Japan, the Foolproof Way, and liquidity traps
Lars E.O. Svensson

Princeton University

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Note: This page is no longer updated. See Topics.htm, heading Japan, instead.

What is new on Japan, the Foolprof Way, and liquidity traps Top

New paper: "Monetary Policy and Japan’s Liquidity Trap," September 2005.

The Foolproof Way Top

"Monetary Policy and Japan’s Liquidity Trap," prepared for the ESRI International Conference on Policy Options for Sustainable Economic Growth in Japan, Cabinet Office, Tokyo, September 14, 2005, PDF. Abstract.

The line: Monetary policy in Japan has focused on reducing expectations of future interest rates, but a more effective policy in a liquidity trap is to increase expectations of the future price level. The Foolproof Way is likely to be the most effective policy to do this.

"Comments on Bernanke, Reinhart, and Sack, 'An Empirical Assessment of Monetary Policy Alternatives at the Zero Bound'," presented at the Brookings Panel on Economic Activity, Washington, DC, September 9-10, 2004, revised November 2004, PDF. Abstract.

The line: The Bernanke-Reinhart-Sack paper mostly focuses on alternative policies in a liquidity trap to affect expectations of future interest rates. But the problem in a liquidity trap is rather to raise private-sector expectations of the future price level.

"Challenges for Monetary Policy,'' presented at the meeting of the Bellagio Group of the G10, held at the National Bank of Belgium, Brussels, January 26-27, 2004, PDF (98 KB).

"Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank" (with Olivier Jeanne, IMF), July 2004, PDF. Abstract. Data (Excel file).

"The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large Open Economies," Version 1.2, July 2004, PDF. Abstract.

"Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives 17-4 (Fall 2003) 145-166. PDF (191 KB). Abstract.

"Escaping from Deflation and a Liquidity Trap," talk at the Hong Kong Institute for Monetary Research, Hong Kong Monetary Authority, Dec 17, 2002, overhead slides (71 KB).

"Monetary Policy and Real Stabilization," September 2002, in Rethinking Stabilization Policy, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 29-31, 2002, 261-312, PDF. Abstract. (Chapt. 4, "The Zero Bound, a Liquidity Trap and Deflation," contains a discussion of the foolproof way.)

"How Japan Can Recover," Personal View, Financial Times, Sep 25, 2001. (A simplified version of the non-technical summary of the Graham Lecture below.)

"The Foolproof Way of Escaping from a Liquidity Trap: Is It Really, and Can It Help Japan?" The Frank D. Graham Memorial Lecture, Princeton University, April 5, 2001. Non-technical summary | Overhead slides (PDF, 79 KB)

"The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies 19(S-1), February 2001, 277-312, PDF (185 KB). Abstract. (This is the detailed academic version of the Foolproof Way.)

Others' articles related to the Foolproof Way (articles on www.ft.com are often dated the day before the FT print version) Top

Coenen, Günter, and Volker Wieland, "The Zero-Interest-Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," presented at the Carnegie-Rochester Conference, Carnegie-Mellon University, Nov 22-23, 2002, revised 2003. (Contains a comparison between three proposals for Japan of Orphanides and Wieland, McCallum, and Svensson.)

Allan Meltzer, "Depreciate the Yen," FT.com, Apr 15, 2002.

"O'Neill turns on Japan in clash over weaker yen," FT.com, Jan 22, 2002.

Haruhiko Kuroda, "The yen's fundamental weakness," Personal View, FT.com, Jan 22, 2002.

Comment: The above two articles indicate substantial misunderstanding (at the highest level of the US Treasury and the Japanese Minstry of Finance) of the role of the exchange rate in escaping from a liquidity trap and jump-starting Japan.

"US appears set to accept weaker yen," FT.com, Jan 9, 2002.

"Japan plays its final card in battle to revive growth," FT.com, Jan 8, 2002. Comment.

"On the slide", The Economist, Jan 5, 2002. Comment.

Comment on the above two articles in FT.com Jan 8 and The Economist Jan 5 (and some newsletters from various investment banks). Unfortunately, the above two articles do not get the analysis right. They assume that the only effects of a depreciation of the yen are a rise in the Japanese price level due to increased import prices and a stimulation of exports. Fortunately for Japan, the effects of a depreciation and a peg of the yen depend on the whole policy package and will be much more widespread under the foolproof way. (A number of newsletters from various investment banks make the same mistake.)

The foolproof way consists of a whole package with (1) a price-level target path starting above the current price level and rising at the rate of a long-run inflation target, (2) a temporary peg of the yen at a level corresponding to an initial real depreciation clearly below any reasonable long-term real exchange rate, and (3) an exit strategy in the form of abandoning the peg, floating the yen and adopting an inflation target once the price level has reached the price-level target path.

This will jump-start Japan by creating inflation expectations (since after the intial real depreciation of the yen, the real appreciation back to reasonable long-run real exchange rate can with a peg only occur through inflation), reducing long real Japanese real interest rates (by the increased inflation expectations and by the circumstance that the long Japanese real interest rate plus the expected real appreciation must with free capital mobility be approximately equal to the long US real interest rate) and by stimulating the exporting and import-competing sectors. The resulting increase in activity and the increased inflation expectations will cause domestic inflation to pick up and fulfill the inflation expectations, the domestic price level will rise and eventually hit the price-level target, at which point the peg is abandoned the Bank of Japan moves to an inflation target with a float.

Thus, the main effect of a depreciation of the yen and a peg is not not the immediate effect on inflation trough domestic prices of imports (the so-called "direct exchange rate channel to inflation"), nor are improved relative prices for exporting and import-competing sectors the only stimulative effect on the economy.

"Yen hits fresh low as Tokyo shifts policy," FT.com, Dec 17, 2001.

FT editorial: "Sinking sun," Financial Times, Dec 14, 2001.

"BoJ rules out purchase of foreign bonds," Financial Times, Dec 13, 2001.

Inteview with Governor Hayami: "A Hard Choice for Japan," Financial Times, Dec 3, 2001.

The Economist on the foolproof way: "Let it fall?" The Economist, Nov 29, 2001.

"Risk-averse BoJ reluctant to think radical on economy," Financial Times, Nov 29, 2001.

"Tokyo hails yen slide but rules out intervention," Financial Times, Nov 27, 2001.

"BoJ Deflects US Pressure on Bonds," Financial Times, Nov 23, 2001.

US backs Japanese proposal that could drive yen lower: "Bank of Japan Examines Foreign Bond Purchase," Financial Times, Nov 22, 2001.

"Bank of Japan Looks for New Weapons in the Fight Against Deflation," Financial Times, Nov 22, 2001.

FT editorial: Editorial comment: "Halting Japan's Deflation," Financial Times, Nov 14, 2001.

Martin Wolf endorses the foolproof way: Martin Wolf, "Japan on the brink," Financial Times, Nov 13, 2001:

"Thus there has to be a change in monetary policy. The suggestion of an inflation target, made by Takatoshi Ito of Hitotsubashi university in the FT of October 23, no longer looks enough. Given the extent of the deflation, it would not be credible. Another idea, advanced by Mr Congdon, would be for the government to borrow direct from the banks and use the proceeds to buy its bonds from the non-bank private sector. That would increase the broad money supply. The question is how swiftly that would translate into a rise in demand and prices."

"Preferable to either is the idea of a price level target, via a commitment to a depreciated exchange rate, as suggested by Lars Svensson of Princeton University (FT, September 25 2001). Such a target can be achieved by Japan alone, provided it is prepared to create money to purchase foreign exchange. Once the price level is achieved, the country can shift to orthodox inflation targeting."

Bennett McCallum, "Japanese Monetary Policy Again," Shadow Open Market Committee, Oct 15, 2001.

Bennett McCallum, "Japanese Monetary Policy," Shadow Open Market Committee, Apr 30, 2001.

FT editoral endorses the foolproof way: Editorial comment: "Let the Yen Fall," Financial Times, Oct 1, 2001:

"The authorities must take another jump forward. Jolting the economy into life requires a burst of inflation. But an inflation target is probably insufficient because consumers would be justifiably sceptical that it would be met.

There is a credible alternative. The BoJ and government can commit to an exchange rate target because they can print and sell unlimited quantities of yen. A falling yen would raise competitiveness. More importantly, it would raise inflation expectations. If consumers believed the yen would be undervalued for a long time, prices would be certain to rise. With expectations of inflation, real interest rates would fall and consumption should get a lift. The authorities could then institute a credible inflation target."

"A healthy Japanese economy is good for the rest of the world. Other countries must therefore support the additional measures needed, even if that means temporarily accepting a super-competitive Japan."

Paul Krugman, "The Fear Economy," New York Times Magazine, Sep 30, 2001:

"Lars E.O. Svensson ... has produced the most fully worked-out proposal for Japanese recovery."

Generally on the zero bound, liquidity traps and Japan Top

Discussion of Alan J. Auerbach and Maurice Obstfeld, "The Case for Open-Market Purchases in a Liquidity Trap," FRBSF and SIEPR Conference on Finance and Macroeconomics, San Francisco, Feb 28-Mar 1, 2003, overhead slides (117 KB).

Discussion of McCallum, "Inflation Targeting and the Liquidity Trap," FRBSF and SIEPR Conference on Asset Prices, Exchange Rates and Monetary Policy, Stanford University, March 2-3, 2001, overhead slides (PDF, 58KB).

"The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies 19(S-1), February 2001, 277-312, PDF (185 KB). Abstract.

"How Should Monetary Policy Be Conducted in an Era of Price Stability?" (section 5 and appendix B), in New Challenges for Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas City, held at Jackson Hole, Wyoming, August 26-28, 1999 (IIES Seminar Paper No. 680, CEPR Discussion Paper No. 2342, NBER Working Paper No. 7516), PDF (0.4 MB). Abstract.

Updated oktober 16, 2007 .
Comments and suggestions are welcome.