Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
- Macroeconomic Policy and Measures for the Financial System -

Senior Fellow, RIETI

Forth Installment

Macroeconomic Policy and Measures for the Financial System
- Divided arguments (Part 1)

Disagreeing with Professor Krugman

The function of money as a medium of exchange or as a means of payment is always realized through financial institutions, such as banks, unless cash is delivered by hand. The existence of financial institutions should be the most important element in considering an economic model that emphasizes the role of money as a medium of exchange. However, money in this role is downplayed in arguments based on current macroeconomics. Meanwhile, the financial system (the overall system of financial institutions) is simply treated as an ambiguous entity. The following reveals a dispute with Professor Paul Krugman (Princeton University) over a column of mine that appeared on the Internet.

The dispute was triggered by an English translation of a column contributed to the weekly Shukan Bunshun, which I posted on voxEU (a website where economists from Europe and North America post their columns and introduce their research on current events) on April 1. The following is an excerpt from that column:

I suspect that since the fall of 2008 economists and researchers in Europe and North America have been relying too heavily on the hope that "expanding public spending will bring about economic recovery." Judging from Japan's 20-year experience after the collapse of its economic bubble, merely supporting aggregate demand with more fiscal spending and monetary easing will buy you some time but will not resolve the root cause of the problem. For the U.S. and global economies to return to stable growth, a fast and drastic disposal of nonperforming assets is needed, even if it is difficult politically. Countries in Europe and North America that are expecting too much from macroeconomic policies, including the expansion of public spending might walk the same road as Japan did, when it turned away from the disposal of nonperforming loans in the 1990s.

Professor Paul Krugman, renowned columnist and 2008 Nobel laureate in economics, commented on my column. Prof. Krugman posted a counterargument to my column on his blog in the electronic version of The New York Times, although he did say he basically agreed with my views. The following is the gist of Prof. Krugman's argument:

I doubt that Japan pulled its economy out of its slump after the bursting of the bubble economy through bank reform (or the disposal of nonperforming loans). The macroeconomic data shows that the Japanese economy expanded from 2003 through 2007 on rising exports. You cannot find data showing the evidence of banks affecting the economy (Prof. Krugman appears to assume a phenomenon such as rising capital expenditure with the expansion of bank credit.) Ultimately, I suspect the disposal of nonperforming loans had nothing to do with the economic recovery.

I then published a response to Prof. Krugman's comment in a column. The following is an English translation of my column written in Japanese in The Asahi Shimbun:

I believe that the rise in exports was possible because the disposal of nonperforming loans was on the right track, and widespread Japanese distrust in the financial system (distrust in the settlement of funds, or in the implementation of payments, or in the financial intermediary function, a function providing a medium of exchange), was attenuated. The Unites States and China were enjoying robust growth in the late 1990s and the early 2000s, which begs the question of why Japan did not expand its exports in the late 1990s, but managed to do so after 2000. I understand that there are a number of factors, including exchange rates and progress in the division of labor in Asia. However, it seems to me that the difference in the status of the financial system in both periods (widespread distrust in the system due to nonperforming loan problems in the 1990s vis-a-vis attenuated distrust in the 2000s) is important. When I posted the argument in a column on voxEU on April 27, Prof. Krugman's reaction was posted on his blog in The New York Times the next day

Which is the driving force behind economic recovery, the disposal of nonperforming loans, or exports?

If the expansion of bank credit had been the driving force of the economic recovery, corporate capital expenditure should have increased. However, there was no such tendency when the Japanese economy recovered, argues Prof. Krugman, concluding that the return to health of the banking system after the disposal of nonperforming loans had nothing to do with the economic recovery. Prof. Krugman says that not only in Japan but during financial crises around the world in the past, the driving force behind the recovery was increases in exports (typically due to drops in currency value). He pointed out that the difficulty in the current global crisis is that the existing formula for pulling economies out of financial crises does not hold, since the entire world is in crisis and the global economy cannot recover by increasing exports (from Earth to some other market) in accordance with the formula. (Prof. Krugman jokes, "The only thing we can do is to export to Mars.")

I have not written further counterarguments in English. However, I have not been convinced by Prof. Krugman's views. First, he assumes that returning the financial system to health will prompt companies to expand capital expenditure, a view that considers only one aspect of the functions of the financial system. His view is based on the assumption that unsound financial institutions cause credit crunches, which will (excessively) contract the supply of funds to companies, which in turn will limit investment and slow the economy down. However, if uncertainty and distrust surrounding the payment intermediary service (the fund settlement function, which is a major function of the financial system) increases, credit crunches occur not only on the fund supply side. Even if financial institutions would like to extend loans, borrowers might not borrow because of the uncertainty and distrust. Moreover, corporate activities associated with payments through the financial system are not limited to capital expenditure. Payment through financial institutions, including the payment of wages and the payment for purchases of raw materials and intermediary goods, is related to every aspect of production and sale, as well as to investment. I suspect that Prof. Krugman's argument does not take into sufficient consideration the effects of impediments to a broad array of payment types.
(To be continued)

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the August 24, 2009 issue of Kinzai Financial Weekly

November 5, 2009

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