Scott Sumner  

Fiscally inefficient monetary policy

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Here is Noah Smith:

Abe is the most effective national leader in the world right now. I never thought I'd say this, but he's an example that the rest of the world should be following.

This time around, Abe didn't ignore the economy. Backed by economic adviser Koichi Hamada and Bank of Japan Governor Haruhiko Kuroda, Abe first implemented the biggest monetarist push in world history. He went the opposite direction of Europe, and -- unlike the United States -- he gave every indication that the shift toward monetarism was permanent. The result: Japan has escaped deflation. The stock market is up, growth is way up and even wages are finally starting to rise.

In other words, unlike everyone else in the world, Abe listened to Milton Friedman, and the results are looking good. As the Fed contemplates not whether to taper its quantitative easing but rather how fast, it might want to look at what's happening in Japan.


I agree with Smith, although that doesn't mean I think Japan will necessarily persevere with its 2% inflation target on a long term basis. Long term bond yields are still close to zero. (They need an NGDP prediction market.) Oddly, the fact that long term bond yields have not risen is powerful evidence in favor of the recent Japanese policy shift. To see why, we first need to consider why most of the time monetary stimulus doesn't work.

Consider a country with a big national debt. You might think that monetary stimulus would help by speeding up the growth rate of NGDP, and hence reducing the debt/GDP ratio. Unfortunately, nominal interest rates generally rise one-for-one with faster trend NGDP growth, offsetting any fiscal advantage.

[Yes, an unanticipated NGDP growth spurt can help by raising NGDP before rates have adjusted, but I'm considering sustained policy regimes, not "one off" ideas that will be paid for later with a future loss of credibility.]

There is one exception to the general rule that monetary stimulus doesn't help the fiscal situation in the long run---the zero nominal interest rate boundary. Suppose NGDP growth is so slow that the equilibrium nominal bond yield is far below zero. In that case the actual interest rate on government debt will be "too high", and the government will waste enormous sums of tax money on unnecessary interest expenses.

The fact that Japan was able to adopt a more expansionary monetary policy without having to pay significantly higher rates on borrowing indicates that fiscal policy was incredibly inefficient. Consider the following example:

1. Over the past 20 years the Japanese NGDP growth rate has been roughly zero. The Abe government has indicated they are shooting for roughly 3% NGDP growth. If the higher NGDP growth rate does not lead to higher nominal interest rates (a big if), then Japan can run a much larger deficit without raising the debt ratio.

2. Suppose the Japanese debt is 200% of GDP (it depends how you define it.) In that case, at zero percent NGDP growth the Japanese government cannot run any persistent deficit without the debt/GDP ratio exploding. If NGDP growth averages 3% then the deficit can average 6% of GDP without any increase in the debt ratio. That's a huge free lunch! And it shows how massively inefficient Japanese monetary policy has been since 1993---the monetary policy has created huge fiscal inefficiencies.

By the way, the Japanese stock market was around 8700 right before (candidate) Abe announced his monetary stimulus plan. The announcement raised stock prices, and they rose further with his big election victory and subsequent changes at the Bank of Japan. By May 2013 the Nikkei index had crossed 15,000. Since then it has moved sideways. Market monetarists believe that asset markets move in anticipation of the effects of macro policies.

PS. It should be noted that when Smith talks about "monetarism" he is correctly describing the views of Milton Friedman. But Friedman is no longer alive, and in today's world these views are better described as "market monetarist." When market monetarists began pushing for monetary stimulus in late 2008 and early 2009 we were widely viewed as eccentrics. We were told our ideas would never work at the zero bound, and even if they did the Japanese electorate was dominated by old people and would never vote for these policies. Negative interest rates? Don't be crazy, the Germans would never allow that. You seriously think that the Fed could offset massive payroll and income tax increases and a spending sequester, and that GDP growth would accelerate (in 2013)? At the zero bound? Are you nuts? You think mere "forward guidance" in Britain by a new BoE head could dramatically speed up the recovery? That's like believing in the tooth fairy.

It looks like the expectations fairy does exist after all.

In retrospect, 2013 was the year everything fell into place. The natural experiments in Japan, the US, Britain, the eurozone, and Sweden were there for everyone to see. Now market monetarist views are in some respects becoming almost conventional wisdom. Just as with some of the better old monetarist ideas, the Keynesians will absorb them, rename them "new Keynesian," and discard what they don't want. In 20 years they will be in the textbooks, but no one will have ever heard of market monetarists. I'm OK with that; like Borges, I long for oblivion.


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COMMENTS (8 to date)
James Bailey writes:

People usually talk about monetary policy being less effective at the ZLB, and you have argued before that it still works. But I don't recall you previously outlining a mechanism by which monetary policy can be more effective at the ZLB- it seems like that deserves a post of its own, or really an academic paper of its own.

ThomasH writes:

"In that case (zero NGDP growth), at zero percent NGDP growth the Japanese government cannot run any persistent deficit without the debt/GDP ratio exploding."

Does this apply no matter what the real rate of return on the investment is? Of does zero NGDP growth imply a low real rate of return on government investment?

Andrew M writes:

People usually talk about monetary policy being less effective at the ZLB, and you have argued before that it still works. But I don't recall you previously outlining a mechanism by which monetary policy can be more effective at the ZLB

This has been the topic of more posts tha I can count between here and TheMoneyIllusion.

QE, elminination of IOR,currency depreciation, etc., all discussed at great length over the last few years.

Rajat writes:
Just as with some of the better old monetarist ideas, the Keynesians will absorb them, rename them "new Keynesian," and discard what they don't want. In 20 years they will be in the textbooks, but no one will have ever heard of market monetarists.
Not necessarily - if the young superstars who have latched on to market monetarism continue to grow in stature, it may survive. And the things that Krugman and SWL etc have said are all widely available forever. It's much harder for a small group of progressives to rewrite history in the age of the internet.
James Bailey writes:

"This has been the topic of more posts tha I can count between here and TheMoneyIllusion.

QE, elminination of IOR,currency depreciation, etc., all discussed at great length over the last few years."

These are all reasons why monetary policy can still work at the zero bound, but not, as far as I know, reasons why it actually gets more effective at the zero bound than it was above the bound.

Don Geddis writes:

@James Bailey: I didn't see a claim that monetary policy is directly more effective at the zero bound. What I saw Sumner say above ("[bad] monetary policy has created huge fiscal inefficiencies"), is that good monetary policy can allow fiscal policy to be far more efficient.

Scott Sumner writes:

I answered this a couple days ago but it didn't stick. Briefly, Thomas, the answer to your first question is yes.

Don and Andrew seem to have answered James's question.

Iktar G writes:

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