Scott Sumner  

Concrete steps for Mr. Cochrane

About those wacky libertarians... What's Libertarian About Betti...

John Cochrane has a post on Japan's long period of near-zero CPI inflation, and then adds this footnote:

Update David Beckworth on the same topic. I'm less of a NGDP target fan. It's like saying all the Chicago Cubs need is a "win the world series" target. OK, but what do you want them actually to do differently? What 3 trillion of QE wasn't enough, but 6 will do the trick? I know the answer, that talk alone tweaks some off equilibrium paths to generate more "demand" today. And monetary policy does seem to be just talk these days. But still... I'm also less of a fan of looking at monetary aggregates. At zero rates, money = bonds, and MV=PY becomes V = PY/M. But it's a well stated analysis in these terms, and nice coverage of the fiscal theory at the end.
I must say I don't like this footnote. The off hand remark about the Equation of Exchange doesn't really make any sense. John probably has in mind something about the quantity theory breaking down at zero-rates because V becomes unstable, but my pet peeve is when people confuse the Quantity Theory (which is a theory) with the Equation of Exchange (which is an identity.)

The more important issue is John's request for specific actions that the Japanese could take to hit their NGDP target. Unfortunately, Prime Minister Abe announced a 6 600 trillion yen NGDP target without mentioning a date (which sort of defeats the whole purpose.) But I'm going to go with David Beckworth's estimate of 2020 as being roughly the target date. That's the sort of time period that makes sense for an elected politician. A 50-year target would be just silly, as Abe won't be around then. Also note that Japan's NGDP is currently 5 500 trillion yen, so it's easier to think of the target as a 20% increase over 5 years, which is slightly under 4%/year (due to compounding.)

John seems to assume that market monetarists like David and I think in terms of money supply targeting. But that's old school monetarists. We favor a policy stance that the market expects to lead to on target NGDP growth. There are many ways of doing this, and not surprisingly all have drawbacks. But we live in a messy imperfect world, so what do you expect?

1. NGDP futures targeting. This is the optimal policy, in my view. Have the BOJ peg the price of a 5 year forward NGDP futures contract, in order to equate the policy target with the market forecast.

Problems include a possible risk premium, and the need to set up such a market. The latter problem is easy to solve in a technical sense, but perhaps not a political sense. The risk premium is real, but very unlikely to be of macroeconomic significance. It doesn't much matter if the actual growth rate is 3% or 5%, rather than 4%. You just want to avoid the negative NGDP growth of 1993-2012.

2. Let's say NGDP futures are off the table. What other concrete steps are possible? I'd say currency depreciation is a plausible option---it worked for FDR. But how much should the yen depreciate? This is tricky, but becomes much easier if you assume the monetary authority does not control the real exchange rate in the long run, and that 2020 is far enough out to be the long run. Then you estimate the current market expectation of Japanese NGDP growth between now and 2020. It's probably about 5% total, or 0% RGDP and 1% inflation per year over the next 5 years. So we are currently about 15% short of the 20% target in terms of market expectations.

Now consider that the current value of the yen reflects those same market expectations. So the BOJ should do a 15% depreciation of the yen against a trade weighted basket of exchange rates, and then peg it at that new level. If the 5-year forward price is different from the spot price, you'd probably want to depreciate the 5-year forward exchange rate by 15%. There are some technical issues here relating to how quickly you'd like the policy stance to converge to the new target.

The drawback is that other countries would complain. Let them squeal! It's time for the Japanese to do something about deflation. In any case, ANY effective policy will cause the yen to depreciate, as we saw after Abenomics was announced.

3. There are many other market approaches, which all have drawbacks. You could instruct the research staff of the BOJ to construct a model linking NGDP expectations with a basket of market indicators, such as TIPS spreads, equity prices, exchange rates, etc. Then instruct the BOJ to do open market operations until this basket of indicators predicted on-target NGDP growth. You could even do an FDR, and depreciate the yen by 15% against gold. But that's risky if gold prices are volatile (and they are).

You may wonder how these solutions solve the so-called "liquidity trap" problem. They don't, but they do make it easier to see that there actually is no liquidity trap problem; it's a myth. To his credit, Paul Krugman has been very upfront in acknowledging and even defending the implications of the liquidity trap model. If the central bank can't create inflation, then ipso facto it can't influence the nominal exchange rate---at all. But we know from recent history in Japan and Switzerland that central banks can influence the exchange rate quite dramatically, even at the zero bound.

Interestingly, there was the same sort of skepticism in the 1930s. Naysayers claimed FDR would not be able to devalue the dollar against gold, via his gold buying program. They claimed that he'd be able to influence the Treasury's buying price of gold, but not the international market price. But they were proved wrong. He raised the official price from $20.67 to $35 an ounce, and made it stick in the international markets. So in fact there never was a liquidity trap problem, but this needs to be rediscovered over and over again by economists who are not familiar with monetary history. One example of the rediscovery of FDR's policy was Lars Svensson's proposal "foolproof plan" for exiting a liquidity trap.

Comments and Sharing

COMMENTS (13 to date)
baconbacon writes:

My(incomplete)understanding of the FDR gold purchasing is that they dictated a sale price of $20, ordered that US citizens sell gold to the government at that price, banned transactions in the opposite direction for non governments and then raised the price to $35. Perhaps I have the order wrong or the time line is a lot more stretched out, but I don't see that the Fed could do the equivalent now.

Scott Sumner writes:

Bacon, Yes, they banned gold ownership by Americans, but that was not an essential part of the policy---it was a side issue. You can do the exact same thing without banning gold ownership.

Jeff writes:

Yes, it's obvious that all FDR needed to do to raise the gold price was announce that the Treasury will buy unlimited amounts of gold for $35 per ounce from anyone. If the announcement itself was not perceived as 100 percent credible, he might actually have to buy some gold, but probably not that much.

Same thing with exchange rates. Suppose the Fed announced that it was targeting the exchange rate at a particular level, and that it would not sterilize the foreign exchange operations it took to meet that target. If the market actually believed the Fed was serious, most likely it wouldn't have to do very much intervention at all, due to what Nick Rowe has described as the Chuck Norris effect.

I think Cochrane understates the Chuck Norris effect.

baconbacon writes:


I disagree, banning redeem-ability for gold was crucial for the scheme to work. Gold had to stop being a (major) medium of exchange, the fact that the nominal price of gold "held" at $35 was only possible possible because there was large scale confiscation and no ability to arbitrage the situation.

Mr. Econotarian writes:

The 1933 Gold Clause Ban was required because of the large number of contracts written with "payable in gold" clauses, which would have put debtors significantly underwater after devaluation instead of them benefitting from devaluation.

The Gold Clause Ban was an incredible expansion of Federal power and challenged in the Supreme Court. More details here:

B Cole writes:

Nice post. Cochrane has explained that his goal is minor deflation and 0% interest rates. So Cochrane has devised some theories to justify such a stance, and has become a NeoFisherian.

But boy! Talk about hand-waving! The NeoFisherians say if you lower interest rates, then inflation falls too, just like magic.

Volcker really was lucky. Cochrane says Volker was a success, because Reagan was running primary surpluses ( which Reagan did not run until the seventh year of his presidency ). That explains how Volcker raised rates that brought inflation down. You follow that, right?

Once again, I must sadly conclude that macroeconomics is just politics and fever in drag.


Scott Sumner writes:

Bacon, What do you mean by "arbitrage the situation"? Also recall that the ban only applied to Americans. People in other countries could redeem US dollars for gold. And lots of Americans cheated, bought gold and stored it in London.

Mr. Econotarian. Yes, although I think it was justified. The alternative was even worse.

Jason writes:
Japan's NGDP is currently 5 trillion yen
I believe the yen amounts are missing a couple of zeros.
LK Beland writes:

I believe it is 500 and 600 trillion yens, rather than 5 and 6.

baconbacon writes:

@ Scott-

If US government had left the convertability window open in both directions then any person (or bank more likely) that anticipated the devaluation would have traded dollars for gold at $20 an ounce, waited a few months and traded back at the higher rate.

Banning gold holdings for US citizens prevented (or at least greatly reduced the risk) of the market punishing the Fed for setting the wrong rate. The fact that non US citizens "could" trade dollars for gold was fairly incosequential. There were far fewer buyers and sellers of gold among dollar users thanks to these rules and foreign governments could redeem dollars for gold at $35 an ounce which severly reduced their incentive to sell their gold to the public at other price. The closest description to the gold market in these times was a cartel between the major governments.

Federico writes:

Scott, this comment was very interesting: "Naysayers claimed FDR would not be able to devalue the dollar against gold, via his gold buying program. They claimed that he'd be able to influence the Treasury's buying price of gold, but not the international market price". Do you know of any articles that go into depth into that statement? It would be interesting to make a deeper comparison between the naysayers then and the naysayers now (that claim CBs can't create inflation)

Scott Sumner writes:

Thanks Jason and LK, I fixed it.

Bacon, That sort of restriction would in no way inhibit arbitrageurs who saw the devaluation coming. They could have bought a hard currency like French francs and then swapped back into dollars after the devaluation. And of course lots of Americans did hoard gold at the end of the Hoover administration, as they didn't know the ban on gold holdings was soon going to be imposed.

I don't think the British banned gold ownership when they devalued, although someone should check that.

Federico, I have a book coming out in December that goes into detail on that issue.

TallDave writes:

Interesting how much debate still revolves around the relative ineffability of inflation.

Looking forward to the book!

Comments for this entry have been closed
Return to top