The paper used in my previous post is a gold mine, and we are far from exhausting all its riches. If there are any GMU professors reading this, I have a question. Are academics allowed to present someone else’s paper in a seminar (if we correctly identify the author?) I would like to present Bernanke’s paper next time I do a seminar. If you think that strange, read the rest of this post and the previous one as well. BTW, the Bernanke paper I am discussing in these two posts is titled:
Japanese Monetary Policy: A Case of Self-Induced Paralysis?
The answer is yes; now let’s get into the details of what went wrong. The opening sentence sets the scene:
The Japanese economy continues in a deep recession. The short range IMF forecast is that, as of the last quarter of 1999, Japanese real GDP will be 4.6% below its potential. This number is itself a mild improvement over a year earlier, when the IMF estimated Japanese GDP at 5.6% below potential.
So the level of output is 4.6% below trend. Does that sound familiar? On the other hand things are getting better. Over the past year growth was 1% above trend. So the “recovery” is well underway. Time to tighten monetary policy? I think you already know the answer. For Japan, no. For the US in 2010? I fear the answer may be yes. Then there is this:
Japan’s weakness has also imposed economic costs on its less affluent neighbors, who look to Japan both as a market for their goods and as a source of investment.
And isn’t that also true for the US today? Bernanke then discusses flaws in the Japanese banking system, before focusing on the main topic:
In the short-to-medium run, however, macroeconomic policy has played, and will continue to play, a major role in Japan’s macroeconomic (mis)fortunes. My focus in this essay will be on monetary policy in particular. Although it is not essential to the arguments I want to make””-which concern what monetary policy should do now, not what it has done in the past””-I tend to agree with the conventional wisdom that attributes much of Japan’s current dilemma to exceptionally poor monetary policy-making over the past fifteen years (see Bernanke and Gertler, 1999, for a formal econometric analysis). Among the more important monetary-policy mistakes were 1) the failure to tighten policy during 1987-89, despite evidence of growing inflationary pressures, a failure that contributed to the development of the “bubble economy”; 2) the apparent attempt to “prick” the stock market bubble in 1989-91, which helped to induce an asset-price crash; and 3) the failure to ease adequately during the 1991-94 period, as asset prices, the banking system, and the economy declined precipitously. Bernanke and Gertler (1999) argue that if the Japanese monetary policy after 1985 had focused on stabilizing aggregate demand and inflation, rather than being distracted by the exchange rate or asset prices, the results would have been much better. (emphasis added.)
Look at the section I italicized. Isn’t that exactly what I said caused the current steep recession? Bernanke continues . . .
Bank of Japan officials would not necessarily deny that monetary policy has some culpability for the current situation. But they would also argue that now, at least, the Bank of Japan is doing all it can to promote economic recovery. For example, in his vigorous defense of current Bank of Japan (BOJ) policies, Okina (1999, p. 1) applauds the “BOJ’s historically unprecedented accommodative monetary policy”. He refers, of course, to the fact that the BOJ has for some time now pursued a policy of setting the call rate, its instrument rate, virtually at zero, its practical floor. Having pushed monetary ease to its seeming limit, what more could the BOJ do? Isn’t Japan stuck in what Keynes called a “liquidity trap”?
I will argue here that, to the contrary, there is much that the Bank of Japan, in cooperation with other government agencies, could do to help promote economic recovery in Japan. Most of my arguments will not be new to the policy board and staff of the BOJ, which of course has discussed these questions extensively. However, their responses, when not confused or inconsistent, have generally relied on various technical or legal objections””-objections which, I will argue, could be overcome if the will to do so existed. My objective here is not to score academic debating points. Rather it is to try in a straightforward way to make the case that, far from being powerless, the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism.
I had a number of posts last year arguing that the Fed doesn’t realize how much easier things would be if it took the plunge, that a much more expansionary policy would not be more risky, but in fact would be much less risky for the economy.
So what was the basic problem? Was it the banking crisis, as most people think? Or was it something much deeper, was it a fall in NGDP that caused the worsening of the financial crisis:
I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult. (italics added.)
Increased NGDP? I hope that I don’t even need to say anything. I must have written something almost identical at least a 100 times in the past year.
But how do we know that then problems are monetary? Perhaps they are structural:
Taken together with the anemic performance of real GDP, shown in Table 2, column (5), the slow or even negative rate of price increase points strongly to a diagnosis of aggregate demand deficiency. Note that if Japan’s slow growth were due entirely to structural problems on the supply side, inflation rather than deflation would probably be in evidence.
But haven’t some countries in the past prospered with stable prices, or even mild deflation?
Perhaps more salient, it must be admitted that there have been many periods (for example, under the classical gold standard or the price-level-targeting regime of interwar Sweden) in which zero inflation or slight deflation coexisted with reasonable prosperity. I will say more below about why, in the context of contemporary Japan, the behavior of the price level has probably had an important adverse effect on real activity. For now I only note that countries which currently target inflation, either explicitly (such as the United Kingdom or Sweden) or implicitly (the United States) have tended to set their goals for inflation in the 2-3% range, with the floor of the range as important a constraint as the ceiling (see Bernanke, Laubach, Mishkin, and Posen, 1999, for a discussion.) Alternative indicators of the growth of nominal aggregate demand are given by the growth rates of nominal GDP (Table 1, column 4) and of nominal monthly earnings (Table 1, column 5). Again the picture is consistent with an economy in which nominal aggregate demand is growing too slowly for the patient’s health. It is remarkable, for example, that nominal GDP grew by less than 1% per annum in 1993, 1994, and 1995, and actually declined by more than two percentage points in 1998. (emphasis added.)
Holy cow! Are you telling me that NGDP fell by 2% in 1998? More importantly, look at the italicized sentence. Inflation below the 2% to 3% range is to be avoided just as strenuously as inflation above the 2% to 3% range. What other indicators do we have that money has been too tight?
The yen has generally strengthened over the period, which is consistent with the deflationist thesis. As I will discuss further below, even more striking is the surge of the yen since 1998, a period that has coincided with weak aggregate demand growth and a slumping real economy in Japan. As column (2) shows, however, the fact that inflation in Japan has been lower than in the United States has left the real terms of trade relatively stable. My interpretation is that the trajectory of the yen during the 1990s is indicative of strong deflationary pressures in Japan, but that a too-strong yen has not itself been a major contributor to deflation, except perhaps very recently. Columns (3) and (4) of Table 2 shows rates of change in the prices of two important assets, land and stocks.
The table shows falling stock and land prices. So we have the same stock price/real estate/exchange rate indicators I used to call out the Fed in late 2008, being used by Bernanke to call out those reactionaries at the BOJ.
OK, things are kind of deflationary, but how do we know it’s the BOJ’s fault. What do traditional monetary policy indicators show?
A glance at Table 3 suggests that the stance of monetary policy has been somewhat different since 1995 than in the 1991-94 period. As mentioned earlier, there seems to be little debate even in Japan that monetary policy during 1991-94 was too tight, reacting too slowly to the deflationary forces unleashed by the asset-price crash. Interest rates came down during this period, but rather slowly, and growth of both narrow and broad money was weak. However, one can see that there has been an apparent change in policy since 1995: In that year the call rate fell to under 0.5%, on its way down to effectively a zero rate today, and lending rates fell as well. The fall in the nominal interest rate was accompanied by noticeable increases in the rates of money growth, particularly in the monetary base, in the past five years.
I can just imagine my Keynesian readers saying “See Sumner, after 1995 there was nothing more the BOJ could do.” Here’s the very next paragraph from Bernanke:
Monetary authorities in Japan have cited data like the 1995-99 figures in Table 3 in defense of their current policies. Two distinct arguments have been made: First, that policy indicators show that monetary policy in Japan is today quite expansionary in its thrust””- “historically unprecedented accommodative monetary policy”, in the words of Okina quoted earlier. Second, even if monetary policy is not truly as expansionary as would be desirable, there is no feasible way of loosening further””-the putative liquidity trap problem. I will address each of these two arguments in turn (the second in more detail in the next section).
The argument that current monetary policy in Japan is in fact quite accommodative rests largely on the observation that interest rates are at a very low level. I do hope that readers who have gotten this far will be sufficiently familiar with monetary history not to take seriously any such claim based on the level of the nominal interest rate. One need only recall that nominal interest rates remained close to zero in many countries throughout the Great Depression, a period of massive monetary contraction and deflationary pressure. In short, low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease. (Italics added.)
If you are “sufficiently familiar with monetary history” please continue. If not, get out of my blog and go read some 1938 vintage Keynesian blog. But what about real interest rates:
A more respectable version of the argument focuses on the real interest rate. With the rate of deflation under 1% in 1999, and the call rate effectively at zero, the realized real call rate for 1999 will be under 1%, significantly less than, say, the real federal funds rate in the United States for the same period. Is this not evidence that monetary policy in Japan is in fact quite accommodative?
I will make two responses to the real-interest-rate argument. First, I agree that the low real interest rate is evidence that monetary policy is not the primary source of deflationary pressure in Japan today, in the way that (for example) the policies of Fed Chairman Paul Volcker were the primary source of disinflationary pressures in the United States in the early 1980s (a period of high real interest rates). But neither is the low real interest rate evidence that Japanese monetary policy is doing all that it can to offset deflationary pressures arising from other causes (I have in mind in particular the effects of the collapse in asset prices and the banking problems on consumer spending and investment spending). In textbook IS-LM terms, sharp reductions in consumption and investment spending have shifted the IS curve in Japan to the left, lowering the real interest rate for any given stance of monetary policy. Although monetary policy may not be directly responsible for the current depressed state of aggregate demand in Japan today (leaving aside for now its role in initiating the slump), it does not follow that it should not be doing more to assist the recovery.
A couple comments here. Real interest rates were very high during the crucial period late last year when things fell apart. Second, he goes on to show how monetary policy errors of omission could be associated with low real rates, if there are banking problems and a deep and prolonged recession:
My second response to the real-interest-rate argument is to note that today’s real interest rate may not be a sufficient statistic for the cumulative effects of tight monetary policy on the economy.
. . .
To take an admittedly extreme case, suppose that the borrower’s loan was still outstanding in 1999, and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rate””-for example, the cumulative gap between the actual and the expected price level“”-in assessing the effects of monetary policy. (emphasis added.)
Or how about the cumulative gap in AD, as measured by nominal GDP? And here’s another difference from the gold standard period:
Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.
OK, OK, monetary ease is needed, but what more can the BOJ do?
The second argument that defenders of Japanese monetary policy make, drawing on data like that in Table 3, is as follows: “Perhaps past monetary policy is to some extent responsible for the current state of affairs. Perhaps additional stimulus to aggregate demand would be desirable at this time. Unfortunately, further monetary stimulus is no longer feasible. Monetary policy is doing all that it can do.” To support this view, its proponents could point to two aspects of Table 3: first, the fact that the BOJ’s nominal instrument rate (column 1) is now zero, its lowest possible value. Second, that accelerated growth in base money since 1995 (column 4) has not led to equivalent increases in the growth of broad money (column 5)””-a result, it might be argued, of the willingness of commercial banks to hold indefinite quantities of excess reserves rather than engage in new lending or investment activity. Both of these facts seem to support the claim that Japanese monetary policy is in an old-fashioned Keynesian liquidity trap (Krugman, 1999).
It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However, as I will argue in the remainder of the paper, liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand. Our diagnosis of what ails the Japanese economy implies that these actions could do a great deal to end the ten-year slump.
I recall that Japanese unemployment rate averaged about 5% during their long slump, well above the usual 2% rate. In the US there are many who believe that unemployment during 2008-18 may average 8%, well above our usual 5% rate. It’s a pity that our central bank can’t do anything about our 10-year slump.
PS. In the previous post there are more quotations from this paper, all showing that the Fed refuses to undertake policy actions in the US that 11 years ago we pressed upon the Japanese in a similar situation.
HT: Marcus Nunes