Continued from "Special New Year’s Colloquy: Priority Issues for Public Policy Research (Part I)"

KEIICHIRO KOBAYASHI (moderator): A major issue facing Japan today is how monetary policy should be managed in a rapidly aging society with stubbornly persistent deflation. At a recent Foundation symposium, Hitotsubashi University Professor Makoto Saito called it a puzzle with no solution, and the established theoretical frameworks don’t seem provide any answers. How do you think Japan should tackle this challenge?

KIMINORI MATSUYAMA: I think we’ll just have to build a new framework. One recent trend in macroeconomic theory is the use of something called HANK, or Heterogeneous Agent New Keynesian models, as a basis for monetary policy.

Unlike the standard model, HANK looks at variables like age distribution and income inequality. Age distribution is particularly important. Household circumstances change a great deal with age. People in their forties spend a lot on home loans and education, while the expenditures of people in their sixties center on their own health. In the past, it was felt that including such variables would make modeling impossibly complex, but with today’s powerful computers and computer programs, that’s no longer an insurmountable obstacle. And this, in fact, is the direction in which economic research is moving.

MOTOSHIGE ITOH: I’m continually reminding myself of the importance—especially for old-school types like myself—of consciously making use of these new computation-intensive methodologies.

At the same time, I feel that my early training in the classics of economic theory has taken on new meaning amid the developments of recent years. When I learned about deflation and the liquidity trap, for example, I never imagined I would live to see it actually happening in the Japanese economy. But it happened. And now I find myself rethinking what I learned.

Classical economic theory supported the idea that in a free market, prices and wages adjust themselves optimally over the long run, so it’s best to leave everything to the market mechanism. Keynes came along and rejected that approach. He called the long-term equilibrium of classical economics a “never-never land,” insisting that the real world is a series of short runs, and called for bold intervention to address disruptions in the real economy.

Today’s reflationists claim that price fluctuations can be controlled through monetary policy—in other words, that prices will rise again if we expand the money supply. That may be true in theory, but in the real world it takes at least five years for the market to respond, and in the meantime, people are grappling with all kinds of problems. Monetary policy is implemented through a series of short-term measures, but it demands a long-term mindset. Perhaps if everyone shared that mindset, the tenor of the debate would be different.

KOBAYASHI: It seems to me that the new HANK models are an attempt to revive and quantify some of the intuitive elements of Keynesian economics that were largely ignored by the new classical macroeconomics—such as the principle of effective demand, which actually goes back to the nineteenth century.

MATSUYAMA: The discipline of economics is constantly evolving, and the job of each economist is to contribute to that evolution. But how do we choose a direction? I’m often asked by graduate students what would be interesting economic problems to study. But to me, there are so many interesting problems in economics that the hard part is choosing which ones to focus on. One important reason for listening to those with the real world knowledge is that it helps in setting our priorities.

Advancing a Cross-Disciplinary Approach

KOBAYASHI: When the subprime mortgage crisis of September 2008 triggered a global recession, economists began questioning the theory of rational expectations at the heart of neoclassical economics. Since then, they seem to have settled for fine-tuning models within that theoretical framework. Do you think they’ve gone far enough? I think it would be exciting to see some attempt to fundamentally change or expand the framework. How do you feel about the general direction of economics today?

MATSUYAMA: Well, there are a lot of economists in the world, and each of them is free to try out his or her ideas. You can never know the value of an idea until you try. That’s what makes economics so exciting.

ITOH: I don’t think there’s a single model that can explain every phenomenon. I still believe there’s great value to Robert Lucas’s hypothesis of the formation of rational expectations. But does it account for the subprime mortgage crisis? No. Like Sachs, we need to find the model that matches the real-world situation—or, if there isn’t one, develop it.

KOBAYASHI: Again, it’s a matter of identifying the principles relevant to the condition we’re trying to treat.

ITOH: One hot trend in recent years is behavioral economics. Its real-world emphasis has made it fairly popular in business circles. I’m not sure how well it fits into the larger scholarly framework of economics, but it does help explain certain things.

KOBAYASHI: In the information services industry, businesses collect and analyze data with a view to predicting customer behavior and targeting advertising. It’s an area that incorporates both microeconomics and behavioral economics. I imagine this kind of analysis of “big data” could provide some useful feedback for economists.

ITOH: I was reading about recent progress in artificial intelligence and the way machine learning has led to huge improvements in Google Translate. Deep learning allows Google Translate to automatically absorb advanced linguistic principles from the material it processes. It makes you wonder what scholarship will look like in the future. In the old days, research meant applying one’s own mental faculties to propose and test economic models. As computer technology develops, perhaps it will all come down programming, although I have my doubts.

MATSUYAMA: I don’t think the importance of theoretical research will diminish in the least. In the 1960s, there was a lot of enthusiasm for [Keynesian] large-scale econometric models, but they fell out of favor entirely in the 1970s. Invariably, some unanticipated change in behavior alters the rules of the game and how it’s played.

ITOH: Those of us who were educated in neoclassical economics tend to restrict ourselves to a certain limited range of topics. Yet it seems to me that the application of economic thinking to fields outside the purview of orthodox economic theory can yield important advances—though some may call that “economics imperialism .” Of course, as a think tank, we need to carry out specialized research in such traditional areas as monetary policy, fiscal policy, and international trade. But I think there’s going to be a growing role for a more cross-disciplinary approach, such as political economy. This kind of inquiry lies outside the capabilities of computer programs.

KOBAYASHI: The same is true of social security, healthcare, and education. There’s already a growing body of work on the economics of education, but the complexity of our healthcare and pension systems makes them difficult subjects for economic analysis. Meanwhile, the policymakers responsible for these systems often have no real understanding of economics.

MATSUYAMA: Still, doctors and nurses are all human beings, and hospitals are, in a sense, business enterprises, so the economic perspective is important. One thing we can do is to confront policymakers and executives who are lacking in such a perspective and point out some of the economic issues they need to be concerned about.

[The late] Gary Becker came under fierce criticism from scholars in the field of education for applying economic principles to educational policy. But attitudes have changed, and today it’s generally acknowledged that economics has something to contribute to almost every area of public policy.

ITOH: In the government’s Council on Economic and Fiscal Policy, a key focus of the deliberations on healthcare reform is the need to visualize market data. For example, when you compare per capita healthcare costs by prefecture, you find that healthcare is substantially more expensive in western Japan than eastern Japan. Costs are especially high in Kochi, Nagasaki, and Kagoshima Prefectures and particularly low in Saitama, Chiba, and Kanagawa. We don’t know for certain why this is, but one hypothesis is that hospitals in western Japan have a higher ratio of hospital beds per person, leading to higher per capita expenses. You need clearly presented, accurate data to even raise that as a potential issue. And it has to be done correctly. This is something a think tank can contribute. Apart from the number of beds, experts have pointed out discrepancies in the percentage of patients undergoing dialysis and gastrostomy. Something we’re not aware of is occurring somewhere in the system. The world is full of data whose collection and analysis could help us identify public policy issues that require greater attention.

KOBAYASHI: If you can cite hard data, then you can get the issue on the agenda.

Policy Challenges Ahead

ITOH: One role of a think tank, I believe, is to offer its own point of view on the big issues and trends of the day. Take globalization. The international organizations and systems dedicated to liberalization of trade in goods and services—from GATT [General Agreement on Tariffs and Trade] and the World Trade Organization to various free trade agreements—are at a turning point. People in the Office of the US Trade Representative are saying that the status quo is untenable. The biggest factor is China. GATT and the WTO were established by the industrially developed countries, then opened up to the emerging economies, with the goal of maximizing the benefits of free trade. But the Doha round of WTO negotiations has stalled, and there’s no end to the impasse in sight. Any further progress will involve including China and the other emerging markets in a new rule-making process, but the obstacles are daunting.

KOBAYASHI: This may be beyond the scope of economics, venturing into the realm of global governance systems.

ITOH: It’s the very same problem that preoccupied Keynes in the mid-1940s.

KOBAYASHI: Using the logic and perspective of economics to address problems that transcend the discipline—such as how to manage the world economy given the current tensions between the United States and China—that’s quite a challenge.

MATSUYAMA: Raising new issues is a key component of our role as a think tank. It demands constant effort: using applicable theory to interpret real-world phenomena, seeking honest feedback from people with real-world experience and knowledge, and integrating those insights as necessary to come up with convincing policy proposals.

As chief scientific adviser, my first job is to serve the Foundation’s researchers and other stakeholders. In addition, there are a few things I’d like to undertake on my own initiative in order to encourage young scholars with an interest in policy studies. For example, I’d like to provide clear, accessible Japanese-language summaries of outstanding policy-research articles published in peer-reviewed journals overseas. In addition to giving a boost to budding Japanese policy researchers, such a collection of information could conceivably be used as teaching material for undergraduate courses.

Above all, I’d like to convey to people—young scholars in particular—what an exciting and rewarding field policy research is. The truth is, I didn’t choose to study economics because I wanted to be an economist. Instead, I found the field so fascinating that I kept going wherever my curiosity led me, until, lo and behold, I became an economist. Along the way, I became interested in policy issues thanks to the influence of my mentor, Jeffrey Sachs.

Japan is full of talented young scholars. If we can show them how exciting policy research is, many of them will choose a policy issue as a research topic. Then the overall quality of policy research will improve before we know it. If that happens, then I’ll feel like I did the right thing in accepting this position.

KOBAYASHI: It sounds like a good way to promote policy literacy among young scholars and among the general public as well.

As part of my work with the Foundation, I’m currently involved in a joint research project called Future Design in collaboration with Tatsuyoshi Saijo of the Kochi University of Technology, among others. We’re exploring ways of designing social systems from the standpoint of such cross-generational sustainability issues as the global environment, population decline, and public debt, to ensure that future generations inherit a healthy society and environment. One of our goals is facilitating the emergence of actors who will represent the interests of future generations in today’s political decision-making process.

In 2015, we conducted an experiment in which we had residents of Yahaba in Iwate Prefecture come up with long-term plans for the municipal water supply and sanitation system, which is currently operating in the black. The citizens broke into four groups of five or six members each to draft basic plans extending to 2060. Two of those groups were assigned to represent the interests of people living today, but the other two groups were told to adopt the perspective of people who would be alive in 2060. The group representing today’s generations both thought that since the system is currently operating with a surplus, rates should be reduced, and the surplus distributed among the residents. But the future-generation groups thought it would be best to put aside funds to pay for replacement of infrastructure later on, and they ended up supporting a rate increase even though the system is in the black right now. The town ended up raising its water rates in 2017. By changing our decision-making processes, we might just be able to come up with solutions to such long-term issues as climate change, demographic aging, and globalization.

Thank you so much for your time and your valuable observations.