Meltdown Macroeconomics: Could The Disaster Aftermath Be Expansionary?

One of the fears gripping the capital markets right now is that the Japanese catastrophe could cripple the still-struggling global economic recovery (such as it is)and create a dreaded W-shaped recession. Paul Krugman explains in the New York Times why that is not only unlikely, but that the investment required to rebuild may be providing much needed global stimulus:

"Life and business go on; so I guess we have to talk about the economic impact of the Fukushima nightmare.

One set of impacts involves disruption of supply chains: Japanese chips and other components are an important part of world manufacturing — you really need to think of China, Korea, Japan and so on as being part of an East Asian manufacturing complex –and it’s not clear yet just how much damage will be done.

But what I’m hearing a lot is worries about financial impacts. Japan will clearly have to spend hundreds of billions (dollars, not yen) on damage control and recovery, even as revenue falls thanks to the direct economic impact. So Japan will become less of a capital exporter, maybe even a capital importer, for a while. And this, so the story goes, will lead to soaring interest rates.

But so far, um, not.

What’s going on? The story about rising interest rates would be right in normal times. But we’re not in normal times: we’re — still — in a liquidity trap, with short-term rates up against the zero lower bound.

As I tried to explain almost two years ago, one way to think about a liquidity trap is that it’s a situation in which the amount people would save if we were at full employment — S in the figure below — is greater than the amount businesses would want to invest, even at a zero interest rate. So there are, in effect, excess desired savings floating around.

So government borrowing doesn’t have to come at the expense of private investment, driving up interest rates; instead, it just mobilizes some of those desired but unrealized savings.

And yes, this does mean that the nuclear catastrophe could end up being expansionary, if not for Japan then at least for the world as a whole. If this sounds crazy, well, liquidity-trap economics is like that — remember, World War II ended the Great Depression.

So, back to Japan: I’m terrified about the possible loss of life; nervous about the disruption of world production; not worried at all about the impact of Japanese borrowing on world bond markets.