Fiscal Policy Again? A Rebuttal to Mr Krugman

Fiscal stimulus is a much-needed temporary painkiller, but it is not enough to put the global economy on a path to recovery. This column argues that some economists – led by Paul Krugman – invest too much hope in the effects of fiscal stimulus while turning a blind eye towards the bad-debt mess. Stringent inspections and evaluations of bank assets by financial regulators, followed by sufficient infusions of taxpayer-funded capital will be the only effective means of clearing away the oppressive uncertainty.

Leaders of the G20 agreed on a global fiscal spending target of $5 trillion at their early April meeting in London. Fiscal stimulus is a much-needed temporary painkiller, but it is not enough to put the global economy on a path to recovery.

We cannot rescue the world economy and quell market anxiety until the US and Europe clean up the balance sheets of their financial institutions by aggressively disposing of bad assets, as I argued in my Vox column earlier this month. Nobel laureate and New York Times columnist Paul Krugman took issue with my argument on his blog, but he seems to have missed a critical point. This is not a minor quibble. The question is whether fixing the banks is a necessary condition for a sustainable recovery. The answer matters for the overarching architecture of the world’s recovery effort.

The danger of putting fiscal policy to the fore

US and European economists – led by Mr Krugman – have recently shown an alarming tendency to invest too much hope in the effects of fiscal stimulus while turning a blind eye toward the bad-debt mess.

As part of this, Krugman quoted a passage from my Vox column that claims, in essence, that Japan’s stock market and economy only rebounded after the banks were cleaned up, specifically after the disposal of bad debt was accelerated following the temporary nationalisation of a troubled major bank and the creation of the Industrial Revitalisation Corp. The Japanese government’s generous injections of capital into the banking system without stringent asset inspections and pork-barrel fiscal spending in the 1990s did nothing but provide temporary pain relief.

Krugman disagrees with my interpretation of events. He writes:

“I have a problem. You see, it’s hard, looking at the data, to see much role for bank reform in Japan’s recovery, such as it was.”

He argues that Japan’s 2003-2007 recovery was driven by an export boom.

This is very much in line with Krugman’s line of reasoning since last year. He has continuously stressed the need for aggressive fiscal expansion to tame the global financial crisis. His comments about my essay reveal his desire to divert the attention of the American public from the headache of the bad asset disposals and refocus it on the importance of government spending. But his reasoning is problematic.

Why did exports help in 2003 but not in late 1990s?

True, exports did contribute greatly to Japan’s economic recovery that began in 2003. But in the late 1990s Japan’s major trade partners – the US and China – enjoyed robust growth, which greatly boosted demand for Japanese products. Clearly there was much room for growth in Japanese exports in that period as well. Why then did Japan fail to make an export-driven economic comeback in the late 1990s? The answer lies in the difference between debt situations in the later 1990s versus 2003 – between the two export-led demand surges, Japan had cleaned up its bad-debt problem. In short, export-induced, demand-led growth was a necessary but not sufficient condition for Japan’s recovery.

Bad debt offsets an incipient export boom in the late 1990s

In the late 1990s, Japan’s banking system was hobbled by a tremendous amount of delinquent loans. Companies and households were tormented by uncertainty and anxiety. The situation cramped economic activity, making it impossible for Japan to capitalise on its opportunity to ramp up exports. A series of failures among major financial institutions from November 1997 through 1998 compounded the slump. Incidentally, the historical depreciation of the yen during this period should have bolstered export-driven growth, but that did not happen because of the banking crisis.

By 2003, however, the removal of bad debt was well underway and market anxiety had been alleviated. This revitalised economic activity stoked export growth. It is safe to say that eliminating the bad debt set the stage for Japan’s export-driven economic rebound.

Cleaning up bad debts require huge amounts of political energy

Disposing of nonperforming loans requires strong political will and rigorous asset evaluation. National consensus and considerable political energy are vital for carrying out this job. What should not take place is the liquidation of viable economic activities; what needs to happen instead is the elimination of uncertainty surrounding the valuation of the bad assets (I am not a simple-minded “liquidationist”’ as those in the 1930s).

  • Stringent inspections and evaluations of bank assets by financial regulators, followed by sufficient infusions of taxpayer-funded capital seems to be the only effective means of clearing away the oppressive uncertainty.

These policies require an extreme amount of political energy.

Government inspections are vital because market forces cannot solve the bad debt mess. Bank executives have a strong incentive and legitimate power to increase the selling prices of bad loans and related assets, while information asymmetry makes it almost impossible for buyers to know the fair prices of those assets. Moreover, the bankers have little incentive to sell bad assets at fire-sale prices as long as fiscal and monetary policies support the financial system, i.e., the government continues to act as the bankers’ bank.

Sending the wrong message

If Krugman – who won the Nobel Prize in economics last year and enjoys a high profile – continues emphasising the importance of fiscal expansion while downplaying the need to tackle the bad asset problem, he will be giving the US public an excuse for avoiding the painful job of dumping the toxic assets.

His theory will mislead US citizens into believing that big government spending can save the day, thereby making it impossible to build the solid political consensus needed for grappling with the challenge of eliminating bad assets.

As this will substantially delay the cleansing of US balance sheets, it will in turn delay the recovery of the world economy.

Why is so much emphasis being placed on fiscal expansion now? A dubious theory

According to standard economic theory, fiscal stimulus works well when there is nominal price rigidity, but this condition has nothing to do with the current financial crisis. Western economists are claiming that massive fiscal spending will dispel the pessimism that now prevails in the markets, and generate optimistic expectations. That, they imply, will push up asset prices. This is reminiscent of the theory concerning the effectiveness of fiscal expansion as a tool for fighting an economic downturn that was expounded by John Maynard Keynes during the Great Depression in the 1930s.

Modern economics supports the notion that widespread optimistic expectations contribute to economic recovery. But it has yet to be proven that large-scale fiscal expansion creates these expectations (or causes asset prices to rise). In fact, Krugman is only one of many internationally recognised economists asserting that fiscal spending for general demand stimulus such as public works projects – but not for the disposal of bad assets – can alter macroeconomic expectations. It is hard to fathom why they are advancing such a dubious theory when they must be fully aware that this argument has no theoretically robust basis.

Lessons for Japan’s policy in today’s crisis

In Japan, policymakers are now considering an additional 15 trillion yen in fiscal spending for economic stimulus measures. Unless the US makes some headway in the disposal of its bad assets, however, there will be no hope for a full-fledged recovery of the world economy. If the Japanese government’s only response to the crisis is to increase spending – thereby following in the footsteps of the US – it may end up bearing the negative consequences of the US’s reluctance to tackle the real problem of bad loan disposal.

Such an approach might achieve nothing but a further increase in Japan’s staggering public debt, already the worst of any major industrialised nation. Japan must remember the lessons from its past policy mistakes and continue urging the US to embark on an all-out effort to fundamentally dispose of the bad assets in its financial system.


Krugman, Paul (2009). “Japan’s recovery,” April 2, 2009, 8:48 am, blog entry on The Conscience of a Liberal.
Kobayashi, Keiichiro (2009). “Fiscal policy again? A rebuttal to Mr. Krugman”, Point of view, in The Asahi Shimbun newspaper.
Kobayashi, Keiichiro (2009). “The G20’s Blind Spot: President Obama must squarely face the bad asset problem”,, 1 April 2009.

About Keiichiro Kobayashi 1 Article

Affiliation: Research Institute of Economy, Trade and Industry (RIETI)

Keiichiro Kobayashi is currently Senior Fellow of Research Institute of Economy, Trade & Industry, (RIETI) and also Research Director at the Canon Institute of Global Studies (CIGS), and Visiting Professor of Chuo University.

He joined the Ministry of International Trade and Industry in 1991 and was Fellow at RIETI from 2001. He received MA in mathematical engineering in 1991 from the University of Tokyo and Ph.D. in economics in 1998 from the University of Chicago. He was a guest editorial writer at the Asahi Shimbun News Paper from 2002 to 2007.

He has extensive experience in macroeconomics research in areas such as endogenous growth theory, business cycles theory, financial crisis, and bad debt problem. He received the Nikkei Economics Book Award (2001) and the Osaragi Jiro Critics award (2002) both for the publication of Trap of the Japanese Economy (Co-authored with Sota Kato. Published in 2001 by Nihon Keizai Shinbun Sha. Written in Japanese).

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