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.  

A Paradox of Flexibility or Central Bank Incompetence?

Paul Krugman and Mark Thoma are again making the case against increased wage flexibility in a depressed economy. They contend that rather than helping labor markets clear, increased wage flexibility in a slump will create wage cuts that only serve to lower incomes. In turn, spending will weaken and further stoke the existing deflationary pressures. Policy makers, therefore, should avoid the siren call of reforms that enhance wage flexibility.

This so-called "paradox of flexibility" dates back to John Maynard Keynes, was endorsed by James Tobin, and continues to be advocated by prominent New Keynesians like Gautti Eggertson. Despite this long pedigree, there is a big problem with this view: it assumes that central banks are incompetent. The only reason wage cuts should lead to deflation and a sustained decline in aggregate nominal income is because monetary policy allows it to happen. This very point was demonstrated by none other than Gautti Eggertson and his coauthors in a 2012 paper:

[C]onsider demand shocks. For an increase in price flexibility to be destabilizing we find that the key condition is that the central bank does not raise/cut the nominal interest aggressively enough in response to movements in inflation. Intuitively, what is going on is that a higher price flexibility can trigger unstable inflation expectations if monetary policy does not act aggressively to counteract this by raising/cutting interest rates.

So there is no "paradox" here, but just good old fashion policy failure. Even at the ZLB this is true, since there are policy options--both monetary and fiscal--that can hold back deflation. Even the Fed's flawed approach over the past four years has done that. Fed polices have kept both deflation at bay and nominal income growing, even in the face of a shrinking structural budget deficit. So why fret about increasing wage flexibility? Reforms that improve the working of relative prices by enhancing wage flexibility should be no problem given the Fed's track record. Yes, the Fed could be doing more, but that is far different than saying it would allow the collapse of the price level and aggregate nominal incomes needed for this "paradox of flexibility" to arise. 

Given a competent central bank, increased wage flexibility is fully consistent with growth in aggregate employment and income. Moreover, it probably would hasten a quicker recovery than monetary policy alone could generate. This slump has been so long that many cyclically unemployed individuals may have become structurally unemployed. Labor market reforms that increase wage flexibility would help them. We can have our cake and eat it too when it comes to wage flexibility.

The Right Type of Tapering

Ramesh Ponnuru and I have a new article at the New Republic where we argue the Fed should not consider tapering unless it is tied to a NGDP level target. If the target were based on pre-crisis trends over the "Great Moderation" period, then the dollar size of the economy is about 10% too small. If it is based on the CBO's full-employment level of NGDP then it is about 6% short. Either way, there is still a large aggregate nominal expenditure shortfall. The FOMC should make tapering conditional on closing this gap.

The FOMC and Bernanke, however, signaled a different type of tapering last week that sent the markets into a tailspin.Yes, Bernanke said the tapering would be based on the pace of recovery, but he also mentioned a timetable which raised questions about whether monetary policy will truly be state contingent. There may have more than this tapering confusion that rattled markets--such as China's tightening of policy--but the Fed clearly failed to signal a future path of monetary policy consistent with supporting the ongoing recovery. This is more passive tightening of monetary policy. 

The Fed should realize it is not doing it right when The Telegraph's Ambrose Evans-Pritchard, President James Bullard, and IMF Managing Director Christine Largarde all agree the FOMC botched it last week. The Fed can make this right by talking up the right type of tapering. The kind that is conditional on closing the NGDP gap.

It's Time for the Bank of England to Adopt a NGDPLT

Evan Soltas is right. Mark Carney's arrival provides a great opportunity for monetary regime change at the Bank of England:

Mark Carney's arrival as the new head of the Bank of England on July 1 is an opportunity for the U.K. to rethink monetary policy. As a Canadian, Carney is an outsider, and he'll have a clean slate because the central bank’s two current deputy governors are leaving as well. I'm hoping the U.K. seizes the moment and embraces an idea that Carney has flirted with in recent speeches -- adopt an explicit target for nominal gross domestic product.

The Bank of England adopting a NGDP level target (NGDPLT) would be a great catalyst for other central banks considering a move to NGDPLT. The Fed is halfway there with its QE3 program and Japan's Abenomics program is not too far behind. Just like the Bank of New Zealand and the Bank of Canada were important first movers toward inflation targeting regimes, the Bank of England may be the important first mover toward a world where NGDPLT is the norm. 

As the Eurozone crisis has so vividly demonstrated, it is well past time we leave the barbaric practice of inflation targeting behind and move on to a more humane monetary policy regime of NGDPLT.

The Tapering Talk and Rising Yields Are a Sign of Recovery

There seems to be a growing consensus that the recent rise in long-term interest rates is the result of the Fed indicating it may taper its asset purchases. Fed Chairman Ben Bernanke's comments before Congress on May 22 and the subsequent release of FOMC minutes allegedly sparked concerns the Fed was going to tighten policy sooner than expected. This understanding is reflected in this Bloomberg article:

Bond prices have slumped since Bernanke told Congress’s Joint Economic Committee on May 22 the Fed could scale back stimulus efforts “in the next few meetings” if the employment outlook shows “sustainable” improvement. He stressed that any decision would depend on what the economic data showed and that a move to reduce the pace of purchases would be delayed if recovery falters and inflation falls further.

[...]

The yield on the 10-year Treasury note was 1.93 percent the day before the committee hearing and went on to trade at a 14-month high of 2.29 percent last week...The sell-off in Treasuries has triggered convulsions in capital markets elsewhere...“Central banks have given a sense of near total control, driving volatility and bond yields to historic lows and compressing risk premia,” said Michala Marcussen, global head of economics at Societe Generale SA in London. As the “countdown” to the end of the Fed’s quantitative-easing program advances, “volatility and higher bond yields are making a return.”

This is very compelling narrative, except that it is probably wrong. This popular view is so caught up in what Bernanke said that it is missing the forest for the trees. Other developments have been happening to long-term yields that suggest the tapering talk is a red herring. These can be seen in the next few figures.

First, long-term interest rates started increasing at the beginning of May. Bernanke's comments and the FOMC minutes occurred several weeks later. Therefore, the timing is way off for the tapering explanation. Something else is happening here:

Second, as noted by Jim Hamilton and Michael Darda, long-term interest rates on safe sovereign assets around the world are going up and are doing so in a similar manner. So whatever is affecting U.S. long-term interest rates is also affecting global yields.

So what could be affecting all these yields over the past few months? How about an improved economic outlook? We are now halfway through 2013 and the U.S. economy has been relatively resilient to fiscal austerity and Japan's first quarter growth has been better than expected. Maybe investors see these developments and are becoming increasingly more confident. If so, they would be rebalancing their portfolios accordingly and, in the process, driving up the natural rate of interest. This possibility is a point that Market Monetarists like Lars Christensen have been making for some time.

Note the implications of this understanding. If monetary policy does spark a robust recovery it should lead to higher interest rates, not lower ones. Higher yields mean, then, that QE3 is working. Chairman Bernanke made this very point at a prior congressional hearing:

Earlier this year, Chairman Bernanke made the point that rising interest rate reflect “The fact that interest rates have gone up a bit is actually indicative of a stronger economy,” Bernanke said in Washington today in response to questions from members of the House Financial Services Committee. That indicates the Fed’s stimulus is working, he said.

It also means that most observers have misinterpreted Bernanke's remarks on tapering. For him to even consider tapering implies he believes a solid recovery may be finally taking hold. But, by his own admission, a solid recovery means higher interest rates. Commentators, therefore, should be viewing his tapering talk and higher yields as a sign of progress, not as a sign of Fed tightening.

Some, like Gavin Davies, do see the rising yields as a sign of an improved economic outlook, but still worry about the decline in expected inflation. He notes the rising nominal treasury yields can be broken down into rising real yields and falling expected inflation:

Here too there is a benign explanation for these developments: a positive supply shock. As Ryan Avent explains, there appears to have been some growth in global productive capacity. One example would be the increased oil production in the United States. Positive supply shocks like this tend to put upward pressure on the natural interest rate and downward pressure on inflation. If this assessment is correct, then we need not worry about the declining inflation as noted by Lars Christensen.

Of course, the U.S. economy is a long way from full employment and the short-term natural interest rate may still be below zero. But these developments should give us pause and force us to recognize that once a strong recovery takes hold, we should eagerly anticipate rising interest rates.  Embrace the rates!

P.S. Count this post as my long-overdue second part of my Bernanke Friday Night Special Part I.

A Foolproof Approach to Monetary Policy For Both Fiscalists and Monetarists

Cardiff Garcia says we all need to get along. At least the fiscalists and market monetarists who believe there is still a aggregate demand shortfall. He makes the case that both sides should tolerate and even embrace each other. Here is Garcia on market monetarists:

But there is one sense in which even the monetarist position is amenable to fiscal stimulus, and it is this. A belief of the market monetarists is that if NGDP level targeting were properly embraced, then the awful outcomes characteristic of a Great Recession — a slowdown of NGDP growth, calamitous falls in asset prices, the disintegration of usable collateral — would be avoided in the first place...

As such, the very impetus for using fiscal policy to stabilise the economy and accelerate the recovery would be unnecessary...The monetarists therefore wouldn’t be inconsistent if they were to say: Sure, keep fiscal stabilisation policy at the ready in case we fail. We just don’t think it will be necessary. If it does turn out to be necessary, well, go for it.

Okay, but not all fiscal policy is equal. Fiscal policy geared toward large government spending programs is likely to be rife with corruption, inefficient government planning, future distortionary taxes, and a ratcheting up of government intervention in the economy. So I will pass on this type of fiscal policy. Fiscal policy, however, that largely avoids these problems and directly addresses the real issue behind the aggregated demand shortfall--an excess demand for safe, money-like assets--I will endorse. And that form of fiscal policy is a helicopter drop, a government program that gives money directly to households. The Fed would finance it and the Treasury Department would deliver it to each household. This idea is not new. It was originally suggested by Milton Friedman and recently discussed by the conservative AEI. So it should have appeal across both parties.

Here is how I would operationalize this policy. First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits. 

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman's vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia's request it would satisfy both fiscalists and monetarists. What is there not to like about it?

P.S. I would be glad to submit this proposal to Representative Kevin Brady for consideration in his centennial commission on monetary policy. It would be great to see Congress discuss reforming the Fed along these lines.

What the Great Natural Experiment Reveals About QE

There is a great natural economic experiment unfolding. And it is not the QE3 versus U.S. fiscal austerity debate that some of us have been debating. Rather, it is the United States versus the Eurozone and the different policy "treatments" their economies are receiving. Jim Pethokoukis explains:

[W]e have an intriguing natural economic experiment. Two large, advanced economies are both undergoing fiscal austerity from spending cuts and tax increases. But one is recovering, though glacially, from a previous downturn; the other is deteriorating.

The likely difference: monetary policy. Not only did the Federal Reserve slash short-term interest rates to nearly zero way back in 2008, but it has also embarked upon a massive bond-buying program known as quantitative easing. The European Central Bank, however, only last month cut its key interest rate to 0.5 percent, still higher than the Fed-funds rate. And the ECB’s “unconventional” monetary policy has been far more modest, with bond purchases less than a tenth the size of the Fed’s. Its goals have also been more limited: stabilizing southern Europe’s debt markets and avoiding a financial crisis. At a recent speech in Frankfurt, Germany, St. Louis Fed president James Bullard said that unless Europe adopts an aggressive bond-buying program, it risks an extended period of low growth and deflation like what Japan has experienced since the 1980s.

This policy treatment explains the different NGDP trajectories in this figure: 

What is puzzling to me is how anyone could look at the outcome of this experiment and claim the Fed's large scale asset programs (LSAPs) are not helpful. Some claim the LSAPs are just helping the rich, at best, and may even be deflationary. But it is not hard to imagine how much higher U.S. unemployment would be were it not for the Fed's QE programs. Just look to Europe's unemployment rate, as noted by Pethokoukis. Yes, the LSAP programs are far from ideal but they are keeping Americans from experiencing the unemployment seen in Europe.  In other words, QE is helping the lives of ordinary working people in the Unites States. And there are many ordinary working Europeans whose lives would be much better off if the ECB were to more closely follow the Fed's actions.  

The insights from this natural experiment should give QE critics pause. And so should the fact that these these programs are helping shore up the supply of safe assets. Critics who see the slow recovery and point to the Fed's LSAPs simply are not doing the right (if any) counterfactual.