TCS Daily

The Statism Trap

By Arnold Kling - May 28, 2003 12:00 AM

"...being a modern country, Japan has not allowed its banks to fail."
--Paul Krugman, Sept. 30, 2001

"The Japanese Government agreed at the weekend to use taxpayers' money to shore up the nation's fifth-biggest bank after executives said its capital had fallen below legally required levels."
--Associated Press, May 18, 2003

Paul Krugman believes that the Japanese experience has lessons for the United States. I would agree, except that Krugman has learned the wrong lessons. He thinks that the bank bailouts are a good thing, that Japan's problem is a "liquidity trap," and that the U.S. also could fall into a liquidity trap.

In my view, Japan's bank bailouts are a policy mistake, the liquidity trap is irrelevant, and Japan's trap is its statist economic model. I hope that the United States can avoid falling into the statism trap.

What Liquidity Trap?

Theoretically, there is a point at which interest rates are so low that they cannot go any lower. That lower bound is around zero, because would-be lenders would hold cash rather than lend money at a negative interest rate. At that point, the monetary authority would appear to be helpless. Injecting additional money will not reduce interest rates, and therefore it will not stimulate the economy. That is what Keynes called the liquidity trap.

Krugman is prepared to argue that the United States today is in a liquidity trap, because the overnight lending rate that the Federal Reserve manipulates is close to one percent, which is dangerously close to zero. Recently he wrote, "those of us who worry about a Japanese-style quagmire find the global picture pretty scary."

However, in the real world, as opposed to economics textbooks, there is more than one interest rate. Most interest rates in the U.S. economy are far from zero. For example, the ten-year Treasury yield is 3.3 percent. Accordingly, I am not persuaded that we are in a liquidity trap. On the other hand, I do believe that in an elastic economy the key interest rates are not necessarily subject to Fed influence.

Long-term interest rates in Japan are below one percent. But otherwise, Japan does not behave much like a country in a liquidity trap. In a liquidity trap, the loss of effectiveness of monetary policy is mirrored by increased effectiveness of fiscal policy. You can run big budget deficits in a liquidity trap without raising interest rates, so that Keynesian stimulus should be really effective. That has not been the case in Japan. In Japan, both fiscal and monetary stimulus have been ineffective.

Japan's Statism Trap

There are many conceivable explanations for Japan's economic woes. For example, as Australia's Ken Henry succinctly pointed out, the aging of Japan's population was bound to reduce its growth rate. There is even a case to be made that Japan suffers from another Keynesian malady, the "paradox of thrift," in which increases in saving fail to add to investment and instead stall the economy.

However, I think that the most convincing overall explanation for Japan's long decline is that its centralized, bureaucratic industrial policy ran out of steam. Brink Lindsey, in his book Against the Dead Hand, writes that even at its peak, Japan was a "deformed 'dual economy' - a vibrant and dynamic international sector that all the world envied and feared, and a much larger, but largely stagnant, domestic sector that the world all but ignored."

It is misleading to evaluate statism on the basis of the government's ability to produce winners. In fact, I think history shows that it is possible for states to fund successful enterprises. On the other hand, where statism falls apart is in its inability to cut its losses when the government makes a bad bet. The difference with the private sector is that the government is almost totally incapable of winnowing out losers. In the long run, heavy government involvement inevitably leads to suffocation, as "zombie" businesses backed by the government suck all of the oxygen out of the economy. That is what Japan has been experiencing for the past decade.

In his analysis of the sources of economic under-performance around the world, Edward Prestott found that much of the problem in Japan comes from inefficient use of inputs. His measure of "total factor productivity" shows a large shortfall relative to the U.S., with a notable decline in recent years. He points a finger at Japan's state-controlled financial sector.
"The candidate mechanism by which centralized financial systems adversely affect productivity is as follows. Inefficient producers are subsidized in order to preserve jobs. This has the perverse effect of lowering productivity and decreasing overall employment in the economy. Japan is [a] depressed country with a highly centralized financial system controlled by the state. Perhaps this accounts for the 17 percent decline in its productivity factor in the 1991-2000 period."

About Those Banks...

In Krugman's demand-oriented analysis of Japan's economy, propping up the banks, which in turn prop up zombie enterprises, has been a positive factor. Other economists, presumably including Prescott, would view the ongoing bank bailouts as part of the problem rather than part of the solution.

It is true that when banks are fundamentally solvent but temporarily illiquid, it can be helpful for the government to step in and prevent a bank "run." Deposit insurance performs this function automatically.

However, it is not true that banks should not be allowed to fail. What the Japanese government has done has amounted to trying to cover up and paper over that country's version of our corporate accounting scandals or the 1980s savings and loan crisis. Instead of writing off bad assets and re-allocating capital to efficient uses, the Japanese have effectively remained in denial about bad loans, so that they kept pouring their abundant savings into bankrupt companies and insolvent banks.

The U.S. and Japan

Krugman's story of the liquidity trap is meant to suggest that the United States could end up like Japan. However, in my view our economy will not fall into a Depression because of price deflation, a liquidity trap, or any other demand-side bogeyman. What we have today is an economy whose capacity is growing very rapidly, because of high productivity growth, with demand failing to keep up. I am persuaded that this calls for more fiscal and monetary stimulus, but I don't think we ought to confuse this with a Depression.

If we should worry about becoming like Japan, that is because we cannot be completely confident that we will be able to stay off the road to statism. There are plenty of politicians who believe that we "need" a crash program on energy, a national broadband initiative, and/or single-payer health insurance. Even without such programs, we may slide toward statism if we fail to phase out Medicare.

I hope we remain a capitalist country. If nothing else, I think it would be desirable to maintain diversity.

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