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Deflation, Globalization, and the New Paradigm of Monetary Economics

April 16, 2003

Council on Customs, Tariff, Foreign Exchange, and Other Transactions, Ministry of Finance   Tokyo, Japan

The Japanese Ministry of Finance held the fourth session of the Council on Customs, Tariff, Foreign Exchange and Other Transactions on April 16, 2003. Joseph Stiglitz was invited to be the keynote presenter on the topic of deflation and globalization. The copy of his speech is provided.

It is a real pleasure to be here. What I am going to try to do today is to talkabout some of the issues facing Japan, but I am going to try to approach it froma more theoretical perspective. There is a book that I have written with mycolleague at Columbia, Bruce Greenwald, called The New Paradigm of MonetaryEconomics that will be coming out fairly shortly. What I want to do today is tofirst talk about this new paradigm of monetary economics and then to comment onhow that new paradigm sheds some light on the particular problems that arefacing Japan today.

I am going to begin with a brief and fairly quick discussion of some of theproblems of traditional Keynesian macroeconomics. This goes back sometime, theseconcerns go back several decades. The problem was that it was recognized thatmuch of traditional Keynesian microeconomics was not based on micro-foundations.And in particular in the 1970s there was concern that the behavior could not bededuced from hypotheses of rational actors maximizing utility of profits.

A second aspect was that traditional Keynesian economics did not seem to addressthe problems of the day and made assumptions that seem inconsistent with whatwas widely observed. In particular, Keynesian economics as its traditionallyformulated focused on problems arising price rigidities. In the 1970s, theproblem was not price rigidity, the problem with inflation. And today, manycounties are worried about deflation. So obviously, the notion that there arerigid prices does not make any sense in a world in which we are worried aboutprices coming down year after year. And indeed, interestingly, even in the1930s, the assumption of price rigidities really did not make a lot of sense.Prices actually fell by about 30 percent during the Great Depression. And it isone of the great swindles that we persuade students for generations, the idea ofwage and price rigidities by never showing them the data. But in fact, pricesand wages fell down enormously and that means that we have to think about intimes of economic downturn, think about problems of downward price movements,that is to say deflation.

A second important problem with standard theory was that at the coremacroeconomics, of course, is monetary theory. But the theory of money that hasbeen the basis of much of macroeconomics does not make a lot of sense. Again, itis one of those great ideas that if you repeat it long enough and often enough,students come to believe it, but it really makes no sense, and it has made lessand less sense over time. The basic standard idea is that money is needed fortransactions. You need money to engage in transactions. And that that leads to atransaction's demand for money. The equilibrium interest rate is determined asthe intersection of the demand and supply for money. And that determines theinterest rate and the interest rate then determines investment, and there is achain of reasoning that goes along that way.

If you think about it for a minute, one recognizes that money is not needed formost for most transactions. Today, we almost never use money. Typically when Ivisit another country, I do not even change any money. I use my credit cardcompletely and that is true with most transactions today. Moreover, most moneyis interest bearing. In fact, the interest rate on money is simply the T- billrate minus a little transaction cost. I will show you a slide in a few minutesillustrating that, but the basic point is, that the interest rate that peopleget on their demand deposit which is what most money is, has nothing to do withthe transaction's demand for money. It is just determined by the transactioncost of converting T-bills into money. That means that the opportunity cost ofmoney, that is the difference between interest rate on-I use the term cashmanagement account, I should be careful because that saying a registered trademark of Merrill Lynch and in United States I would be hold before intellectualproperty for using a brand name, but I think you will understand what I mean.These are interest-bearing brokerage accounts that most people keep their moneyin today, most people with money keep their money in. That is to say people whodo not have any money do not keep their money there, but people with largedeposits use these kinds of brokerage accounts. So the opportunity cost of moneyis only the difference between interest rate on CMA accounts and T-bills andthat is simply determined by the transaction cost of CMA accounts and it isunrelated to economic activity.

Thirdly, most transactions are trades in assets and not directly related toincome generation. In fact, if you look at the volume of transactions, it is intrillions of dollars, and that is people buying and selling stocks andcurrencies, and that is to say not related to income generation, but that iswhat monetary theory is supposed to be about-not transactions but about incomegeneration. That would not be a problem if there were stable relationshipbetween income generating transactions and total transactions. But in fact, therelationship between the two was not stable over the business cycle.

And finally, the one of the basis of transactions demand for money was based onthe stability of velocity or the stability of the demand curve for money. But infact, it has exhibited enormous instability, which has led to the end ofmonetarism in most countries, fortunately.

This leads to a number of empirical puzzles and problems. One of them is thatthe standard theory puts a great deal of emphasis on the role of real interestrates, in determining economic activity. But as that first chart shows, realinterest rates for long periods of time have been almost constant. You cannotexplain anything by a constant. You cannot explain the business cycle by aconstant. So in fact, what one sees there is yes there are periodic changes butthey are not cyclical in nature. So it is very hard to use variability in realinterest rates as a central feature of a business cycle theory.

Secondly, if you turn to the next statement, there is a little evidence of thefact that real interest rates on investment in the United States. As I say,there are a large number of empirical studies, but in general, these studiessuggest that the dependence on investment on real interest rates is verylimited. And what we see in the United States, for instance, in the most recentrecession is that as the Fed has cut the nominal in the real interest ratesthere has been no effect on the investment. It has had some effect on consumerbehavior through refinancing a mortgage, but very little effect on theinvestment. Interestingly, a number of empirical studies suggest that there isconsiderable evidence of effects of nominal interest rates on the investment,which is of course, inconsistent with standard neo-classical theory which saysthat just real interests rate matter.

And part of explanation lies with the final observation on this chart, which isthat investment equations in which cash flow and net worth appear significant.This is an interesting episode in intellectual history. The first investmentequations that were done by Meyer and Kuh in the 1950s show cash flow effectsthat were significant. Then Modigliani and Miller wrote their paper andneo-classical theory grew and everybody said you cannot have cash flow effects,that is inconsistent with economic theory. So it became a heresy to have a cashflow affecting your investment equation. That continued until basically the1980s when the imperfect information theories developed, which said that cashflow and real balance effects are important. Then it became permissible to runregressions again with cash flow and real balance effects in. And lo and behold,what they found was what Meyer and Kuh found in the 1950s that those are verysignificant. So the standard investment equations basically of Paul Jorgenson donot work as well as alternate specifications.

There are host of other anomalies in questions. For instance, one of thestandard theories in macroeconomics is that inventories are supposed to bestabilizing. They should be a buffer. You should invest inventories in downturnsand reinvest in booms. In fact, if you look at the data, they are pro-cyclicalrather than anti-cyclical. A second example is that the experts often do notseem to increase as much as one would have expected after a large devaluation,large depreciations, which were seen very clearly in the East Asia crisis. Andfinally, there are problems with the movements of real product consumption wagesover the business cycle, which are either anomalous or not addressed by thestandard theory.

Two of the important questions which the standard theory does not really addressare why some shocks get amplified, which while the standard theory says that theeconomy has a number of buffers that should stabilize the shock rather thanamplify them. And finally, why the effect of some shocks seem so persistent.There are number of phenomena, reasons why you would expect that if you have ashock, one period negative, another period should be positive and the two shouldgo against each other. Therefore, you should find a great deal inter-temporalstability. But in fact, we see persistence in adverse shocks.

These problems on the empirical side have gone hand in hand with some advancesin economic theory, which have undermined much of the standard theory. And therewere two aspects of that that I want to mention. One related to the Nobel Prizein 2001 and the other one to the Nobel Prize in 2002. One of them focused onimperfect asymmetric information, which leads to imperfections in product, laborand capital markets. The others are the systematic irrationalities in behaviorwhich Kahnemann, Tversky and many others have identified, which have reallyundermine some of the basis of rational behavior. In particular, I will commentabout that in a few minutes, some of the implications. Anyway, to go back to thefundamental problem that was posed two, three decades ago, the fact that therewas the lack of micro-foundations for standard macroeconomics. There were twoalternative approaches. One was a theory of new classical and real businesscycle theories that were based on the standard microeconomics and tried to forman aggregate macroeconomics based on standard, neo-classical economics. Andsecond are a set of new Keynesian theories.

I first want to explain why the new classical and real business cycle theoriesfailed. Of course, I do not think they would agree with me on this, but I thinkthis is quite overwhelming, the failures. The fundamental problem, of course, isthat the models assumed away the problems that were to be explained. If you aregoing to try to explain unemployment, you cannot begin with the model thatassumes full employment. As Chairman of the Council of Economic Advisors, one ofthe problems I faced with, we had a higher macroeconomists and many of the verygood macroeconomists were coming out of places like the University of Chicagoand Minnesota. And all these economists believed that there was no such thing asunemployment. I had this image of hiring one of these and then having a meetingwith the President, and you have to remember President Clinton was elected onthe platform of jobs, jobs, jobs and he was very worried about unemployment. Ijust could imagine this meeting between this economist from the University ofChicago and President Clinton and President Clinton says, "I am very worriedabout unemployment" and this economist saying, "There is no such thing asunemployment. People are just enjoying leisure." And they might say, "Theydo not seem very happy about all this leisure. Leisure, you are supposed to beenjoying yourself." And he says, "That is a problem for the psychiatrist andpsychologist, not the problem for the economist." So I decided not to hire oneof the Chicago, Minnesota economists. Because I felt that he would fire meinstead and I would join the unemployed.

More broadly, it ignored mounting theory and evidence concerning imperfect,asymmetric information and irrationalities. This is really an important problembecause the basic methodology in the Chicago kind of approach is that therepresentative agent model. Now, think about a minute, all the work onasymmetric information on how capital markets have problems, based in asymmetricinformation, which I happen to think very important. If you have arepresentative agent, the only way you can have asymmetries of information, areif you have people with schizophrenia. That is to say, half their brain does notknow what the other half the brain knows. And that does not make any sense. Ifyou have only one person in the economy, you cannot have problems of asymmetricinformation. So the very basic methodology that underlay new classic economicsand real business cycle are the representative agent was doomed to failure ifyou think that one of the key problems is lack of imperfections of informationand asymmetry of information. It was just a methodology that could not work.Moreover, Shiller and others have emphasized that the stock markets exhibitirrational exuberance and pessimism, herd behavior. I think there is arecognition that this plays a very important part in the economy. AllanGreenspan, for instance, has emphasized the importance of irrational exuberanceand I think he today might talk about irrational pessimism.

Obviously, I think the problem of asymmetries of information are important andin fact, the host of corporate, accounting and banking scandals in the UnitedStates and Europe are related to imperfections of information and those scandalstoday are having, I think, significant macroeconomic effects. Moreover, if youlook in greater detail at the rational expectations model, you discover thatmost of the results have nothing, nothing to do with rational expectations, butdepend on perfect market assumptions. In fact, in some work that I did a numberof years ago with Peter Neary in Dublin, was that with market imperfections andrational expectations, the efficacy of government policies actually increased,not diminished. So rational expectations may actually make government policymore effective. What gave all the results of the rational expectation schools isthe assumption of market clearing. But of course, that was what you were tryingto analyze. Just to try to explain why that is so, think about the followingway:
one of the reasons that the government policies has limited efficacy has to dowith leakages-that if I increase incomes today, some of that is saved andleads to increased income tomorrow. But if people have rational expectations andthey realize that, and they realize their income tomorrow is going to be higher,that means they are going to consume more today. So there are theseinter-temporal feedbacks that actually increase the efficacy of policy if youhave strong rational expectations.

Finally, rested on a number of implausible assumptions such as the major sourceof disturbance and technology shocks, and the economy randomly becomes lessefficient. I think to me it was absolutely clear that those sets of approachesbased on trying to move from standard, perfect market models to an aggregatemacroeconomics was not going to succeed in explaining most importantmacroeconomic phenomena. So that leads one to try to think about alternativeformulations. And in fact there were two branches of what are sometimes callednew Keynesian economics. One is based on a more traditional rigid wages andprices, but as I said before, wages and prices are not rigid and many of thetheories like those of the new Chairman of the Council Economic Advisers, GregMankiw, are very unpersuasive and I hope he has better luck in his economicadvice than he does in this economic theory. The alternative approach is basedon debt deflation theories. Irvin Fisher, who was a Professor at Yale,emphasized the problems caused in the Great Depression by the fact that wagesand prices were falling and the fall decreases in asset prices. And in many wayswhat I am going to try to argue is this is the intellectual framework that oneought to be using in Japan and many other countries. This is a theory that Ihave developed with my colleague Bruce Greenwald and in particular it is basedon theories of asymmetric information and asymmetries in the speeds of priceadjustment. Obviously today, I can only hint at the broad outlines, but I wantto talk about a few of those.

The underlining idea is that we emphasize a great deal of imperfections ofcapital markets, and in particular, this leads to credit rationing of what wecall inequity rationing. That is to say, imperfections of capital markets thatlimit the use of equity markets in raising new funds, and therefore limits theability to spread risk. And that means that firms act in a risk averse way, italso means that firms' balance sheets matter, matter for production,investment, employment and all decisions and so do firm cash flows. It provides,in another words, explanation, for instance, the kinds of investment equations Idescribed earlier where real balance effects in cash flow effects do matter, aswell as, what is happening in the banking system. I will come to that in asecond. It also means that household and government balance sheets and cash flowalso matter.

One of the interesting aspects of this theory is that it focuses not only on thedemand side but also on the supply side. But it is very different from Reaganitesupply side economics. In other words, it focuses on some of the limitations onthe willingness and ability of firms to produce. In particular, since productionis risky, and risk cannot be fully divested, shocks to the economy can affectthe willingness and ability of firms to produce. It is especially relevant insmall open economies. The reason why-and this is one of the observations thatactually led us to the development of this theory-for small open economies,there should never been an aggregate demand problem. Simply by changing theirexchange rate, they should face a horizontal demand curve. They should be ableto sell as much as they want in the market. So if demand were the only problem,you would never see unemployment. Because just by adjusting exchange rate, youcan get as much demand as you wanted. The fact is that aggregate supply is asimportant as aggregate demand and when there is a shock to the economy, theability and willingness of firms to supply may be reduced. Particularlyimportant in this area is the supply of credit can be a critical constraint.Here in East Asia, one saw that in a very important way in the East Asia crisis.Because even as the country devalued, and their exchange rates fell, exportsincreased very little. And the reason was they could not get the working capitalthat they needed to increase their production. Actually Japan played a veryimportant role in the Miyazawa Initiative in providing some of the workingcapital that allowed the expansion of production that helped reunite theseeconomies.

One of the consequences of this is that demand and supply are very closelyintertwined. Demand shocks at one period have consequences for supplies insubsequent periods. Adverse effects on from balance sheets lead to lowerproduction, and adverse effects on bank balance sheets lead to lower creditsupply. So the important notion here is that shocks to demand in one periodaffect supply in the next period. And remember what I said earlier, one of thedifficult questions that one needs to explain is the persistence of the effectsof shocks. This theory then explains that in a very neat way. Because it says ifyou have a demand shock one period, it has effects on the ability andwillingness to both demand and supply in future periods. Finally, it alsoemphasizes the importance of redistributions. Redistributions, for instancecaused by large price changes, matter because of important non-linearities. Inother words, many of the changes that go on the economy are changes in prices.Say the price of oil goes up, that makes oil producers better off, oil consumersworse off. In a closed economy, in a standard economic theory, that would makeno difference because the gains to one would be offset by the lost to another.

You think of the global economy the same way. You have an oil price shock. Thegains to some should be offset by the losses to others. But once you recognizethat there are these real balance cash flow effects and they are non-linearities.The gains to one may not offset the losses to the other. Losses are felt morestrongly than the gains. And therefore, shocks can have a very strong negativeeffect. Again, let me give you an example where that was brought home veryforcefully. There were the oil price shocks that affected the United Statesnegatively and most other countries in the early 1970s, 1973 and 1979. Butinterestingly, in 1986 there was another oil price shock, in which the priceswent down. Now, standard theory said when the prices went up, you are worse off,when the prices go down you should be better off. But in fact, the US economywas hurt both times. That is because of these large distribution effects.

So leads to the new monetary paradigm which focuses not on base money, not onmoney that the transactions demand for money. It focuses on credit, credit asthe real engine in the economy. In fact, you can think of it as thegeneralization of loanable funds theory that was developed actually parallel tothe Keynesian theory by Robertson in Cambridge. But it is markedly differentfrom the old loanable funds theory because the key issue in the supply of creditis the problem of information, certifying who is credit worthy, monitoringcredit worthiness and that brings one to the institutions, the banks, whichprovide credit. Firms also provide credit. In our fully developed theory we lookat credit supply not only by banks but also by firms and by other institutionsin society. But the important point is that banks are specialized institutionsthat focus on the problems of information, ascertaining credit worthiness andmonetary enforcing loan contracts. One can view banks as firms that engage inthese credit services. But that entails risk bearing. And the reason why Icannot describe here in full detail, but one can separate out the informationservices from the risk bearing. Those are intimately intertwined and the resultof that is that as it provides credit information and provides credit, it has tobare risk. But the willingness in ability to perform this risk depends on bank'sbalance sheets. So that when the bank's balance sheets are adversely affected,the supply of credit gets adversely affected.

The theories focus then, on how shocks to the economy and policy-both macropolicy and regulatory policy-affect banks and others, including firm'sability and willingness to provide credit. One of the important aspects of thisis that there is often been this dichotomy that you think of regulatory policyas a micro-policy and central banks involved in macro policy. One of theimportant things that this emphasizes is that regulatory policy-bankregulations-have major macroeconomic effects. Again, to turn to the UnitedStates as an example, the reforms and regulations that were part of the 1989 USBanking Law were the major factors leading to the economic recession in 1990-91.One of the things that the Clinton administration did in 1993 to help theeconomy get out of the recession was to change the regulatory structure. So wevery much view regulations as part of macroeconomic policy. The problem was thateverybody recognized there was a problem of credit crunch. And that had to dowith the ability and willingness of banks to supply credit. So we had to thinkabout how we would affect the willingness and ability of banks to provide creditand that has to do with regulatory policy.

The theory pays special attention to bankruptcy, credit interlinkages amongfirms, which are as important as standard equilibrium product and factorinterlinkages. The new paradigm provides a framework for thinking aboutdeflation and alternative policy responses. Deflation and particularlyunexpected deflation leads to real balance sheet effects which can averselyaffect aggregate demand. In other words, what happens when you have deflation isthat you pay back more than you thought you were going to have to pay back inreal terms. You are worse off. The United States had a very important episodedeflation in the end of the 19th century and it was leading to some very seriousproblem for the US economy. Interestingly, the election of 1869 was fought theissues of monetary policy. It was the key issue in the election. The slogan ofthe Democratic candidate was that we shall not be crucified on the cross ofgold. And what that meant was the Democrats, who represented small farmers thatwere the debtors, said we have to increase the money supply. At the time, forcentral banks, the major method of increasing money supply was going from thegold standard to bimetallic gold and silver standard. That would have increasedthe money supply that would have undone the deflation. So you think of monetarypolicy as something that should be reserved to independent central banks, here ahundred and some years ago, it was the central issue of the political debate ofthat time.

This is in addition to the traditional real interest rate effects that many ofthe people have discussed here and elsewhere recently, when you have deflation,even when you have zero interest rates, nominal real interest rates can be quitehigh. In the Great Depression when the prices were falling ten percent a year,nominal interest rates were zero, real interest rates were 10 percent-nowonder economic activity was choked up. It is not that bad here in Japan, butthe important point is that when there is deflation there are these realinterest rates effects.

Globalization has lead to some deflationary bias in the global economy. Closerintegration could mean that there is deflationary contagion. Right now here inJapan, there is a lot of concern precisely about that issue, about whether theinexpensive supply of goods from China and deflation in China is leading tolower prices of inputs into Japan, and that is one of the structural factorsleading to a deflationary bias in Japan. Moreover, there are some otherstructural features that more competition is also leading to downward pressureson prices.

There is another important aspect that I not going to have much time to talkabout today, but I just wanted to note it because I think that it is one of themost important issues on the global architecture. We had a lot of discussionsfive years ago about reforming the global financial architecture. Unfortunately,it did not get at what I view as some of the most important issues. And this isone of them. The global reverse system means substantial global income is simply`buried' in the ground every year. What am I talking about? What I amtalking about is the fact that there are now more than $2 trillion of reservesand every year, something like several hundred billion dollars are added toreserves. What does that mean? That means that every year, several hundredbillion dollars of income are taken and put into the ground. Now the form weshould go with right now is US dollar bills. In the past, the deflationary biasassociated with the global reserve system was offset by the fact that manycountries ran loose monetary policies and this was offset by countries living bytheir means. But in today's global climate, that is no longer true. Everybodywants to have trade surplus. But you cannot have a trade surplus because one ofthe basic definitions is that sum of the trade surpluses have to equal sum ofthe trade deficits. So if China and Japan and few other countries are havingsurpluses and the rest of the world have deficits. But as they try to get rid ofthose deficits, it is like a hot potato as goes from one country to another. Andthe traditional way of getting rid of the deficit is trying to deflate youreconomy. That is, of course, what happened in Korea and East Asia. So it is asystemic problem in the global system.

Right now, we see this kind of mentality affecting Europe. At the same time, thestability pact in Europe means they have a limited ability to use expansionaryfiscal policy. Meanwhile, the central bank focusing exclusively on inflationmeans that they cannot use the monetary policy and Europe is, therefore, in whatyou might call a low income deflationary bias.

Now I want to come fairly quickly to the prescriptions. The theory suggests thatone ought to focus on the balance sheets. Shifting from deflation to inflationmay help the balance sheets, undoing the damage that deflation has done inincreasing the real value of debts. And the problems are particularly severe inJapan and other countries where there have been an asset bubble that breaks.Because when you have the asset bubble that breaks, it really destroys balancesheets. Moreover, shifting from deflation to inflation may lead to lower realinterest rates.

Now, there are three aspects of policy frameworks that I want to mention. Thefirst is moving from the deflation to inflation. The second is depreciation ofthe currency, a weaker yen. And the third I want to talk very briefly about isthe bank balance sheet because there are a lot of discussion of the problem ofnon-performing loans. In terms of-I should say depreciation, not devaluationbecause it is a quasi-flexible exchange rate, so I meant depreciation.Obviously, it will improve Japan's balance sheet, given its large creditorstatus.

The second point I want to emphasize, and this is quite important, the mindsetof central bankers around the world has been largely set by the problems of the1970s and 1980s when they were thinking about inflation, and that is what wastaught at graduate schools, that is what was taught in the economic courses.There is a real challenge for both central bankers and macroeconomists moregenerally, to begin to think about not an inflationary world, but deflationaryworld. And many of the things get turned upside down when you change yourmindset. For instance, one of the arguments against depreciation is that it isinflationary because the cost of your inputs goes up. And it is one of thereasons that IMF always is telling countries do not depreciate, do not devaluebecause they are always worried about inflation. They are fighting the war ofthe 1970s. That war is largely over. We want to go to the next war. In thatworld-the world of deflation-when the currency depreciates, it undoes thedeflation. And that is a good thing. So what was bad in the inflationary worldbecomes good in the deflationary world. And there are lots of examples of thiskind of change in mentality that one has to go through. And of course, thesebalance sheets effects, these anti-deflationary effects are in addition to thenormal trade benefits that results from depreciation.

Finally, let me talk just a minute about the issue of the bank balance sheetsand nonperforming loans. There is a lot of mystery and confusion in this area.One needs to separate out the issues of management from the issues of balancesheets. If you move nonperforming loans off the bank's balance sheets, movethem into a government corporation or some other corporations, and you pay thefull market value for them, you do not improve the balance sheet. It does notchange the bank's net worth. You solve the management problem, banks may ormay not be well suited for resoling these problems. They may not be well suitedfor dealing with nonperforming loans. But you do not solve their balance sheetproblems simply by moving the nonperforming loans off the balance sheet.

What does improve the bank balance sheet is if you take those nonperformingloans off the balance sheet, and you pay them as if they were performing loans.That is to say you subsidize the banks. But obviously, you can improve the bankbalance sheets by subsiding them in any way. So the real question is, is theagenda an agenda for subsidizing the banks or is it an agenda for management,which means, saying that they are not well equipped for restructuring loans.These two quite different agendas have been confused. It may well be that onewants to subsides the banks and I think there are some good arguments forrecapitalizing banking system, but if you do that, the government should getfull value for it. It should get an equity interest in the banks if itrecapitalizes them or has some other claims on the private banks. There is noreason why it should be giving these free gifts. But if you do not have thatkind of transparency, you are likely to make some very significant mistakes andit has some serious problems.

I also want to point out, and this is the final point, there are someunconventional ways which provide, by which one can recapitalize the bankingsystem which do not just move the problem of the, they do not, at the same time,worsen the government's balance sheets. In other words, there is a realproblem here. If you have a hole in the bank's balance sheet and you fill thatby government, you have just moved that from one place in the society toanother. And that may be a good thing to do, but you ought to recognize that youare not changing the underlining problems. You are just moving it around andthat is where the redistribution issues that I talked about before make adifference. The theory that I described says that those distribution issues areimportant. They should not be ignored. But you should recognize again what youare doing.

I am running out of time, I have a slide here that you can look at, trying toexplain why [break in tape] that I think one might want to think about, which istemporary consumption tax cut, may be more effective than income tax cuts for acouple reasons. First, the fact that it is temporary is more credible becausegiven the huge debt GDP ratio, it is more likely that those taxes will beincreased in the future, so that the temporary nature is credible. Whereas apermanent income tax cut is not credible. Secondly, by being temporary, youagree to inter-temporal substitution effect (i.e., induce people consume nowwhile there is a sale on consumption).

The key questions are following. I think there is an increasingly broad sense ofconsensus that one needs to reverse the deflation. And one needs the advantagesof depreciating the currency, the yen. So those two, there is a general, broad,increasing consensus on those two objectives. The problem is that those areendogenous variables. The rate of inflation or the rate of deflation is not amatter of government fiat and in the market economy the exchange rate is not amatter of government fiat. They are both endogenous variables. So the realquestion is and the hardest question is what government policies are there thatwill result in undoing the deflation and will result in a depreciation of thecurrency. There are number of policies which one can talk about and that havebeen discussed in Japan. I actually think that there is not one single panacea.One needs a whole set of policies because the problem is sufficiently severe. Itis going on for decade that one should actually have several policies. So inthis discussion today, I thought I would bring up one policy that is a littlebit unconventional and when I raise it, I almost worry that I might lose my cardas a credited economist because it is almost like heresy to say what is in thenext sentence.

Printing money, that is almost worst sin that economist commit. But one has tounderstand, again going back to the point I made before, when you are in aninflationary economy it is different from deflationary economy. In inflationaryeconomy, you should take away my card, my Ph.D. in inflationary economy. If Isay printing money, you should look at me and say where did he get his Ph.D.from? But in a deflationary economy, the things may be just the opposite. At thevery least, it seems to be an idea that is worth discussing. So the idea is tofinance some of the deficits by printing money. There is no evidence of adiscontinuity. That is to say, if some people say "if you start printingmoney, won't you have hyper inflation." That is the theory that says thatthe world is very discontinuous and certainly my observation about themoderation of both the Central Bank and the Ministry of Finance in Japan is thatonce they start printing money, they will not just turn the printing pressesfaster and faster. It will be very moderate. In fact, the real danger is theywill not do enough, not that they will do too much. So there is no evidence as Isay of discontinuity, a moderate amount will not set off rampant inflation andeconomic theory would say that there is, you could adjust the amount to get theright amount of inflation. It has a number of advantages over debt finance. Oneof them is that with debt finance, you have to keep ruling over the debt-everythree months, six months, year, five years. By issuing money, you do not haveto. It is permanently out there.

There is a second important advantage, that in most accounting frameworks, it isnot treated as part of government debt. One of the problems of Japan today isthat because it has run deficits year after year, the debt/GDP ratio now is thehighest among the G7 by a considerable amount. And that is beginning to havesome effect on rating agencies and one worries about a scenario in which we knowmarkets are irrational, we know markets can panic and one worries with opencapital markets that if the debt/GDP ratio gets too high, there could be thatkind of panic. If you ask the question, if your deficit/GDP ration is sevenpercent a year, in five years that is 35 percent. You add that to your already135 percent debt/GDP ratio, and the number keeps getting larger and larger. Soit is clear that the current strategy cannot continue and you have to thinkabout an alternative. One of the points is that this printing money can be usedto help recapitalize the banks. I talked about unconventional ways that wouldnot add to the debt burden of the government. This is one way, one of theseveral possible ways. In fact, this is a strategy which worked in Sweden in theGreat Depression.

There are some important lessons that even if the prescription works, it willnot address Japan's longer run problems. There are structural problems, aswell as aggregate demand problems. The two are intertwined. But I believe verystrongly, that one cannot affectively address the structural problems until oneaddress the aggregate demand problems. If you do not address the aggregatedemand problems, you resolve some nonperforming loans, you will get more innonperforming loans in another year or two years. And that, of course, has beenthe history in many countries.

I think there are opportunities for addressing some of the long-run productivityproblems, structural problems. For instance, one of the issues is that the levelof productivity increases in the service sector has not been matched at in themanufacturing sector. If you look around the world, the economies, there havebeen a major change in the structure of most of, many of the advance industrialeconomies, moving from manufacturing to the service sector. And economies thathave been most successful like the United States and UK have had enormousproductivity increases in the service sector. And yet, this is one of thesectors which is lagged behind in Japan. So that in some sense, that structuralproblem is one of the things that I think needs to be addressed. But thosestructural issues as I set repeat can best be addressed when the economy is in amore robust situation. Unless Japan does something about the continuing shortrun lack of aggregate demand, there is a real risk that the structural reformsactually exacerbate these long run problems as financial problems mount andinvestments in new technology wane.

Let me just come to some general conclusions. There is I think a new need for anew macro theory and a new paradigm for monetary economics. I think thedeficiencies in the standard Keynesian economics and the deficiencies in realbusiness cycle in rational expectations theories are sufficiently great thatthere is a need for alternative theory, one particularly adapted to the kind ofsituation that Japan faces with deflation. I think the new theory that I triedto outline here very briefly provides a better explanation of a host ofphenomena. Most importantly, the new theory actually provides insights into howto think about the variety of policy issues, approaches which are in many wayssignificantly different from those of either the standard Keynesian economicsand/or those of the rational expectations real business cycle theories. So Ihope in the discussions that we have, we can try to talk about the extent towhich this new theory provides insights into the situation in Japan. Thank you.

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