Free Exchange directed me to a recent speech by Jeremy Stein:

Imagine that it is 18 months from now, and that with interest rates still very low, each of the trends that I identified earlier has continued to build””to the point where we believe that there could be meaningful systemic implications. What, if any, policy measures should be contemplated? It is sometimes argued that in such circumstances, policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability…As we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability.

Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns. If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior…Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation””namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot. Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front.

I wonder how much Mr. Stein knows about Fed policy during the 1920s.  The paper does not mention that 1929 was the last time the Fed tried to implement his proposed policy.  Indeed the paper does not discuss Fed policy during the 1920s—a very disturbing omission.   (Recall that I argued that only the very best monetary economists in the world should be allowed to serve on the FOMC.  Stein’s brilliant, but isn’t he a finance guy?)

During the 1920s NY Fed President Benjamin Strong was under a lot of pressure to “do something” about the stock market boom.  He resisted, arguing the Fed should focus on stabilizing prices and output. (Hmmm, what is the sum of the growth rate of prices and the growth rate in output?)  He died in August 1928, and the new leaders of the Fed finally had their chance.  They raised interest rates in late 1928, and then in early 1929, and then in mid-1929.  But it didn’t do any good.  Stocks kept soaring higher and higher.  And there’s a reason it didn’t do any good.  Stocks are very long lasting assets.  Investors care much more about the future performance of the economy than the current setting of very short term interest rates.  As long as the economy was booming and there is no inflation, why should stocks have fallen?

But the Fed didn’t give up, and by the late summer of 1929 short term rates were at 6%.  Recall that this was a very high real rate, as there was deflation during the 1927-29 business cycle expansion, despite the fact that the economy was booming.  So the trend rate of inflation in 1929 was almost certainly negative. Finally money got so tight that the economy tipped into depression.  And it was (expectations of) the depression that caused the stock market crash, not the high interest rates.  Indeed stocks hit the all time high in early September 1929, when interest rates were also near an all time high in real terms.  Only when the Fed caused the economy to tank did the stock “bubble” finally burst.  (BTW, studies have shown that stocks were not overpriced in 1929.)

The problem here is that monetary policy is a very blunt instrument.  Stein is wrong in assuming that the Fed has specific monetary policy tools that can surgically attack bubbles.  But they do have regulatory policies that can and should be used to prevent excessive risk taking in the banking system.

I know what you are thinking; “Sumner, we get that you don’t agree with Stein, but no reason to accuse him of child abuse.”

I have two responses:

1.  I don’t consider spanking to be child abuse.

2.  Governor Strong had this to say shortly before he died:

Must we accept parenthood for every economic development in the country?  That is a hard thing for us to do.  We would have a large family of children.  Every time one of them misbehaved, we might have to spank them all.

Excessive NGDP growth requires a good spanking—the rest of the misbehaving children need to be addressed with regulatory measures.

Here’s Paul Krugman:

The Fed could and did cut rates, helping to cushion the impact of spending cuts. It can’t do anything like this now, because the Fed funds rate has already been cut more or less to zero in an attempt to fight the effects of financial crisis.

Austerity right now is a really, really bad idea.

When I starting blogging, and started defending the EMH, I faced three anti-EMH arguments:

1.  The obviously irrational housing price bubble.

2.  The continual success of Warren Buffett.

3.  The amazing returns earned by the hedge funds.

As you are about to see, all three critiques of the EMH have been recently discredited.  Let’s start with the hedge funds.  Here’s a recent article from the Economist, showing their early success was just a fluke:

Then there’s the amazing Mr. Buffett.  Once again, the Economist comes to my defense:

Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009.

Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

A further advantage has been the stability of Berkshire’s funding. As many property developers have discovered in the past, relying on borrowed money to enhance returns can be fatal when lenders lose confidence. But the long-term nature of the insurance funding has protected Mr Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market.

These two factors””the low-beta nature of the portfolio and leverage””pretty much explain all of Mr Buffett’s superior returns, the authors find.

Then there’s the housing bubble.  What goes up . . . stays up 4 times out of 5.  That’s right, the housing bubble of 2005-06 was not something that would inevitably burst, as the anti-EMH proponents insist.  Indeed if you look at the US, Britain, Canada, Australia and New Zealand, it is the US that is the outlier.  All saw big price gains during the boom years, but only the US bubble burst.  The other 4 countries still have very high house prices:

Inevitably some commenters will insist that the EMH is not true.  Yes, but no economic theory is precisely true.  However it is and will always be a very useful model.

Asset prices are unforecastable; but here’s one thing that can be accurately forecast:  One hundred years from now all the top finance departments will still be teaching this theory that almost everyone insists is “false.”  And yet 99% of the “anomaly” studies published in econ/finance journals and constructed through tedious data mining will be long forgotten.

A few years ago I started to push the view that most economists had misinterpreted the Japanese liquidity trap.  The BOJ had not tried valiantly to inflate, and failed.  Japan was not “stuck” in any sort of trap.  The low interest rates and bloated base did not mean easy money.  I often point out that the BOJ tightened twice (2000 and 2006) when there was no inflation, which made mild deflation almost inevitable.  At one time I got into a bit of a debate with Paul Krugman:

Hmm. I see that Scott Sumner has a post heatedly attacking the idea that Japan is stuck in a deflationary trap; he insists that Japan has deflation because that’s what the Bank of Japan prefers:

“I was under the impression that the Bank of Japan was an ultra-conservative bank, and liked mild deflation. Indeed I thought that was pretty widely understood. I guess not.”

He guesses right: that’s not at all the view of those who have been following Japanese monetary policy since the 1990s, and have even talked to BOJ people now and then. I’m sorry to say that the fact is that Japan is in a deflationary trap. You can argue that the BOJ should have done more “” and I would. But persistent deflation isn’t a target, it’s what has happened because conventional monetary policy has lost traction and the BOJ isn’t willing to be more adventurous.

Here’s Paul Krugman yesterday:

What you need in this situation is a negative real interest rate “” which means that you need some expected inflation, because nominal rates face the zero lower bound.

But Japanese policy has never sought to achieve this. Deficit spending has put part, but only part, of the excess desired private saving to work; this has mitigated the slump, but not produced a booming economy, except perhaps briefly circa 2007. And the Bank of Japan has always pulled back on monetary policy when the economy looks better, instead of doing what it should, which is to keep the pedal to the metal until the inflation rate is solidly into positive territory.

I don’t think his position has technically shifted, as a close look at the earlier post tells a similar story to the recent post.  But I do think there’s a sort of change in emphasis.  Earlier he was skeptical of the ability of the BOJ to get Japan out of a deflationary trap.  Now he’s (correctly) pointing out that all this talk of stimulus is boosting the expected rate of inflation in Japan.  They are not “stuck.”  So I see the “pedal to the metal until the inflation rate is solidly into positive territory” as emphasizing that effort matters, it isn’t all about managing expectations.  And that wording seems slightly closer to the monetarist perspective on Japan.  Again, these are slight differences of nuance so I don’t want to make too much of it. He might argue that “pedal to the metal” resolve was a way of managing expectations.

It’s harder than most people assume to pin down the difference between new Keynesianism and market monetarism.  Perhaps we are simply more confident that the BOJ can succeed if it tries.

Here’s one way of putting it.  Krugman and I both agree that the failure to put the pedal to the metal was a sufficient reason for deflation to persist. I also view it as a necessary condition, whereas Krugman tends to be a bit circumspect about how big the “expectations trap” hurdle would be if the BOJ became determined to inflate.

Pico Iyer?  Krugman’s post reminded me of a recent article in the NYR of Books, entitled “Masters of Doing Nothing at All.”  Here’s the opening sentence:

Japanese literature is often about nothing happening, because Japanese life is, too.

PS.  In case I have any Japanese readers, here’s what I posted on November 15, 2012:

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.”

And here’s a graph of the Nikkei since that date, up 32.3% in less then 3 months:

Don’t say I didn’t tell you!  Beats the rate of return on that account at the Postal Savings Bank.   🙂

PPS.  Paul Krugman jumped on board the Abe bandwagon on January 11, when they announced a fiscal stimulus proposal.  By then the stock market was already up sharply, mostly on persistent rumors of a 2% inflation target for the BOJ.  But I’ve been talking about this issue from day one of the Great Nikkei Bull Market.

PPPS.  Not much help to investors in America, as the yen has fallen sharply.  But the Japanese CPI has barely budged, so it’s a pretty big real increase in Japan.

PPPPS.  The smiley face is because as much as I’d like to take credit for a lucky call, I still believe in the EMH.

HT:  Saturos

In late 2010 David Glasner did a study showing that TIPS spreads and stock prices became highly (and positively) correlated around 2008. Previously the correlation had been rather weak.  The most plausible interpretation is that the stock market began to root for higher inflation (and by implication higher NGDP) at about the time when the US economy began to suffer from a demand shortfall. Michael Darda sent me a graph showing that more that two years later the correlation persists:

It’s easy to data mine enough time series to find spurious correlations.  It’s much harder to develop a model that continues to do well after the results are published. It looks like David Glasner’s model passes that test.