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March 28, 2012

[SSJ: 7323] Re: Why Noda is pushing for a tax increase

From: Arthur Alexander
Date: 2012/03/28

A few comments by another economist:

Expectations: It was Paul Krugman in 1998 who re-awoke the idea of the liquidity trap at zero interest rates and the means for climbing out of the trap. ("It's
Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, 2:1998.) The basic idea was that expectations had to shift until people believed that prices would start to rise. The main issue was always how to change expectations. The BOJ at the time has a simple response: We can't do it, no one can do it, no one would believe us if we said otherwise.

Krugman called for very public commitment to high inflation for as long as it took, with concurrent increases in the monetary base. The main problem with this advice is that it was not credible; as soon as things turned around, the central bank would end its policy. Although no central bank took this particular advice, the role of central bank commitment in modifying expectations has been a lesson now learned.

The very difficult problem is what kind of policy can a central bank put into effect and how can it credibly commit itself to this policy such that it changes price expectations and prices. This problem has produced a number of PhD dissertations over the past 15 years.

We see the Fed and BOJ developing new ways of saying that they are in it until things turn around. As has been noted by others, simply pumping out money, by itself, is not very effective. However, when a long-term, believable commitment is added to the mix, there does seem to be an effect from quantitative easing.

To Ron Dore's idea of separating held-to-maturity assets from the others. Banks now do this on their balance sheets. However, the held-to-maturity bonds and other assets are only a small part of their holdings, about 3-5% in the megabanks. The rest are called "trading assets."

Arthur Alexander

Approved by ssjmod at 11:32 AM