Structural Traps, Politics and Monetary Policy

Structural conditions pose a challenge to monetary policy, as the example of Japan shows. In this paper we develop the concept of structural trap, where the interplay of long‐term economic development incentives, politics, and demographics results in economies being unable to efficiently reallocate capital from low‐ to high‐return uses. The resulting macroeconomic picture looks like a liquidity trap – low GDP growth and deflation despite extreme monetary easing. But the optimal policy responses are very different and mistaking them could lead to perverse results. The key difference between a liquidity trap and a structural one is the role of politics. We show how, in the Japanese case, longstanding economic incentives and protections and demographic trends have resulted in a political leadership that resists capital reallocation from older protected low‐return sectors to higher‐return newer ones. If the Japanese case is instructive, in a structural trap, extremely loose monetary policy perpetuates deflation and low GDP growth, because unproductive but politically important firms are allowed to survive and capital reallocation is prevented. By preventing the needed reduction in excess capacity, a structural trap condemns reflationary policies to failure by making the creation of credible inflation expectations impossible. Faced with a structural trap, an independent central bank with a price stability mandate should adopt a monetary policy stance consistent with restructuring. If political resistance is high, monetary policy decision makers will need to keep nominal rates high enough to ensure that capital reallocation takes place at an acceptable pace.