.  .  .  and then there are days where I read something like this (from the FT):

The debate about the effectiveness of unconventional monetary policy measures such as quantitative easing remains perennially inconclusive. Yet the experience of Japan suggests there is one clear negative outcome from ultra loose monetary policy: it does structural damage to the economy.

PS.  I suppose if one is looking for examples of “ultra loose” monetary policy causing damage to an economy, then the US during the 1930s could also be cited.

HT:  John S.

Satures sent me this link from the New York Times:

Mr. Bernanke was also asked why the Fed does not lower or eliminate the interest rate “” already at 0.25 percent “” that it pays banks for excess reserves kept at the central bank to encourage more lending.

He said that Fed officials had not ruled out that idea but that so far it appeared the benefits would be very small and that there were concerns that eliminating the interest takes away a tool used to control broader interest rates.

That’s obviously false, so what is Bernanke’s point?

A few days ago I did a post discussing the recent Japanese proposal for a 3% inflation target.  Britmouse recently sent me a link suggesting it was an NGDP targeting proposal, not an inflation target:

The head of Japan‘s biggest opposition party said he will make Prime Minister Yoshihiko Noda‘s management of the world’s third-largest economy a key issue in seeking to unseat him in next month’s election.

“This election will be a fight to win back Japan,” Shinzo Abe told reporters at Liberal Democratic Party headquarters yesterday in Tokyo after parliament was dissolved for the Dec. 16 vote. “I will do all I can to end the political chaos and stalled economy.”

Public support for Noda plummeted as he pushed through a bill doubling the five percent sales tax in a bid to rein in the world’s largest public debt and restarted some nuclear reactors following last year’s Fukushima disaster. Opinion polls show his Democratic Party of Japan is set to lose power, making way for the country’s seventh leader in six years.

In a nationally televised press conference, Noda said he decided to call the election after reaching deals to pass a deficit financing bill and electoral revisions. Polls show four- fifths of voters support neither main party, signaling that the next prime minister may have to form a coalition government.

Abe advocates increased monetary easing to reverse more than a decade of falling prices and said he would consider revising a law guaranteeing the independence of the Bank of Japan. (8301) In an economic policy plan issued yesterday, the LDP said it would pursue policies to attain 3 percent nominal growth. The party governed Japan for more than half a century until ousted by the DPJ in 2009.  (Emphasis added.)

The Liberal Democratic Party (which isn’t particularly liberal or democratic) seems to be running on a market monetarist platform.  In the world’s third largest economy.  And it’s likely to win. Interesting.

There are two types of currency intervention; policies aimed at moving the nominal exchange rate, and policies aimed at moving the real exchange rate.  I notice that many economists confuse these two policies, even though they are so different that they shouldn’t even be taught in the same course.  Nominal exchange rate control is properly taught in monetary economics, and real exchange rate control is properly taught in intermediate macro.

To make this distinction easier to see, I’m going to create two imaginary examples; Switzerland and China.  Switzerland will try to depress the nominal exchange rate to prevent deflation, and China will attempt to depress the real exchange rate to boost exports.  I am not claiming that these examples conform to the actual policies of Switzerland and China, indeed I think they do not.  Rather they conform to how many people visualize these two countries, so I’ll play along and use them as pedagogical devices.

Let’s say that both countries implement their policies by having the central bank buy foreign exchange.  Why are these policies totally different?  To answer that question, we need to focus on two key variables; the monetary base and government saving.  You decrease the real exchange rate by increasing government saving.  Period.  End of story.

You reduce the nominal exchange rate (and prevent deflation) by increasing the monetary base.  It doesn’t much matter what you buy, although the Swiss might find it convenient to buy euros, as they are using the euro/SF exchange rate as a policy instrument.  They change the monetary base in order to change the exchange rate, in order to change the price level.  Why not cut out the middleman and target CPI futures?  Good question.

A recent Wall Street Journal article discussed recent Swiss policy

The Swiss National Bank SNBN.EB +1.00% has pulled off what was thought to be a near-impossible trick: unloading billions of euros without the wider market noticing.

Switzerland’s central bank said Wednesday that the proportion of its currency reserves held in euros fell to 48% at the end of September, down from 60% at the end of June, indicating that it aggressively sold euros for other currencies throughout that time, most notably in favor of sterling and dollars.

.  .  .

The SNB had imposed its lower limit on the euro’s exchange rate against the Swiss franc in September 2011, amid a relentless surge in the value of the franc against the euro””the currency of its biggest trading partners. As a result, the bank bought a huge pile of euros in order to keep the franc competitive. A too-strong currency makes it more difficult for Swiss exporters to compete in global markets, because their products either become more expensive overseas or their profit margins drop, or a combination of both.

So far, the SNB’s so-called floor has been broken only once, when the euro dipped fractionally under 1.20 franc in April.

The bank has repeated its resolve to hold the floor in place, and with the situation in the euro zone improving, its policy is unlikely to change.

“We feel that the central bank can easily still defend the floor, so there is very limited downside to the euro against the Swiss franc,” said Jaco Rouw, senior investment manager at ING Investment Management in Amsterdam.

Of course if the Swiss swapped those dollars for US equities, nothing would happen to the SF/euro exchange rate.  And if they swapped the US equities for Swiss equities, nothing would happen to the SF exchange rate.  It makes no difference what the SNB purchases, what matters is the monetary base.  The only reason they purchased euros is that it made it slightly easier to hit their SF/euro target exchange rate.  That’s all.

During normal times when interest rates are positive, you only need a very small purchase of foreign exchange to raise the base enough to hit your nominal exchange rate target.  Have the central bank buy 1% of GDP in financial assets, and you’ll depreciate your currency by 10% to 20%.  (Of course when at the zero bound central bank purchases may be less inflationary, especially if viewed as temporary.)

In contrast, even during normal times it takes massive government saving to have a significant impact on the level of national saving, and hence the real exchange rate.  And a central bank purchase of forex need not have any effect of national saving.  If they add T-securities to the balance sheet of the central bank and delete an equal amount of domestic assets, then there is no impact on national saving.

I’m no expert on Chinese forex purchases, but the amounts are so large that I presume it’s not being used as ordinary “open market operations.”  That is, I assume the $3 trillion in purchases far exceeds the rise in the monetary base.  So somehow the central bank is acting as an agent of the Chinese government, and making purchases that boost total government saving.  And this depreciates the real exchange rate.

Why do people confuse these two types of intervention?  Because they look similar at first glance.  Although the Swiss central bank may buy foreign currency, it is obviously the quantity of SF that matters, not the asset being bought.  And although the PBofChina might buy lots of foreign exchange, it’s obviously the impact on Chinese government saving that matters, not the fact that saving is being boosted via central bank purchases of US Treasury debt.  The same impact on the real exchange rate would occur if a Chinese sovereign wealth fund gobbled up lots of French and British and Brazilian equities, and the central bank let the yuan float.

However because wages and prices are sticky, any policy that depreciates the real exchange rate will also tend to depreciate the nominal rate in the short run.  And vice versa.

PS.  I’m in Singapore right now.  I recommend Japan Airlines for the following reasons:

1.  Low price, short travel time (only 24 hours from Boston!)

2.  They use the new Dreamliner.  It doesn’t seem to fly faster (wasn’t that a claim?) but they are better than the average airplane.  More spacious.

3.  They show Japanese films!  Previous to this flight I’d watched maybe two films in my life on airplanes.  I watched two Japanese films on just the Boston-Tokyo leg of the flight.

4.  Ultra-polite Japanese stewardesses.

5.  Some of the meals (not all) were not awful.

Just got here, but my initial impressions are that taxis and hotels are cheap and everyone drives luxury cars (presumably due to the big car tax.)  And everything in Singapore seems to go smoothly, just as people claim (knock on wood.)

Each day I check out the major stock markets.  This morning I saw that Hong Kong and Singapore were down over 1%.  Britain, Germany and France were also down.  But the Japanese market, which tends to move with the other Asian markets, was up by 1.90%.  That’s a surprisingly large divergence.  Is there any news?  It turns out that there is news, but only if you don’t believe in “liquidity traps.”  Travis Allison sent me the following:

The yen slumped to the lowest in more than six months against the dollar on prospects Japanese elections next month will hand power to an opposition party that advocates more aggressive monetary easing.

.   .   .

Japan’s currency weakened to almost a two-week low versus the euro on speculation the vote will favor Shinzo Abe, who called for the central bank to provide unlimited stimulus.

.   .   .

“The leader of Japan’s opposition is coming down quite heavily, saying what he would like the Bank of Japan (8301) to do in terms of easing and that’s pressuring the yen,” said Jane Foley, a senior currency strategist at Rabobank International in London.

.   .   .

The yen dropped 1.4 percent to 81.39 per dollar at 8:47 a.m. New York time, after touching 81.46, the weakest level since April 25. It depreciated 1.7 percent to 103.92 per euro.

.  .  .

Japanese Prime Minister Yoshihiko Noda will dissolve parliament tomorrow, triggering an election that polls show his Democratic Party of Japan will lose. The vote for the lower house will be held on Dec. 16, acting DPJ secretary-general Jun Azumi said yesterday.

“The biggest economic problem is prolonged deflation and a strong yen,” Abe, the head of the largest opposition Liberal Democratic Party, said in a speech in Tokyo today. “Markets will only start to react once unlimited monetary easing is conducted.”

The Bank of Japan must cut its benchmark interest rate to zero or even lower to boost lending, Abe said. The rate is currently set at a range of between zero and 0.1 percent. Earlier this month, Abe said the BOJ should conduct monetary easing until the nation achieves 3 percent inflation. Consumer prices excluding fresh food fell 0.1 percent in September, declining for a fifth month.

Of course if you are one of those Keynesians who do believe in liquidity traps, then you’d have to conclude that this speech had no impact on the Japanese exchange rate, or the Japanese stock market.

And if you believe in liquidity traps then you also must believe that the fact that the Swiss franc has been stable at 1.20 per euro for the past 14 months is just an amazing coincidence, having nothing to do with the fact that in September 2011 the Swiss government announced a policy of pegging the SF at 1.20 per euro.

And yet most economists do seem to believe in liquidity traps.  In future decades people will look back on this era and just shake their heads.

PS.  In 2 days I will be in Japan, for my first time ever.  But only for 2 hours.