Wednesday, July 31, 2013

Abenomics as a Fulfillment of Milton Friedman's Policy Prescriptions

Today would be Milton Friedman's 101st birthday. What better way to celebrate his birthday than to recognize that Abenomics is largely a fulfillment of the policy prescriptions he outlined for Japan 13 years ago. Here is Friedman in 2000 (my bold):
[T]he Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
In other words, Friedman was calling for large scale asset purchases (LSAPs) long before it was vogue and understood that for the purchases to help the economy there must be a sufficiently large and permanent expansion of the monetary base. On the latter point, Friedman knew that even though the monetary base and treasuries may be near perfect substitutes in a zero lower bound environment, they would not be in the future. And since investors make decisions on what they think will happen in the future, a monetary base injection that is expected to be permanent and greater than the demand for the it in the future is likely to affect spending today. 

The importance of the public believing the monetary base expansion will be permanent can be illustrated by looking back to the early part of the Great Depression. As seen in the figures below, the monetary base grew rapidly between 1929 and early 1933 compared to previous growth. Yet during this time the money supply and nominal GDP continued to fall. The reason this monetary base growth did not stall the collapse of financial intermediation and aggregate spending is because it was still tied to the gold standard. Consequently, the public did net expect a large, permanent expansion of the monetary base. But that all changed with FDR in 1933. He created what Christy Romer calls a "monetary regime shift" both by signalling through articles, speeches, and movies a desire for a higher price level and by abandoning the gold standard which led to even more rapid monetary base expansion. This shift is apparent in the figures below. FDR's actions caused the public to expect a permanent monetary base expansion that would raise future nominal income. A sharp recovery followed in 1933. 1

The key, then, to making monetary policy expansions work in a slump is to create the expectation that at least some part of the monetary base expansion will be permanent. Japan's first try at quantitative easing in the early-to-mid 2000s failed on this front as noted by Scott Sumner and Michael Woodford. Here is Woodford:
The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan’s experiment with QE, the added reserves were all rapidly withdrawn in early 2006...
Well that was then and this is now. Prime Minister Shinzo Abe has committed the government to a radical monetary regime shift that is similar in spirit to FDR's actions in 1933, as noted by Christy Romer. This program, called Abenomics, aims to permanently double the size of the monetary base and end the long run of deflation. It currently is engaged in asset purchases that are triple the size of the Fed's relative to GDP. And the Bank of Japan has committed to doing more if needed.2 So this is a big regime shift and one that arguably fulfills Milton Friedman's policy prescriptions for Japan. 

It is too early to know for sure whether Abenomics is working, but the evidence so far suggest it is making a difference. Here is Ambrose Evans-Pritchard:
Abenomics is working," says Klaus Baader, from Societe Generale. The economy has roared back to life with growth of 4pc over the past two quarters – the best in the G7 bloc this year. The Bank of Japan's business index is the highest since 2007. Equities have jumped 70pc since November, an electric wealth shock.
"Escaping 15 years of deflation is no easy matter," said Mr Abe this week, after winning control over both houses of parliament, yet it may at last be happening.
Prices have been rising for three months, and for six months in Tokyo. Department store sales rose 7.2pc in June from a year earlier, the strongest in 20 years.
I think Milton Friedman would be happy to see Abenomics if he were alive. Happy birthday Milton Friedman. 

1Fiscal policy, though expansionary, was modest at this time. Thus Romer attributes, correctly in my view, most of the 1933 recovery to the new monetary regime.
2There is more to Abenomics including some modest fiscal policy stimulus and structural reforms. For now, though, the main part is the new monetary regime.

P.S. Whether one increases the monetary base through open market operations or through helicopter drops, the point that the increase remain permanent holds. See Willem Buiter for more this point.  


  1. The first key is to verify causation. There is a possibility that monetary and real economy are responding to a third force and gets causation wrong. And yes I read Milts monetary history.

    1. A sufficient reason for the success of leaving the gold standard was the fax machine. Imagine the fed using typewriters today. We would call them luddites, but their policy would be horrible.

    2. Thanks for your insights in your blog.

      But, it seems to me that Mr. Matt Young is right. As you know, there are three arrows in Abenomics. It is not wise to consider the first arrow (monetary stimulus) alone is causing the better economic performance so far. Clearly, the second arrow (fiscal expansion) is also affecting the economy positively. (The third arrow, the effect of structural adjustment is hard to tell in the short run.)

      Besides, it is now argued that the fourth arrow (fiscal consolidation) needs to be triggered towards the center of the target of Abenomics. 3% point hike of sales tax rates would reduce the aggregate demand by about 1.8% of GDP. I am very skeptical with the fourth arrow even aggressive monetary policy by the BOJ could generate positive economic growth after April 2013.

      In sum, Abenomics as a fulfillment of Milton Freedman policy prescription is questionable, in spite of my full respect of late Freedman.

      Tomo Nakamaru

      Chief Economist
      Macro Investment Research Inc.

    3. Tomo, I acknowledged fiscal policy in footnote two. However, as Mark notes in a comment below fiscal policy has been only a small part of the stimulus as measured by the cyclical-adjusted or structural government budget balance.

  2. Excellent blogging.

    Side issue: We keep hearing that the Fed is "very accommodative." Unfortunately, even Market monetarists refer to the fed as being accommodative.

    But the Fed is just loosening the monetary noose it has around the economy's neck. Remember, inflation is at 1 percent on the PCE.

    As we see from Japan, low interest rates alone mean nothing, Japan had ZLB for 20 years, and the yen soared in value, and they had minor deflation.

    Okay, so forget interest rates.

    The question is, "Is the Fed QE program large and aggressive enough?"

    Maybe--so far, the recovery is very slow.

    Sadly, the MM'ers have let the anti-Fed-stimulus crowd steal the language. The Fed is being pictured as recklessly accommodative, experimental, and now may get a female dove as Chairwoman etc.

    The Fed is not being accommodative. The Fed may, in fact, still be too tight and is too tight if one looks at inflation, growth rates and unemployment.

    And yes, we need lower regs and taxes. I cannot think of a time in postwar history when we did not need lower taxes and regs. So what?

  3. David,

    You wrote, "even though the monetary base and treasuries may be near perfect substitutes in a zero lower bound environment, they would not be in the future." But if the monetary base is permanent, that means we will still have trillions of excess reserves in the banking system. And as long as there are excess reserves, the Fed Funds rate and short-term treasuries (through arbitrage) will stay near zero in the absense of IOR. The only way short-term treasury rates can go up with the presence of excess reserves is if the rate on IOR goes up. But then we're still in the same situation as we are at the ZLB: money and treasuries are near perfect substitutes (even with positive rates). And according to your own theory, that should not be inflationary.

    1. Jared, you raise an issue I ignored since I was talking about Japan. But still, the permanent expansion of the monetary base point holds with some qualifiers for the Fed.

      First, treasury rates and the federal funds rate can go up even if IOR does not. Here is how. Imagine a really robust recovery takes hold in the US economy. This will improve the economic outlook and increase the demand for loans and other forms of financial intermediation. The increased demand for loans and financial intermediation will at some point increase market interest rates. And the Fed could decide to keep the IOR at 0.25%, even as market rates head up. If so, banks at this point will start investing their funds in the higher yielding treasuries and banks loans rather than park it at the Fed for only 0.25%. This, in fact, is what prior to 2008. Back then the IOR was effectively 0%. Now it is positive. There should be no difference moving forward if a positive spread between the IOR and market interest rates once again emerges. This would be inflationary.

      This process would also eventually lead to a permanent increase in the currency portion of the monetary base. That is, the bank reserves (which in aggregate haven't changed in quantity)over time would be turned in currency. With a robust recovery, this process would be quickened. This too has historically happened.

      The Fed, however, has made it clear it plans to reduce the total amount of bank reserves and not allow the above process to occur. In other words, the Fed will not allow a permanent expansion of the monetary base that fuels supports broader nominal growth.

    2. David, I don't think that's quite right (note: even though I talk in terms of the Fed, I think this applies to Japan and the BOJ as well). I thought the point of your original post was that a permanent increase in the monetary base will lead to inflationary expectations because of the recognition that treasuries and money will not always be near perfect substitutes, which will cause more spending in the current period. My point, contrarily, was that a permanent increase in the base will lead to the PERMANENT CONDITION OF MONEY AND SHORT-TERM TREASURIES BEING NEAR PERFECT SUBSTITUTES, and, therefore, should not increase inflationary expectations or increase spending (unless due to systemic error). But your reply to me put the cart before the horse. You assumed spending had increased from the start. That could be the case, but I would argue, and I think you would have to agree, that it was NOT due to the permanent increase in the base because your example assumed a spending increase even before money and treasury rates diverged.

      But even given your scenario, short-term treasuries will not in fact rise. If market participants are investing in more treasuries, as you say, this will just bid up their price, and inversely reduce yields (down to the IOR). Treasury rates will not be able to go up because any time they might, a bank with excess reserves earning 0.25% will quickly bid the treasury rate down to approximately 0.25%. Furthermore, these transactions will just move reserves from the buyer's bank to the seller's banks, so they will still be parked at the Fed. While individual banks can get rid of excess reserves (by buying stuff and lending overnight to other banks), the market as a whole cannot. Only the Fed can add or subtract reserves from the banking system through OMO's (and cash withdrawals will reduce reserves too, but why would everyone start carrying huge wads of cash around?).

      What happened prior to 2008 was very different than what's happening now. Prior to 2008, the Fed would not allow an excess of reserves to exist. If there was an excess, the Fed Funds Rate would drop, and since the Fed targets that rate, they would suck the excess out with open market sales or repos. This is what the trading desk would do on a daily basis: ensure that the right amount of reserves (no excess; no shortfall) were held by banks. Now, since they've injected an excess amount of reserves, the IOR has become the de facto FFR (although because some reserve accounts, like the GSE's, are not subject to IOR, the FFR is actually slightly lower than 0.25%).

    3. Jared,

      I agree the IOR has become the defacto FFR, but that need not be the case when the economy recovers. When a recovery happens, interest rates across all assets and the term structure go up in varying degrees. This is because the higher current and expected economic growth will one, increase demand for credit by firms and households and two, decrease saving. In short, the natural interest rate will rise and push up all interest rates. In this environment, the Fed is forced to raise the IOR to the short-term treasury rate or there will be inflation. The Fed is the follower, not the leader.

      My point is that if the Fed were (1) not to raise the IOR and (2) not reduce bank reserves then you get the story Sumners, Woodford, and I are talking about above. This is the permanent expansion of the monetary base that matters.

      Now let me respond to your claim that banks will arbitrage treasury rates back down to the IOR in such an environment. This can't and won't happen. Here is why. Given the improved economic growth, investors in general are expecting interest rates to be high and treasury prices to be low. Consequently, though they will still hold some treasuries, they overall will be diversifying away from them to avoid capital losses. If banks try to fight this, as you claim they will,it will be a losing battle. Their $1.8 trillion in reserves is not going to go very far in a $12 trillion treasury market. Moreover, banks will not fight this battle in the first place. They too are investors and will be diversifying into higher yielding loans. Remember, the demand for credit is up and with improved credit risks and bank health, banks will respond. This all will lead to a rapid expansion of inside money, spending, and inflation.

      In short, market rates can go up even if the Fed holds the IOR down. Now the Fed has clearly stated it wants steady inflation. It can achieve that by either reducing bank reserves or raising the IOR once the economy starts recovering.

      And yes, I understand (and even stated in my first reply) that the total amount of reserves will not change. What will change, again assuming IOR stays at 0.25 and Fed does not reduce total reserves, is that the excess reserves will all be turn into regular bank reserves as more bank lending take place for a given supply of reserves. And yes, most of the bank reserves will gradually be pulled out into cash. It is happening even now.

      Finally, my assumption of a robust recovery is warranted since the whole point of the post was to show that the right kind of monetary easing (like they are doing in Japan) will create expectations of a recovery and kick start the process I outline above.

    4. I really appreciate you taking the time to address my concerns. I'm still confused about one thing in particular though: your claim that $1.8 trillion of reserves won't go very far in a $12 trillion market. We've already agreed that reserves don't leave the system with bank asset purchases; they only get moved around. So even if the banks that currently hold the excess reserves use them all to acquire $1.8 trillion of treasuries, there will still be $1.8 trillion of excess reserves* (caveat discussed below); they'll just be held by different banks. Because reserves can't exit the system unless the central bank drains (which we're assuming it won't), those reserves will always* be there, effectively creating an infinite demand for treasuries yielding anything greater than IOR. Therefore, as long as there are excess reserves in the system, this demand will not allow the market rate for short-term treasuries to rise above IOR. And, again, I'm stressing this point because if rates shouldn't diverge, then market participants should not expect inflation simply due to a permanent increase in the monetary base.

      * If the banks purchase all the treasuries from non-banks, then deposits will increase by $1.8 trillion, shifting some of the excess reserves to required reserves. But since the US has roughly a 10% reserve requirement (I'm not sure about Japan; are they more like us or like Canada and the UK who don't have any reserve requirements?), there will still be $1.62 trillion of excess reserves . In fact, it would take an increase in lending and deposit creation of $18 trillion before all the current reserves would become required reserves. Considering M1 is currently only about $2.5 trillion, getting to that point is going to take some time. That's why I don't think markets would respond by spending more now just because they expect interest rates between reserves and treasuries to diverge in 20 years or so. And that's why I don't think the Fed's claim that they will drain those excess reserves is very credible. If they try, asset prices will plunge harming the recovery. If inflation picks up, they will have to raise IOR, which will just add reserves.

      As far as Abenomics working so far, I think Japanese markets have responded, not for the reason you cited, but because they believe Abe will do WHATEVER IT TAKES, through monetary or fiscal policy, to increase inflation. We'll see how long markets keep believing this.

    5. Jared, I know you don't believe banks will invest all their excess reserves in treasuries as the economy is improving, bank loan demand is increasing, and yields are rising. Banks are investors looking to maximize their risk-adjusted returns too. As the economy improves, that means investing in higher-yielding loans. There is a reason the FOMC (and even MMT-types) have said that Fed will need to raise the IOR in the future to contain inflation if the Fed's balance sheet is still large.

      I should have mentioned this earlier, but forgot I did a related post here: This post was mentioned by Steve Randy Waldman in this piece here:

      I do think, though, that you are right that banks could in theory could buy up all treasuries if they wanted to do so. So I will concede my excess reserves to total public debt comparison is off. However, the question is will they do that? And for the reasons laid out above, the answer is no.

    6. This is in response to the above and the comments you left at Cullen Roche’s site:

      I’m still not clear how the rate on T-bills could rise if IOR stays low in your scenario. I’m also not exactly sure what you mean by “banks will [not] invest all their excess reserves in treasuries as the economy is improving.” I actually think your expression reveals an even more fundamental disagreement between us. Reserves just facilitate payment clearance. If a bank purchases a treasury from a non-bank, a new deposit is created and an equal amount of reserves will be transferred from the purchaser’s bank to the seller’s bank. The reserves don’t get used up, in any sense (as I think your quote above implies). They’re still there, earning IOR on some bank’s balance sheet. If IOR remains low in an expanding economy, you’re right that banks will look to maximize their risk-adjusted returns and increase lending, but the banking system, as a whole, will not be able to get rid of the low yielding reserves (except as I explained above: increased lending/deposit creation will slowly turn the excess reserves into required reserves, but that process will take decades given the current amount of excess). So banks stuck with the excess reserves earning zilch will pounce on a T-bill that earns anything more than zilch, even while lending is increasing. But this just passes the buck. Some new bank will now be holding the reserves. It’s this process of eternal recurrence (to get Nietzschean on you!) that will not allow T-bill rates to go up. If the Fed doesn’t raise IOR, it seems to me that we’re stuck with zero rate T-bills, even with a permanent increase in the base.

      I am really trying to understand your position. I’m just hitting a roadblock.

  4. "Fiscal policy, though expansionary, was modest at this time. Thus Romer attributes, correctly in my view, most of the 1933 recovery to the new monetary regime."

    I recently calculated the the cyclically adjusted general government budget deficits and their changes from E. Cary Brown’s “Fiscal Policy in the “Thirties: A Reappraisal” (American Economic Review, Vol. 46, No. 5, December 1956, pp. 857–879). This reflects state and local budgets as well federal, but as you might imagine most of the impact comes from the federal budget . Note that I’ve reversed the signs of the changes so that positive corresponds to fiscal stimulus and negative corresponds to fiscal consolidation (everything is in percent of potential GDP):

    Year Balance Change
    1929 -0.804 ——-
    1930 -1.364 0.56
    1931 -3.311 1.95
    1932 -0.854 -2.46
    1933 1.005 -1.86
    1934 0.172 0.83
    1935 -0.056 0.23
    1936 -1.078 1.02
    1937 1.828 -2.91
    1938 0.608 1.22
    1939 -0.147 0.76

    As you can see the largest cyclically adjusted deficit as well as the largest increase in the deficit took place in calendar year 1931.The largest deficit under FDR was in 1936 and it is less than one third as large. One has to be careful with 1929 and 1933 since the fiscal years ran to the middle of the year and calendar 1929 was half Coolidge’s doing and 1933 was split between Hoover and FDR. But it’s clear that the fiscal stance was much tighter under FDR than Hoover with probably the only cyclically adjusted fiscal year deficit being run in FY 1936 and the only balanced budget under Hoover by this standard being in FY 1933.

    1. FDR era also jacked taxes up as well.

  5. "There is more to Abenomics including some modest fiscal policy stimulus and structural reforms. For now, though, the main part is the new monetary regime."

    The fiscal stimulus under Abenomics is much smaller than popularly perceived. It is only 10.3 trillion yen or about 2% of GDP. To get a good idea of its actual impact I suggest consulting the IMF Fiscal Monitor.

    In October 2012 Japan's cyclically adjusted general government primary balance was projected to be (-7.5%), (-5.5%) and (-4.5%) of potential GDP in calendar years 2013-15 respectively. In April this was revised to (-8.7%), (-6.1%) and (-4.8%) of potential GDP in calendar years 2013-15 respectively:

    A sum of the differences yields 2.1% of potential GDP.

    In 2012 Japan's cyclically adjusted primary balance was (-8.4%) of potential GDP. Thus the change in cyclically adjusted primary balance, which is of course a measure of the fiscal stimulus, has gone from (+0.9%), (+2.0%) and (+1.0%) of potential GDP in calendar years 2013-15 respectively before Abe to (-0.3%), (+2.6%) and (1.3%) in calendar years 2013-15 respectively after Abe.

    In other words fiscal policy goes from being contractionary to mildly stimulative in 2013 and becomes even more contractionary in 2014 and 2015.

    Many people are enthused with the fiscal side of Abenomics not realizing that Japan has already had a wildly expansionary policy stance since 2008 with little to no impact on NGDP.

    1. Mark, great stuff. Scott Sumner is right. You need to be blogging. I plan to do a post using your information above. Thanks!