The perplexity that is Japan

This week in the blogosphere Japan captured the center of attention. Noah Smith started the debate pointing out that Japan isn't a textbook example of anything, claiming that neither monetary nor fiscal stimuli will work there.
"It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The “short run” for Japan is over and done. We are not looking at a “short-run” fluctuation caused by sticky prices. This has implications for policy. It means that we can’t expect the “first arrow” of Abenomics – quantitative easing – to boost the real economy through the kind of channel described by a New Keynesian or AD-AS model. ...  
...But I don’t think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. ... [and even declining wages]
I’m not sure I know any model that describes Japan; ... my guess is that it’s a world in which “Aggregate Demand” and “Aggregate Supply” are not as distinct entities as they are in Econ 102. In an AD-AS framework, either the AD curve or one of the AS curves shifts on its own. But in Japan, it may be that what looks like supply shocks (falling productivity) and what look like demand shocks (deflation) may actually be due to the same cause [Indeed, and this cause is structural, not temporary]
...whatever world Japan is living in may have multiple equilibria. It may be that Japan is trapped in a “bad equilibrium”, and it will require a “big push” to kick it back to the “good equilibrium”. ... 
In any case, we shouldn’t be thinking about Japan solely in terms of our standard textbook models. The real world appears to be much weirder than those toy environments."
I suggest reading the whole post. It contains some good basic explanations of certain macroeconomic models which a reader interested in economics could find useful. Besides his argument makes a lot of sense. Japan has had both signs of an AD shock - the 1990s bubble burst followed by persistent deflation (liquidity trap?) and an AS shock - falling productivity for the last 20 years. This is probably why conventional measures haven't been too effective:

The immediate response came from the two biggest advocates of fiscal and monetary stimuli, respectfully, Paul Krugman and Scott Sumner

Krugman insists Japan's story is a liquidity trap:
"But Japan has been in a liquidity trap during the whole period Smith looks at. Monetary expansion is ineffective unless it can raise expectations of future inflation. Deflation is definitely not going to help. In fact, by raising the real burden of debt, it makes things worse...
A corollary is that while sticky wages are a real phenomenon — the evidence just keeps getting stronger — their importance has to be appreciated correctly. You need them to understand what we’re seeing, which is the failure of deflation to appear in the US now (and the slow pace of deflation in Japan). They are not, repeat NOT the reason either Japan or we have failed to recover."
This is a somewhat similar argument to the one made by Richard Koo and his balance-sheet recession story. I find neither convincing enough to truly explain the perplexity of Japan. And I've explained this several times before. 

Sumner, on the other hand, argues the problem was monetary tightening from the BOJ:
"Japan’s NGDP is lower than 20 years ago, that’s the biggest fall in AD I’ve ever seen. The only question is why has Japan suffered such a big adverse demand shock, spread out over 20 years. And the answer is simple; the BOJ has had an unusually tight monetary policy. The BOJ has produced 20 years worth of adverse AD shocks. In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation. In 2006 they cut the monetary base by 20%. I’ve often disagreed with Bernanke, but he’d never do anything THAT crazy. Indeed Bernanke wrote some powerful pieces criticizing the insanity of BOJ policies as far back as the late 1990s."
Here's why I find that argument hard to believe:

Sumner correctly points out that BOJ has cut rates in 2000 and 2006, however I can't see how the massive QE done before, after and in between these cuts was helpful for the economy. In addition the year 2006 was portrayed as the start of a recovery for the Japanese economy (at least that's what Koo claims). 

Possibly the best comment in the debate was provided by Arnold Kling, who like Smith rejects the standard macro argument. In addition, Kling is the only one who admits he knows nothing of Japan. 
"I think we need to get away from static thinking, including AS-AD and RBC. In static thinking, there is a full-employment equilibrium out there, if everyone would just adjust to it (match the right person with the right job, or cut wages by enough, or whatever). In the dynamic world of PSST, new opportunities to reconfigure production constantly arise. Some of these create ZMP situations, in which (some) workers’ value to the firm drops essentially to zero. These workers are released into the economy as free resources. Entrepreneurs can try to pick up these free resources and do something profitable with them. But it may take some time for entrepreneurs to figure out exactly what this “something profitable” might consist of.

I know nothing about Japan. But if I were looking for the source of its problems, I would examine the cultural, legal, and institutional factors that surround the formation of new businesses. If what you had during Japan’s post-war resurgence was an economy based on top-down industrial policy and cronyism, and what you need to fix the problem today is bottom-up entrepreneurial energy and creativity, then, as Noah suspects, the solution is not going to come from wiggling interest rates and deficits."
This is the part of the argument I subscribe to. Japan is a great example of how things don't seem to work as people would think in terms of standard macro models. It's primarily because the world is much more complex than that. Economic models are precisely that - models! They are an approximation of reality. Really good ones like the the New Keynesian or the RBC can perhaps explain a lot of the usual variation created in the economy. But when the marginal error does happens it's probably due to something much deeper than AS-AD. It is a mixture of factors, where the third industrial revolution technological shock is surely one of the most important ones. One thing is certain, Japan doesn't need standard policies, it needs something new. Abenomics is not necessarily something new - it's just one big package of standard policies. 


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