Overcoming Japan’s Liquidity Trap
Tanweer Akram, PhD
13th International Post Keynesian Conference, Sep 15-18, 2016, Kansas City,
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
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.
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.
DISAPPOINTING GROWTH FOR MORE THAN TWO DECADES!
THE COUNTRY HAS EXPERIENCED PERSISTENT DEFLATION
FROM ULTRA LOW INTEREST RATES TO NEGATIVE INTEREST RATES
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
• 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?
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
• 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”.
KRUGMAN’S AND BERNANKE’S SOLUTIONS TO JAPAN’S LIQUIDITY TRAP
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???]
BERNANKE/KRUGMAN PROPOSALS: THE OLD WINE OF QTM?
• MV = PQ
• 𝝆 𝑬
= 𝒊 − 𝝅 𝑬
• ↑ 𝑯 ⇒↑ 𝑴 𝐚𝐧𝐝/𝐨𝐫 ↑ 𝑴 ⇒↑ 𝝅 𝑬
(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.
KRUGMAN & BERNANKE: I. FISHER, A.C. PIGOU AND M. FRIEDMAN
based on the
ideas of Fisher,
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
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.
HOWEVER INVESTMENT DEPENDS NOT JUST ON THE INTEREST RATE
• 𝕀 ≤ 𝑭 𝒓 𝑬
, 𝒊 where 𝑟 is the expected rate of profit, 𝑖 is the interest rate.
• 𝒓 𝑬
= 𝑮 𝑺 𝑬
where the expected rate of profit depends on expected sales (effective
• 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 𝒓 𝑬
≥ 𝒊 ⇒ 𝑰 = 𝑭 𝒓 𝑬
, 𝒊 but 𝒓 𝑬
< 𝒊 ⇒ 𝑰 < 𝑭 𝒓 𝑬
, 𝒊 .
• 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!
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.
JAPAN STILL HAS PLENTY OF SCOPE TO RAISE PRODUCTIVITY
• 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
• Policymakers should encourage higher labor force participation rate among
women and senior citizens. Better childcare and paternity benefits may increase
fertility rate slightly.