May 28, 1998

It sounds like an idea from the Groucho Marx school of monetary policy Japan's central bank should flood the economy with cash, and solemnly swear to Japanese consumers that it will keep the printing presses cranked up even if signs of inflation emerge. In short, it should "promise to be irresponsible."

Tokyo's policymakers have tried a number of silly ideas over the past seven years, but even they haven't thought of anything so completely off the wall as this. The credit goes to Paul Krugman, the economics professor at the Massachusetts Institute of Technology who earned notoriety for his 1994 article calling Asia's economic miracle a myth.

Krugman has taken pains to point out that he never predicted last year's Asian crash; his argument merely suggested that the growth rate in Asia's tiger economies would gradually slow over time. But his reputation as a pundit on the region has grown, and he is now turning his attention to Japan with an article called "Japan's Trap," published in early May on his Internet home page.

Japan has already tried pulling its principal monetary lever--interest rates--with little success. Since September 1995 the Bank of Japan has kept its discount rate at a record low of 0.5%. Now officials at the central bank are suggesting that an even further cut could be in the works, although they decided not to act at a policy meeting on May 19. But with the rate so close to zero already, a new cut probably wouldn't have much effect.

To economists, the failure of super-low interest rates to boost Japan out of recession is a tell-tale sign of a "liquidity trap," a theoretical possibility first noted by John Maynard Keynes. This can happen, Krugman says, when people expect their country's total production to decline over the long term--as many Japanese do. Consumers then hang on to their yen, fearing a decline in future income. They try to save and avoid borrowing even if the interest rate is zero.

The solution, says Krugman, is for the central bank to fan the flames of inflation. If Japanese expect prices to rise sharply, they would rush to borrow and spend ahead of the price hikes, and Japanese factories could rev up for full production. That would put paid to the recession--or so the theory goes.

Already, the Bank of Japan has been increasing the supply of cash in circulation, which normally would encourage inflation. As of May 10, banknotes worth ¥47.5 trillion ($350 billion) were in circulation, up 11.4% from a year earlier. But market players generally interpret that rise as a one-time response to the failure last November of Yamaichi Securities and other financial institutions. The bank may have pumped in liquidity to prevent more failures, according to the consensus view, but it won't keep doing so.

That perception is the nub of the problem, Krugman believes. "Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise," he writes. "The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible--to make a persuasive case that it will permit inflation to occur."

It's a clever idea--but a dangerous one too, in the view of some economists. Krugman "is completely mistaken," says Takatoshi Ito, an economics professor at Hitotsubashi University. "The central bank's credibility will plunge over the long term, and that's not desirable." Ito agrees Japan is in a liquidity trap, but like many other economists he thinks a tax cut and measures to get land transactions moving are the key to stimulating the demand that would drive an economic recovery. "We need to make these steps the kick-off to structural reform," he says.

Krugman concedes that structural reform--in particular, cleaning up Japan's banking mess--might stimulate demand by making banks eager again to lend money. But he says other reforms, while they would increase productivity, might not do much to address the core issue consumer pessimism about the future. "Measures that raise Japan's supply capacity but leave demand where it is will not help the situation; indeed, if unemployment rises as a result of increased efficiency the country might actually be worse off," he writes.

Is there any chance the Bank of Japan will adopt Krugman's idea? Masaru Hayami, the courtly 72-year-old central-bank governor, is hardly the type to make a public declaration of irresponsibility. But quietly, the central bank may already be leaning in the direction Krugman indicates. Jeffrey Young, chief economist at Salomon Smith Barney in Tokyo, thinks it's likely that the Bank of Japan will soon carry out a "sustained, permanent injection" of money into the economy. And the bank was quiet when the yen dropped on May 18 below 136 to the U.S. dollar, its lowest level since 1991. A weaker currency would increase import prices and thus counteract deflation.

Even if printing more money works in the short term, it wouldn't change Japan's need for basic reforms such as deregulation and an end to wasteful public-works projects. But a growth spurt resulting from renewed demand and fuller use of Japan's productive capacity could buy the country some time for changes. And if Japan's central bankers are lucky, they won't have to look like Groucho Marxists to make it happen.