Debt deflation of this sort already seems to be happening on a limited scale. Real GDP has stagnated for almost four years - a calamity by previous Japanese standards - and inflation is already negative, probably by much more than the fractional decline in prices shown in the official data. Clearly, the massive overvaluation of the yen has been the main reason for this squeeze on the real economy, and that has proved very resistant to falling interest rates. But foreigners have become increasingly frustrated by what they have seen as inaction by the central bank in the face of a very dangerous situation. Calls for the BOJ to pump money into the system have been loud and persistent. How could the BOJ do this, and what would be the effects? The first point to note is that the central bank cannot force the private sector to hold money balances if it does not wish to do so. Even if money could be dropped on the economy by Milton Friedman's hypothetical helicopter, there is no guarantee that the private sector would choose to hold it at the ruling level of interest rates and nominal GDP. Instead, they would seek to "off-load" the sudden influx of money balances, either by purchasing bonds and other assets (which would drive interest rates down), or by purchasing goods, which would increase prices and nominal GDP.
Eventually, the private sector would choose to hold the extra money balances because two key components in the demand for money - interest rates and the nominal value of transactions - would have moved in the right direction. In the absence of the Friedman helicopter, the main way that a central bank in the real world can increase the "supply" of money is to buy bills and bonds in the open market from the private sector. Under most normal circumstances, this will simply drive down interest rates, and this in turn will increase demand for money. Hence, an increase in what is generally called the "supply" of money is in fact equivalent to a cut in interest rates - there is no alternative way of inducing the private sector to hold the extra money balances. Monetarists who imply that the supply of money can be increased independently of a change in interest rates, and who suggest that this provides the authorities with an additional instrument of monetary control, are in most circumstances wrong. So far, BOJ operations during 1995 have exactly fitted this pattern. They have injected liquidity into the system, and have accepted a sharp decline in short- and long- term interest rates.
For the past few months, narrow money in Japan has been growing at an annual rate of about 12 per cent as a result. This, however, has failed to stimulate economic activity, and analysts have started to complain that the economy is stuck in a "Keynesian" liquidity trap, in which monetary policy becomes powerless to stimulate activity. In fact, it has become common to say that this is the first example of such a trap occurring in any country during the post-war period. This seems wrong for now - but it could become true quite soon.
Keynes had two things in mind when he coined the term "liquidity trap". First, he believed that under very specific conditions, a central bank could find it impossible to reduce interest rates below a certain level. Second, he argued that, even if interest rates could be reduced, the effect on GDP might be very slight, since neither consumption nor investment would be very sensitive to lower rates. The first of these factors - a downward limit to interest rates - does not apply to Japan. This happens when interest rates drop so low that the entire private sector believes that the next move in rates can only be upwards. This means that nobody in the private sector will hold bonds, since there is a fear of impending capital loss when interest rates start to rise.
In these conditions, the central bank cannot reduce interest rates in the normal manner by buying bonds - the more they try to buy, and more the private sector wishes to sell to them, so the bond price refuses to rise and the bond yield stays the same. Clearly, with both short- and long-term interest rates tumbling in Japan this year, it can hardly be said that a liquidity trap is operating in this sense. However, Keynes thought that the trap would probably start to operate when bond yields fell as low as 2 per cent, roughly 0.8 per cent below the present level in Japan. If the BOJ continues to drive short-term interest rates down from their present level of only 0.8 per cent, it is possible that long bond yields could drop towards Keynes' magic 2 per cent, and the first condition for a liquidity trap could then apply. The second condition applies already.
Investment in Japan is hardly likely to respond significantly to lower interest rates, since there is already a massive surplus of unused plant capacity - the legacy of the "bubble" economy of the late 1980s. There is no sign of any consumer response to lower interest rates, so the economy remains in a precarious state. Rumours abound of impending bankruptcies among Japan's previously invincible industrial companies, land and real estate prices have not yet reached bottom, and only a fraction of the balance sheet repair job has so far been completed among financial institutions. The BOJ has now made a decisive break with the cautious monetary easing it pursued for so long, and appears determined to ease monetary conditions as rapidly as possible. There is no guarantee that the private sector will choose to hold an increased proportion of this liquidity in foreign currencies - something which would be needed to puncture the yen bubble. We return to the remaining option, which Keynes saw would be needed. If the private sector will not spend, and cannot be induced to do so quickly enough by easing monetary policy, the public sector must take on the responsibility. Fiscal policy must be decisively eased again, and soon.