Monday, 17 June 2013


It's been a while since I talked about monetary policy and I've meant to write a specific blog-post about it for a long time. With Abenomics well under way and some initial successes to show for it, some discussion on this very subject seems timely.

Scott Sumner's blog is one of my favourite place for monetary matters. As I will explain later on, I do not share Prof. Sumner's ideas but his blog is great to keep abreast of any new developments with regards to monetary policy or monetary thinking.

Two entries caught my attention a few weeks ago and pushed me to finally get on with writing this post, "Nunes on Krugman" and "Bartlett on Keynes" , but Scott Sumner also wrote about Abenomics specifically: "Why 'Will Abenomics succeed?' is the wrong question" .

More recently, I've read Noah Smith "The Zero Upper Bound" on the subject of Japanese monetary policy as well as John Mauldin's thoughts on the same...
I will state upfront that I'm reading Scott Sumner's blog in a bit of an on-and-off manner and so, when I will say, later on, that I don't quite understand his reasoning, the fault might very well be a lack of application on my side rather than any shortcoming on Prof. Sumner's side.

This background explanation being done, let me move to the main meat of this post: The most pressing issue about monetary policy, these days, is whether it can do more to help the economy. Interest rates are close to zero. Long term interest rates aren't much higher. This is known as the Zero Lower Bound (or Liquidity Trap) issue.

Many economists, not just Scott Sumner, have argued that the Fed is not powerless at the ZLB. 

Indeed, Ben Bernanke himself stated so very clearly in a speech in 2010. Despite the ineffectiveness of the classic Central Bank's tools - short term interest rates - "(...) the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary (...) The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether (...) the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool".

And, in 2002, Ben Bernanke became famous for a speech detailing the unconventional options a Central Banker might use... A Forbes article makes a useful summary of these unconventional tools here.

But the article's ending is pretty stark: In a conclusion titled 'Futility Of The Fed', the author, Robert Barone notes that:

"Over the past 2 years, Fed actions appear to have had little impact on aggregate demand.  In 2002, when he outlined these non-traditional tools, Bernanke said he had no idea of the magnitude of their effectiveness. Today, however, we have a couple of years of historical data on which to judge (...) the impact of QE2 on the Treasury yield curve was a statistically significant but moderate 15 basis points (...) Thus, despite their demonstrated impotence, we expect that the Fed will use tools #4 and #5 in an effort to lower longer-term Treasury rates and simultaneously attempt to reduce private sector rates. The success of such moves is much in doubt, especially if their balance sheet is constrained".

However, many, with Scott Sumner as their cheerleader, would disagree with this conclusion of ineffectiveness. And the initial successes of Abenomics could also be used to provide proofs that Robert Barone is sadly mistaken.

In the same vein, referencing the blog-post I mentioned earlier, Marcus Nunes, argues that the reason we have had a recovery, however slow, is down to monetary policy: "In 1937 real government purchases recoiled 4.2% and the economy tanked. In 2012 real government purchases were 4.8% below the 2010 level and the recovery is slow! Surely something is going on that´s making comparable ‘fiscal austerity’ so much less damning in 2012 than in 1937. And that ‘something’ is monetary policy".

Still, I think all of us would agree we remain in a deeply unpleasant place, with unemployment still far too high, despite some recent good news in the USA. And, of course, as we will see, Japan is far from out of the woods.

So what could the Fed or any other Central Bank do?

According to Market Monetarists, the Fed could start targeting NGDP and raising inflation expectations.

Why would this make things better? Well, I am not entirely clear on that. In a quick exchange, Scott Sumner told me that inflation would boost RGDP through 'sticky wages'. Researching his blog further and that of other Market Monetarists, I gather that there are at least two mechanisms involved.

The first one is that, with wages nominally sticky, inflation lowers real wages - thus helping boost employment as lower wages means more demand for labour/more labour hoarding. Some, like Neil Irwin, have explained the comparatively low unemployment  rate of the UK in this recession as a consequence of the higher inflation the country experienced. 

A second and different take is that, with a credible threat of inflation at 3-4-5% (with RGDP between 0 and 2%, at best, at present), people would stop trying to save and start consuming/investing. As a consequence, RGDP would rise and, pronto, all would be well in the best possible world.

To quote Sumner, from 2009 (via a Lars Christensen article)QE primarily works not through interest rate effects but through "injecting more cash into the economy than the public wishes to hold. The only way to get rid of these excess (real) cash balances is to spend them on goods, services and assets, thus driving aggregate demand higher."

I find this scenario extremely unlikely and fraught with dangers.

I'll start with the fact that this is playing with money and people's perception of its worth. In general, as opposed to, say, "gold-bugs" I am not prone to panic about public trust in fiat money and the like. Still, I think playing games with money is a bit... off. And I wouldn't want to find out what happen if people suddenly and massively decide that our money isn't worth the paper it's printed on...

I could also point out that it is quite unclear where all this QE money is ending and what it is actually doing to the economy and to asset prices. Some people say that the stock markets around the world are rising because of it. Not everyone agrees but I think it is quite possible that at least some of the excess liquidity is leaking across asset classes and helping push prices of commodities, shares, high yield bonds etc higher. And I don't see this as a good thing. The idea that this will lead to a boost of consumption via a wealth effect is probably overdone and I'd have thought we have had quite enough of asset bubbles bursting in the past twenty years to give this strategy a rest.

However, my main issue with the idea that threatening and delivering an inflation of 4-5% is that I do not believe that the consequences would be consumers resuming consuming and companies resuming investing.

Individuals may not be entirely financially cognizant but most of us have some kind of idea about the amount of money we'd like to save or we'd feel would be necessary for us to retire or to take care of our children's education etc. Basically, we/households have saving objectives.

And, thus, in the absence of real wage increases or changes to expectations with regards to wages, increasing inflation, like increasing taxes, will not change our saving objective but it will raise its pre-inflation, pre-tax cost.

So - getting back to Abenomics, I am quite nervous but for reasons different than most economists I've read.

The rising of interest rates that is right now worrying so many people was to be expected. 

Lars Christensen, in his September 2011 paper 'Market Monetarism' clearly states that "it should be noted that Market Monetarists do not expect to see the impact of QE in a fall in bond yields. Rather, Markets Monetarists would actually expect bond yields to rise if the policy worked, as effective QE would push up inflation expectations and hence long-­‐term bond yields. This is exactly what happened both after the US Federal Reserve announced the first round QE in late 2008 and after the second round of QE (QE2) in the second half of 2010."

If Japan's public finance cannot take a rise in interest rates or, rather, if the rising NGDP does not more than compensate the rising of the interest payments on the stock of debt, then, as noted by some, Japan is dead anyhow, unable to afford a recovery. At least not a Market Monetarist one and they've already tried with all their might a fiscal deficit one...

So, no, this is not what really worries me. This is already baked in, one way or the other. Either the BOJ delivers enough NGDP growth to overcome the issue of interest payments or Japan will have to actually default/hyper-inflate.

What worries me is that Japanese people will see inflation rearing its head, will realise that their real salaries are getting slashed and that, contrary to Market Monetarists' expectations, lower salaries does NOT lead to more demand for labour (see here and here as to why and how) and their reaction will not be to consume more but to try even harder to save for their retirement etc. The consequence will be a stagflation, the worst of all possible (peacetime) worlds.

This is a rare instance in which I hope to high heavens being proven wrong. Either way, Japan is going to be (again) a case study for the world. This time, not for its industrial and organisational know-how but for its macro policy adventurism...


  1. Hah. I remember having to write about Bernanke's theorising at the time. Who'd have thought we'd still be on this same argument three years later.

    1. That's the beauty of economics. It can takes ages for a phenomenon to play out and, in any case, the data is more often than not noisy enough to make it relatively hard to definitely crush an idea or theory.

      Still, I think Japan will be a pretty big case-study... :)