Japan’s Hopeful Experiment

I’ve made it clear that I very much approve of Japan’s new monetary aggressiveness. But I gather that some readers are confused — haven’t I been arguing that monetary policy is ineffective in a liquidity trap?

The brief answer is that current policy is ineffective, but that you can still get traction if you can change investors’ beliefs about expected future monetary policy — which was the moral of a paper I wrote on Japan, lo these 15 years ago. But I thought it might be worthwhile to go over this again.

So, at this point the United States and Japan (and Europe) are all in liquidity traps: private demand is so weak that even with short-term interest rates at zero, spending falls far short of what would be needed for full employment. And interest rates can’t go below zero (except trivially, for very short periods), because investors always have the option of simply holding cash. Incidentally, this isn’t just a hypothetical: there has been a surge in currency holding, although a lot of it is $100 bills held overseas.

Under these circumstances, normal monetary policy, which takes the form of open-market operations in which the central bank buys short-term debt with money it creates out of thin air, has no effect. Why?

Well, the reason open-market operations usually work is that people are making a tradeoff between yield and liquidity — they hold money, which offers no interest, for the liquidity but limit their holdings because they pay a price in lost earnings.

So if the central bank puts more money out there, people are holding more than they want; as they try to offload it, they drive rates down in the process.

But if rates are zero, there is no cost to liquidity, and people are basically saturated with it; they’re holding money simply as a store of value. And a central-bank operation that swaps money for debt basically changes nothing. Ordinary monetary policy is ineffective. The flip side of this, by the way, is that all those fears about how “printing money” in this slump would lead to runaway inflation were predictably wrong.

If you paid attention to the Japanese story from the last decade, you knew that simply expanding the central bank’s balance sheet did little, and certainly wasn’t inflationary. Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be.

And while investors shouldn’t care about what the central bank does now, they should care about what it will do in the future. If investors believe that the central bank will keep the pedal to the metal even as the economy begins to recover, this will imply higher inflation than if it hikes rates at the first hint of good news — and higher expected inflation means a lower real interest rate, and therefore a stronger economy.

So the central bank can still get traction if it can change expectations about future policy.

The trouble is that central bankers have a credibility problem — one that’s the opposite of the traditional concern that they might print too much money.

Instead, the concern is that at the first sign of good news they’ll revert to type, snatching away the punch bowl.

The Bank of Japan did just that in the 2000s. The hope now is that things have changed enough at the Bank of Japan that this time it can, as I put it all those years ago, “credibly promise to be irresponsible.”

And that’s why I’m bullish on the Japanese experiment, even though current monetary policy has little effect.