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Are There Risks to Abenomics?

In the long-run, Paul Krugman says, responding to Koo and Smith and Rowe, the real interest rate on JGB is determined by the supply-side factors of risk tolerance, time preference, and growth--none of which are affected by Abenomics. In the short-run, Paul says, Abenomics raises expected inflation and thus reduces the short-term real interest-rate on the debt--that is the point of the policy.

Since today's long-term real interest rates are a combination of today's short-run short-term rates and the long-run future's short-term rates, Abenomics unambiguously reduces the overall cost of financing Japan's government debt and thus improves rather than erodes the fiscal position.

I think that Paul's conclusion is ambiguously correct--as long as you buy Paul's model, which has a Keynesian unemployment short-run and a classical full-employment supply-side determined long-run, with today's long-term real interest rates and thus debt sustainability a fixed-weight average of the two.

But what if we were to adopt an even more Keynesian model? But if we said that there was a Keynesian short-run, a classical long-run, and a medium-run that could be either?

It might be that right now the market expects a long high-unemployment medium-run--in which r < g. the value of the debt gets eroded for a generation and which will be followed by a long-run in which r > g but in which the eroded debt is sustainable. But if Abenonomics turns that medium-run from a Keynesian unemployment régime in which r &ltl g to a classical full-employment régime in which r > g, Japan might suddenly switch to a fiscal-dominance high-inflation régime in which today's real value of JGB is an unsustainable burden..

Moreover, to the extent Abenomics succeeds in boosting the economy's risk tolerance, the wedge between the private and public real interest rates will fall. Thus Paul might be completely correct in his belief that Abenomics will lower the real interest rate--but which real interest rate? The real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable.

Do I think that these are worries that should keep Japan from undertaking Abenomics? I say: Clearly and definitely not. Do I think that these are things that we should worry about and keep a weather eye out as we watch for them? I say: Clearly and definitely yes. Do I think these are things that might actually happen? I say: maybe.