Thursday, July 16, 2015

Explaining the Japan Syndrome: Quantitative Easing, Slow Growth, and Low Inflation

When Japan's post-Plaza Accord bubble economy popped in 1991 its government applied conventional Keynesian remedies, including low interest rates and big government deficits. All the experts were shocked when the economy failed to revive smartly from the crash, and even more surprised when "quantitative easing" also failed to revive the economy and ignite inflation.

The problem couldn't be Keynesian economics, so it had to be that Japan was a special case. But after the crash of the 2000s real estate bubble in the US and Europe the same thing happened. Interest rates were reset to zero, as in ZIRP, quantitative easing was implemented to flood the world with money, and growth was pitiful. So What Went Wrong?

In a recent paper "Understanding Benign Liquidity Traps: The Case of Japan(pdf)", Stefan Homburg of Leibniz University, Hannover, Germany, runs a couple of computer models and comes up with an answer.

The reason that Keynesian economics didn't work is because of "credit constraints" that prevented corporations from issuing as much debt as they might have wanted. And then meant less growth and lower prices. At least, Homburg's models can repeat the Japan experience if you assume that some sort of credit constraint applies.

But what sort of credit constraint? After all, the whole point of Keynesian expansionism is to take the safety valves off the economy and let her rip. Homburg cites the following possibilities:

  • Lack of collateral and declining land values.
  • Direct financial regulation, e.g., Basel Accords.
  • Unanticipated consequences of financial regulation.
We saw that in the United States mortgage borrowing cratered after the crash because so many people were underwater on their mortgages.

The first round of the Basel rules were applied in the early 1990s. The idea was to constrain bank lending to avoid bank failures. Some people might say that bankers know how to run their businesses better than professors and international bureaucrats.

I suppose you could say that in the aftermath of a crash the politicians and the bureaucrats rush to "do something" and typically that something is to impose tough new financial regulations at the very time that savvy investors like Mr. Potter are buying up bankrupt Bailey Building and Loans.

In other words it is during the post-crash period that credit standards should be relaxed, and then gradually resumed as the economy improves and animal spirits start to revive. But in the US we implemented Dodd-Frank and its evil twin the Consumer Financial Protection Bureau to bury the financial system in regulation and paperwork.

There is another explanation, and that is that the the government's first priority is the financing of its debt. Low interest rates and credit constraints actually help the government in the post-crash period since it keeps the government's interest cost down and allows it to continue to reward its supporters without interruption. So it is possible that the "lost decade" in Japan and the slow Obama recovery are not a bug but a feature within the halls of the ruling class. After all, there hasn't been a revolution or riots in the streets. So what if the people are suffering under low growth! They don't seem unhappy enough to change their ruling class.

Greece, on the other hand...

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