Paul Krugman recently contested my argument that Japan is not stuck in any sort of deflationary trap. Ryan Avent already showed why Krugman doesn’t have much of an argument:
And…I’m genuinely mystified. The only thing I can think of that would square this circle is if Mr Krugman and I are using different definitions of the word “prefer”. As best I can tell, he has conclusively shown that Mr Sumner is right, and Japan hasn’t been in a deflationary trap. It just needs to fire all of its central bankers.
I’m not surprised that Krugman wants to claim the BOJ is stuck in a deflationary trap; he published the best model we have to explain why that might happen. But I’m afraid it didn’t happen, and although Avent’s post is pretty definitive, even he didn’t address all of the problems with Krugman’s argument.
Let’s start with his response to my admission that my view is the minority view:
He guesses right: that’s not at all the view of those who have been following Japanese monetary policy since the 1990s, and have even talked to BOJ people now and then.
So Bank of Japan officials are not publicly admitting to favoring mild deflation. Is that really surprising? And regarding “those who have been following Japanese monetary policy since the 1990s” (does that include me?), I was under the impression that many of them were highly critical of Japanese monetary policy for being too contractionary. That sort of criticism of the BOJ is hardly consistent with the view that the Japanese are “stuck” in some sort of deflationary trap.
As far as I can tell, the Fed has an implicit target of roughly 2%, maybe a bit less. The ECB is about the same, perhaps a bit lower. The BOJ has target of stable prices, which means zero inflation. I don’t know what inflation index they use, but their CPI has been amazingly stable since February 2002 (roughly when the QE started.) The CPI was 100.1 on February 2002, and is now 99.7. That’s a grand total of 0.4% deflation over a period of 8 years! Price stability just doesn’t get any better than that. Other that a few months in 2008, when oil prices soared, the Japanese CPI never moved more than 1% up or down from the February 2002 figure. (BTW, the Bullard study that I was commenting on looked at 2002-10 data.) If you don’t like my February 2002 starting point, the Japanese CPI has fallen by a grand total of 0.5% since June 1993, a period of 17 years. Not per year—total. So if the CPI is their target, then the Japanese just might be the most skilled central bank in all of world history. Who else has produced such absolute price stability!
Now I will admit that the core inflation rate shows a bit more deflation, but it’s still pretty close to price stability. (Eyeballing the graph in the Bullard paper, it looks like about 0.3%/year deflation since 2002.) So the BOJ really isn’t very far off target, even if you use the core rate. But let’s take the worst case, and assume the BOJ prefers stable prices to very slight deflation. I still think Krugman is wrong. And the reason is that the BOJ abhors positive inflation like a vampire fears sunlight. So when there is any sign of inflation, the BOJ immediately does something contractionary. They always err on the side of mild deflation, even if their first best choice is precisely zero inflation.
Krugman points to the large increase in the monetary base during the early 2000s, but skims over the big drop in 2006, indeed doesn’t even consider it to be that dramatic. I’d consider a drop of over 20% from peak to trough to be pretty dramatic, as far as I know it is larger than any monetary base drop experienced by the US in the past 100 years, including the Great Deflation of 1920-21. But let’s say Krugman’s right and that it’s no big deal; that still doesn’t explain why it occurred. The explanation seems obvious to me; the BOJ was terrified that after years of very mild core deflation, they might have 1% inflation. So they tightened monetary policy, just as you’d expect a central bank to do if it wasn’t “trapped.”
Krugman also argues that depreciating one’s currency is not as easy as it looks, and points to the Swiss case. First of all, I think we both agree that there is no technical barrier to depreciating a currency; the central bank can offer to sell unlimited amounts of its currency at a lower value than the current exchange rate. The risk Krugman refers to is that they might have to buy up a lot of assets, and then later sell them off to prevent an outbreak of inflation (with a risk of capital losses.) That’s a fair point, but it probably applies more to a small country whose currency is a popular safe haven, than to Japan. It’s hard for me to believe that the sort of monetary base increase required to depreciate the yen would expose the BOJ to unacceptable risk of capital loss. And if it did, it begs another question; if they don’t want a big and volatile monetary base, what the heck are they doing setting a zero inflation target? A two or three percent inflation target will result in a much lower monetary base to GDP ratio, and probably a more stable one as well.
So here is where we are:
1. The Japanese are supposedly stuck in a deflationary trap, even though their CPI has been amazingly close to their zero long run inflation target.
2. Even the core CPI shows only exceedingly mild deflation
3. Every time the rate of inflation threatened to break above zero, the BOJ tightens monetary policy.
4. It’s known that temporary currency injections are ineffective, but the BOJ nonetheless sharply reduced the base in 2006 only a few years after doing QE.
5. The BOJ refuses to set a 2% inflation target, like normal central banks.
How in the world is all that not consistent with a central bank that officially targets zero inflation, but would prefer a bit of deflation to a bit of inflation? And since absolutely perfect price stability is a practical impossibility, didn’t the BOJ get the mild deflation that they clearly prefer to mild inflation? So what precisely is the problem? Where is the policy failure? I just don’t see it.
Sometimes I think you need to stand back and look at how policymakers act, not what they say. For example, every time President Carter or President Clinton put out feelers about normalizing relations with Cuba, Castro would commit some outrage, to undercut the initiative. At some point don’t you have to ask yourself whether Castro really wants 100,000s of rich Cuban-American tourists flaunting their wealth, buying up hotels in Havana. How long would communism last if Castro couldn’t use the trade embargo as an excuse? (Which is precisely why an anti-communist like me has always been opposed to the embargo.)
My hunch is that if Krugman was sitting around a poker table with his former colleagues Svensson, Bernanke and Woodford, having a few beers, they wouldn’t be talking about how sorry they felt for the poor BOJ officials, unable to escape their quicksand-like deflationary trap. The only debate would be over whether they were incompetent buffoons or evil reactionaries. (I believe they are well-intentioned reactionaries.)
I’ll grant Krugman one very important point. He was one of the first to point to the conservative nature of modern central bankers, and how their strong desire to maintain a reputation as inflation fighters threatens to drive the world into deflation (or at least disinflation.) It looks like Krugman might have been right. But I’m not willing to grant them a sort of “central bankers will be central bankers” excuse. The world shouldn’t have to spend trillions on fiscal stimulus just because central bankers have made a fetish of stable prices.
Believe me, if you put 12 Paul Krugmans on the BOJ policymaking board, you’d get inflation.