyond the level that would push the interest rate to zero is simply substituted for zero interest bonds in individual portfolios… with no further effect on either the price level or the interest rate,” so that the economy’s price level and output become independent of the current money supply (pp. 145-146, Figure 1). He stresses that “the possibility of a liquidity trap does not depend on the ad hoc nature of the IS-LM model, that it can occur in a model that dots its microeconomic i’s and crosses its intertemporal t’s” (p. 143) – the trap is not a Keynesian artifact but a feature of fully rational, intertemporally consistent behavior once nominal rates hit their floor.

A liquidity trap requires that the required (full-employment) real interest rate be negative, a condition that in the model’s simplest form holds when current output is expected to exceed future output by enough that (y/y)^ρ < D* (the discount factor) (eq. 5, p. 147); intuitively, the trap arises “if the economy’s future output is expected to be sufficiently less than its current output.” In the flexible-price version, this negative required real rate does not by itself create unemployment – the economy simply deflates now in order to generate the needed future inflation, with any excess money hoarded rather than spent (pp. 147-148). Introducing predetermined (sticky) prices, the “Hicksian” liquidity trap, converts the same negative-real-rate condition into an actual output shortfall, since output must now adjust to demand rather than price doing all the adjusting (pp. 148-149, Figure 2).

No. Even with perfectly mobile capital, the paper shows that imperfect integration of goods markets (because a liquidity trap requires only the relevant consumption-based real interest rate to be negative, not the real interest rate on internationally traded bonds) can still leave a country stuck in a liquidity trap, and the “beggar-thy-neighbor” effect of escaping via currency depreciation is shown to be quantitatively modest under reasonable parameter values: for risk aversion around 2 and a traded-goods share near 0.2, an inflationary policy that raised Japanese output by 5 percent would require a current-account swing of only about 1 percent of GDP, “far short of the huge surpluses envisaged by” some commentators (pp. 164-165).

Krugman argues that the observed disconnect between rapid monetary-base growth and stagnant broad money and bank credit “is to be expected even if the banks are financially healthy,” because in a liquidity trap the central bank cannot move broad aggregates by construction, which undercuts the inference that weak banks are the reason policy isn’t working (p. 175). He further argues the timing is wrong for a bank-centered explanation: a review of press coverage found “few allegations of credit rationing in Japan before the second half of 1997,” years after the bubble burst, and the credit crunch coincided with the announcement of new capital adequacy standards in October 1997 rather than with the original loss of bank solvency – consistent with banks previously having an incentive, given implicit government guarantees, to over-lend rather than under-lend (pp. 175-177).

The author states that “my guess is that in retrospect it will seem clear that Japan’s 1998 output gap was 8 percent or more. But one can make a very strong case that it will exceed 5 percent” (p. 171), reasoning from Okun’s Law calculations and from the OECD’s own downward revisions to Japan’s estimated potential growth rate (from 3 percent to 1.6 percent over just three years), which he argues likely reclassify genuinely cyclical shortfalls as structural trend. He is explicit about the imprecision: “Obviously there is no precision in this estimate.”

Combining an output-gap estimate of 4 to 5 percentage points still needing to be closed by monetary means (after allowing for fiscal stimulus and banking clean-up) with standard econometric estimates of the interest-rate reduction needed to close a given output gap, Krugman arrives at a suggested managed-inflation target of “4 percent inflation for fifteen years,” immediately adding: “This target should not really be taken seriously. Rather, it should serve mainly to stimulate serious research” (pp. 181-182). He estimates the associated yen depreciation at roughly 20-25 percent, describing this too as “still more of a stimulus to debate than a serious estimate” (p. 182).

Krugman highlights two general lessons: first, that “one must be careful about making inferences from divergences between the growth of monetary base and of broad monetary aggregates,” since a liquidity trap economy will show this divergence even with healthy banks; second, that “whatever the specifics of the situation, a liquidity trap is always the product of a credibility problem: the public believes that current monetary expansion will not be sustained. Structural factors can explain why an economy needs expected inflation; they can never imply that credibly sustained monetary expansion is ineffective” (p. 166).

The author closes by extending the warning beyond Japan: “Germany and France currently have short-term interest rates of only 3.5 percent, and Europe faces Japanese-style demographics; could a liquidity trap happen to the European Monetary Union? Economists now know that the liquidity trap is not a historical myth: it can and does really happen sometimes, and we had better try to understand it” (p. 183).