Paul Krugman has a new post on Japan, which makes some good points. He considers the possibility that Japan will never escape the zero rate trap. I don't think that we have a good sense of what that scenario implies, but it does call into question one important transmission channel for fiscal policy---permanent monetary injections.
He also argues that the main problem in Japan today is not that deflation leads to high unemployment (it is currently 3.4%), rather that deflation leads to a high and rising ratio of public debt to GDP. I've frequently made the same argument.
But here I think Krugman goes off course:
And here's the thing: under current conditions, with policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion.
I don't understand that claim, as NGDP growth in Japan has accelerated since the beginning of 2013, despite:
1. Fiscal austerity (higher sales taxes)
2. Worsening demographics (compared to the late 1990s and early 2000s.)
And yet despite those headwinds the unemployment rate has fallen under Abenomics. If that's not monetary offset, I don't know what is.
The Japanese should further increase the national sales tax and/or cut government spending, and offset the effect with further depreciation of the yen. The Keynesian model says the BOJ cannot depreciate the yen at the zero bound, but last time I looked they had depreciated it from 80 to 120/dollar.
Who are you going to believe: Keynesian liquidity trap theory or your lying eyes?
PS. A 2% or 3% NGDP target, level targeting, would also help.