Memo to Tokyo: Cut Taxes, Print Money

Fortune issue: January 11, 1999


Memo to Tokyo: Cut Taxes, Print Money

First Principles

By N. Gregory Mankiw

Let's play Name That Economy. Here are the clues:

Unemployment is rising, and production falling. Most prices are declining, and deflation's end is nowhere in sight. Asset values are depressed. The banking system is in crisis. Interest rates are near zero, but households and firms are too worried to spend and go further into debt. Government policymakers are paralyzed as their concerns about long-term fiscal solvency stop them from doing anything meaningful about the economy's immediate problems.

So what economy is this? If you guessed the U.S. economy circa 1933, you're right. And if you guessed the Japanese economy circa right now, you're also right. The most amazing thing about the current slump in Japan is how familiar it all seems.

Luckily, the Japanese downturn is nowhere close in magnitude to the Great Depression--at least not yet. Unemployment in the U.S. reached 25% in 1933, while in Japan today it is still less than 5%. Yet when a new patient comes to a doctor with a familiar set of symptoms, the doctor does well to look back at the old case to see what helped that patient survive, even if the new patient is not quite as sick.

So what caused the Great Depression, and how did the U.S. survive? Most economists still analyze this episode using some version of the theory proposed by John Maynard Keynes in his classic work The General Theory of Employment, Interest, and Money. Keynes' basic insight was that depressions result from inadequate aggregate demand: Production and employment fall below their potential, he argued, when households, firms, and the government together aren't spending enough to keep everyone working. The solution, according to Keynes, is for the government to goose up spending in any way it can--by printing money, cutting taxes, or increasing spending itself.

Looking back, it is tempting to think that F.D.R. saved the U.S. economy by implementing this Keynesian advice. Indeed, the unemployment rate did fall from 25% in 1933 to just under 10% in 1941. The economy's production of goods and services, as measured by GDP, grew an average of 8% per year.

Yet the macroeconomic consequences of the New Deal were not nearly as great as is sometimes suggested. In a 1992 study, What Ended the Great Depression?, economic historian Christina Romer summarized the view of many economists when she wrote that "fiscal policy contributed almost nothing to the recovery from the Great Depression." Large cuts in taxes or increases in government spending might have helped, as Keynesian theory predicts, but in the 1930s they were not really tried to any significant degree.

According to Romer, "Nearly all the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion." That expansion in turn had several causes, including the decision of the Roosevelt Administration to devalue the dollar. Most important, however, was political instability in Europe, which led to an inflow of gold to the U.S., as people sought a safe haven for their funds on this side of the Atlantic.

Armed with this bit of history, what should Japanese policymakers do now? The answer is simple: Cut taxes and print money. Better yet, combine the operations. Why not print up some 100,000-yen notes, and stick one in the pocket of every Japanese citizen? Some people might put the money under their mattresses--the Japanese are notoriously thrifty, after all--but some will surely spend it and provide the stimulus to aggregate demand that is so sorely needed.

Fortunately the Japanese government is starting to head in this Keynesian direction, but it has not moved nearly fast enough. In his recent book, Restoring Japan's Economic Growth, economist Adam Posen argues that a large part of the problem has been a discrepancy between words and deeds. Over the last decade Tokyo has announced several large fiscal expansions, but by the time these expansions were enacted, they were less than half as large as was promised.

Like the U.S. during the 1930s, Japan has been reluctant to follow Keynesian advice. As Posen puts it, Japanese policymakers were given the opportunity to fight the last war, and they have chosen to adopt the strategy that lost.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.