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Overcoming Japan’s Liquidity TrapTanweer Akram, PhD

13th International Post Keynesian Conference, Sep 15-18, 2016, Kansas City, MO, USA

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IMPORTANT DISCLAIMER AND DISCLOSURE• Disclaimer: The author’s institutional affiliation is provided solely for

identification purposes. Views expressed are solely those of the author and the standard disclaimer applies. The views are not necessarily those of Thrivent Financial, Thrivent Investment Management, or any affiliates. This is for information purposes only and should not be construed as an offer to buy or sell any investment product or service.

• Disclosure: Tanweer Akram’s employer, Thrivent Financial, invests in a wide range of securities. Asset management services are provided by Thrivent Asset Management, LLC, a wholly owned subsidiary of Thrivent Financial for Lutherans.

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MOTIVATION AND MAIN POINTS

• Japan has experienced economic stagnation, deflation, and low interest rates for more than two decades. The Japanese economy appears to be in a liquidity trap, a condition in which an economy fails to rebound and lending and borrowing remain tepid despite low interest rates.

• How can Japan overcome its liquidity trap? Though necessary proposals along the spirit of Bernanke and/or Krugman are not enough. “Credible” commitment to low interest rates, even negative rates, and quantitative easing may not be sufficient to restore prosperity and decent growth. Bernanke and Krugman type policies might indeed be very useful to stabilize the financial system and keep government bond yields low or even target long-term interest rates.

• Overcoming liquidity trap requires Keynesian 2.016+ strategies.

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KEYNESIAN 2.016+ POLICIES

• First, the Japanese authorities need to institute Keynesian policies of

support effective demand through increased public spending in infrastructure and human capital, and direct job creation, keep taxes low instead of ferreting over fiscal sustainability, and raise real incomes of the majority of the population.

• Second, Japan also needs Schumpterian policies of creative destruction to promote entry/exit of firms, innovation, and the collaboration of the public sector, universities, and private firms in R&D to raise labor productivity and to create new technology, products, processes, and services.

• Third, Japan needs to encourage selective immigration and take other measures to increase population growth. At the same time the authorities should try to raise labor force participation rates for women and senior citizens.

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DISAPPOINTING GROWTH FOR MORE THAN TWO DECADES!

Japan, Real GDP growth

%

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

1985 1990 1995 2000 2005 2010 2015

Japan, Gross Domestic Product, Total (Excluding FISIM), Constant Prices, SA, AR, JPY [c.o.p. 1 year]

Source: Macrobond

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THE COUNTRY HAS EXPERIENCED PERSISTENT DEFLATION

Index

90.0

92.5

95.0

97.5

100.0

102.5

105.0

107.5

110.0

112.5

19941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016

GDP (Expenditure Approach) Domestic Demand

Source: Macrobond

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NOMINAL GDP HAS BEEN STAGNANT

Japan, Nominal Gross Domestic Product

Current Prices, AR, SA

JPY, tr

illion

200

250

300

350

400

450

500

550

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Japan, Gross Domestic Product, Total, Current Prices, SA, AR, JPY

Source: Macrobond

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LOW PRODUCTIVITY GROWH AND SLOW LABOR FORCE GROWTH ARE THE UNDERLYING CAUSES OF THE COUNTRY’S SLOW GROWTH

USA JPN USA JPN USA JPN1980-1989 3.7 4.4 2.0 1.1 1.7 3.31990-1999 3.4 1.1 1.5 0.3 1.9 0.82000-2009 2.0 0.9 0.7 0.0 1.3 0.92010-2014 2.1 0.9 1.3 0.2 0.8 0.7

Real GDP Growth (%)

Employed Labor Force Growth (%)

Labor Productivity Growth (%)

Sources: Macrobond; Author's calculations

Trend Growth in Real GDP, Employed Labor Force, & Labor Productivity

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FROM 128MM JAPANESE PEOPLE IN 2010 TO JUST 107MM IN 2050

Japan, Midyear Population, U.S. Census Bureau

%, m

illion

80

85

90

95

100

105

110

115

120

125

130

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050Source: Macrobond

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THE LABOR FORCE (15-64 YRS) HAS BEEN SHRINKING SINCE 2000

Japan, Labor Force, Total

No. o

f Pers

ons,

millio

n

56

57

58

59

60

61

62

63

64

65

66

67

68

69

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014Source: Macrobond

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CONSUMPTION GROWTH HAS BEEN WEAK. RAISING SALES TAXES DO NOT HELP!

Japan,, Private consumption total, Constant Prices, SA, Index, 2005=100

Index

85

90

95

100

105

110

115

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Macrobond

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CORE CPI HAS BEEN WEAK IN TANDEM WITH WEAK WAGES

Japan, Employees' Cash Earnings and Core CPI

Smoothed

%, y/

y, 12-m

o MA

-4

-3

-2

-1

0

1

2

3

4

5

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Core CPI Cash Earnings

Source: Macrobond

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INVESTMENT REMAINS SOFT: PUBLIC SECTOR WEAK, PRIVATE SECTOR FLAT

JPN Real Private & Real Public Gross Fixed Capital Formation

JPY, tril

lion

0

10

20

30

40

50

60

70

80

90

100

110

1980 1985 1990 1995 2000 2005 2010 2015

Real Public Gross Capital Formation Real Private Gross Fixed Capital Formation

Source: Macrobond

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FROM ULTRA LOW INTEREST RATES TO NEGATIVE INTEREST RATES

Japanese Government Bonds (JGB), Bid, Yield

%

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

2 Year 5 Year 10 Year

Source: Macrobond

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WHAT IS A LIQUIDITY TRAP?

• An economic condition which arises when, despite low interest rates, investors prefer to hold money (cash) rather than invest in the expansion of gross fixed capital. As a result monetary policy becomes ineffective in boosting the nation’s productive capacity (equipment, software/intellectual property, and structures). Low interest rates fails to induce borrowing/lending.

• Due to increased uncertainty, investors prefer to hold money (cash) rather than bonds and riskier securities.

• Doesn’t this sound like Japan in the past two decades?

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THE BOJ BALANCE SHEET IS BLOATEDJapan BOJ Total Assets and JGB Holdings

JPY, tril

lion

50

100

150

200

250

300

350

400

450

500

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

JGBs BOJ Total Assets

Source: Macrobond

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THE BOJ’S DECISION IN JAN 2016: NEGATIVE POLICY RATES!• Pay 10bps on excess reserves created to date under QE. • Pay zero interest rates on reserves held under minimum

reserves, reserves corresponding to BOJ funding for lending scheme(s), and various other balances.

• Charge 10bp interest on the remaining reserves (negative interest rate). The BOJ stated that “it will cut the interest rate further into negative territory if judged as necessary.”

• Regarding asset purchases, the BOJ reiterated that it “will not set a lower bound for yields on its JGB purchases”.

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KRUGMAN’S AND BERNANKE’S SOLUTIONS TO JAPAN’S LIQUIDITY TRAP

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KRUGMAN AND BERNANKE SEE “EASY MONEY” AS THE SOLUTION• Krugman (1998a and 1998b) and Bernanke (2000 and 2002).• Credible commitment to a continuous increase in the money supply and the

expansion of the central bank’s balance sheet. This will increase the public’s inflation expectation. [when??? Isn’t this like the quantity theory? But central bank balance sheet expansion does not necessarily lead to credit expansion by banks and financial institutions].

• The key assumption is that monetary accommodation will lead to higher inflationary expectations. Higher inflationary expectations will mean that real interest rate will be low.

• Their view is that lowering the nominal interest rate as low as possible will induce investment. [But where is the evidence???].

• But if the nominal interest rate cannot be reduced below some “lower bound” then the central bank ought to engage in the purchase of long duration assets and reduce long-term interest rates. [It is true that central bank can control interest rates and buy anything as long as it is permitted by law]. The wealth effect due to higher asset prices can boost consumer spending. [okay, but what’s the evidence for Japan???]

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BERNANKE/KRUGMAN PROPOSALS: THE OLD WINE OF QTM?• MV = PQ

• (This really is a strange idea but a quite popular view. Alas!)• Is this the old wine of the Quantity Theory of Money?• However, there is no reason to think that an increase the central

bank’s balance sheet can lead to an increase in banks’ loans and financial institutions’ lending to the real economy and that firms will boost investment just because the central bank is expanding its balance sheet, lowering the policy rate or other rates, and/or purchasing assorted financial assets.

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KRUGMAN & BERNANKE: I. FISHER, A.C. PIGOU AND M. FRIEDMAN• Ultimately,

Krugman’s and Bernanke’s proposals are based on the ideas of Fisher, Pigou, and Friedman and indeed even partly on Keynes’s (1930) Treatise on Money!

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JOAN ROBINSON ON THE QUANTITY THEORY OF MONEY

• “No one who understand the rules of logic ever expected a truism, such as MV=PT, to tell us anything that we do not know without it, but in inexpert hands the Quantity Equation can lead to great confusion.  … First, it leads people to discuss changes of prices without making the vital distinction between a change due to a change on the side of demand,  … and a change of price due to a change on the side of supply … .Second, it leads people to attribute some kind of direct influence upon prices to change in the quantity of money, so that some writers seem to suggest that bank-notes have feet, and run into shops and bid up prices as soon as they are printed.”  [Joan Robinson 1969 edition, p.77]. (emphasis added).

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LOW INTEREST RATES AND LIQUIDITY TRAP

• Keynes (1936) held that “if investor expect interest rate to rise more than the square of the current interest rate they would prefer to hold money instead of bond because of capital loss” and “the lower the rate of interest, the more likely that liquidity trap will be sprung, since the longer it takes to recoup the capital loss through higher interest rates earnings and thus the higher the probability there will be a reversal in interest rates.” (Kregel 2000)

• Intuition: The lower the rate of interest the higher the duration of a bond. This means it takes more time to recover the capital loss of an interest rate rise to be offset from reinvestment earnings due to the rise in the interest rate. So investors hold cash rather than bonds, prefer liquidity over riskier assets and investments.

• Liquidity trap arises from fundamental uncertainty and generalized pessimism about the prospects of returns to capital and even capitalism.

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HOWEVER INVESTMENT DEPENDS NOT JUST ON THE INTEREST RATE• where is the expected rate of profit, is the interest rate.• where the expected rate of profit depends on expected sales (effective

demand).• If the expected profits and expected sales are poor, if the outlook is not good

and uncertain, businesses and investors will not expand capacity. “Animal spirits” won’t return even if interest rates are low (or even negative).

• When but . • Policymakers can take various measures to restore animals spirits. A

combination of pubic spending in infrastructure and human capital, direct public sector employment, no tax hikes and a favorable tax regime can enhance effective demand and restore animal spirits.

• Policymakers should be willing to experiment to see what works!

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KEYNES, SCHUMPETER, AND HAYEK

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KEYNESIAN POLICIES 2.016+ = KEYNES 1.936 + SCHUMPETER 1.934• Keynesian policies: Fiscal policy and monetary policy must

be accommodative. These policies are necessary prerequisites to overcome cyclical weakness. It is a not a good idea to raise taxes in the name of fiscal sustainability. The authorities should aim to restore real and nominal wage growth.

• Schumpeterian policies: Structural reforms to foster higher productivity growth are also important. The authorities should promote collaboration among public sector, universities, and firms for R&D. The government should supports innovation in the public sector, enable industrial transformation, and develop human capital and capabilities.

• Keynesian policies aimed at full employment make creative destruction palatable, encourage firms to take risks, and ensure effective demand.

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JAPAN STILL HAS PLENTY OF SCOPE TO RAISE PRODUCTIVITY

USA and JPN Labor Productivity per Hour Worked (2013 PPP Dollars)

PPP D

ollar

0

10

20

30

40

50

60

70

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Germany Japan United States

Source: Macrobond

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DEMOGRAPHICS

• What does unfavorable demographics imply? • A shrinking labor force will lead to supply constraints and

weaker aggregate demand. With a shrinking labor force, labor productivity growth is absolutely essential for maintaining and improving Japan’s per capita real income.

• Japan needs to become more open to immigration. Immigrants will increase the amount of available labor. First generation immigrants also tend to have higher birth rate. It can also increase demand for goods, services, and housing. This is by no means easy in Japan given the closed nature of the society and historical experience.

• Policymakers should encourage higher labor force participation rate among women and senior citizens. Better childcare and paternity benefits may increase fertility rate slightly.