Liquidity traps and stupidity traps
By Scott Sumner
Many people are puzzled by the fact that Japan continues to fall short of its 2% inflation target. Some attribute this the Japan being in a “liquidity trap”. But surely that can’t be the complete explanation. If Zimbabwe can find a way to inflate, it’s hard to believe that Japan would be unable to debase its fiat money. If they don’t know how, I’d be glad to show them. No charge.
In macroeconomics, causation occurs on many levels. In my book on the Great Depression I pointed to real wage shocks, and then deeper causes like deflation and New Deal polices, and then deeper problems like gold hoarding, and then deeper problems like fear of bank failure, fear of currency devaluation and lack of international cooperation on monetary policy. And then deeper causes of that lack of cooperation (bitterness over WWI, Smoot Hawley, etc., etc.)
So what is the deeper cause of Japan’s “lowflation”. Back in 2010, John Taylor wrote a post describing how the US used to pressure Japan to avoid depreciating the yen. Taylor does not suggest that this policy caused Japan’s 1997-2012 deflation, but it certainly might have.
Is this still true today? This article caught my eye:
If United States president-elect Donald Trump’s appointment of Peter Navarro to head a new Council of Trade is the prelude to strained relations between Beijing and Washington, the United States will not wish to alienate Japan at the same time.
Japanese economic policies that might ordinarily raise US eyebrows could instead pass unchallenged. The yen could fall further in value.
I don’t believe that the US would actually stop Japan form depreciating the yen. In my view we are a “paper tiger”. But Japan may see things differently, and be reluctant to risk a trade war.
You might wonder why Japan doesn’t adopt another type of expansionary monetary policy—one that does not involve depreciating the yen. The problem here is that any effective monetary stimulus will depreciate the yen, regardless of whether it is accomplished by the BOJ buying domestic assets or foreign exchange.
That’s one reason why I call this a “stupidity trap”. US pressure on Japan is based on an EC101-type error. Indeed it’s based on four such mistakes:
1. The idea that monetary stimulus can create inflation without depreciating a currency.
2. The idea that Japan’s currency account surplus shows that its currency is “undervalued”. In fact, it merely shows that Japan saves more than it invests, not surprisingly for a thrifty country with a falling population.
3. And it’s based on the misconception that it’s possible to prevent Japan from depreciating its real exchange rate (which is what matters for trade), by preventing it from depreciating its nominal exchange rate. Instead, if the equilibrium real exchange rate falls, and the nominal rate is held fixed, Japan’s real exchange rate will fall via deflation.
4. It’s based on the misconception that a current account surplus in Japan somehow steals jobs from America.
In freshman economics we try to teach students that these ideas are myths. But these views are widely held by people in places like the Treasury Department, even under previous administrations that tended to favor free trade.
Imagine what we’ll get with the Trump administration.