The Bank of Japan (BOJ) is the Japanese equivalent to America's central bank, The Federal Reserve (The Fed). Basically, it's their bankers' banker. So when the BOJ says it can't fight deflation anymore, that means the Japanese people are now at the mercy of Japanese government efforts to do that fighting for them:
A Japanese government official who attends Bank of Japan policy board meetings said the central bank has provided adequate stimulus and it’s the "government’s turn" to try boosting demand.
"The BOJ has pretty much done everything it can do," Takashi Wada, a parliamentary secretary at the Cabinet Office and a ruling party member, said in an interview in Tokyo on Dec. 22. "It’ll probably be hard for the Bank of Japan to find more effective policy tools. So, it will be the government’s turn to make more of an effort with policy steps."
Monetary Policy is what central bankers like the BOJ and the Fed do. Manipulating money supply is their reason for being, and it's the essence of how supply-side economics work. Here, the philosophy is dominated by Friedman.
Fiscal Policy is what governments do. It combines spending and taxation, and it's the essence of how demand-side economics work. Here, the philosophy is dominated by Keynes.
Japan has been fighting the monster of liquidity-trap deflation (a hallmark of depression) since the early 1990's:
The Lost Decade is the time after the Japanese asset price bubble's collapse within the Japanese economy, which occurred gradually rather than catastrophically. The strong economic growth of the 1980s ended abruptly at the start of the 1990s. In the late 1980s, abnormalities within the Japanese economic system had fueled a massive wave of speculation by Japanese companies, banks and securities companies. A combination of exceptionally high land values and exceptionally low interest rates briefly led to a position in which credit was both easily available and extremely cheap. This led to massive borrowing, the proceeds of which were invested mostly in domestic and foreign stocks and securities.
Recognizing that this bubble was unsustainable, the Finance Ministry sharply raised interest rates in late 1989. This abruptly terminated the bubble, leading to a massive crash in the stock market. It also led to a debt crisis; a large proportion of the debts that had been run up turned bad, which in turn led to a crisis in the banking sector, with many banks being bailed out by the government.
Michael Schuman of Time Magazine noted that banks kept injecting new funds into unprofitable "zombie firms" to keep them afloat, arguing that they were too big to fail. However, most of these companies were too debt-ridden to do much more than survive on further bailouts, which led to an economist describing Japan as a "loser's paradise." Eventually, many became unsustainable, and a wave of consolidation took place, resulting in only four national banks in Japan.
Sound familiar? Speculative investment bubbles in stock markets and real estate, followed by crashes, followed by too-big-to-fail bank bailouts.
The Bank of Japan began increasing interest rates in 1990 due in part to concerns over the bubble and in 1991 land and stock prices began a steep decline, within a few years reaching 60% below their peak. In response, Japanese policymakers tried a series of government stimulus programs and bank bailouts. A 2.4% budget surplus in 1991 turned to a deficit of 4.3% by 1996 and 10% by 1998, with the national debt to GDP ratio reaching 100%. In 1998, a $500 billion bank rescue plan was implemented to encourage bank lending and borrowing. The central bank also attempted to increase inflation (which devalues savings over time), to encourage consumer spending. Krugman wrote that by 2003, the Japanese economy began to recover, helped by imports from the U.S. and China that helped Japan achieve a real growth rate of 2%. He wrote the recovery was "provisional" and there was significant risk of a return to a liquidity trap.
Total GDP = domestic spending by Consumers, Businesses, Foreigners, Government
In the mid-to-late 2000's in Japan, spending by consumers, businesses, and government was largely flat, so whatever sustained Japan came from foreign investment and net exports. With the growth of supply of consumer goods for export from emerging Asian markets, net exports from Japan have steadily declined in recent years, reigniting Japanese liquidity-trap deflation fears as posited by Krugman and others:
Irwin Kellner manages to get all scared about inflation in the face of a deflationary environment. To do this, he has to come up with a novel theory: that the prices that matter are those of things we buy frequently, as opposed to big-ticket items bought less frequently. And the reason for this is ...???
Why care about Kellner? Because he represents a significant body of opinion, which is basically worried because of the expansion of the monetary base. Yet both logic and experience show that when you’re in a liquidity trap, big rises in the monetary base aren’t inflationary — in fact, they can be virtually irrelevant.
Which brings me to a very insightful talk by Adam Posen, my favorite Japan expert (and now on the policy board of the Bank of England). There’s a lot in this talk, but let me just focus on one issue: the effects of Japan’s "quantitative easing" policy, which involved pushing up the monetary base in the hope of getting some traction.
Base money was expanded at very high rates for about 3 years. Deflation just kept on going. Actually, this has a moral beyond not to worry about inflation. It’s also a reminder that it’s hard to make monetary policy effective in a liquidity trap.
So Japan tapped out its Fiscal Policy a few years ago, and now its Montary Policy is failing it, too. And yet, deflation continues. Why is deflation bad?
There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.
So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.
And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.
A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago, debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.
Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.
In short, liquidity-trap deflation is insidious, infectious, and intransigent. It's a pit, and Japan is back in it. America was in the same pit in the 1930's, and we got out of it only when that massive government spending program known as WWII got us out of it.
Fiscal Policy writ large is what got us out of it, followed by the Fiscal Policy known as the Marshall Plan that got Europe out of theirs after the war, followed by Fiscal Policy in Japan started their economic miracle.
Megan McArdle asks: Will the U.S. Be Jealous of Japan's 'Lost Decade'?
It is, of course, possible that there was some way that Obama could have made the stimulus popular enough that Olympia Snowe, et al. would have gone along. But Paul Krugman hasn't really outlined anything more convincing than "Tell them it's a good idea, dammit!!!"
Given those political constraints, you need to accept that US policy is never going to be made by Paul Krugman, or perfectly enlightened politicians operating seamlessly within one of Krugman's models. I can't see how we were ever going to get even to the relatively modest figure (almost double) that Krugman wanted, much less a stimulus figure that would have pushed us closer to full employment. The bond markets might have revolted, and the voters certainly would have. If stimulus depends on near-perfect execution to work, then it's a bad idea and we should abandon it.
On the question of whether we'll envy Japan, I think we just don't know. Tyler Cowen suggests some reasons why things might be even worse than Krugman implies. On the other hand, one can argue that Japan's propensity for avoiding short-term pain meant they avoided a short, sharp crisis in exchange for a lengthy period of stagnation.
So far, we've been emulating Japan's experience, and now, their toolkit for escaping the pit is empty. Our own Fed's toolkit is almost empty, too, so Monetary Policy is almost over for us, and if you think Fiscal Policy in the form of increased government spending is coming, I point you to the recently-hailed austerity plans of Governor Chris Christie (Tea Party Republican-NJ) who canceled a multi-billion-dollar Hudson River tunnel project and Governors-elect Scott Walker (TPR-WI) and John Kasich (TPR-OH) who canceled their states High-Speed Rail projects, and recent efforts in Europe to foist Austerity upon Greece, and Ireland, with more small Euronations to follow soon, too.
American Monetary Policy is almost over, and Austerity will abort adequate Fiscal Policy. What will America's economic future look like without another FDR-style stimulus? Watch Japan... and learn.