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September 23, 2012

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Posted: 23 Sep 2012 12:06 AM PDT

Is Japan Doomed?

Posted: 22 Sep 2012 11:24 AM PDT

Noah Smith:

Time to Japanic?, by Noah Smith: The Atlantic has a big story on the impending Japanese crash; one of the authors is the brilliant Simon Johnson. ...
This prophecy is hardly unique; I have beaten this drum myself. If Japan doesn't change course, it will have a major crisis within the next decade.
If. But what people need to understand is, the Japanese government does have the power to avert a crisis. It is not inevitable.
There is one way that the crisis can definitely be averted: Raise taxes. Japan's fiscal woes can be boiled down to one sentence: Japan has European levels social spending and European levels of aging with American levels of taxation. But this could change; if Japan raised taxes to European levels, crisis would be instantly averted. According to analyses I've seen, this would require raising Japan's taxes from their current level of 32.5% of GDP to somewhere between 40% and 50% of GDP. That's comparable to France or Sweden. Painful, but not impossible.
Now for the rumor (rumor always being a large component in Western analyses of Japan). My sources at the Bank of Japan and Ministry of Finance tell me that domestic Japanese investors are betting that, after all the grumbling and fighting and ending of political careers, Japan's government will suck it up and raise taxes. This, my shadowy sources say, is why pension funds are still willing to put the Japanese people's money into JGBs.
But this story is not really outlandish. It's similar to what we're observing in America right now. U.S. borrowing is at all-time highs, but demand for Treasuries shows no sign of flagging, and most of that demand - more than in the past - is from domestic U.S. investors. Yes, we have shown a reluctance to raise taxes - witness the apocalyptic debt ceiling fight from last year. But if the public really thought the U.S. government was willing to default, domestic Treasury buyers would be heading for the exits. That they are not heading for the exits probably indicates that they believe that when push comes to shove, the U.S. government will suck it up and raise taxes. There are signs that the Republicans are quietly recognizing the necessity of this. At this point, it's just a fight between Democrats and Republicans to see who takes the fall for raising taxes - that's what the "fiscal cliff" is really all about.
Japan seems to be in a similar situation. It is not really unusual or outlandish at all. Everyone in the country still seems to believe that the government will continue to function. The day that that that belief falters - or is proven wrong by main force, when interest payments swamp the primary budget - is the day that Japan collapses (the same goes for the U.S.). But if Japan's government is less dysfunctional than the often skittish Western press believes, that day will never come.
(Anyway...oh yeah, I did mention that there might be two ways out of Japan's fiscal trap, didn't I? The other way is to use monetary policy to create negative interest rates. If that can be done in a stable way (without accelerating inflation) and if stable growth persists, then Japan can use an "inflation tax" to erode the value of its government debt instead of an actual tax. Econ bloggers (and commenters), who tend to believe that central banks can hit any NGDP target they want, will probably advocate this "solution"...)

One Rule to Ring Them All?

Posted: 22 Sep 2012 09:25 AM PDT

In macroeconomic models, if everything works perfectly -- if all markets clear at all points in time, prices are fully and instantaneously flexible, people have the information they need, and so on -- then monetary policy will have no affect on real variables such as output and employment. Only nominal variables such as the price level will change. This is known as monetary neutrality.

In order to get non-neutrality, i.e. in order to make it so that changes in the money supply can change real output and employment in a theoretical model, there must be a friction of some sort. One popular friction is price/wage rigidity, but it is not the only type of friction that can generate non-neutralities. Any friction that prevents optimal and instantaneous response to a shock will overcome neutrality and restore the ability of the Fed to affect the course of the real economy.

The point I want to emphasize is that the optimal monetary policy rule depends upon the underlying friction that is being used to generate non-neutralities in the theoretical model. For example, Calvo type price rigidity combined with some sort of social objective function such as maximizing the welfare of the representative household often gives you something that resembles the standard Taylor rule (though whether the level and/or the growth rates of price and output belong on the right-hand side of the Taylor rule depends upon the nature of the friction, i.e. even in this case the standard Taylor rule may not be the optimal rule).

I am willing to believe that during the Great Moderation the standard Taylor rule may have at least been close to the optimal rule. If you believe price frictions were the source of the mild fluctuations we had during that time, then theory tells us that's possible. What puzzles me is why people think the same rule should work now. I don't think that Calvo type price rigidities are the reason for the problems we are having right now, and hence this does not give us much insight and explanatory power for the Great Recession. Mild price sluggishness is plainly and simply not the dominant friction at work right now, and if that is the case, why would we think the same monetary policy rule should be optimal? If, in fact, there has been a switch in the dominant type of friction affecting the economy -- and I would argue there has been -- it would be quite remarkable for the same monetary policy rule to be optimal in both situations.

So, I have to agree with Paul Krugman:

Self-contradictory Fed Bashing: David Glasner continues to be unhappy with the Bernanke/QE bashers, this time going after claims that the Fed's monetary policy was too easy before the crisis.
Much of this discussion is couched in terms of the Taylor Rule, which John Taylor originally suggested — a rule that sets the Fed funds rate based on inflation and either unemployment or some measure of the output gap. This was a clever idea, and has proved useful as a rule of thumb for both description and prediction. But a funny thing happened on the way to the crisis: Taylor and others have elevated this rule to sacred status — and not only that: they have insisted that the original coefficients Taylor suggested, which he basically pulled out of, um, thin air, are sacrosanct.
Surely this is silly. ...

Krugman is not making the argument that the nature of the friction has changed and therefore the optimal rule should change as well. That's my argument so blame me, not him. But the idea that the Taylor rule should have "sacred status" is "silly," and I don't understand why Taylor and others insist that the coefficients of the rule -- let alone the rule itself -- are optimal always and everywhere (there may be a robustness argument -- this is the best possible rule in the face of model uncertainty -- but that's not the argument being made).

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