Let’s say the U.S. becomes another Japan or for that matter let’s say Japan has become Japan. Still, we all know that capital depreciates. That raises the return on replenishing and rebuilding the capital stock. Even though wealth is falling, it raises the marginal rate of return on investment. Which in turn should spur aggregate demand and also credit creation. At some point you have to get the roof fixed. If alien invasion can work, what about a slower rotting away of the same output?
That’s a slow, ugly and painful way to end a downturn, but the deeper question is whether it will work at all. It doesn’t seem to have worked in Japan and they’ve had enough time for a lot of capital to rot away. This paper measures depreciation rates (for America) and estimates that physical capital, without repair, has an average survival time of thirteen to sixteen years.
Why has it not worked in Japan? I see (at least) two options:
1. The boost to aggregate demand has to be based on sustainable increases in real wealth, rather than deteriorations in wealth. Maybe so, but then monetary and fiscal policy won’t work either, or more accurately the fiscal policy will work only if the resulting outputs are fairly valuable. Keynesian pyramids won’t do the trick. Of course, people who stress “the broken window fallacy” will likely side with this response.
2. As the capital stock depreciates, it is repaired slowly but steadily, enough to keep the MP of K from rising very much and thus there is enough capital replacement to thwart recovery. (People who stress “the broken window fallacy fallacy” may prefer this option!) That sounds plausible, but if I think about it long enough my worries multiply.
The argument implies that the real problem is low and enduring real rates of return, and not simply that a monetary trick is distorting those rates of return. The marginal real rate of return keeps on creeping up and the decisions of investors keep on pushing it back down, but only so much; apparently the economy wants to stay in this low output, low rate of return corridor. That’s closer to a TGS story than to a “we can fix this with AD” story. (Alternatively, do you wish to argue that there is a collective action problem with the slow accretion of the “investment of repair” and that we should tax it and save it all up for one big bang of recovery? I can see the model but does anyone actually believe this?)
Does the argument imply a funny non-linearity? It implies that, say, a stimulus of $2 trillion will be more than twice as effective as a stimulus of $1 trillion. Bombs falling are better than slow rot, and so on. That could be true, but I see a lot of hand-waving on the issue. It would seem to boil down to psychology and multiple equilibria (“the confidence fairy”?) and thus I am suspicious of very definite predictions along this particular dimension. Of course, sometimes bombs really wreck a place; ever been to Bosnia?
It is worth pondering our views on capital depreciation and whether they are consistent with our other beliefs about macroeconomics and also about Japan and why it has remained in its downturn so long.