Jan 14, 2013

Krugman's Russian Roulette for Japan

Paul Krugman praises PM Shinzo Abe for his "unorthodox" fiscal and monetary policy.
Whatever his motives, Mr. Abe is breaking with a bad orthodoxy. And if he succeeds, something remarkable may be about to happen: Japan, which pioneered the economics of stagnation, may also end up showing the rest of us the way out.
As Krugman says, Abe's policy is "old-fashioned pork-barrel". Since Abe knows little of economics, his policy was actually implemented by Financial Minister Tarou Asou, who was expelled from Prime Minister by 2009 election.

Krugman is right when he says that monetary policy is irrelevant because Japan is trapped by deflation. So he recommends a Keynesian fiscal policy to push Japan out of long recession. Although it has had little effectin the US, he insists it was too little and urges American government to spend much more, which Abe and Asou are trying to do.

However, it is not obvious that such policy can get Japan out of stagnation and maintain growth for a long time. Indeed there is a GDP gap of minus 3.1 percent, so potential output might be achieved by filling this gap by government spending theoretically. Krugman seems to assume that there are multiple equilibria a la Cooper-John as follows:

If government spending could push Japanese economy out of A, an inferior equilibrium, it might reach a superior equilibrium B. If such an equilibrium exists, for example, an inflation by 2 per cent would be a self-sustaining path theoretically. But it is implausible because money stock (M2)  is very stable since 1992 while monetary base fluctuated as high as 36 per cent as follows.

Growth of monetary base (green) and M2 (red) in Japan (%)

If, on the other hand,  such superior equilibrium doesn't exit, Krugman's Big Push is a risky policy that might push Japanese economy out of equilibrium forever as follows.

Of course we don't know whether we are in an inferior equilibrium of multiple equilibria or only one stable equilibrium. But as Japan is facing far more serious financial risk than that of the US, Krugman's recommendation might be a Russian Roulette for Japan.

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