Market monetarism: a first look

One of the more confusing of the macroeconomic debate is the emergence of a profusion of schools of thought with very similar names, but very different viewpoints. The one I’ve had most to deal with is Modern Monetary Theory. I had a go at this topic here and . My brief summary is that MMT pretty much coincides with traditional Keynesian views in the context of a liquidity trap, but that I reject the claim commonly made in popular presentations of MMT, that increased government spending doesn’t imply increased taxation.

Then there’s New Monetarism, associated with Stephen Williamson. He and I had a set-to a while back, which entertained many but didn’t produce a lot of enlightenment, and left me disinclined to put a lot of effort into understanding the differences between New and Old Monetarism. (For the record, I’m pretty much an Old Keynesian, but I have learnt a fair bit from New Keynesians like Akerlof and Shiller).

The third entrant is “Market Monetarism” associated mainly with Scott Sumner (though Wikipedia tells me the term was coined by Lars Christensen). I was aware in general terms that Sumner advocated a more expansionary monetary policy in response to the current crisis (I agree), that he prefers Nominal GDP level targeting to inflation targeting as the basis for monetary policy (I agree again though I’d prefer targeting levels rather than growth rates) and that he thinks this would be sufficient to fix the problem without any role for fiscal policy (I disagree). However, I wasn’t really aware that these ideas formed the basis of a school of thought, and I still haven’t investigated the underlying theory in any detail.

Sumner has commented on my recent posts on fiscal and monetary policy with a couple of his own, so I guess it’s time for me to look more closely at what he is saying. A first response is over the fold.

There is a lot in these posts that makes no sense at all to me – I usually find that in cases of this kind there is fault on both sides. Responding to all Sumner’s claims seems likely to produce the worst kind of blogospheric mess, so I’ll focus on what I take to the key point.

In his first post, Sumner is mainly concerned to use me as an example of his claim that the economics profession wrongly equates low interest rates with easy money.

He starts with a bit of a gotcha, in that the original version of my post looked at a huge reduction in nominal rates of interest (from 17.5 per cent to 5.25 per cent) without adjusting for the small change in inflation expectations that took place at the same time (from about 7 per cent to 4 per cent). As I said in the update, the example works just as well if you look at the reduction in the real rate from 9 per cent to 1 per cent. But this is a side issue, since Sumner says “real interest rates are not much better.

At this point, it's difficult to see why Sumner is bothering to pick bones with me. The idea that the stance of monetary policy can be assessed as expansionary, neutral or contractionary depending on whether the interest rate controlled by the central bank is at, above, or below its real long run average neutral value isn't just mine. It's that of nearly all economists, notably including the US Fed. UpdateThe neutral value changes gradually over time in response to a variety of factors, but is sufficiently stable that it can be regarded, for most purposes, as a long-term average, typically assumed to be in the range 1.5 per cent to 3.5 percent. End updateSumner claims that “People get defensive when I make fun of the view that low interest rates mean easy money” but doesn’t name any names. Does anyone really deny that this is the standard view?

So far, despite a lot of heat, there is no real disagreement. Sumner says, and I agree that, under normal conditions, most economists assess the stance of monetary policy by looking at the real interest rate controlled by the central bank. This wasn’t always the case. The term “monetarism” is generally associated with Milton Friedman’s view that the central bank can and should target the rate of growth of (some measure of) the money supply. This definition has a lot of problems, though it has the merit that it’s applicable even when nominal interest rates have reached the lower bound of zero. But that doesn’t matter much because Sumner doesn’t like Friedman’s approach any more than I do.

Sumner’s alternative, as I understand it comes down to three propositions
(1) The central bank can set policy to achieve whatever rate of nominal GDP growth it desires
(2) Nominal GDP growth can be regarded as a policy instrument, in the same way as the cash rate or, in Friedman’s version of monetarism, the money supply
(3) The best measure of the stance of monetary policy is the expected rate of nominal GDP growth

If you grant the first of these propositions, the others follow pretty directly. But most economists, including central banks, don’t think it’s true, at least in the context of a liquidity trap. It’s hard to assess the argument without a clear and quantified statement of what monetary policies would be needed to end the current recession. Perhaps Sumner has set this out somewhere, and if so, can link to it. It’s worth pointing out that the Keynesian advocates of fiscal stimulus, notably including Romer and Krugman, have been willing to specify the size of stimulus they think was needed in 2009 and would be needed now.

If you don’t accept (1), then the whole argument becomes circular. An expansionary monetary policy, on Sumner’s view, is one that expands the economy. In that case, of course, expansionary policy could never fail, in much the same way as treason never prospers.

Going a bit more out on a limb, I don’t think the validity of the liquidity trap argument depends on whether interest rates have reached the zero lower bound. The economy is in a liquidity trap when people want to build up money balances, regardless of the consumption and investment opportunities available to them. If central banks face such a situation, they may give up on interest rate reductions, even before the rate hits zero, if only to avoid making their impotence obvious.

Anyway, that’s enough from me. I expect there will be plenty of responses and I hope they may help to illuminate the issues.

91 thoughts on “Market monetarism: a first look

  1. @pac

    “Have market monetarists addressed the concerns raised here regarding a futures market?”

    I once had an extended discussion with Mike Sankowski about this issue. I pointed out that we already have central banks that practice Inflation Targeting (IT), and we already have inflation derivatives markets. Why don’t inflation derivatives suffer from these same problems?

    He responded with the following list:

    “1. The central bank isn’t using them to set policy
    2. The central bank isnt’ acting as market maker for these markets
    3. Inflation is more easily and more accurately calculated, if you can believe it
    4. Inflation markets leverage existing IRS and treasury markets”

    So I pointed out:

    1. “The central bank isn’t using them to set policy”

    This is not true. For example even though the Fed is not officially practicing Inflation Targeting it uses TIPS in setting policy:

    “The staff also looks at measures derived from comparing yields on nominal and inflation-indexed Treasury securities (the breakeven inflation rate). Measures of inflation compensation derived from the market for inflation-indexed securities are influenced by changes in inflation risk premiums and liquidity premiums, and analyses are constrained by the fact that these markets have been operating in the United States for only a relatively short period. Nevertheless, unlike survey measures, breakeven inflation rates are determined in a market in which investors back their views with real money. Moreover, breakeven measures of inflation expectations provide information on the expectations of a different group of agents–financial-market participants–which can be compared with the views of economists and consumers as represented by surveys.”

    http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm

    2. “The central bank isnt’ acting as market maker for these markets”

    In cases where there are inflation protected notes and bonds the treasury is the market maker. In my opinion this is a distinction without a difference.

    3. “Inflation is more easily and more accurately calculated, if you can believe it”

    With respect to easily calculated there’s two different issues involved. There’s obviously more data that must be collected to calculate NGDP. But fundamentally this is simply a matter of arithmetic. Calculating inflation on the other hand is a science. I doubt very seriously you’ll be able to convince me that aggregate price indicies are “easier” to calculate given all of the various issues involved.

    With respect to accuracy there’s two main ways of measuring the size of the revisions of the components of national income and product accounts: 1) Mean Revision (MR) and 2) Mean Absolute Revision (MAR). For rate targeting MAR is the more appropriate measure, and in fact the MAR of inflation is usually smaller than the MAR of NGDP. However, for level targeting MR is more appropriate. And at least in the US (Page 27):

    “The MRs for the price indexes for GDP and its major components are generally not smaller than those for real GDP and current-dollar GDP and its major components.”

    http://www.bea.gov/scb/pdf/2011/07%20July/0711_revisions.pdf

    In fact over 1983-2009 the MR for the final revision to quarterly NGDP is 0.14 whereas over 1997-2009 the MR for the final revision to the GDP deflator and the PCEPI is 0.20 and 0.12 respectively. And over time the revisions have trended downward:

    http://www.bea.gov/scb/pdf/2008/02%20February/0208_reliable.pdf

    so I suspect that the MR for NGDP is actually smaller than PCEPI over 1997-2009.

    4. “Inflation markets leverage existing IRS and treasury markets”

    Yes, but they didn’t until the inflation markets were set up.

    That was the last time I ever talked to Mike Sankowski.

  2. These conversations remind me of my last year in my undergraduate studies when I did an empirical study on the efficiency of monetary policy in a small and open economy. At the time, in the mid-1970s, monetarism was popular and the question of interest was inflation. The test results supported the monetarist hypothesis of the intertemporal relationship between monetary policy, defined as changes in the base money, and inflation, as measured by CPI.

    A few years later I realised that the test results had become obsolete because the test period belonged to the so-called Keynesian period, characterised by tight regulation of the private sector part of the financial system, relative to what evolved thereafter. The permanent (in terms of my life) knowledge acquisition for me from this empirical study was knowledge of Fourier transformation and cross-spectral analysis.

    I switched to the axiomatic approach to economic theory (Arrow-Debreu methodology). In this area one can’t simply come up with an idea and find a few numbers in support of it. Both the history of the development of theoretical models, including those of sub-disciplines such as Finance, Development Economics, International Trade, Monetary Economics and the history of the institutional environment become relevant.

    One of the arguments, presented by one or the other version of monetarists on this blog-site, tries to establish that monetary policy is effective even if the nominal interest rate is close to zero (or zero) – which Keynesians call the liquidity trap. Numbers are presented, all of which I would consider superfluous (including, or rather in particular, arithmetic transformations such as quarterly averages).

    The reason is that the liquidity trap has not changed but the Fed in the USA has used another policy instrument, currently called ‘quantitative easing’ (QE). Lets have a look at what happens, in terms of the mechanics of implementation, and in terms of effect.

    a) The daily management of a nominal interest rate target (cash rate in Australia), involves something which is related to QE, but within narrow upper and lower bounds of the cash rate and a very restricted set of securities. We call it open market operations. These operations by the ‘Central Bank’ (eg RBA) intersect with the private financial system. IMHO, this is enough evidence that the separation of ‘monetary policy’ and ‘Finance’ is artificial.

    b) From a) it follows that, if the private sector financial system differs among ‘countries’, both in terms of regulation and in terms of culture (which may be linked via risk preferences) then it is extraordinarily irrelevant to discuss ‘monetary policy’ of country A, using a mental model belonging to country B. The data is not comparable. This is the reason for my gripe with some criticisms of the ECB.

    c) From a) it follows that countries which have a functioning payment system (which is part of the responsibility of a ‘Central Bank’), then a nominal interest rate target is quite sufficient and, IMHO, it is a preferred policy target because there is no meaningful measure of ‘inflation’ which would correspond to the Fisher-equation to estimate the ‘real interest rate’, outside the gold standard or if there is only one commodity in ‘the economy’. Furthermore, it is impossible for a Central Bank to target the ‘real interest rate’ when this variable can be calculated only retrospectively. On a related predecessor thread, our host, Prof Q, tried to salvage their argument that it is inflation expectation which matters. The response was: ‘the data was not available’. And another furthermore, the nominal interest rate target is observable by everybody and, those who want to, can observe how the private financial sector reacts to any changes in the target rate, form their own expectations, work out their own ‘real interest rates’ (plural, including the ‘own interest rate’ – real – in their segment of the labour market, in some financial securities and physical assets markets) and make decisions. This is a bit of the famous ‘real world’. It looks very different from macro-models but quite comprehensible from the perspective of these dreaded axiomatic models (which take only preferences and resource constraints as axiomatic in the sense that they are the two fundamental elements of ‘an economy’). I venture to say it is also more comprehensible to people, like Ikonoclast, who say they are neither a mathematician nor an economist (but can read, write, do arithmetic and think).

    d) The idea of an ‘inflation market’ is another one of those ideas where adding the word ‘market’ is supposed to be something desirable. What actually happens is nothing other than another set of financial securities is created. The idea that these securities can reflect inflation expectations is not convincing for those people who are aware that all prices are interrelated. Traders in these financial securities are motivated in the same way as traders in all other financial securities.

    e) QE, as carried out in the USA was, in a sense, necessary because the payment system of the USA in the first instance and, thanks to globalisation of the financial system, the rest of the world was at risk of collapse (critical point). Surely, this problem is very different from evaluating the ‘stance of monetary policy’ in the context of a ‘business cycles without critical points’. (Ikon, do you remember my post around the Lehman event, when I said now the proverbial Wall Street bankers and their associates are running to the government which has a bigger balance sheet than their own to exchange their junk securities, denominated in fiat currency units for official currency units?). I believe it was obvious to many people that the GFC was the outcome of agents in the private sector of the financial system being able to issue various types of debt securities with increasingly impenetrable complexities, all of which were denominated in fiat currency units. Hence, their bankruptcy would affect the payment system and the US had to defend its currency. Mark Sadowski’s excerpt from the Fed documents confirms the exchange of private sector created debt, denominated in US currency units, for actual US fiat money. All this is not visible from annual balance sheets because the numbers aren’t colour coded. The numbers are prefixed with US$.

    How does one salvage the belief in monetarism? Here are some suggestions:
    i) One takes out the critical points in the time series
    ii) One re-examines the period which contains critical points and reaches a retrospective conclusion about the past.
    iii) One chooses data that is available at the time when one looks at it without asking whether the data was available in decision making time.
    iv) One adopts a policy objective, which appears to be quite consistent with macro-economic policy talk. For example, the terms ‘recession’ and ‘depression’ have been banded around in the press for so long that one can reasonably expect anybody who offers the potential for eliminating recessions and depressions must be on the right track.
    v) Nominal aggregate income is a good candidate. It does not violate any of the monetarists’ dictums, including the quantity theory of money and the restatement of the quantity theory of money and the Fisher equation. It is a macro-economic variable. It allows a blurring of the distinction between a monetary policy target, which is under the control of the ‘Central Bank’, and activities that are under the control of the private financial sector, which subsequently require QE. In this degenerate sense, the ‘quantity of money’ is under the control of ‘government’.

    As a non-believer, I note

    Nominal income level is consistent with a huge number of alternative scenarios faced by people in the real world (as lived rather than calculated). It is useful to consider the limiting scenarios.
    a) A nominal income level target is consistent with only two individuals out of say 300million to trade with each other and 300million – 2 are starving.
    b) A nominal income target is consistent with every one of the say 300million people to have equal incomes.

    Furthermore, a nominal income target is quite consistent with ‘business as usual’ for the private part of the financial system and monetary policy becoming defined as QE if they’ve done it again.

    I totally reject Mark Sadowski’s assertion that : “QE has effects that are the same as if a central bank reduces the policy rate. In particular, real interest rates decline, inflation expectations rise and the currency depreciates. These are the classic financial market effects one might observe when the central bank eases monetary policy away from the zero lower bound. Thus QE is basically expansionary monetary policy, no different in its effects from reducing the policy interest rate, which increases domestic demand, and if done to a sufficient extent will reduce the unemployment rate.”

    PS: Contrary to Mark Sadowski’s assertion in a related predecessor thread that the Fama-Fischer-Jensen Efficient Capital Market Hypothesis is related to Samuelson’s work, the said authors of the hypothesis make it perfectly clear their random walk model has its origin in the work of a French mathematician, Louis Bachelier, who published a his theory of speculation in 1900. As for randomness in prices in a general equilibrium context, see Beth Alan’s work on approximate equilibria..

  3. @Mark A. Sadowski

    Your discussion of sectorial flows demonstrates that public sector deficits, by providing cash flow to the private sector, do in fact mitigate the effects of private sector deleveraging. Given that the money supply, outside of the relatively minor currency component, is the liability of the banking sector, private sector deleveraging is by definition deflationary.

    I other words public sector deficits have mitigated the effects of private sector deleveraging by supporting private sector cash flow and is not evidence of error in the theory that Japan is in a balance sheet recession. In fact, given the lack of inflationary pressure in the Japanese economy, it is contrary to your argument.

  4. @Ernestine Gross

    “c) From a) it follows that countries which have a functioning payment system (which is part of the responsibility of a ‘Central Bank’), then a nominal interest rate target is quite sufficient and, IMHO, it is a preferred policy target because there is no meaningful measure of ‘inflation’ which would correspond to the Fisher-equation to estimate the ‘real interest rate’, outside the gold standard or if there is only one commodity in ‘the economy’. Furthermore, it is impossible for a Central Bank to target the ‘real interest rate’ when this variable can be calculated only retrospectively. On a related predecessor thread, our host, Prof Q, tried to salvage their argument that it is inflation expectation which matters. The response was: ‘the data was not available’.”

    In the canonical Fisherian theory of interest, there is, at any moment of time, a unique equilibrium rate of interest (actually a unique structure of equilibrium rates for all possible combinations of time periods), increasing thrift tending to reduce rates and increasing productivity of capital tending to raise them. While uniqueness of the interest rate cannot easily be derived outside a one-commodity model, the assumption does not seem all that implausible in the context of the canonical Fisherian model with a given technology and given endowments of present and future resources. In the real world, however, the future is unknown, so the future exists now only in our imagination, which means that, fundamentally, the determination of real interest rates cannot be independent of our expectations of the future.

    An estimate of inflation expectations is thus useful not only for assessing monetary policy stance in via its interest rate policy but for conducting such policy in real time. The fact that the RBA first adopted a call rate target in January 1990 during a period when no measure of inflation expectations was available, and perhaps consequentially downward adjustments in short term rates were much slower than in the three previous such adjustments and, most importantly, that this was immediately followed by the most serious recession in Australia since the Great Depression seems telling. It also bears some resemblance to US interest rate policy from July 3, 2008 through October 7, 2008 when the fed funds rate remained pegged at 2.00% despite the fact 5-year inflation expectations as measured by TIPS plunged from 2.72% to 0.62%.

    “And another furthermore, the nominal interest rate target is observable by everybody and, those who want to, can observe how the private financial sector reacts to any changes in the target rate, form their own expectations, work out their own ‘real interest rates’ (plural, including the ‘own interest rate’ – real – in their segment of the labour market, in some financial securities and physical assets markets) and make decisions.”

    The fact that the nominal interest rate target was fully observable by everybody and people were completely free to work out their own real interest rates did not shield them from the worst effects of such a policy in the 1990 Australian recession or in the 2008 U.S. financial crisis, did it?

    “This is a bit of the famous ‘real world’. It looks very different from macro-models but quite comprehensible from the perspective of these dreaded axiomatic models (which take only preferences and resource constraints as axiomatic in the sense that they are the two fundamental elements of ‘an economy’). I venture to say it is also more comprehensible to people, like Ikonoclast, who say they are neither a mathematician nor an economist (but can read, write, do arithmetic and think).”

    In the real world nominal incomes are far more easily observed and comprehended than any measure of interest rates could possibly be.

    “Hence, their bankruptcy would affect the payment system and the US had to defend its currency.”

    Except that during the 2008 financial crisis the dollar was soaring in value due to surging demand until the Fed stepped in with nearly $600 billion in temporary reciprocal currency arrangements (i.e. central bank liquidity swaps) with foreign central banks to help provide liquidity in U.S. dollars to overseas markets.

    “Mark Sadowski’s excerpt from the Fed documents confirms the exchange of private sector created debt, denominated in US currency units, for actual US fiat money.”

    Private label MBS, CDOs, stocks or corporate bonds were accepted as eligible collateral by the Fed’s emergency credit and liquidity programs. However the Fed currently only holds about $2 billion of such assets.

    “Nominal income level is consistent with a huge number of alternative scenarios faced by people in the real world (as lived rather than calculated). It is useful to consider the limiting scenarios.
    a) A nominal income level target is consistent with only two individuals out of say 300million to trade with each other and 300million – 2 are starving.
    b) A nominal income target is consistent with every one of the say 300million people to have equal incomes.”

    And so is every otherwise totally worthwhile government policy that is not designed to directly designed to address the distribution of income.

    “Contrary to Mark Sadowski’s assertion in a related predecessor thread that the Fama-Fischer-Jensen Efficient Capital Market Hypothesis is related to Samuelson’s work, the said authors of the hypothesis make it perfectly clear their random walk model has its origin in the work of a French mathematician, Louis Bachelier, who published a his theory of speculation in 1900.”

    I never claimed Paul Samuelson was the origin of Eugene F. Fama, Lawrence Fisher, Michael C. Jensen and Richard Roll’s EMH. I said that the *simplest form* of the Random Market Idea was stated by Samuelson in 1965. (The name of the paper is “Proof that Properly Anticipated Prices Fluctuate Randomly”.)

  5. @sdfc

    “I other words public sector deficits have mitigated the effects of private sector deleveraging by supporting private sector cash flow and is not evidence of error in the theory that Japan is in a balance sheet recession.”

    Again, Japan’s private sector financial surplus is more a story about the government sector’s business cycle driven borrowing needs than of the private sector’s balance sheet repair driven savings needs, so there’s little evidence that it has anything to do with deleveraging.

    “In fact, given the lack of inflationary pressure in the Japanese economy, it is contrary to your argument.”

    You’re assuming that a lack of inflationary pressure even with low nominal interest rates can only be caused by a so called “balance-sheet recession”.

    As of August 2008 the BOJ had increased its monetary base by 124.2% from its average level in 1990 (keep in mind this period encompasses Japan’s 2001-06 QE). By comparison, as of August 2008 the Fed increased its monetary base by 200.3% from its average level in 1990, and based on data from the BOE’s Statistical Abstract, in August 2008 the BOE’s monetary base was 276.5% larger than the total liabilities on its balance sheet in 1990.

    So given how slow monetary base growth has been in Japan it’s not at all surprising that they have no inflation.

    “Given that the money supply, outside of the relatively minor currency component, is the liability of the banking sector, private sector deleveraging is by definition deflationary.”

    The following graph displays data taken from the Summary Table of the BOJ’s Monetary Survey. This particular series of data is only available from April 1998 through April 2008. An earlier series excludes foreign banks and a later series, which begins in April 2003, includes claims on other financial corporations, which the earlier two series do not. The graph shows nominal GDP (NGDP), the M2 measure of money supply at year’s end, credit market debt (loans and securities and other than shares and denoted CMD), the amount of credit market debt excluding the financial sector, and the amount of such debt listed in the Summary Table of Japan’s Monetary Survey subdivided by sector at year’s end and with public non-financial corporate debt included with the non-government category. The aggregate credit market debt data comes from Japan’s Cabinet Office:

    Japan’s depository institutions do have a substantial proportion of the non-government credit market debt excluding financial sector credit market debt with the share rising from 57.6% in 1998 to 62.4% in 2007. And the share of government credit market debt held by depository institutions rose from 23.2% to 26.2%. But the overall share of credit market debt excluding financial sector credit market debt fell from 45.6% to 43.8%.

    So your implicit claim that money supply growth is constrained by the supply of debt that can be placed on the asset side of depository institution balance sheets seems wanting.

    What would we discover if we had equivalent data for financial sector credit market debt? Well the newer series shows that claims on financial sector fell from 43.1% of all financial sector credit market debt at the end of 2003 to 30.4% at the end of 2007. So were we able to include financial sector credit market debt over this time period it would likely reduce the share of total credit market debt held by depository institutions and it would result in an even stronger downward trend in the depository institution share of total credit market debt.

    And thanks to deflation Japan makes the perfect counterpoint to the widespread delusion that money supply growth is dependent on debt growth. In most countries the existence of inflation means that most nominal quantities tend to grow over time giving rise to spurious correlations. This of course also applies to money supply and total nominal credit market debt. But in Japan total nominal credit market debt has declined repeatedly since 2000. Here is the graph of Japan’s M2 money supply and total nominal credit market debt indexed to 100 in the year 2000:

    Note that total nominal credit market debt declined in 2001, 2006, 2008 and 2009 and yet M2 grew continuously.

    One thing you won’t hear from Koo is that Japan’s growth following its original QE was a lot stronger than most people realize. To fully appreciate the significance of this it’s important to examine Japan’s fiscal policy stance during the Lost Decade. In my opinion the most objective way of judging fiscal policy stance is the change in the general government structural balance. The structural balance is adjusted for the business cycle and thus any changes should represent policy rather than the state of the economy. The IMF provides estimates of Japan’s general government structural balance from 1994 on so we can compute the changes from 1995 on:

    With the exception of calendar years 1997 and 2001 fiscal policy was expansionary during 1995-2003. Do we know anything about the fiscal policy stance prior to 1995? An excellent summary of the Japanese discretionary fiscal stimuli programs is Anita Tuladhar and Marcus Bruckner’s “Public Investment as a Fiscal Stimulus: Evidence from Japan’s Regional Spending during the 1990s” (IMF Working Paper No. 10/110, April 2010). Appendix Table 8 lists two fiscal stimuli for 1993 and one each for 1992 and 1994, so fiscal policy was obviously expansionary for the entire 1992-96 period. It also lists nine fiscal stimuli and three tax cuts during 1995-2002, but none during 2003-07. The fiscal tightening in 1997 is explained by the fact that Japan raised its consumption tax from 3% to 5% on April 1, 1997. The fiscal tightening in 2001 seems to have been passive. The expansionary fiscal policy of 2003 represents a carryover of the effects of the 2002 fiscal year, which ended on March 31, 2003.

    Considering that the BOJ’s call rate wasn’t lowered below 1% until July 1995 and didn’t get below 0.25% until November 1998, Japan’s fiscal policy seems a bit backwards. Away from the zero lower bound there’s absolutely no rationale for doing fiscal stimulus unless one wants to see the spectacle of competing policy levers cancel each other out, and yet Japan did eight fiscal stimuli and three tax cuts during 1992-98. On the other hand, if one truly believes in the Keynesian concept of the liquidity trap, then one would want to do fiscal stimuli when the policy rate is pinned to the zero lower bound, and yet Japan practiced five consecutive years of consolidation during fiscal years 2003-07, a time when the policy rate was never as high as 0.5%.

    So with that background out of the way, and recalling that Japan’s original ry?teki kin’y? kanwa (QE) was officially announced in March 2001, and didn’t really kick into gear until December 2001, how did the Japanese economy do? Here’s a graph of Japans’ annual CPI inflation and harmonized unemployment rate:

    Note that aside from the consumption tax induced increase in 1997 Japan’s inflation rate dropped nearly every year from 1991 through 2002 and then edged upward until there was consecutive years of consumer price inflation in 2006-07 for the first time in nearly a decade. Unemployment increased nearly every year through 2002 and then dropped in 2003 for the first time since 1990, and then continued to drop every year through 2007. And it’s worth noting that even the Nikkei 225 gave its thumbs up during 2003-07, with the index rising from less than 7900 in April 2003 to over 18,000 in June 2007, which is still by far the greatest stock market rally in Japan since the beginning of the Lost Decade(s).

    And as long as I’m on the subject of Japan’s unemployment rate it needs to be repeated frequently that mindlessly comparing it with other countries is a huge mistake. Japan’s Okun’s Law coefficient or the percentage points that GDP falls for every one point increase in the unemployment rate, has been estimated to be as high as five, or more than double that of the U.S. This is due in part to the fact that the self employment rate in Japan is also high, and that for various reasons institutional employers are more likely to cut back on hours and productivity than let employees go. And finally, Japan’s natural rate of unemployment is unusually low with the OECD’s current estimate of Japan’s Non-Accelerating Inflation Rate of Unemployment (NAIRU) equal to 4.3%. In short, what constitutes a high unemployment rate in Japan is very different than what constitutes a high rate of unemployment most other countries.

    And let’s take a look at Japan’s real GDP (RGDP) during this period:

    Yes, there does appear to be a period of decent growth during 1994-97 but considering Japan hadn’t really hit the zero lower bound yet and fiscal policy was expansionary throughout 1992-97 except for the last three quarters of 1997, it would be surprising if there wasn’t. What’s more interesting is the even longer period of above average growth during 2003-07 when the BOJ’s call rate was below 0.25% except for the last eleven months of 2007, and fiscal policy was contractionary for all but the first quarter of 2003. But when you recall that this latter period overlaps comfortably with the period of Japan’s QE things seem far less mysterious. It seems one can’t find evidence of the liquidity trap no matter how hard you try.

    And I want to dispel another myth about this period that Krugman himself has served to inculcate. That is the myth that Japan’s relatively good economic performance during 2003-07, which some have called the “Koizumi Boom”, was driven by net exports. Here’s what Krugman said about this is in February 2009:

    http://krugman.blogs.nytimes.com/2009/02/18/the-eschatology-of-lost-decades/

    “…Koo writes about the gradual rebuilding of private balance sheets, preparing the ground for recovery; and Japan did in fact have a fairly convincing bounce-back from 2003 to 2007.

    The chart above is a quick-and-dirty summary of the sources of Japanese growth from 2003 to 2007. It shows the change in real GDP, the change in real consumer spending, the change in real business investment, and the change in real net exports, all as percentages of 2003 GDP. What we see is nothing special happening to consumption, which grew more or less at its long-term trend growth rate, and only a modest investment boom. Exports were the driving force behind recovery.

    And needless to say, we can’t all export ourselves out of a global slump…”

    This is wrong on a number of different levels, and since I know that Krugman knows better, I can’t quite forgive him for saying that. To see why here’s Japan’s net exports during this period:

    Japan’s net exports increased from 1.34% of GDP in 2002 to 1.69% of GDP in 2007. Thus net exports added only 0.35% to Japanese GDP during 2003-07, or about 0.07% a year on average.

    So why are Krugman’s results so different from mine? In nominal terms both exports and imports soared during 2003-07. But thanks to a sharp increase in the average price of Japanese imports only exports increased dramatically in real terms.

    This is fine from the standpoint of real growth accounting, but the issue at hand was, and is, aggregate demand, which is measured strictly in nominal terms. To claim that net exports drove Japan’s growth during this period is to claim that the source for the increased aggregate demand came from abroad when in fact it came from the Japanese QE, which succeeded by not only stimulating foreign nominal demand for Japan’s exports through a reduced real effective exchange rate, but also by dramatically increasing Japan’s nominal demand for imports.

    Knowing how to correctly measure aggregate demand is key to understanding why expansionary monetary policy is a positive sum game rather than a zero sum, or even a negative sum game, as people like Koo claim.

    Finally, the Japanese quick and severe withdrawal of QE must in retrospect be regarded as an enormous failure.

    Here’s a graph of RGDP of Japan, the U.S., Germany and the U.K. indexed to 100 in 2007Q1:

    The BOJ reduced the monetary base by 24.4% from January to November 2006 and economic weakness followed within months. Japan was one of the first major economies to have negative RGDP growth when it fell in 2007Q3. RGDP fell 4.7% at an annual rate in 2008Q2, and 4.0% at an annual rate in 2008Q3, causing Japan to suffer serious consecutive quarterly declines in RGDP before the U.S. did the same. RGDP proceeded to fall 12.4% at an annual rate in 2008Q4 and 15.1% at an annual rate in 2009Q1. All told RGDP fell 9.2% from peak to trough.

    In short Japanese RGDP fell sooner, faster and further than every other major country this recession. It’s hard not to connect the dots between this result and the BOJ’s sudden and sharp withdrawal of QE, given one literally followed upon the other within months.

  6. @Mark A. Sadowski

    Indeed, you did not claim that “Paul Samuelson was the origin of Eugene F. Fama, Lawrence Fisher, Michael C. Jensen and Richard Roll’s EMH” and you said” the *simplest form* of the Random Market Idea was stated by Samuelson in 1965.”

    But Paul Samuelson’s paper is not relevant in relation to the methodological problem with empirical tests, which I raised in relation to your methods, and which I tried to illustrate with reference to the Fama-Fisher-Jensen test of their EMH.

    Paul Samuelson’s paper is not relevant in this regard because it contains a theoretical analysis. I don’t know whether Paul Samuelson knew about Louis Bachelier’s 1900 thesis in French. I know Fama wrote that he does know.

    It seems to me, rightly or wrongly, you are an expert in mixing things up for apparently no other reason than wanting to give the impression that you have an answer. It is getting a little tiresome, if I may say.

    Anyway, you now agree that QE is due to an emergency situation with origin in the international web of proverbial Wall Street bankers and their ‘innovative’ securities and does not prove the invalidity of the liquidity trap.

    Indeed, you provide evidence that the crisis in the private part of the financial sector was so severe that there was a system switch, at least temporarily, where the international private financial sector transactions were replaced with cooperation between central banks.

    It may have been lucky that the Fed kept ‘the interest rate’ at 2% for the time period you specified (which I take as given). Imagine they had lowered it and the Lehman event would have happened a few days before Christmas rather than on 15 September 2008.

    I don’t agree with your proposal that a monetary objective which, as you agree, totally ignores its effect on the wealth distribution, is useful.

    Furthermore, taking your stance seriously would require policy measures, such as confiscating wealth accumulated by those who benefitted in terms of relative wealth accumulation before their house of debt cards of various colours and shapes collapsed (cause of GFC). I am not convinced many people would agree with this but would prefer all policy measure, monetary and otherwise, to be directed toward preventing private finance sector created crises. (Even if people would agree with confiscation, I would suspect that a lot of the confiscated stuff would be quite useless for the masses of people who lost savings, lost jobs, lost their houses.)

    You say: “In the real world nominal incomes are far more easily observed and comprehended than any measure of interest rates could possibly be.”

    I would say those who say they belong to the “99%” know that too and they don’t like what they see.

    Otherwise your reply does not relate to what I had written.

    You agree that the US government was forced to defend its currency in 2008 by buying junk securities in exchange for fiat money.

    What? The Fed is still holding US$2billion worth of junk – about 5 years after the event! And you propose business as usual (ie let them lose and when they do it again just do more QE to keep the nominal aggregate income level).

    You finally acknowledge that the ‘Fisherian theory’ holds for an economy with 1 commodity.

    Sorry to say, the proponents of monetarism, in whichever form, are still stuck with the 19th century technology of theorising, the ‘Fisherian theory’ as you call it. What if Irving Fisher would disagree with you if he would be alive now?

    Surely a mathematical economist, like Irving Fisher, would be interested in Roy Radner’s mid-1970s work on Sequence Economies and the problems created by securities markets for getting ‘an equilibrium’ (not to mention a unique one). Why aren’t you?

  7. @Ernestine Gross

    “Indeed, you did not claim that “Paul Samuelson was the origin of Eugene F. Fama, Lawrence Fisher, Michael C. Jensen and Richard Roll’s EMH” and you said” the *simplest form* of the Random Market Idea was stated by Samuelson in 1965.”

    But Paul Samuelson’s paper is not relevant in relation to the methodological problem with empirical tests, which I raised in relation to your methods, and which I tried to illustrate with reference to the Fama-Fisher-Jensen test of their EMH.

    Paul Samuelson’s paper is not relevant in this regard because it contains a theoretical analysis. I don’t know whether Paul Samuelson knew about Louis Bachelier’s 1900 thesis in French. I know Fama wrote that he does know.”

    And all of this is hugely irrelevant to your original claim which was:

    “Contrary to Mark Sadowski’s assertion in a related predecessor thread that the Fama-Fischer-Jensen Efficient Capital Market Hypothesis is related to Samuelson’s work, the said authors of the hypothesis make it perfectly clear their random walk model has its origin in the work of a French mathematician, Louis Bachelier, who published a his theory of speculation in 1900.”

    I never made such an assertion. Period.

    “Anyway, you now agree that QE is due to an emergency situation with origin in the international web of proverbial Wall Street bankers and their ‘innovative’ securities and does not prove the invalidity of the liquidity trap.”

    On the contrary. QE has effects that are the same as if a central bank reduces the policy rate. In particular, real interest rates decline, inflation expectations rise and the currency depreciates. These are the classic financial market effects one might observe when the central bank eases monetary policy away from the zero lower bound. Thus QE is basically expansionary monetary policy, no different in its effects from reducing the policy interest rate, which increases domestic demand, and if done to a sufficient extent will reduce the unemployment rate.

    “It may have been lucky that the Fed kept ‘the interest rate’ at 2% for the time period you specified (which I take as given). Imagine they had lowered it and the Lehman event would have happened a few days before Christmas rather than on 15 September 2008.”

    Or the financial crisis might have been totally averted, as it was in the many other countries that instead chose to ease monetary policy during this time perod.

    “Furthermore, taking your stance seriously would require policy measures, such as confiscating wealth accumulated by those who benefitted in terms of relative wealth accumulation before their house of debt cards of various colours and shapes collapsed (cause of GFC).”

    It’s not clear to me why this would be necessary. Most, if not all, of the financial wealth that was lost in the U.S. due to the GFC has been recovered.

    “I am not convinced many people would agree with this but would prefer all policy measure, monetary and otherwise, to be directed toward preventing private finance sector created crises.”

    A policy of nominal income targeting very likely would avoid, or at the very least ameliorate, the incidence of financial crises.

    “Even if people would agree with confiscation, I would suspect that a lot of the confiscated stuff would be quite useless for the masses of people who lost savings, lost jobs, lost their houses.”

    The vast majority of the wealth that is held by the very wealthy is financial wealth. I doubt that it would be totally useless to the nonwealthy.

    “I would say those who say they belong to the “99%” know that too and they don’t like what they see.

    Otherwise your reply does not relate to what I had written.”

    I was referring to the “99%”, or rather the “90%”, and in particular that portion of the 90% which don’t pay any attention to macroeconomic issues, which is to say the vast majority of people.

    “You agree that the US government was forced to defend its currency in 2008 by buying junk securities in exchange for fiat money.”

    No. As the exchange rate of the dollar soared during the financial crisis its value was never in doubt. If anything the dollar was, and continues to be, too expensive.

    “What? The Fed is still holding US$2billion worth of junk – about 5 years after the event! And you propose business as usual (ie let them lose and when they do it again just do more QE to keep the nominal aggregate income level).”

    Most of the Fed’s credit and liquidity programs came to an end in July 2010. What I proprose addresses monetary policy issues only. A nominal income target would reduce the probability of the Fed needing to engage in such programs.

    “You finally acknowledge that the ‘Fisherian theory’ holds for an economy with 1 commodity.”

    While uniqueness of the interest rate cannot easily be derived outside a one-commodity model, the assumption does not seem all that implausible in the context of the canonical Fisherian model with a given technology and given endowments of present and future resources.

    “What if Irving Fisher would disagree with you if he would be alive now?”

    Perhaps oddly to you, I don’t think that he would.

    “Why aren’t you?”

    I’m more interested in Roy Radner’s work suggesting monetary policy has an effect when introduced when markets are incomplete.

  8. @Mark A. Sadowski

    There is one point I need to clarify for the record, namely

    No, I did not make up something in your name or wrongly assert you mixed up theoretical with empirical matters.

    On the related predecessor thread, On the inefficiency of monetary stimulus, I had written:
    I cannot agree [With your assertion] that: “One must use the data that is available”. I would say one first has to ask whether the data available is suitable for the question one wants to answer and if the answer is No, then the available data is plainly useless. Ignoring methodological problems in quantitative research results in false objectivity. [FN1]: In the FN1 I gave an example in support of what I said. I wrote :The plethora of papers that claimed to have tested the semi-strong form EMH in the 1970s and 1980s are useless because they didn’t test the hypothesis they claimed to have tested. …]

    In reply you wrote your re-interpretation of the original hypothesis in question and: “So I like to call EMH the Random Markets Idea, or RMI. The simplest form of the RMI was stated by Paul Samuelson in 1965: “Properly anticipated prices fluctuate randomly.” ”

    Otherwise,

    The Roy Radner model of a Sequence Economy (sequence of commodity and securities markets) belongs to the post 1950 general equlibrum models which use the axiomatic approach as in Arrow-Debreu. Prof Radner’s mid-1970 model does not contain a government or a monetary authority. It is a general equilibrium model of a competitve private ownership economy. (My own 1988 general equilibrium model with complete but partially segmented markets with multinational firms, is also a model of a competitive private ownership economy. There is no government in this model. The model merely extends the Arrow-Debreu model to a incorporate one feature of the ‘global economy’, namely that not all people intereact in the same market; ‘bounded rationality’ of a kind if you like. The Fisher Separation theorem does not hold in this model. Prof Debreu did not object nor did he walk out. )

    If Monetarists are not interested in theoretical progress since 1950, as seems to be the case, then this is fine with me. One does not have to listen to monetarists.

  9. @Ernestine Gross

    “Prof Radner’s mid-1970 model does not contain a government or a monetary authority…If Monetarists are not interested in theoretical progress since 1950, as seems to be the case, then this is fine with me. One does not have to listen to monetarists.”

    Logically speaking, a model that does not contain a monetary authority is not very likely to have any implications for monetary policy, is it?

  10. Mark A. Sadowski :@Ernestine Gross
    “Prof Radner’s mid-1970 model does not contain a government or a monetary authority…If Monetarists are not interested in theoretical progress since 1950, as seems to be the case, then this is fine with me. One does not have to listen to monetarists.”
    Logically speaking, a model that does not contain a monetary authority is not very likely to have any implications for monetary policy, is it?

    I do not agree with you because:.

    1. What constitutes ‘money’ is by now means a question to which there is a unique answer. (This is supported by history).
    2. Monetary authorities are legal constructs, invented by people. The rules (constitution) of the authorities differ.
    3. The rules which govern the behaviour of a monetary authority (institutional environment) are not separable from the type of ‘money’ or rather ‘monies’.
    4. It may be counter-intuitive from a daily life perspective, but from a theoretical point of view, it is not logical to exclude the possibility that there are many possible institutional frameworks (and this is supported by history).
    5. On the contrary, a restriction to the institutional environment at a particular period in a particular place is neither interesting nor ‘logical’ from a theoreticians point of view because it would result in models where it is difficult to distinguish between theoretical knowledge and dogma.
    5. In the Arrow-Debreu model, the institutional environment is a complete market for commodities. In the Radner model, the institutional environment is a sequence of commodity markets and securities (privately issued contracts to transfer wealth in a state contingent environment in a multi-period but finite economy. All agents are assumed to be ‘competitive’ (price taking).
    6. It is interesting from the point of view of systematic theoretical research to see whether the change in the institutional environment, from Arrow-Debreu to Radner, raises any new theoretical problems. If it doesn’t then there is no need to proceed (because there is ‘nothing new’ and rhetorical talk doesn’t count). Radner assumed all individuals in the society can have different expectations about what will happen (state of nature) in the future but they agree on the relative prices (of commodities and securities) if a particular state of nature does occur (a realisaton). Not the same as the Lucas rational expectations. But this assumption did not cause a problem. The most significant new problem (which turns out to be relevant for ‘monetary policy discussions) is that there is no natural lower bound on the portfolio choices of securities (ie negative quantities can be held and there is no limit on those.)

    Insight: If there is no limit on negative quantities of privately issued securities then it is of course possible that under (at the time) unexplored conditions, the system is ‘explosive’ or ‘does not work at all’ (complete market failure).

    I am not quite sure how to describe the problem of non-existence of a solution in words and at the same time indicating what one can expect in an actual economy where over time more and more different types of privately issued securities are introduced, all of which can influence quantities and prices, without the aid of rather technical language.

    None of these models is prescriptive. Further information about the actual conditions is required to gain insights. For example:

    The insight I take from Radner’s and subsequent work is that it is impossible for a monetary authority to prevent financial crisis in an environment where private agents (eg the proverbial Wall Street bankers) can issue various types of debt securities with increasing complexity, denominated in fiat currency units. The behaviour of the ‘monetary authority’ becomes compliant (ie exchange fiat money for the junk debt securities to prevent a collapse of the payment system with consequences that are unknowable in detail). This is what we have observed with QE in the US. To come up with a ‘real interest’ rate, however approximated, as the clue to the puzzle just doesn’t cut it.

    By contrast, in Australia where the payment system was not immediately threatened (the regulation of the private financial sector is also different from that of the USA), the then Head of Secretary, Dr Ken Henry, advised the then Rudd Government to literally give a little bit of fiat money to every person who had lodged a tax return and had income less than or equal to a specified amount. This policy was adopted by the government. IMHO, this policy is closer to the desirable aspects of a ‘market economy’ and it signals who is in control of the local currency unit such that the term ‘monetary authority’ hasn’t lost its natural meaning. Whether you call this fiscal or monetary policy is, as far as I am concerned, a question of detail of the actual institutional environment. What matters is that the injection of fiat money went to the right people quickly.

    (I am running out of time. Hope that in the end the lengthy conversation was mutually satisfactory after all, in one way or another.)

  11. “Head of Secretary” should read “Head of Treasury” – another example where I make a half-correction resulting in nonsense. Sorry.

  12. @John Quiggin

    I may be speaking out of turn, but I think the stance taken by the MMT crowd is that looking at the absolute level of interest rates is a bad indicator. I think they would agree that lowering an interest rate target definitely represents an easing and raising one, a tightening.

    To say that the absolute level of interest rates is a good indicator is to say that monetary policy was much tighter in the US in the late 1970s than it is now. Given that we had high and rising inflation in the late 1970s and we have stable and below “target” inflation now, does that really make sense?

    Or is inflation not primarily a monetary phenomenon?

  13. And below is an update of the wealth distribution down-under following the Lehman event of 15 September 2008:

    http://www.smh.com.au/business/lehman-liquidators-and-hangerson-the-winners-in-australian-saga-20130912-2tm7t.html

    It is highway robbery. Legal highway robbery apparently.

    The idea that looking at a calculated ‘real interest rate’ misses the point by a distance further than the circumference of the earth.

    There is an urgent need to have quantity restrictions on various types of securities with zero being a possibly optimal number for a lot of these securities. There is also a need for an ‘enterprise agreement’ for lawyers and other rent seekers, signed with the government.

    I’d like to remind, my academic background is in general equilibrium theory of the neo-classical type. All models I am aware of have a minimum wealth condition, about which little seems to be known among various schools of monetarists.

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