Bryan Caplan sent me the following question:

Bill Dickens wants to bet me that looser Japanese monetary policy won’t boost Japanese NGDP.  What victory conditions should a market monetarist consider prudent and probative?

So I thought I’d see what others think.

I don’t like these sorts of bets, as I see some ambiguity here.  Is the bet over whether the BOJ will adopt easy money?  Or whether NGDP will rise if it does adopt easy money?  Given that I define easy money as rising NGDP, I think you can see my dilemma.  I’d rather we just go ahead and set up an NGDP futures market.

PS.  I seem to recall that Japan’s NGDP is now lower than 20 years ago, even though its population is higher.  But its population is now falling.  I believe Japan’s NGDP will rise at least 1% per year going forward.

Here’s Paul Krugman:

But in the world we’ve been living in this past quarter-century or more, inflation expectations haven’t moved much, and nominal interest rates have, in practice, been a pretty good guide to the stance of monetary policy.”

Throughout the post, Krugman seems to imply that nominal interest rates are a good guide to the stance of monetary policy as long as inflation expectations are fairly stable.  And also that inflation expectations have been fairly stable in recent decades.  This would seem to lead to the absurd conclusion that monetary policy must have been very expansionary in 2008 because nominal interest rates fell sharply!

Now let’s first get one thing out of the way.  Words mean what the public thinks they mean.  Most people agree with Krugman that low rates mean easy money, so in a sense that is what low rates mean.  There is no generally accepted definition of what we mean by the “stance” of monetary policy.  So I won’t try to argue that Krugman has made some sort of simple mistake here, but rather that nominal rates are just about the most useless definition of monetary policy one can imagine.  Here are some possible indicators of the stance of monetary policy:

1.  Nominal interest rates

2. Real interest rates

3.  The monetary base

4.  M2

5.  The trade-weighted exchange rate

6.  Commodity price indices.

7.  Gold prices

8.  The CPI

9.  TIPS spreads

10.  Expected NGDP growth.

Obviously I favor number 10, but let’s talk about one I don’t favor, the monetary base.  During the decade prior to the subprime crisis the base had been trending upward at about 5% per year.  Then between August 2007 and May 2008 the base leveled off.  This sharp slowdown in base growth was associated with:

1.  Slower NGDP growth

2.  Sharply falling nominal (and real) interest rates

The NGDP figures suggest that money was getting tighter, as the Fed was stopping the printing presses.  The interest rates were signaling (according to Krugman) that money was getting easier.  Which definition is the most useful in this case?  I think it’s pretty obvious.

Now let me be clear on one point.  THE MONETARY BASE IS ALSO A LOUSY INDICATOR OF THE STANCE OF MONETARY POLICY.  Over the past 5 years the monetary base has been just as bad as nominal interest rates.

I believe that if Paul Krugman gave this issue some thought he’d have to end up agreeing with me.  Some might argue that NGDP doesn’t measure the tightness of monetary policy, but rather the results.  They say we need to look at the input into monetary policy, and that’s nominal interest rates.  But why nominal interest rates?  Those are just one of many variables that the Fed influences in the short run.  Policy also influences gold prices, exchange rates, commodity prices, TIPS spreads, M2, etc., etc.  Indeed if we want the most direct policy tool of all, it would be the base.  The Fed uses changes in the base to target all the other variables, including the fed funds rate.

No, if we look for Krugman’s hidden assumptions here we need to ask why he thinks nominal rates are not as good an indicator as real rates.  Think about it; nominal rates are easier for the Fed to target than real rates.  And I think the answer is clear.  Whether Krugman realizes it or not he must be making some assumptions along the following lines.  “If we used nominal rates when inflation is unstable that would lead to the absurd conclusion that money was really tight during the German hyperinflation.”  If I’m right, then Krugman is using the macroeconomic outcome to infer something about the reliability of nominal rates as a monetary policy indicator.

So that’s probably why Krugman ends up with real rates being superior when inflation is unstable (and of course they are identical when inflation expectations are stable.)   But here’s the problem, inflation isn’t the only thing that distorts interest rates, real growth is also very important.  Thus a tight money policy can lead to expectations of recession, and this can depress even real interest rates.  This happened in the 1930s, and it’s happened again since 2008.  Both Krugman and I think real growth plus inflation is a better Fed target that inflation alone.  So it would be really useful to have a sense of whether our measure of “easy money” is consistent with what we think monetary policy should be doing to NGDP.  If a so-called easy money policy leads to much slower NGDP growth, then there is something very wrong with our monetary policy indicator, just as there would be if “tight money” led to hyperinflation.

Remember, there are at least 10 possible indicators; it’s not just NGDP and nominal rates.  Thus we need to be pragmatists and pick the most useful indicator.  You can’t just announce nominal rates are the right indicator among those 10, you must justify your choice.  Ben Bernanke was being very pragmatic back in 2003 when he rejected both money and interest rates, and suggested more useful indicators of the stance of monetary policy:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman  . . . nominal interest rates are not good indicators of the stance of policy . . .  The real short-term interest rate . . . is also imperfect . . .  Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

Yup.

Ultimately it makes no sense to talk about easy and tight money, only money that is too easy or too tight to hit the policy objective.  I’m begging my colleagues to adopt a more sensible terminology so that we can stop speaking to each other using different languages.

PS. Starting next week I will cut back on blogging for some travel.

HT:  Marcus Nunes

As usual, Paul Krugman gets right the the essence of the problem:

Actually, Tobin-Brainard is to many of the controversies that swirl around banks and money as IS-LM is to controversies about interest-rate determination. When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes” “” it’s a simultaneous system.

Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.

Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio “” they’re holding fewer securities and more reserve “” and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.

Yup, that’s all it means.  Krugman begins the post by acknowledging that there is a group with very different views:

I’m actually kind of reluctant to even get into this, because any discussion of these issue brings out the people who believe that they have discovered the hidden secrets of the monetary universe, somehow missed by generations of economists. But here goes anyway.

I get lots of commenters coming over here breathlessly telling me the wonderful news—it’s been discovered that banks don’t actually loan out reserves! How does one even respond to that sort of ferver?  Now I have a simple answer; “it’s a simultaneous system.”  I can stop wasting so much time in the comment section.

Here’s Kevin Erdmann (aka kebko):

Here is the forecast, appended to actual past LFP rates (in blue):

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The most important thing to note here is that the current slope of the line basically tracks the slope we have seen since 2000.  You don’t need a disillusioned labor force that’s given up in order to explain this decline.

There are periods in the late 70’s, late 80’s, late 90’s, and mid-oughts, where LFP goes above trend during especially strong labor markets.  The sharp curvature of the curve makes it hard to see these, but once we correct for this trend, there is nothing special about LFP behavior.

One mistake I see a lot of people making is that they compare the current LFP rate to the rate at the peak of 2007, so they are capturing all of the cyclical variation plus 6 years of a very sharp secular decline.  Because the secular decline started in the late 90’s, conventional wisdom also attributes the secular trend in the labor market of the 2002-2007 recovery to a weak recovery.  In truth, the LFP in 2007 was well above trend, and a very strong labor market was masked by demographics.  So the demographic factors here tend to be dismissed as a result of placing errors on top of errors in our analysis.

I don’t have strong views on this subject, but his analysis seems plausible to me.

This also reminded me that it can be misleading to compare “depressions” in tiny countries with depressions in huge countries.  A tiny country like Latvia can produce at a level much further above it’s natural rate than a very large economy like the US. Thus a 25% drop in RGDP from the peak might lead to a milder depression in Latvia than in the US.

PS.  The labor market is still in bad shape.  But if it was in as horrendous shape as the employment numbers suggest, then I very much doubt Obama would have easily been re-elected.  The 7.4% unemployment rate captures the current situation pretty well.  And that’s still a bad economy.

.  .  .  as long as the public believes it’s true?  I’m disgusted with the Western media, the way they keep picking on China.  Henan is a poor, heavily polluted inland province of 90 million people.  So what if the lion at their zoo looks a bit dog-like:

That shows why the China bears are oh so wrong.  No country with that level of creativity, that enthusiasm to “git er done” will ever get stuck in a middle income trap.

Fortunately the Economist magazine dares to tell the truth about China:

China is broadly right about one thing: its environmental problems do have historical parallels. With the exception of Chongqing, the largest municipality, most Chinese cities are no more polluted than Japan’s were in 1960 (see chart 1). Excluding spikes like that in Beijing this year, air quality is improving at about the same rate as Japan’s did in the 1970s.