Posted by: Dirk | December 21, 2009

The Future That Didn’t Work

The above is the title of chapter in Paul Krugman’s The Return of Depression Economics. It deals with Japan and the malaise it spent in from 1991 until, well, now. Those who have noticed Paul Krugman’s call to reflate the economy in his NYT column Bernanke’s unfinished mission might want to have a look in that chapter. Here’s the main idea from the column:

The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.

So, the idea is to get investment up by buying assets and paying with money, which should end up somewhere in the real economy either as consumption or investment, thereby leading to expectations of inflation. To be honest, I am quite critical of that idea. Paul Krugman had pointed out that a paradox of thrift is at work, and taking away opportunities for people to save would probably be a bad idea.

I would argue that the liquidity freed up through a money-for-assets program would not find its way into the real economy completely, but would rather lead to more deleveraging. Just how much liquidity would drain into the reduction of debt depends on circumstances. If the money is invested in foreign markets via carry trades the effect of the policy might be very, very small. The time of the closed economy is over, and money market operations might have very strange effects these days:

In response to rising inflation, the Reserve Bank of New Zealand (RBNZ) raised the official cash rate from 5.0 percent in 2003 to its current level of 8.25 percent. However, competition in the mortgage market, in part reflecting banks’ access to abundant international liquidity, slowed the transmission into mortgage rates. Searching for yield, international investors responded to the wide interest rate differential, and inflows of foreign capital appreciated the exchange rate.

This is a very complex issue, and stakes are high.


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