Friday, October 22, 2010

A Review on Krugman's Argument - Japan - Still Trapped

By Dias Satria
1. Introduction
Japanese economy has caught in a stagnation and deflation in almost a decade. Svensson (2003) summarizes that two factors which trigger Japan caught in a trap are policy mistakes and a failure to coordinate policies to recover Japanese economy.

There are some debatable arguments related to the Japanese policy to escape Japan from the liquidity trap. One of debates comes from Krugman that said Japanese economy has caught in a liquidity trap. He highlights the importance of a negative real rate of interest to equilibrate the economy, to match saving with investment in Japan.

This paper will outline Krugman's point of view on his article "Japan: still trapped", and give an opinion about his argument that a negative real rate of interest is necessary to restore full employment. This paper will also relate cagan's stability model to krugman analysis and point out the role of fiscal policy in maintaining stability of the Japanese economy.

2. An overview about Japanese economy and Krugman's argument

Since 1990, Japan has fallen to a stagnation and deflation in economy. There are several causes which make Japan continued to recession. A high saving's rate and low consumption rate in Japan, for example, have led to a terrible drop in demand and cause Japan difficult to recover the economy. Furthermore, yen appreciation to dollar has also been a serious problem which led to cause the economic bubble, asset price deflation, and the liquidity trap. (Okimoto, 1999)

Krugman reveals some facts that Japan caught in a trap, such as : the low short term interest rate which have reached nearly zero, BOJ actions to stimulate demand by lowering interest rate is ineffective and some money hoarding transactions. To explain the economic situations on Japan, he started his analysis from the basic IS-LM model. (1) (2)

From the first equation, saving (S) and investment (I) are contingent on the level of real income (y) and real interest rate (r). Meanwhile in the second equation, i is the nominal interest rate, the real rate plus expected inflation.

He argues that the concept of liquidity trap happens when saving exceed investment at full employment even at zero real interest rate - that . It can be clear from the graph above that the solution for the interest rate to match saving and investment equal at full employment is a negative real rate of interest. This is the critical point for Krugman to stress the importance of negative real rate of interest to restore full employment. In this point of view, he argues that, given zero interest rate, a positive expected rate of inflation is needed to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

3. Critiques on Krugman's argument

In order to make an understanding about Krugman's argument, its better to review about the concept of liquidity trap. What make Krugman's is incomprehensible is about the distinction between the cost and the return on capital. Rogers (n.a) argue that Krugman is not clearly to explain about the distinction between the cost and the return on capital. Furthermore, he also think that Krugman's concept to come out from liquidity trap by setting a negative cost of capital to equate to the negative return on capital makes no economic sense.

From Roger's idea, what is important for Japanese economy to escape from liquidity trap and to recover the economy is the positive marginal efficiency of capital (MEC). It means that to induce new investment the rate of return over cost must exceed the rate of interest. Thus, as the difference between what is returned and the costs constitute the profits, to induce new investment, the rate of profit (marginal efficiency of capital/MEC) must exceed the interest rate.

Roger also reveals the relevance of Wicksell theory to recover Japanese economy. This idea is understandable because if the money rate of interest was below the natural rate of return on capital, people would borrow at the money rate to purchase capital, thus rising demand for some resources and also their prices. In this terminology, price stability would result only when the money rate of interest and the natural rate of return on capital-the marginal product of capital-were equal.

4. Cagan convergence condition and Japanese economy

In order to simplify an economic instability in Japan, I will use a Cagan convergence condition, which has developed by Cagan in 1956. He has developed a model of hyperinflation by deriving such condition, as shown below. (3) (4) (5)

We can substitute to the equation. So. From the first equation, we substitute, and drop variables that are not involved in this convergence analysis, so we set. Thus, We can apply that equations to the matrix.

To solve simultaneous differential equations, the necessary and sufficient conditions for stability are that the determinant of 2x2 matrix be positive and that the trace be negative. Thus, it must statisfied, or So.

In early 1990s, Japanese economy has fall into the bubles economy in property and share price. In such situation of liquidity trap, the interest elasticity of money demand is to be expected so high. Furthermore, ZIR Policy of Bank of Japan Then would set nominal interest rate nearly to zero. Another component in cagan model (speed people adjustment expectation) is likely to rise, thus from the condition, the Japanese economy is predicted unstable and would fall into a deflation spiral.

This term-deflationary spiral-can clearly explained by Svensson (2003) that the situation of deflation would give a negative consequence to Japanese economy. First of all, deflation situation would increase the real value of nominal debt which may cause some indebted households and firms to bankrupt and fall in asset prices. Furthermore, this problems would trigger instability in financial system due to banks would face a collateral loses value and bad loans.

He also reveals that instability in Japanese economy is deteriorating with a deflationary spiral due to a rising unemployment rate in Japanese economy and a rigid wage. In this case, due to deflation the real wages would not go down, but increase, further escalating unemployment rate. All in all, this may contribute to a further drop in aggregate demand, a further increase in deflation and a further increase in the real interest rate.

5. The role of fiscal policy in Japan

The role of fiscal policy to escape Japanese economy from a liquidity trap is still debatable. Although some people might argue that Expansionary fiscal policy is powerful to be a stabilization policy when economy goes into the recession, to restore full employment in a liquidity trap. This policy, instead, has led Japan to a massive national debt. Krugman (1998) actually pay almost no attention to the role of fiscal policy in Japan. He argues that the fiscal policy would have no effect if consumers really do exhibit something like Ricardian equivalence. In this case, People would anticipate a policy of higher government debt by increasing their saving, because they expect that there would be a tax increases or a reduction of government benefit. Furthermore, he also argues that some fiscal spending in Japan are unproductive to stimulate its economy.


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