Here’s Milton Friedman during the early stages of Japan’s Great Deflation:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Friedman never would have dreamed that Japan’s nominal GDP in 2013 would be far below 1993 levels.  Nothing like that has ever happened in a country with a fiat money central bank.  Ever.

But Friedman would be even more shocked by the reaction of the rest of the world to Japan’s insane descent into deflation and falling NGDP. Japan is being attacked for running excessively expansionary monetary policies by the Very Serious People:

Referring to the Bank of Japan’s move to ultra-loose monetary policy and similar action by other central banks, Axel Weber, former Bundesbank president and now chairman of UBS, warned that the spread of the approach was “heading into dangerous territory”.

Mr Weber, speaking at the World Economic Forum in Davos, said that the current generation was “living at the expense of future generations” because monetary policy was encouraging people to pull out all the stops to continue consuming heavily. “We are trying to keep a speed limit for our economies that is simply unsustainable,” he said.

The debate on whether monetary policy could do more to boost growth or whether further action would have negative side effects came as International Monetary Fund forecasts again suggested the world recovery would be slower than previously hoped.

Mr Weber’s comments echoed concerns in China and at the central banks of Germany and the UK that Japan’s move to an ultra-loose policy was a bid to drive down the value of the yen that could lead to retaliation from other countries also seeking to boost the pace of recovery through stronger exports.

China’s official Xinhua news agency said on Tuesday that Japan’s “decision to crank up money printing presses is dangerous” and might lead to “currency wars“.

Sir Mervyn King, Bank of England governor, said on Tuesday that if a number of countries sought to lower their currencies it would be “hard to be optimistic about how easy it will be to manage the resulting tensions”.

Jens Weidmann, the Bundesbank president, meanwhile, had described Japan’s new government’s pressure to make the BoJ more proactive as an “alarming infringement” of central bank independence that could lead to “politicisation of the exchange rate”.

.  .  .

Mr Weber’s concerns over monetary policy were supported by Nouriel Roubini of the Stern School at New York University, who had backed the initial moves towards unorthodox policies such as quantitative easing in the financial crisis. “We must care about it,” Prof Roubini told delegates in Davos.

I don’t really have anything to say, other than that the world economy is in the hands of a bunch of people who are stark raving mad.

PS.  This post is not about the merits of a higher inflation target in Japan, nor how Japan is actually doing in RGDP terms.  Comments on those subjects will be ignored.

PPS.  There are recent indications that Japan is already backing away from a 2% inflation target.  Which makes the complaints all the more absurd, if that were possible.

Marcus Nunes and Benjamin Cole have an excellent new e-book on market monetarism and recent Fed policy.   Highly recommended.  I’ll have more to say about this later—I’m rushing to get a paper done right now.

One other quick note.  Caroline Baum has an interesting new piece out on Fed policy, and quotes me extensively.

Joseph sent me a WSJ article by Stephen Moore:

Consider what happened last week when Laura Meckler of this newspaper dared to ask White House Press Secretary Jay Carney how increasing unemployment insurance “creates jobs.” She received this slap down: “I would expect a reporter from The Wall Street Journal would know this as part of the entrance exam just to get on the paper.”

OK, so Jay Carney is an arrogant jerk.  But is that a crime?  Many people would say the same about me.  The problem is that he isn’t just arrogant, he’s uninformed.  Yes, there is a theoretical possibility that UI can lower the unemployment rate, but the evidence suggests just the opposite. See, for example, this essay on unemployment by Larry Summers:

To fully understand unemployment, we must consider the causes of recorded long-term unemployment. Empirical evidence shows that two causes are welfare payments and unemployment insurance. These government assistance programs contribute to long-term unemployment in two ways.

First, government assistance increases the measure of unemployment by prompting people who are not working to claim that they are looking for work even when they are not. The work-registration requirement for welfare recipients, for example, compels people who otherwise would not be considered part of the labor force to register as if they were a part of it. This requirement effectively increases the measure of unemployed in the labor force even though these people are better described as nonemployed””that is, not actively looking for work.

In a study using state data on registrants in Aid to Families with Dependent Children and food stamp programs, my colleague Kim Clark and I found that the work-registration requirement actually increased measured unemployment by about 0.5 to 0.8 percentage points. If this same relationship holds in 2005, this requirement increases the measure of unemployment by 750,000 to 1.2 million people. Without the condition that they look for work, many of these people would not be counted as unemployed. Similarly, unemployment insurance increases the measure of unemployment by inducing people to say that they are job hunting in order to collect benefits.

The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a “reservation wage”””the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase that reservation wage, causing an unemployed person to remain unemployed longer.

Larry’s right.  I’ve seen studies that suggest that extended UI caused the unemployment rate to rise by a half of a percentage point in recent years.  It’s hard to believe that even the most fervent Keynesian would claim that the stimulative effects of the UI insurance extension on AD, by itself, would reduce the unemployment rate by 50 basis points.  So Carney is almost certainly wrong.

Now let me anticipate some objections:

1.  “We are in recession.”  But studies show UI causes higher unemployment even in economies with very high cyclical unemployment.

2.  “Most of the excess unemployment in the US in recent years is due to a demand shortfall, not UI effects.”  I agree.

3.  “So you oppose UI?”  No, I think we should have an UI program, although I’d favor reforms to make it include at least some personal accounts.

Saturos sent me a recent article in The Economist:

THE models that dismal scientists use to represent the way the economy works are sometimes found wanting. The Depression of the 1930s and the “stagflation” of the 1970s both forced rethinks. The financial crisis has sparked another.

The crisis showed that the standard macroeconomic models used by central bankers and other policymakers, which go by the catchy name of “dynamic stochastic general equilibrium” (DSGE) models, neither represent the financial system accurately nor allow for the booms and busts observed in the real world. A number of academics are trying to fix these failings.

Their first task is to put banks into the models. Today’s mainstream macro models contain a small number of “representative agents”, such as a household, a non-financial business and the government, but no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers, rather than profit-seeking firms that make loans opportunistically and may themselves affect the economy.

This perspective has changed, to put it mildly. Hyun Song Shin of Princeton University has shown that banks’ internal risk models make them take more and more risk as asset prices rise, for instance.

.  .  .

In Australia Steve Keen, an economist, and Russell Standish, a computational scientist, are developing a software package that would allow anyone to create and play with models of the economy that incorporate some of these new ideas. Called “Minsky”””after Hyman Minsky, an American economist celebrated for his work on boom-and-bust financial cycles””it places the banking system at the centre of the economy.

A long road lies ahead, however. “Nobody has got something so convincing that the mainstream has to put up its hands and surrender,” says Paul Ormerod, a British economist. No model yet produces the frequent small recessions, punctuated by rare depressions, seen in reality. But “ultimately,” Mr Shin says, “macro is an empirical subject.” It cannot forever remain “impervious to the facts”.

In fact, macroeconomists grossly overrate the importance of banking.  Robert Hall started off a recent survey article with the conventional wisdom:

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis.

Talk about “impervious to facts”!!  The financial crisis of 1931 occurred nearly two years after the Depression began, and was caused by the Great Depression.  The fall of 2008 financial crisis was partly exogenous (the subprime fiasco), but greatly worsened by the severe fall in NGDP between June and December 2008.  Most economists put far too much weight on banking crises as a causal factor, and far too little weight on monetary shocks, i.e. large unexpected changes in expected future NGDP.

Bank lending is not a causal factor—it mostly reflects the growth rate of NGDP.

Matt Yglesias recently suggested that tight money might make incomes more unequal.  That struck me as rather implausible, but Matt did cite a NBER study by Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia (CGKS).

Before discussing the study, let me explain why I found the result surprising.  We know that ultra-tight money in the early 1930s caused a collapse of NGDP, and also made incomes more equal.  The share of income earned by the top percentiles dropped precipitously after 1929.  And that’s not surprising, as income from investments like equities tends to plunge during depressions.  Interest rates also fall sharply reducing interest income.  We saw the same thing happen in 2009, another period of ultra-tight money.  However deep recessions also tend to increase poverty, so I still have an open mind in the question.

So I wondered how CGKS defined monetary policy.  This raised some red flags:

Over the entire sample, contractionary monetary policy shocks lower real GDP, consumption and investment while raising unemployment. Both short-term and long-term interest rates rise immediately while inflation declines after a two-year lag. These results are consistent with a long empirical literature on the macroeconomic effects of monetary policy shocks (e.g. Christiano, Eichenbaum and Evans 1999).

It seems very unlikely that a contractionary monetary policy would raise long term interest rates, at least for any extended period.  Monetary shocks are notoriously difficult to estimate, but I like to use two rules of thumb.

1.  Whatever technique you use, it better be consistent with what we know about the massive interwar shocks, the only shocks that are easy to identify.

2.  Whatever technique you use should be consistent with the reaction of financial markets to the largest monetary policy surprises in recent years.

And what does the interwar period tell us?  It tells us that tight money causes both inflation and short term nominal interest rates to fall almost immediately.  That’s not consistent with the findings of CGKS.

And we also know that in recent decades when the Fed does a major policy change that is unexpected, a tight money surprise tends to reduce both equity prices and long term bond yields within minutes of the announcement, and vice versa.  That’s also inconsistent with the findings of CGKS.

Most economists consider the period since 2008 to have been a period of easy money.  In contrast, I regard it as a period of tight money, and I’m pretty sure that Matt Yglesias does as well.

PS.  Paul Krugman has an excellent post on a slightly different inequality issue.  I recently speculated that he would not care for Joe Stiglitz’s approach to macro, and I was right.