A recent post by Bill Woolsey showed that Japan’s NGDP has been amazingly stable since the early 1990s (with just a dip in late 2008.)  This article in the NYT describes what happened after Japan adopted a stable NGDP monetary policy:

OSAKA, Japan “” Like many members of Japan’s middle class, Masato Y. enjoyed a level of affluence two decades ago that was the envy of the world. Masato, a small-business owner, bought a $500,000 condominium, vacationed in Hawaii and drove a late-model Mercedes.

But his living standards slowly crumbled along with Japan’s overall economy. First, he was forced to reduce trips abroad and then eliminate them. Then he traded the Mercedes for a cheaper domestic model. Last year, he sold his condo “” for a third of what he paid for it, and for less than what he still owed on the mortgage he took out 17 years ago.

“Japan used to be so flashy and upbeat, but now everyone must live in a dark and subdued way,” said Masato, 49, who asked that his full name not be used because he still cannot repay the $110,000 that he owes on the mortgage.

Few nations in recent history have seen such a striking reversal of economic fortune as Japan.

.   .   .

The downsizing of Japan’s ambitions can be seen on the streets of Tokyo, where concrete “microhouses” have become popular among younger Japanese who cannot afford even the famously cramped housing of their parents, or lack the job security to take out a traditional multidecade loan.

These matchbox-size homes stand on plots of land barely large enough to park a sport utility vehicle, yet have three stories of closet-size bedrooms, suitcase-size closets and a tiny kitchen that properly belongs on a submarine.

“This is how to own a house even when you are uneasy about the future,” said Kimiyo Kondo, general manager at Zaus, a Tokyo-based company that builds microhouses.

.   .   .

The decline has been painful for the Japanese, with companies and individuals like Masatohaving lost the equivalent of trillions of dollars in the stock market, which is now just a quarter of its value in 1989, and in real estate, where the average price of a home is the same as it was in 1983. And the future looks even bleaker, as Japan faces the world’s largest government debt “” around 200 percent of gross domestic product “” a shrinking population and rising rates of poverty and suicide.

But perhaps the most noticeable impact here has been Japan’s crisis of confidence. Just two decades ago, this was a vibrant nation filled with energy and ambition, proud to the point of arrogance and eager to create a new economic order in Asia based on the yen. Today, those high-flying ambitions have been shelved, replaced by weariness and fear of the future, and an almost stifling air of resignation. Japan seems to have pulled into a shell, content to accept its slow fade from the global stage.

.   .   .

The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the rational way to act when prices are falling is to hold onto cash, which gains in value. But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people instinctively reluctant to spend or invest, driving down demand “” and prices “” even further.

.   .   .

A Deflated City

While the effects are felt across Japan’s economy, they are more apparent in regions like Osaka, the third-largest city, than in relatively prosperous Tokyo. In this proudly commercial city, merchants have gone to extremes to coax shell-shocked shoppers into spending again. But this often takes the shape of price wars that end up only feeding Japan’s deflationary spiral.

There are vending machines that sell canned drinks for 10 yen, or 12 cents; restaurants with 50-yen beer; apartments with the first month’s rent of just 100 yen, about $1.22. Even marriage ceremonies are on sale, with discount wedding halls offering weddings for $600 “” less than a tenth of what ceremonies typically cost here just a decade ago.

.   .   .

“It’s like Japanese have even lost the desire to look good,” said Akiko Oka, 63, who works part time in a small apparel shop, a job she has held since her own clothing store went bankrupt in 2002.

This loss of vigor is sometimes felt in unusual places. Kitashinchi is Osaka’s premier entertainment district, a three-centuries-old playground where the night is filled with neon signs and hostesses in tight dresses, where just taking a seat at a top club can cost $500.

But in the past 15 years, the number of fashionable clubs and lounges has shrunk to 480 from 1,200, replaced by discount bars and chain restaurants. Bartenders say the clientele these days is too cost-conscious to show the studied disregard for money that was long considered the height of refinement.

“A special culture might be vanishing,” said Takao Oda, who mixes perfectly crafted cocktails behind the glittering gold countertop at his Bar Oda.

After years of complacency, Japan appears to be waking up to its problems, as seen last year when disgruntled voters ended the virtual postwar monopoly on power of the Liberal Democratic Party. However, for many Japanese, it may be too late. Japan has already created an entire generation of young people who say they have given up on believing that they can ever enjoy the job stability or rising living standards that were once considered a birthright here.

Yukari Higaki, 24, said the only economic conditions she had ever known were ones in which prices and salaries seemed to be in permanent decline. She saves as much money as she can by buying her clothes at discount stores, making her own lunches and forgoing travel abroad. She said that while her generation still lived comfortably, she and her peers were always in a defensive crouch, ready for the worst.

“We are the survival generation,” said Ms. Higaki, who works part time at a furniture store.

Hisakazu Matsuda, president of Japan Consumer Marketing Research Institute, who has written several books on Japanese consumers, has a different name for Japanese in their 20s; he calls them the consumption-haters. He estimates that by the time this generation hits their 60s, their habits of frugality will have cost the Japanese economy $420 billion in lost consumption.

“There is no other generation like this in the world,” Mr. Matsuda said. “These guys think it’s stupid to spend.”

Deflation has also affected businesspeople by forcing them to invent new ways to survive in an economy where prices and profits only go down, not up.

Yoshinori Kaiami was a real estate agent in Osaka, where, like the rest of Japan, land prices have been falling for most of the past 19 years. Mr. Kaiami said business was tough. There were few buyers in a market that was virtually guaranteed to produce losses, and few sellers, because most homeowners were saddled with loans that were worth more than their homes.

Some years ago, he came up with an idea to break the gridlock. He created a company that guides homeowners through an elaborate legal subterfuge in which they erase the original loan by declaring personal bankruptcy, but continue to live in their home by “selling” it to a relative, who takes out a smaller loan to pay its greatly reduced price.

“If we only had inflation again, this sort of business would not be necessary,” said Mr. Kaiami, referring to the rising prices that are the opposite of deflation. “I feel like I’ve been waiting for 20 years for inflation to come back.”

One of his customers was Masato, the small-business owner, who sold his four-bedroom condo to a relative for about $185,000, 15 years after buying it for a bit more than $500,000. He said he was still deliberating about whether to expunge the $110,000 he still owed his bank by declaring personal bankruptcy.

Economists said one reason deflation became self-perpetuating was that it pushed companies and people like Masato to survive by cutting costs and selling what they already owned, instead of buying new goods or investing.

“Deflation destroys the risk-taking that capitalist economies need in order to grow,” said Shumpei Takemori, an economist at Keio University in Tokyo. “Creative destruction is replaced with what is just destructive destruction.”

Before commenters like Greg jump all over me, re-read the intro.  I never claimed the adoption of the 0% NGDP growth policy had anything to do with the dreary story described by the NYT.  And I’m not sure it does.  There’s nothing wrong with touting a country as a smashing success in one area, even if you disagree with its policies elsewhere.  I’m always praising Singapore’s fiscal policy, yet I detest many policies of the Singapore government.  It could well be that the bad performance of Japan’s economy was caused by supply-side factors unrelated to monetary policy.  Some bloggers even claim the Japanese haven’t done all that bad.

And yet . . . let’s be honest.  This is a big problem for the 0% NGDP growth fans.  Japan’s slide into stagnation co-incided almost exactly with the (de facto) adoption of a stable NGDP rule.  And it’s the only country I know that has adopted this policy.  And before the policy was adopted most mainstream economists thought deflation was a really bad idea.  Put that all together and I think “zero percenters” have got a massive PR problem.

Yes, the US grew rapidly in the late 1800s under deflation, but we had strong NGDP growth.  Japan doesn’t.  Are there any examples of countries doing well with stable NGDP?  I don’t know of any.  Unless someone can find plausible counterexamples, that makes Hayek’s argument a really hard sell.

Why is this important?  Because Hayek’s argument underlies the Austrian view that monetary policy was too “inflationary” during the 1920s, despite no rise in the price level.  He argued NGDP should have been kept stable, so prices could fall with productivity gains.  This argument also underlies some of the critique of Fed policy in the 2000s, as price inflation wasn’t all that high.  In fairness, some point to the rapid NGDP growth after 2003 as a problem, and I partly agree.  So the critique of the Fed in this case seems stronger from a NGDP targeting perspective.  But still nowhere near as strong as the critique of their policy of allowing NGDP growth to plummet in the midst of a financial crisis.

Paul Krugman recently did a post mocking those Europeans who complain about the Fed actually trying to do its job.  He quoted a European policymaker whining that monetary stimulus in the US would depreciate the dollar and thus hurt Europe.  Here’s Krugman’s response:

In other words, how dare you act to protect your economy from deflation and double-digit unemployment? By doing so, you make our inappropriate tight-money policy even more destructive!

I love it.  But at the same time it’s important to recall Bryan Caplan’s admonition that we Americans are much too quick to perceive harm inflicted by others, and reluctant to recognize when we are the villains.  So I tried to re-work the quotation, so that we could see how our complaints might appear to someone living in China:

In other words, how dare you Chinese act to protect your economy from deflation and double-digit unemployment by refusing to revalue the yuan? By doing so, you make our inappropriate tight-money policy even more destructive!

I look forward to future Krugman posts that point out how America’s China-bashers overlook the fact that the Federal Reserve System has the power to do much more, but simply refuses to use that power.  And how do I know this?  By reading a Paul Krugman post written just one day earlier.

The Great Depression started in August 1929. The Fed first began increasing the monetary base in late 1930, in response to the first bank run (which was rather small.)  The second QE was announced in February 1932 (30 months into the Depression), and was not a reaction to financial distress but rather was an attempt to boost aggregate demand.

This time around things are different.  The Great Recession formally began in December 2007, although I put July 2008 as a mini-peak, before the sharp drop in AD.  The first QE was in response to bank distress, and occurred in late 2008 and early 2009.  Now we will have a second QE announced in early November, either 28 or 35 months into the recession, depending on when you start it.  In other words, it’s right on schedule.

I know what you are thinking: “Don’t be so sarcastic, in other respects we are doing much better this time.  For instance, the Fed has cut rates close to zero.”  The problem is, they also cut rates close to zero in the early 1930s.

“But at least we aren’t raising income tax rates like Hoover did in 1932.”  Well Obama’s trying to.

“But at least we aren’t following Hoover’s high wage policy.”  Didn’t we raise minimum wages by over 40% in the last few years?

“But at least we are not following Hoover’s protectionist policies which started a trade war.”  That’s true, but we have a Nobel Prize-winner trying to push us into a trade war.

“But at least we understand the real problem this time.  In the Depression you actually had lots of conservatives warning about high inflation, even as low prices were the real problem.”   No comment.

“But at least we don’t have people claiming the recession was punishment for speculative excesses abetted by easy money.  Surely Friedman and Schwartz ended that myth about the 1920s once and for all.”  Actually the myth has been revived, by Anna Schwartz.

“But at least we don’t have people claiming that a sharp cut in interest rates and a big increase in the monetary base means money is “easy.”  Surely Friedman and Schwartz’s highly influential work on the Depression dispelled that myth.”  No comment.

“But at least we don’t have the bizarre scenario of the 1930s, where both liberals and conservatives made bogus “pushing on a string” arguments, while simultaneously warning of the risk of high inflation.”  No comment.

“But at least we no longer have people claiming the recession was caused by income inequality–we now understand the root cause is insufficient AD.”  No comment.

“But at least we no longer have people claiming the unemployment is mostly structural.”   No comment.

“But at least we don’t have people arguing that monetary policy should be used to pop speculative bubbles—the disastrous effects of the Fed’s attempt to pop the 1929 stock bubble drove a stake into the heart of that misguided idea.”  No comment.

Want more parallels?  The European debt/exchange rate crisis occurred 5 to 8 months before QE II was announced as a debt crisis hit Germany in June 1931 and Britain left the gold standard in September 1931.  What happened in Europe during the spring of this year?

In fairness to my critics, I should point out that QE II was greeted ecstatically by the stock market.  (The largest 2-day rally in history.)  Yet the policy failed.  In my favor, the reason for it failing (a large gold outflow mostly neutralized the bond purchases) is not operative this time.  But there is certainly a possibility that it will fail again, and that the Fed will need to use more powerful tools like negative rates on excess reserves and level targeting.

In 2002, Ben Bernanke assured us that we have learned the lessons of Friedman and Schwartz:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

In fairness, they did move aggressively enough to prevent what otherwise would have been a depression in 2002-03.

But have we really learned our lessons?  I’m not so sure.  What do you think?

I feel like a lazy bum.  This morning Ben Bernanke created $250,000,000,000 in new wealth before I’d even finished breakfast.  That’s right, his speech led to about a 1/2% pop in equity prices.  Given world markets seem to respond to Fed easing by about as much as US markets, that’s a half percent of roughly $50,000,000,000,000 (aka 50 trillion.)

And don’t say all the gains melted away by lunchtime.  That’s not how equity markets work.  Sure the disappointing consumer data depressed prices a few hours later, but they remain 1/2% above the level they would have been without that easing.

Bernanke didn’t actually say too much new, but he was pretty definitive.  It seems we will get QE, and no change in the 2% inflation target.  That might be viewed as disappointing.  But the speech itself was fairly dovish (or pro-growth.)  Indeed Bernanke staked out an almost Svenssonian position:

1.  He clearly stated that inflation could be too low.

2.  He strongly implied 2% is the right number.

3.  He suggested that current forecasts are for well below 2% inflation.

4.  He said that’s not good enough, policy needs to be more expansionary if inflation is expected to be too low at a time of 9.6% unemployment.

5.  The Fed needed to do something about this situation.

I think Bernanke’s gamble is that 2% inflation will be enough, as long as they go all out for that figure.  Using intro macro, Bernanke’s suggesting that the SRAS curve is now so flat that even getting up to 2% inflation would require much faster RGDP growth.  He considered the initial recovery to be “reasonably strong.”  I disagree, but if that’s his definition of fairly strong, then yes, 2% inflation would probably generate enough growth to satisfy Fed moderates like Bernanke.

The title of this post has a double meaning.  I’m going to argue that monetary policy is really, really important at the zero bound.  And in section 2 I’ll argue that monetary economics talk is also really, really important .  (I know . . . how self-serving for a monetary economics blogger.)

Part 1.  Why policy is important:   Unless you want to be a complete ostrich, I don’t see how anyone could seriously deny that over the past 6 weeks the world equity markets have been repeatedly reacting to a long string of Fed statements and press releases.  Yes, I know that the financial press cannot always be relied upon when they speculate as to what caused stocks to rise.  But if anyone looks at this issue seriously, and with an open mind, I can’t see how they can fail to see the highly persuasive evidence that Fed announcements strongly affect equity markets.  As just one example, the Dow occasionally soars or plummets by several hundred points immediately after a 2:15pm Fed target rate  announcement.

To me, this suggests we shouldn’t even be arguing anymore about “pushing on a string.”  Equity markets are up by 10% to 20% over the last 6 weeks (in both nominal and real terms), that’s a very important effect regardless of whether traders are operating with a faulty model or not.  I can’t imagine how Chicago-type economists can go on about how swapping one zero-interest asset for another does nothing.  Surely an extra $5 trillion in real wealth is something.  They need to stop paying attention to their models, and look at what the markets are saying.

As for Mr. Krugman, his own model says swapping one zero interest asset for another is highly effective, if the action is expected to be permanent.  (If temporary, it isn’t effective whether interest rates are at the zero bound or not.)  Yet Krugman consistently pooh-poohs the prospects for conventional OMOs.  I’m reminded of the stories that people like Richard Kahn had to keep reminding Keynes what he was trying to say in the General Theory.

In my view the whole pushing on a string debate is over.  Case closed.  If people want to close their eyes to how the markets are reacting to hints of Fed easing, that’s their prerogative.   Of course some will argue that it is higher inflation expectations that are doing the job.  But any permanent QE will create higher inflation expectations; that’s the whole point.  And we’ve always known that temporary QE doesn’t do anything.  So what’s the debate all about?

Part 2:  Why monetary pundits matter:   In my view $5 trillion is a reasonable estimate of the amount world stock markets have increased as a result of Fed talk about easing policy since the beginning of September.  That’s 10% of my crude estimate of total world stock market equity.  The exact number isn’t important, just the order of magnitude; $3 trillion or $7 would have the same qualitative implications.  And the total gains to society have probably been far greater, as monetary stimulus also helps workers, not just capitalists.  (Of course it’s a zero-sum game for bond markets.)

So who is responsible for all this wealth creation?  Surely some credit must go to the Fed, after all, they are the institution that is ultimately responsible for determining monetary policy.  But I think others also deserve some credit.  Back in August, before all this occurred, Paul Krugman made the following observation:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

Pretty prophetic eh?  No wonder Brad DeLong is always saying Krugman’s right about everything.  I agree, the Fed (like the Supreme Court) clearly does respond at least somewhat to outside pressure.  So how much credit do we pundits deserve for this stock rally?  Let’s take a conservative figure, assume it’s 10% due to outside pressure and 90% from the Fed seeing the light without any outside influence.  So the pundits created a mere $500 billion in stock wealth since September 1st.  Of course I’d like to take some credit for all this, especially since the Fed mentioned NGDP targeting in its most recent minutes.  But in all honesty I think the markets reacted to level targeting of prices, not NGDP.  I’ve also pushed level targeting, but Woodford and Eggertsson probably deserve most of the credit.  So of the total of $500 billion in new wealth created by pundits pushing for easy money, let’s give Woodford and Eggertsson each 10%.  Perhaps uber-pundit Paul Krugman deserves 5%, and for all us small fry pushing for monetary stimulus I’ll assign a trivial 1% share.  And recall that’s only 1% of the 10% share assigned to all pundits–1/1000 of the total.

In other words, we at TheMoneyIllusion deserve credit for a mere $5 billion dollars in wealth creation.  And I say “we” because it’s a collaborative project.  For instance commenter Marcus Nunes sent me the old Bernanke papers from 1998 and 2003, in which he told Japan to do all the things that we are now telling the Fed to do.  After I posted long excerpts, lots of other bloggers and media outlets started picking up on the story.  Don’t think that Bernanke isn’t aware of what he told the Japanese to do, and don’t think he isn’t aware of all the media outlets quoting those comments.  So I figure Nunes deserves about a billion.  Notice how these tiny crumbs, $5 billion, $1 billion, roughly correspond to the wealth of Facebook’s two founders.

Am I serious?  I’m not quite sure.  It all sounds as ridiculous to me as it must to you.  On the other hand, Krugman’s argument sounds pretty reasonable to me, so I can’t see any good reason why it might not be true.  The bottom line is that no matter how thin you slice it, no matter how trivial the contribution to a sound monetary policy, good advice to the Fed is extremely valuable.  Monetary economics is quite important, too important to be left to amateurs.  Unfortunately, some of our most important monetary policymakers have relatively little training in the field.

BTW, economists at the Fed must be high-fiving themselves after I allocated $4.5 trillion in wealth creation to their brilliant policy ideas.  But before they get too excited, and start dreaming about where they’ll spend their money, I feel it necessary to point out that Fed officials still have some unpaid debts associated with an earlier policy boo boo:

Which proved very costly:

There seem to be two approaches to macro policy, once interest rates hit the zero bound:

1.  The pessimistic view:  In this view, monetary policy can do no more.  Trade balances become a zero sum game.  The US gains from some (not all) contractionary policies adopted by other countries, such as currency revaluation.  If China sharply revalues its currency, it may cost millions of jobs in China, and hurt countries that export materials and machines to China, but it will boost jobs here.  It might not be accurate to claim this is a zero sum game view of the world, but it comes pretty close.  (By the way, I used the term ‘sharply revalue’, as I think a gradual revaluation is in China’s own interest.)

2.  The optimistic view:  Even at the zero bound monetary policy is still the most important factor driving NGDP growth.  It’s not a zero sum game.  A sharp Chinese revaluation might reduce world AD.  A dramatic easing by the Fed would not just depreciate the dollar against goods and services, it would sharply raise world AD, and world RGDP if there is slack in labor markets.  This could easily help overseas firms, even in countries whose currencies might rise a bit against the dollar.  In this view, you don’t look for jobs by trying to take them away from other countries, even countries that might be “misbehaving” according to some sort of arbitrary “rules of the game” that never did and never will exist, but rather you try to generate jobs in your own country by boosting your own AD.

Check out this recent news story—I could have found 100 similar ones over the last month (in case anyone thinks I’m cherry-picking.)

LONDON (AP) — World markets mostly rose Thursday as investors remained buoyed by the prospect of more monetary stimulus from the Federal Reserve. However, predictions of looser U.S. policy have not done the dollar any good as it slid to a 15-year low against the yen and multi-month troughs against the euro and the pound.

.   .   .

Once again the main focus in the markets is on what the Fed is planning to do at its next rate-setting meeting in early November to shore up the U.S. economy and prevent prices from falling. The minutes to the last meeting of the Federal Open Market Committee gave a big hint that the Fed is planning another monetary stimulus, that could involve the setting of an inflation target.

All eyes will be on Fed chairman Ben Bernanke Friday when he delivers a speech on monetary policy, more or less at the same time as monthly inflation figures are set to show price pressures in the U.S. economy remain subdued.

Analysts said it’s no longer a question of if but how and how much money the Fed will pump into the U.S. economy.

Stocks have been buoyant for over a week as investors have priced in the growing likelihood that the Fed would join the Bank of Japan in easing monetary policy further in an attempt to further drive down rates on mortgages, corporate loans and other debt in the ultimate hope of boosting economic activity and supporting prices.

For those who don’t follow world equity markets, the strong stock market rally since September 1 that most are attributing in large part to growing expectations of Fed easing, has been mirrored in the major overseas markets.  Yet a “beggar-thy-neighbor” view of economics would predict that foreign firms should be hurt if the US depreciates the dollar.

After my most recent defense of the EMH, some commenters asked me incredulously whether I really thought investors understood complex economic models as well as the model builders, who are some of the smartest people around.  You misunderstood my argument.  I’m not saying markets are as smart as elite macroeconomists, I’m saying they are much smarter.  Individual investors are often dumb as door knobs, but collectively they understand how the world works even better than some Nobel Prize-winning economists.

That’s why 1000 people can look at a jar of jelly beans and individually not have a clue as to how many there are.  But collectively they know the right answer.  It’s all about the wisdom of crowds.

PS.  Commenters;  I hope to catch up on comments this weekend.