If Krugman Is Right, We Might As Well Raise Taxes

-----A Crash Course on Recessions and Their Radical Cures

(hotWIRED Japan, 10/20/1998 Issue)

by YAMAGATA Hiroo (hiyori13@mailhost.net)

CONTENTS

0. Preface / A More Tasteless One
1. What is a Recession, Anyway?
2. Recession Busters: The Traditional Weapons ...And Their Failure
3. Fuel Inflation! A Weird Idea from Paul Krugman
4. Or We Could Raise Taxes: The Hiroo Scheme
5. So Crazy, It Just Might Work.
About the Author

0. Preface

Japan is in a deep Deep DEEEEEEP recession. But you knew that already. Firms are going bust, unemployment is soaring, banks are in a rut, our future's a nightmare, and after all these years, we still don't see any light at the end of the tunnel. I guess most of my readers are desperately trying to understand the situation. Why is the recession so persistant? Why doesn't the government do something? And for that matter, what is it that should be done? Or... could it be that there's nothing we can do, and we're doomed forever?

Well, no. we're not doomed. There are things that we could do. And yes, the government has been doing a lot according to the traditional solution, but unfortunately, that somehow hasn't worked. In a moment, I'll try to explain what's being done, and talk about some radical, controversial new ideas on how to tackle this recession.... But before we start, do you really know what a recession is?"

1. What is a Recession, Anyway? (skip this if you remember your Economics 101 REALLY well)

What's a recession? Most people actually don't know, but they won't admit it. Pressed hard, they would mumble something about falling stock markets, rising unemployment, stagnant growth and such. Well, those are symptoms of recessions, but not the thing itself. Gotta know your enemy first! Without it, you could be talking gibberish and not know it, like most people you see on TV (including many top class bureaucrats who are supposed to be doing something about it! No wonder the recession doesn't end!)

Technically, a recession is when you have 2 consecutive quarters of shirinking economy. If the GDP figure shows a negative growth for 2 quarters, we're in recession. But that's just a different way of putting things, and doesn't help, does it.

So let's start with the very basics. You know supply and demand. Guys who make and sell stuff are on the supply side. People who buy and consume stuff are the demand guys. These guys come to the market to make deals. They bargain, and they agree on a price. If the stuff is popular, the price goes up. And, if the stuff is unpopular, price goes down until the market clears (i.e., stuff actually gets sold.)

REPEAT THE LAST SENTENCE. If the stuff is unpopular, price goes down until the market clears.
However, this may not always work. What if all the supply guys aren't in much of a hurry and decide to hold out instead of lowering their prices? The market doesn't clear.

Or, think of another example. Unless you're a hopelessly spoiled brat or a completely paralyzed octogenarian (always wanted to use that word), people work. They produce something and sell it as the supply guys, and then take the proceedings and spend it as the demand guys. Now, you've seen Yamaichi collapse, and you're shocked, decide to save some extra money just in case. To do that, you spend less. But then, everyone saw Yamaichi's demise. Everyone decides to do the same thing. Then what? Other people buy less of your stuff, your sales drop, and you won't be able to save much. Shit, you have to spend even less, right? But so does everyone else, and as this goes on, you realize that EVERYONE including yourself is doing very badly. Yikes, it's a recession! Now your future looks really dim. Gotta do a massive restructuring and fire people and spend even less! And so the vicious cycle goes on.

So, this is recession. Demand falls far short of supply, and the market somehow doesn't do its job to adjust them. When this happens for the whole economy, you have a recession. Unemployment rises (i.e., labor is over supplied), office vacancy soars, asset prices (stocks, land...) go bungee jumping without the elastics. These are all signs of insufficient demand. Sounds like Japan, doesn't it?

2. Recession Busters: The Traditional Weapons ...And Their Failure

Then, how should we tackle recession? Since you can't go around destroying supply (not in the short run at least, unless you are willing to resort to terrorist activities), you obviously have to do something about the demand. You want people to do more shopping. How would you do that?

How about lowering prices? That should encourage people to buy more, right? Yes, but unfortunately, in a free economy, you can't force people to do so. What else? There are several standard ways.

Lower the interest rate. Saving becomes less attractive, and people would think they'd rather spend the money. It also becomes easier to take out loans and go shopping.

Increase public spending, like road works and school buildings. This can work, too. Contractors get more money, and they'll start to go shopping.

Cut taxes, and hope that people would spend the extra money.

And last but not least, you can print more money. Through processes that I won't explain here, the extra money will end up in people's pocket and people would do more shopping.

Sounds reasonable, huh? Then, why aren't they taking these measures in Japan?

Actually, they are. They've done everything. Cut interest rates? They are hacking it down like mad. They made a further 0.25% cut just this summer. But it hasn't worked. Besides, the current rate is already below 1%, and there's simply not much more to go.

Public spending? Sure, they are spending a lot, pushing up public works schedule and borrowing money like crazy to finance them. No use. Besides, we're running out of things to do, and the world is becoming suspicious because we are borrowing so much. "Hey, can you really pay that back?" This is why Japanese bond ratings are falling.

Tax cuts? Done that, more or less. Doesn't work. Print money? Yes, we're doing it. But still no avail.

So the bottom line is, the Japanese government IS trying hard. They are not stupid, they are doing their best within their limits. But, their best just doesn't work. And nobody knows WHY they aren't working.

There are advocates for each of the methods above, and they all say they need more of what they advocate for. But many of their wish lists are nothing more than shameless pursuit of self interest. Business people say the government should cut business taxes, real estate people says we need to abandon the real estate holding tax to revive the economy...yer, right. Worse, no one has any good model of the situation, so none of them can say HOW MUCH more. And they won't admit that they don't know, so they try to cover up by making things sound complicated. Sad, isn't it?

But wait! You've been reading the papers, and they say that structural reform and bank clean-ups are essential for Japan's recovery! What about those? Well, those are definitely good things and should be pursued in their own right. But neither have too much to do with the recession.

First, structural reform clears many obstacles for producers, which are the supply guys. That's nice. But not much reform can be done on the demand side. Just think. Is there any structural barrier that keeps you from going shopping? Nothing, right? So, structural reform is a supply thang. Doesn't help.

And solving the bank problem is...well, that may help, but the causal link there is not very strong. The explanation is extremely long-winded, with lots of "maybe"s and "possibly"s and "hopefully"s in between. It's a big deal now because, that's the only familiar thing that hasn't been done yet. Yes, it IS important to clean them up, because banks are important, and also because a real estate guy like me can do a lot of nice things with those properties that banks have stashed away as collateral. But to hail it as a recession fighter is, well, it doesn't have too much substance.

So, we're out of cards. What'll we do now? Pray? But to which god? As you may recall, there are eight million of them in Japan...

And then, a strange thing popped up.

3. Fuel Inflation! A Weird Idea from Paul Krugman

On a seemingly innocent rainy day in May 1998, a weird paper appeared on the Internet. Cheer up Japan, it said. There's still something left to do. Lower your interest rates. Why stop at zero? Let it go negative! And to do that, fuel inflation! Bank of Japan and the government should announce that they shall promote inflation for the next decade or so! This was the paper ,Japan's Trap by Paul Krugman.

Why would this work? Well, with inflation, your money is worth less every second. In Germany after WW I, or in some Latin American countries where they used to run 400000% inflation, the value of their money more than halved every single day or so. People rushed out to buy something (anything!) as soon as they got paid in order to secure their value. In other words, inflation made people go shopping, more or less. Or to be more precise, people expected inflation to continue, so they shopped. (The subtle difference between the last two sentences are crucial. Inflation can happen without people's noticing it, but that doesn't help. People have to EXPECT inflation to go on.)

Well, then. Why don't we create that situation? Let's tell people that we're going to have inflation, and they'll start buying stuff!

This is the basic idea behind Krugman's proposal. Of course, there's more to it than this, and one of the great things about it is that he presents a formal model to explain the current Japanese situation. It explains why other methods failed, why this particular situation applies to Japan, and why this idea should work. It's one of the few models that actually does this.

How did people respond to this?

Everyone sort of...flaked. A lot of people including myself, at first, thought it was a joke that didn't make it on April fool's day, or possibly a submission to The Annals of Improbable Research. Some even were outraged.

This is because inflation has always been considered as an evil curse. The standard formula in people's mind is, Inflation = Price Hikes = Tougher, More Miserable Living Standards, therefore, inflation should be avoided. All over the world, governments are desperately trying to fight inflation, and it's so hard! And now you want the government and the Bank of Japan to actively promote such a thing? Doesn't Japan have enough problems all ready? Back down, Satan! That was the basic response. Comments on his paper went along the lines of "Irresponsible," "Krugman doesn't have a clue to what's going on in Japan," "He's just exploiting his reputation, which he doesn't deserve in the first place," blah blah blah.

However, on closer inspection, the paper was no joke. Even if it was, it wasn't a cheap one. It seemed totally against conventional wisdom, but when you try to attack it, you'll find that exact conventional wisdom smiling straight back at you! This is hard to prove in 30 words, but let me point out that with all the criticism out there, there is not a single argument against Krugman's basic ideas. No one so far has successfully attacked Krugman's model itself, nor even unsuccessfully for that matter. Most criticism to date only points to the side effects of inflation, like a weaker Yen and the Bank of Japan getting bad press. If his ideas are so outrageous and laughable, why can't anybody show us his basic misconception?

That is because, you can't. Krugman's theory is basically right. No one can theoretically deny that inflationary expectation may boost demand. The problem, however, is that we don't have any precedence. Of course, we have precedence of inflation, but nobody ever tried to induce one intentionally. People THINK inflation is a bad thing, we've been conditioned to think so, and especially in Japan where precedence loving bureaucrats rule, there's probably no way that the government or the Bank of Japan would ever adopt such measures (although there's still hope...)

What dweebs, I mean we all know that Prime Minister Obuchi has nothing to lose. Things are as bad as they can get! Why not give it a shot? And as for side effects, well, Paul Krugman has already made a rebuttal against them, and they are pretty persuasive. Do we really need to worry?

4. Or We Could Raise Taxes: The Hiroo Scheme

All right, if that's your attitude, if inflationary expectations are too scary, I have another idea. It's already done, it's been proven to work, and it's side effects are (hear hear) positive! Now listen up.

Raise the VAT.

No, that wasn't a typo. The VAT in Japan is currently at 5%. Make that 7%.

What's going on here? Don't you have to CUT taxes to cure recession? And those of you who are ROFLing out there, yes, I guess you know the official story. In 1996, there was a short period when the Japanese economy was recovering. But, as the official story goes, this was prematurely snuffed by the VAT increase in April 1997. The increased tax obligation smashed down consumption like a cold hard fist, and we were back in recession. Usually, people cite it as a case of misguided government policy destroying a good thing going.
But I am suspicious about this official story. Yes, things looked rosy in 1996 with lots of residential unit sales. But if you asked, many of them weren't buying because they had extra money or anything. They rushed out to buy houses because they wanted to avoid the increased tax obligation next year! Same with other stuff. Why, even I went out and bought a computer (all right, it was second hand, but still...) And THAT pushed up the demand and the GDP figure!
In other words, the VAT raise didn't cool the economy. It could have been the other way around. The expectation of a VAT raise pushed up demand.

So, let's do it again. I'm not talking about raising it right now. Let's announce something like, "2 Aprils from now, the VAT will become 7%!" People would rush out to buy stuff, and demand will recover. But come April, wouldn't the demand drop back? Yes. So, on that very day, we'll make another announcement. "Oh, by the way, we'll make it 10% in 18 months!"

This argument is very similar to that of Paul Krugman. For consumers, there isn't much difference between a 2% inflation and a 2% raise in the VAT. Either way, your money buys less tomorrow. So, we'll try to spend it before that happens. Demand will go up.

Krugman so far has not told us how much inflation Japan would need (he made a ball park guess of 4% over 15 years in a recent paper, "It's Baaack! Japan's Slump and the Return of the Liquidity Trap." By the way, this REALLY IS the title of the paper submitted to the prestigious Brookings. I love this guy...) But my scheme has a precedence, so I can come up with some figures. I wouldn't say ALL of the 3.6% growth in 1996 was the VAT effect, but say 2%? Hey, if you can get 2% growth today in Japan, we'll party.

This plan has several advantages over Krugman's plot.

First, it's oodles easier to carry out. Try to tell the people that we're going to start an inflation (you HAVE to tell. Otherwise, they won't spend!) Even if we hire our Emperor to announce it, I think it would be difficult to prevent a wide scale riot. And how the fuck are you going to persuade the policy makers? Remember, many bureaucrats and politicians don't even understand what a recession is, and they'll never admit it! There's no way in hell we could teach them the need for inflationary expectations.

But a tax raise is easy. It's been done a lot. You know how to do it. And it's easier to have people swallow it. Oh, don't tell them you want to revive the economy with it. Tell them that you need to straighten out the national budget in order to have a recovery. Feed them something like, "We need a stronger fiscal base to cope with this slump. We've been spending a lot, borrowing a lot, and look where we are! Ratings are down, confidence is shattered, Japan premium is up, this just isn't working. What's a country without a strong government?"

Second, it is easier to control. Some people worry that inflation may get out of hand. But the tax rate won't get out of hand. 7% is 7%.

And the final and greatest side effect. This plot may not work. But, it will definitely cure the deficit and restore fiscal health. That can't be bad. If this doesn't work, we'll simply stop it, and start the public spending again.

Now this idea doesn't have a formal model so far. I'm not an economist. Maybe this idea goes against the mainstream idea. I guess a rational expectations guy would say that, "if people knew a tax raise is coming, they would decrease the level of consumption and start saving." However...this did not happen in 1996, did it? So I don't know. I'm not sure about it's effect on the Yen. Umm, shouldn't change, right? But I'm not sure. Also, I have a gut feeling that this scheme is subject to diminishing returns, so the rate of increase should accelerate as this plot continues. But would it? So, for all you economists out there, here's your big chance....

5. So Crazy, It Just Might Work.

I AM disturbed by one aspect of Krugman's (and also my own) idea. And this, I guess, is one other reason that people intuitively reject his proposal. I basically buy things because I need/like them. "This CD player is nice, it'll go nicely with the interior. I'll take it." But under Krugman's regime, people will have a different attitude. "Oh, I don't particularly need this shit, but if I wait, my money would be worth less, so I'll buy it just to secure my value." Now... is this the right kind of demand? They just want to use up their money before their worth wears down. Is this healthy? Should we actively skew people's incentive this way to force them into buying things they don't need? Arguably, any demand is good demand in Japan today... but is it? In another word, Krugman's proposal is basically encouraging wasteful purchases. Is this good?
Of course, 4% inflation is no big deal, we've had those things for breakfast during the 70s. Distortion should be minor, right? But is it? Krugman's idea (and mine) depends precisely on that distortion, and bigger the distortion, the better it works. So, I must ask again; Is the distortion REALLY minor? And although we know it doesn't do much harm, there is a perceived difference when you intentionally force such distortion upon people. The mindset depicted here also reminds me of the bubble period, when people invested without taking any look at the underlying asset....

But still, Mr. Obuchi (he's the Prime Minister, remember?) how do you like to try them out? If they work, they'll call you a genius leader and put you on the cover of Business Week. And should they fail? Don't worry. People won't die or anything. In the long run, demand will definitely come back by the great invisible hand. OK, so in the long run, we are all dead, but I can assure you that it won't be the recession that would kill us. And when we die, we'll at least know you've had the courage to play with an extremely interesting experiment. It would be fun.

There is a standard phrase for plans like this. You often see it in western movies. There's a small town in the west that's repeatedly pillaged by gangsters. All the traditional measures failed. Fighting back just enraged them, and submission didn't make them go away. And then, a stranger comes to town, and he proposes a weird scheme, like "Paint the houses red" (or "Let's hire some samurais," might be more appropriate as a tribute to the late Kurosawa). Is he nuts? But there is some strange logic in his idea. Town folks are moved. The strongest objection comes from the town priest or the doctor. But one by one, people are won over. And then, the mayor's grandchild gets killed. And from under the tears and grievance, the mayor decides to take a shot. Doc is furious. "Mayor, have you gone completely mad!? You'll get us all killed!"
"Doc, there's no other way! Can't you see, they'll kill us all anyway! Yes, it's a weird idea..." And then comes that phrase. "But it's So crazy, it just might work!"
And of course it works. The gangs are caught completely off guard, the town folks are saved, and the stranger walks away into the sunset. The End.

And so, that's the plot. Yeah, I know, life is not a macaroni western... or is it? The fact is, these are clearly options we have, with far more solid theoretical backbone than any of the bank saving monkey schemes that we are running now. Well? Think about it.

About the Author

YAMAGATA Hiroo is a generally obnoxious all-purpose smartass, but he gets away with it because of his big mouth and also because his ability as a translator is impeccable, and he DOES have a point in many cases. Works as a consultant in a so-called Think-tank, but better known as THE William Burroughs traslator in Japan, and also covers a lot of other grounds ranging from architechture and urban design to computers to economics and finance both as a translator and a critic. In Japan where make-no-trouble submission and harmony is THE way to go, his outright confrontational in-yer-face writing style is, well, highly controversial. As such, he is currently being sued for his attitude.
His recent translations include Paul Krugman The Age of Diminished Expectations and Harmony Korine A Crackup at the Race Riots.

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Original articles: Copyright(c) 1998 NTT and NTT-LS All rights reserved. (Like I give a shit.)