Noah Smith writes,

It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The “short run” for Japan is over and done. We are not looking at a “short-run” fluctuation caused by sticky prices.

Pointer from Tyler Cowen.

In textbook terms, Smith is saying that the long-run aggregate supply curve is vertical, so aggregate demand does not matter.

Paul Krugman objects. In textbook terms, Krugman is saying (I am pretty sure) that in a liquidity trap the aggregate demand curve is vertical, so that the long-run aggregate supply curve does not matter.

So it gets back to whether one believes in a liquidity trap. Krugman writes,

the only reason deflation “works” in the standard model is that it increases the real money supply, which leads to lower interest rates; in effect, it acts like an expansionary monetary policy.

It depends what you mean by standard model. Some economists would put the Pigou Effect into the standard model. Krugman can argue–and has argued–that the Pigou Effect does not apply in Japan. Anyway, I personally don’t stake my case against the liquidity trap on the Pigou effect.

But the standard model actually has another channel by which lower prices raise demand, imparting a downward slope to the aggregate demand curve. It comes from the trade balance. If wages and prices go down in Japan, and this is not offset by an appreciation of the yen, then Japanese goods become cheaper in America and American goods become more expensive in Japan. As a result, the demand for Japanese output goes up. If Krugman has an argument that refutes this, I would like to see it.

Not surprisingly, Scott Sumner has a take.

The BOJ has produced 20 years worth of adverse AD shocks. In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation. In 2006 they cut the monetary base by 20%.

So, it’s a sequence of aggregate demand curve shifts. If the Bank of Japan would just hold still for a sec, the economy would find its way back to the long-run aggregate supply curve. As usual, Sumner is coherent, but I am not persuaded.

Smith continues,

But I don’t think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. So an RBC model of the common type can’t be describing Japan’s world either.

RBC being “real business cycle,” in which slow productivity growth is the driver of a recession. For me personally, this is even less plausible than the Keynesian story. PSST is not RBC.

I think we need to get away from static thinking, including AS-AD and RBC. In static thinking, there is a full-employment equilibrium out there, if everyone would just adjust to it (match the right person with the right job, or cut wages by enough, or whatever). In the dynamic world of PSST, new opportunities to reconfigure production constantly arise. Some of these create ZMP situations, in which (some) workers’ value to the firm drops essentially to zero. These workers are released into the economy as free resources. Entrepreneurs can try to pick up these free resources and do something profitable with them. But it may take some time for entrepreneurs to figure out exactly what this “something profitable” might consist of.

I know nothing about Japan. But if I were looking for the source of its problems, I would examine the cultural, legal, and institutional factors that surround the formation of new businesses. If what you had during Japan’s post-war resurgence was an economy based on top-down industrial policy and cronyism, and what you need to fix the problem today is bottom-up entrepreneurial energy and creativity, then, as Noah suspects, the solution is not going to come from wiggling interest rates and deficits.