The foolproof way of escaping from a liquidity trap: Is it really, and can it help Japan?
The Frank D. Graham Memorial Lecture, Princeton University, April, 2001
Lars E.O. Svensson
Japan has already lost a decade to economic stagnation and deflation. With continued bad policy, it may lose another. The zero-interest-rate policy implemented from February 1999 to August 2000, and again from last March, via the “quantitative easing”, is not sufficiently expansionary to induce a recovery. With expectations of deflation, the real interest rate remains positive. But the zero interest rate need not be the limit for monetary expansion. Indeed, there is a foolproof way to jump-start the Japanese economy. (For details, see Lars E.O. Svensson, “The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,” Monetary and Economic Studies 19(S-1), February 2001, Bank of Japan, p. 277-312 (also available at the homepage above).) The Bank of Japan (in charge of monetary policy) and the Ministry of Finance (in charge of exchange rate policy) should cooperate to replace stagnation and deflation by growth and low inflation.
The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved, (2) a depreciation and a temporary peg of the yen, and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. Then, the BOJ and the MOF just have to behave accordingly.
The price-level target path provides the best nominal anchor and also an exit strategy for the temporary peg. It should start above the current price level, by the “price gap” to be undone. Several years of zero or negative deflation has resulted in a price level below previous expectations, increased the real value of debt and contributed to deteriorating balance sheets for firms and banks. The price gap may be 10-20 percent or more. The upward slope corresponds to a small positive inflation target, 1 or 2 %/yr, say.
How to achieve the price-level target? This is the role of the depreciation and the temporary peg. First, a depreciation and temporary peg of the yen is technically feasible. If the peg would fail, the yen would appreciate back to where it were, making it a good investment. Thus, initially there will be excess demand for yen. This is easily fulfilled, though, since the BOJ can print unlimited amounts of yen and sell those for foreign exchange. Indeed, there is a big difference between defending a fixed exchange rate for a strong currency under appreciation pressure (when FX reserves rise) and for a weak currency under depreciation pressure (when FX reserves fall). Thus, the peg can be maintained, and after a day or a few, the peg’s credibility will have been established.
Second, the initial depreciation of the yen should be so large that it results in a real depreciation relative to any conceivable long-run equilibrium real exchange rate. This may require a peg at 140 or 150 yen to the dollar, or even more. Then the future must eventually bring a real appreciation. Thus, the market and the general public must expect a future real appreciation. But with an exchange rate peg, the real appreciation can only occur with a rise in the domestic price level. Hence, by pure logic, once the credibility of the exchange rate peg has been established above, the market and the general public must expect future inflation in Japan. Thus, gloomy deflation expectations will be replaced by optimistic inflation expectations.
Third, the expected future real appreciation of the yen will induce a desirable fall in the long real interest rate in Japan. Indeed, equilibrium on the international capital market requires that the expected real return on investment in Japan and the rest of the world (including expected real exchange rate movements) move approximately in parallel. This fall in the long real rate in Japan can also be seen as the result of the increased inflation expectations noted above.
All this will jump-start the Japanese economy and increase output and the price level. First, the real depreciation will stimulate Japanese export and import-competing sectors. Second, the lower long real interest rate will stimulate Japanese consumption and investment. Aggregate demand and output will rise. Third, the real depreciation, the increased aggregate demand, and the increased inflation expectations will all contribute to inflation and an increasing price level.
The price level will approach the price-level target path from below. When the price-level target has been reached, the peg should be abandoned, the yen floated, and the BOJ should adopt explicit inflation targeting.
The foolproof way can be followed unilaterally by Japan, without cooperation from countries in the region or from the US. Objecting to a real depreciation of the yen is wrong. Expansion in Japan requires a lower real interest rate, and a real depreciation is the mirror image of a lower real interest rate. A real depreciation means that Japanese exporters get a short-term competitive edge, but growth in Japan and increased aggregate demand will increase Japan’s import from the rest of the world. This is therefore not a beggar-thy-neighbor policy. In the medium and long run, the region, the US, and the world will gain from an expansion in Japan.
Other proposals for Japan have focused on introducing inflation targeting and/or depreciating the yen. The foolproof way is consistent with these, but provides better benchmarks, in the form of a peg for the yen, a price-level target path, and an exit strategy for the peg. The peg also provides an arena where the BOJ and the MOF can quickly demonstrate their resolve to end stagnation and deflation and thereby gain credibility.
Finally, the foolproof way does not at all reduce the urgent need for structural reform and a clean-up of the financial sector in Japan.