The context of the delivery of the line is:

Captain: You gonna get used to wearing them chains after a while, Luke. Don’t you never stop listening to them clinking, ’cause they gonna remind you what I been saying for your own good.
Luke: I wish you’d stop being so good to me, Cap’n.
Captain: Don’t you ever talk that way to me. (pause, then hitting him) NEVER! NEVER! (Luke rolls down hill; to other prisoners) What we’ve got here is failure to communicate. Some men you just can’t reach. So you get what we had here last week, which is the way he wants it. Well, he gets it. I don’t like it any more than you men.

From Bloomberg:

What central banks may have the world over is a failure to communicate.

Officials are struggling to spell out their visions for monetary policy, often amid a chorus of competing views. Chairman Ben S. Bernanke is trying to manage expectations about when the Federal Reserve will slow asset purchases and raise interest rates. Bank of Japan Governor Haruhiko Kuroda’s reflation-push is backfiring by driving up bond yields. European Central Bank President Mario Draghi is dashing investors’ hopes he once kindled for extra stimulus.

The muddied messaging already is roiling financial markets, threatening to undermine the confidence of investors, households and consumers and so undoing efforts by central banks to strengthen their economies. The opacity puts policy makers under pressure to improve the communication techniques they’ve been using to restrain borrowing costs.

And it is ironic that while Bernanke is the ‘communications champion’, Greenspan played the role of ‘inscrutable oracle’…and was much more successful!

Related post:

What damage a few words can do!

“The resumption of growth in the U.S. and the accompanying change in monetary policy will lead to a strengthening of the dollar that should persist for a long period”.

What a presumption! But why has this “resumption of growth” view spread like ‘bush fire’?

After the March 20 FOMC meeting the perception must have been that the so0 called Evans-Rule’ and asset purchases was not generating enough traction. In what I call the ‘map of the evidence’ – the set of charts at the end– at about that time inflation expectations turned down, the stock market took a ‘breather’, the 10 year bond yield dropped and the dollar fell against a broad set of currencies.

The statement from the May 1^st FOMC meeting was ‘criminal’, containing highly ‘poisonous’ (new) words, to wit:

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

When the press reports that the Chief-of-Staff notified the President that “the army is prepared”, the likelihood of a ‘fight’ looming up ahead increases markedly! And by ‘fight’ here nobody thought the Fed was contemplating an increase in purchases.

And things changed but not all in the expected direction. For instance, while expected inflation continued to slide, consistent with a premature ‘tightening’ of monetary policy, the long bond yield, the stock market and the dollar exchange rate went up strongly.

Sensing things were not ‘kosher’, on May 22 Bernanke switched the order of ‘releases’, doing the press conference prior to the release of the minutes of the May 1^st FOMC meeting. This is the core of Bernanke´s statement at the PC:

Recognizing the drawbacks of persistently low rates, the FOMC actively seeks economic conditions consistent with sustainably higher interest rates. Unfortunately, withdrawing policy accommodation at this juncture would be highly unlikely to produce such conditions. A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.

Because only a healthy economy can deliver sustainably high real rates of return to savers and investors, the best way to achieve higher returns in the medium term and beyond is for the Federal Reserve–consistent with its congressional mandate–to provide policy accommodation as needed to foster maximum employment and price stability. Of course, we will do so with due regard for the efficacy and costs of our policy actions and in a way that is responsive to the evolution of the economic outlook.

But shortly after, when the Minutes were released the ‘world changed’:

Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September, but many of these participants indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate. A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately, while another participant preferred to add more monetary accommodation at the current meeting and mentioned that the Committee had several other tools it could potentially use to do so.

What´s the quantitative dimension of “a number of participants?” And this ungodly group would like to see a move to ‘tightening’ this Wednesday (June FOMC meeting).

The market´s reaction this time was more ‘sensible’. Inflation expectations continued to fall, the stock market reversed as did the dollar (contrary to the “resumption of growth” crowd). The only thing moving in the ‘wrong’ direction was the long yield. But remembering  Bernanke´s words above, this is likely “temporary”. On this topic see Lars’ post.

Evan Soltas nails it when he says:

If the Fed can’t clarify without tightening, that’s a big problem for monetary policy. The next few stages of the exit are necessarily complex. If it wants to avoid snuffing out the recovery, the Fed will need to clarify its clarifications. Next week won’t be a moment too soon.

To recap, this debate is about the best way to accelerate the recovery and return to pre-crisis trend growth while interest rates are at the zero lower bound. (When rates are above the ZLB, many fiscalists — in particular the neo-Keynesians — are monetarists again.)

spawned a string of posts: David Beckworth, Scott Sumner, Paul Krugman and Simon Wren-Lewis, to mention a few.

In other posts, here and here, for example, I´ve tried to show that monetary policy is ‘king’. David Beckworth has also contrasted the Eurozone and US.

In this post I will show, through a string of examples from several Eurozone countries plus Denmark, although not in the euro is linked to it through a fixed exchange rate between the Danish Krona and the euro, and the US.

The examples show the Fiscal stance – measured by government consumption expenditures in each country which is indexed to 1 in the first quarter of 2007 – the rate of RGDP growth and the Monetary Stance (MP Stance), measured by the NGDP gap.

The NGDP gap is the percent difference between the level of spending (NGDP) and the trend level. For example, if monetary policy is being strongly tightened, the gap is rising at an increasing rate. If monetary policy is ‘less tight’, the gap stops increasing and if monetary policy is expansionary, the gap decreases (or, if positive, increases more).

I´ll use the US as a practical example. Note that beginning in early 2008 monetary policy was strongly tightened. Note also that at that time the fiscal stance was expansionary (Government Consumption was rising), but that did not stop real growth from tanking. When QE1 was implemented in March 2009, monetary policy became much less tight and real growth picked up. In 2010 the fiscal stance became ‘neutral’ (Government Consumption stopped rising) but real growth remained positive and stable. But in any case, monetary policy is still tight and we could say that if the Fed adopted an NGDP level target, monetary policy would quickly become expansionary, increasing real growth and employment , even in the absence of fiscal ‘stimulus’.

But we are going in the ‘wrong direction’. As Evan Soltas puts it in recent post:

If the Fed can’t clarify without tightening, that’s a big problem for monetary policy. The next few stages of the exit are necessarily complex. If it wants to avoid snuffing out the recovery, the Fed will need to clarify its clarifications. Next week won’t be a moment too soon.

The fiscal and monetary stance in the countries surveyed differs ‘far and wide’. For example, in France fiscal stimulus increases monotonically throughout but initially monetary policy tightens strongly and real growth falls precipitously. When monetary policy ‘eases up’, real growth resumes, only to drop again when monetary policy tightens up (when the ECB raises rates in April and June 2011).

In Finland fiscal stimulus has been in place for most of the time but it is monetary policy that clearly determines the outcome.

Much the same, although with different intensity, can be said of the Netherlands. Note here, comparing the Netherlands with Finland, that the ‘one shoe’ monetary policy doesn´t ‘fit all’. The centralized ECB monetary policy has clearly been tighter for the Netherlands than for Finland, implying that real growth in the Netherlands has been worse than in Finland.

Denmark is an example of a country that for a time had an expansionary monetary policy, with the NGDP gap being reduced. But when monetary policy becomes tight again, real growth falters, despite a temporary pick-up in fiscal stimulus.

Countries like Italy and Spain suffer from both ‘afflictions’: Tight fiscal and monetary policy. But from what we observed in the other cases, the fall in real growth is mostly due to contractionary monetary policy.

Finally, Germany is a point ‘off the curve’. Germany has experienced continuous fiscal stimulus and a monetary policy that completely reversed direction and now maintains Germany´s NGDP close to trend. So why, even in such ‘favorable circumstances’ real growth has disappeared?

The chart below may help explain. With real growth in Germany being very export dependent, the growth crash in major customers has stopped export growth in Germany. One more evidence of the inefficient ‘one size (tries) to fit all’ monetary policy!

To summarize, recent market weakness is very easy to explain.  The markets believe that the BoJ needs to do more, and they had previously assumed that the BoJ had a “whatever it takes” approach.  Now they aren’t so sure.  The US stock market doesn’t believe (as strongly) that the Fed needs to do more, but they are strongly opposed to the Fed doing less.

As always; “It’s about expectations of the future policy path, stupid.”

Note how important the US is for other markets. OK that at around the same time as Bernanke ‘messed-up’ with ‘tapering’, in Japan, as noted by Lars Christensen, officials showed worry about the rise in the long yield. The result of these ‘undesirable’ official statements is illustrated below:

In Japan the stock market took a beating, clearly related to the BoJ´s show of reluctance and the Fed´s introduction of ‘taper mania’.

When will they ever learn?

This post is Part 2 of two posts in which I respond specifically to his remarks on Japan’s Lost Decade. Here is Koo on QE’s effect on Japan’s exchange rates:

 “An example of QE having the opposite of expected effect was provided by the Japanese case in 2003-04. At that time, Japan was the only country implementing quantitative easing as it increased monetary base from 100 in 2001 to 170 by 2004, all with zero interest rates. During the same period, the monetary base in the US increased to 130 and in the Eurozone to 120, and both had significantly higher interest rates than in Japan. Although the yen fell at first, the Japanese currency moved strongly higher in 2003, forcing the Japanese government to engage in the largest foreign exchange intervention in history amounting to 30 trillion yen to keep the yen from appreciating. This experience indicated that there is no guarantee that the exchange rate will weaken with a QE.”

Given Koo went to the trouble of using real effective exchange rates in Exhibit 8 when making the claim that there’s not much difference between the change in relative exchange rates among the big four currency areas since 2008 (I may have more to say on this later) I thought it was odd that he obviously switches to nominal exchange rates in this context. When comparing changes in relative exchange rates one obviously wants to take into account different rates of inflation. This is especially the case with a country as unusual as Japan, where there has been virtually persistent deflation since 1995 as measured by the GDP implicit price deflator, as this almost guarantees that the yen will appreciate in nominal terms over time relative to other currencies. The following is a graph of the BOJ’s estimate of Japan’s real effective exchange rate which is trade weighted with respect to 16 different currencies and takes into account their relative inflation rates:

Note that the real effective exchange rate increased sharply from the second half of 1998 through 1999. It plateaued in 2000 and began to noticeably drop in December 2000. Japan’s original ryōteki kin’yū kanwa (QE) was officially announced in March 2001, although there wasn’t a noticeable increase in the monetary base until December 2001.

The foreign exchange intervention that Koo mentions involved only U.S. dollars and ran from January 2003 through March 2004. The real effective exchange rate (which has a 25.82% dollar weight) actually rose from 104.75 in December 2002 to 106.77 in March 2004. Although the 30 trillion yen (actually 35 trillion yen) that the Ministry of Finance, (through the BOJ) spent buying dollars (and which were subsequently converted to U.S. Treasuries) was an extremely large foreign currency intervention in absolute terms (Japan is an important economy after all), it was approximately 40% unsterilized, and so was also effectively an important part of the 48 trillion yen expansion of Japan’s monetary base from March 2001 and January 2006 under QE. For those interested in the interrelationship between Japan’s QE and what John Taylor has termed the “Great Intervention” I recommend reading Tsutomu Watanabe and Tomoyoshi Yabu’s  “The great intervention and massive money injection: The Japanese experience 2003-2004” (Journal of International Money and Finance, Vol. 32, February 2013, pp. 428–443) who conclude, among other things, that the unsterilized interventions during this time period had a greater effect on the yen-dollar rate than the sterilized ones.

In any case the real effective exchange rate fell from 116.25 in February 2001 to 91.09 by March 2006, when the BOJ announced the completion of QE, a decline of 21.6%. Although the monetary base was reduced by about 24.4% between January and November 2006, the real effective exchange rate continued to fall until July 2007, but later surged dramatically towards the end of 2008 as the global Great Recession set in.

Here’s Koo on the importance of government deficit spending in maintaining the money supply during a Balance Sheet Recession:

 “It is indeed with fiscal stimulus that Japan managed to maintain its GDP at or above the bubble peak for the entire post-1990 period in spite of massive corporate deleveraging and commercial real estate prices falling 87 percent nation-wide. This was shown in Exhibit 4. It was also with concerted fiscal stimulus implemented in 2009 that G20 countries managed to arrest the collapse of the world economy triggered by the Lehman Shock.

From the perspective of central banks, the importance of deficit spending by the government is multiplied by the fact that it is also indispensible in maintaining money supply from shrinking when the private sector is minimizing debt. This comes from the fact that money supply, which is a liability of the banking system, starts shrinking when the private sector as a whole starts paying down debt. This is because banks are unable to lend out the money paid back to them by the deleveraging borrowers when the entire private sector is deleveraging at the same time. During the Great Depression, the US money supply shrunk by over 30 percent from 1929 to 1933 mostly for this reason (85 percent due to deleveraging, 15 percent due to bank failures and withdraws related to failures.)

The post-1990 Japan managed to maintain its money supply (Exhibit 7) and GDP (Exhibit 4) from shrinking because the government was borrowing the deleveraged and newly saved funds from the private sector (Exhibit 9).”

Exhibit 9 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. What Koo terms “credit extended to the public sector” is the sum of “claims on government (net)”, “claims on local government” and “claims on public nonfinancial corporations”. Since public non-financial corporations are part of the non-financial corporate sector this is inconsistent with Japan’s flow of funds. It is also inconsistent with the newer Monetary Survey data which includes claims on public non-financial corporations as part of “claims on other sectors”, which is comprised of claims on the non-financial corporate, household and the nonprofit sectors.

The following 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 Koo’s 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 QE was 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 Krugman’s liquidity trap no matter how hard you try.

And in fact before moving on to one last section on Koo and Japan’s Lost Decade, 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:

 “…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. 

And finally, here is Koo on the Japan’s supposedly successful withdrawal of QE in 2006:

“So far the only successful removal of QE was the one engineered by the Bank of Japan in 2006, when its first-ever quantitative easing in history was ended after five years. This removal went without a hitch because the QE was all at the short end of the market. The removal of reserves at the short end under zero interest rates had very little impact on the rest of the yield curve. For example, the yield on 10-year JGBs jumped by about 40 basis points right after the announcement of the end of quantitative easing, but the yield returned to the original level after a few months.”

I’ve already dealt with Koo’s bizarre views concerning the volatility of the money multiplier when the central bank finds it necessary to raise the policy rate near the zero lower bound in a previous post. What I want to do here is reiterate that, contrary to Koo’s opinion, 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.

…Does this mean that “Japan cannot afford recovery”?

No. It means that Japan is already dead. It just doesn’t know it yet.

————————————————————-

If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.

Now I’m going to cry over spilt milk, and ask: why oh why didn’t they do Abenomics earlier, before the debt/NGDP ratio had grown so big? What was all this talk about “balance sheet recessions”, where monetary policy was impotent to increase Aggregate Demand, so fiscal policy had to be used to prevent AD from falling? And how did we suddenly switch from “monetary policy is impotent” to “monetary policy is very dangerous because it will increase AD which will only cause inflation and higher interest rates which will cause default because loose fiscal policy has made the debt/GDP ratio so big”?

And the soundtrack.

The complacency school concedes that the labor market is far from great but argues there is nothing much policy can do about it. Where monetary policy is concerned, there is some reason for this defeatist attitude. The Federal Reserve has worked overtime to spur job creation, and there is not much more it can do. Fiscal policy, however, has been worse than AWOL—it has been actively destroying jobs.

And Blinder was Fed Vice Chair in the ‘glorious 1990s’ (1994-96). If I didn´t know, I wouldn´t believe it.

Related post: Monetary Policy trumps all ‘excuses’.

1. The Fed should not give monetary stimulus a try; they should do it.

2. We don’t favor the same monetary policy.  If we did they wouldn’t favor fiscal stimulus.

5.  The failure of monetary policy is partly bad motives (Rick Perry, etc) and partly ignorance.  I find it hard to believe that ignorance isn’t the biggest part.  I really can’t see how the entire western world would have created this needless catastrophe if they had know from the very beginning that the Fed and ECB could have easily prevented it, without running up debt (indeed shrinking deficits) and without high inflation.  Why don’t people understand that monetary policy could have prevented this?  When I talked to liberal intellectuals in 2008 and 2009 they almost all told me that we needed fiscal stimulus, because the Fed was out of ammunition.  When I asked them where they got that crazy idea, roughly 100% cited a certain famous Nobel-prize-winning public intellectual.

Yes, they misread his message to some extent, but then didn’t Mr. Krugman recently blame Rogoff and Reinhart for not working hard enough to prevent their message from being misinterpreted?

In a later post, Krugman comments on a post by DeLong:

He’s referring to calls for the Fed and other central banks to raise expectations of future inflation as a way to get some traction in a liquidity trap — which is certainly something I and others support. But there are two crucial differences between us and the expansionary austerity types.

First, our expectations argument is a hope; theirs is a plan. I want the Fed, the Bank of Japan, etc. to target higher inflation, in the hope that it might help, but it’s a hope, and meanwhile we need to fight demands for fiscal austerity and even push for stimulus. The expansionary austerity types, on the other hand, are (or were) actually counting on the supposed rise in confidence to avoid what would otherwise be nasty recessions, which have in fact materialized.

Which brings us to the second point: those of us hoping to summon the expectations imp want to do so with policies that are at worst harmless, such as expanding the monetary base under conditions where this has no direct inflationary impact. The austerians, on the other hand, have pushed directly destructive policies — fiscal contraction in depressed economies — in order to achieve their hoped-for shift in expectations.

So this is the difference between “Let’s try this possibly ineffective remedy, it might work and in any case won’t do any harm” and “Let’s do the opposite of what standard analysis says we should be doing, just trust me”.

So you see, Krugman barely pays lip service to monetary policy. It´s only a hope and likely ineffective, so why bother?

Krugman bashes the austerians, and vice-versa, because their respective agendas are diametrically opposed. The market monetarist´s don´t have a political agenda behind their arguments, but if their proposals were tried and succeeded, they would prove Krugman wrong in saying that without fiscal stimulus (more government) the economy would remain subdued. In order to discourage something like NGDP level targeting to be even tried Krugman says it´s like ‘chasing rainbows’, or an ‘impossible dream’.

I´ll try to show that it isn´t an ‘impossible dream’. In doing so, I´ll argue that neither ‘fiscal austerity’ implies at all times a drop in economic activity or that ‘fiscal stimulus’ implies a strengthening in the economy´s performance.

In closing, we´ll see that it´s monetary policy, the stance of which is measured by the level of NGDP relative to trend that is vital for macroeconomic stability.

As measure of real economic performance I use the growth rate of RGDP and unemployment. To measure the stance of fiscal policy I use the raw (not the cyclically adjusted) Federal Government deficit to NGDP ratio,

The set of charts that follow show fiscal stimulus/austerity, RGDP growth and the unemployment rate for distinct but successive periods over the last 20 years.

The two periods on the left hand side depict periods during which there was ‘austerity’ (declining deficit/increasing surplus). Note that during those episodes growth picked up and unemployment fell.

The two periods on the right hand side illustrate periods during which there was fiscal stimulus (rising deficit/declining surplus). During those times growth faltered and unemployment rose. Note that in the recent cycle, after becoming significantly negative despite the strong rise in the deficit, growth picks up, and unemployment falls somewhat when fiscal ‘expansion’ turns to ‘austerity’. But as we´ll see, that´s not because there was ‘more austerity’.

As the next charts for the exact same periods show, higher (or rising) growth and falling unemployment are closely associated with what´s happening to monetary policy (‘expansionary’ if NGDP is above (growing more) than trend and ‘contractionary’ if NGDP is below (growing less) than trend.

So monetary policy is not an ‘impossible dream’. In the more recent episode, even though the ‘NGDP gap’ is still widening, it is doing so at a lower ‘speed’, indicating that although monetary policy is still contractionary, after mid-2009 it has become less so. Note that that was enough to reverse the real growth and unemployment trend, despite ‘fiscal austerity’ kicking in. Just imagine what would have been if monetary policy had been ‘explicitly expansionary’!

This post is Part 1 of two posts in which I respond specifically to his remarks on Japan’s Lost Decade:

“These unusual phenomena are all caused by the fact that private sectors in all of these countries are massively increasing savings or paying down debt despite record low interest rates. According to the flow of funds data, the US private sector (household, corporate and financial sectors combined) today is saving whopping 6.9 percent of GDP (four-quarter moving average ending in Q4, 2012) at zero interest rates The comparable figure for the UK is 3.8 percent, for Ireland 8.6 percent, for Spain 8.1 percent and for Portugal 7.0 percent of GDP (Exhibit 2) all with record low interest rates. In Japan, where the bubble burst two decades earlier, the private sector is still saving 8.8 percent of GDP at zero interest rates (Exhibit 3).

Moreover, in all of the above countries, not only household sector but also the corporate sector is increasing savings or paying down debt at these record low interest rates. This behavior of the corporate sector runs totally counter to the conventional framework of neoclassical economics where profit maximizing firms are expected to be increasing borrowings at these record low interest rates.

Private sectors in all of these countries are increasing savings or paying down debt because their balance sheets were damaged badly when asset price bubbles burst in those countries. In the case of Japan, where the bubble burst in 1990, commercial real estate prices fell 87 percent nationwide (Exhibit 4), destroying balance sheets of businesses and financial institutions all over the country.”

The Bank of Japan has financial transactions data going back to 1964. Where more than one data series was available (1998Q1-1999Q1) I have used the more recent series. The following is a graph of calendar year averages of the financial surplus as a percent of GDP for the non-government sector (which includes public financial institutions and corporations), general government and the rest of the world:

As can be seen the non-government sector was in significant financial surplus from 1993 through 2005, averaging 8.9% of GDP. The largest swing towards surplus occurred between 1990 and 1998, going from 0.5% of GDP to 12.6% of GDP with both ratios being the extreme values for the calendar year averages.

Before moving on, note that the non- government sector was also in significant financial surplus from 1975 through 1986, averaging 7.9% of GDP. This was period of significant disinflation in Japan with consumer price inflation falling from 23.2% in 1974 to 0.6% in 1986. There were recessions in 1973-75, 1977, 1980-83 and 1985-86 and the IMF’s estimates of Japan’s output gap, which only start in 1980, show Japan below potential output through 1987, with the output gap in 1980 (6.5%) being nearly as great as in 2009 (6.8%). Aside from the absence of asset price bubbles the primary difference between this period and the more recent period is that nominal GDP (NGDP) growth rates, inflation and interest rates were higher, with the NGDP growth rate, GDP implicit price deflator inflation rate and the call rate averaging 8.1%, 3.7% and 6.9% respectively during 1975-86 as compared to 0.4%, (-0.8%) and 0.6% during 1993-2005. So interest rates were much higher, but nominal growth rates were also much higher, and thus the interest rate channel of the monetary transmission mechanism had plenty of space with respect to the zero lower bound.

The next graph shows the non-government sector financial surplus disaggregated between the household/nonprofit sectors (what the Japanese term the “personal” sector, and which itself is only available in disaggregated form for 1998Q1 on) and what Koo terms the “corporate” sector (the financial and non-financial sectors combined):

Here you can see very clearly what Koo thinks is the primary symptom of Japan’s Balance Sheet Recession, the shift by the corporate sector from a 9.2% deficit in 1990 to 9.8% surplus in 2003, or a total of 19.0% of GDP. Note that the corporate sector was always in financial deficit prior to 1995 and has almost always been in financial surplus since. Also note that the financial surplus of the household sector is smaller since 1996 than any time prior to that. Thus the corporate sector accounts for the entire non-government sector shift towards financial surplus from 1990-98.

Given the substantial structural differences between the balance sheets of the financial and non-financial sectors I find it curious that Koo lumps the two together under the “corporate” nametag. Here is a graph of the corporate sector financial surplus disaggregated between these two sectors:

Yes the financial sector ran both its largest financial surplus and deficit during the volatile years of 1998-2000, but mostly the financial balance of this sector is relatively small which explains why the non-financial corporate sector accounts for almost all of the changes in balance of the corporate sector. In fact the non-financial corporate sector shifted from a financial deficit of 8.9% of GDP in 1990 to a surplus of 2.8% of GDP in 1998 accounting for 95.7% of the non-government sector shift towards surplus between those years, and the shift to a financial surplus of 9.2% of GDP in 2003 means that the non-financial corporate sector accounts for all of the corporate sector shift towards surplus from 1990-2003.

Koo refers to the effect of the decline in land and share prices in his Exhibit 4 (“Cumulative Loss of Wealth on Shares and Real Estate ~ ¥1500 Trillion”). Stock data for Japan’s non-financial assets are available on a calendar and fiscal year basis from the Cabinet Office from 1969 and thus complete Japanese balance sheet data is only available at an annual frequency. Again, where multiple series are available (1980-1998 and 2001-2009) I have used the more recent series.

As mentioned there are substantial structural differences between the balance sheets of these sectors. As one might imagine the financial sector is much more leveraged with liabilities averaging 95.5% of assets over calendar years 1969-2011 compared to 72.5% for the non-financial corporate sector. Whereas land made up 32.2% of the non-financial sector’s assets at the peak of the Japanese land price boom in 1990, it was only 4.0% of the financial sector’s assets that year. Similarly shares made up only 5.7% and 7.7% of the financial sector’s assets and liabilities respectively at the end of calendar year 1989 (the Nikkei 225 peaked in December 1989). In fact since the financial sector held 138.0 trillion yen and 187.2 trillion yen as assets and liabilities respectively the decline in share prices likely helped to offset the financial sector’s losses due to the decline in land prices.  In any case the decline in land and share prices apparently had little direct effect on the financial sector’s degree of leverage.

As long as we’re talking about the effect of the decline in land and share prices on balance sheets perhaps we should take a closer look at the “87%” figure for the decline in commercial land to which Koo refers. The index he is referring to is the Japan Real Estate Institute Urban Land Price Index for Commercial Land in Six Major Cities. “Six Major Cities refers to the ku-area of Tokyo, Yokohama, Nagoya, Kyoto, Osaka and Kobe. And while no doubt these cities are very important the Real Estate Institute also has All Urban and All Urban except Six Major Cities commercial land price indices that make it clear that the index for the 6 major cities is not very representative of the boom and bust in urban commercial land prices in Japan:

The All Urban commercial land price index, which is more representative of the price of the land that the non-financial corporate actually sector holds, has fallen from 195.5 in 1991 to 60.6 in 2005 or by 68.0% and evidently has been more or less stable since. This helps to explain the actual decline in the value of land on the asset side of the non-financial corporate sector balance sheet. The value of land held by the non-financial corporate sector fell from 634.2 trillion yen in 1990 to 281.8 trillion yen in 2011, or a difference of 352.4 trillion yen and a decline of 55.6%.

Shares made up 317.8 trillion yen or 16.4% of the non-financial corporate sector’s assets and 726.6 trillion yen or 37.5% of its liabilities in 1989. Thus shares were a net liability of 408.8 trillion yen and, as with the financial sector, a decline in share prices would probably have reduced the degree of leverage in the non-financial corporate sector.  In fact shares were a 226.2 trillion yen net liability to the non-financial corporate sector in 2011 or 182.6 trillion yen less than in 1989. This offsets more than half of the decline in the value of land on the asset side of the non-financial corporate balance sheet. All told, the decline in the net value of nonfinancial sector land and shares assets and liabilities between 1989/1990 to 2011 is thus 169.8 trillion yen. Adding in an 11.7 trillion yen decline in the net value of financial sector land and shares assets and liabilities yields a loss of 181.5 trillion yen in corporate sector net worth, which although substantial, is substantially smaller than the 1500 trillion yen figure Koo mentions.

In any case, what I hope I’ve shown so far is that the shift in Japan’s non-government financial surplus by itself is not a new phenomenon, and that its more recent occurrence has been almost entirely due to the non-financial portion of what Koo terms the “corporate” sector. In addition I think it’s clear that Koo greatly exaggerates the damage to the Japanese corporate sector balance sheet from the decline in asset prices.

Another important question to answer is whether there is in fact any evidence that the degree of leverage has any relationship with the non-financial corporate sector financial surplus. Given we are talking about the supposed effect of an asset price decline induced increase in leverage on sector financial flows, there’s really only two simple coherent ways of measuring leverage in this context. The following is a graph of the ratio of liabilities to assets by sector:

And here is a graph of the difference between assets and liabilities (i.e. net worth) as a percent of GDP by sector:

Recall that the ratio of liabilities to assets averaged 72.5% in the nonfinancial corporate sector over 1969-2011. It’s true that this ratio was unusually high in 1989 and was above average during most of 1983-2007, but just eyeballing these graphs it’s hard to see much of a correlation between this measure of leverage and non-financial corporate sector financial surplus.  Similarly, although non-financial corporate sector net worth as a percent of GDP declined from 124.9% in 1990 to 56.4% in 1999, and it was below its average value (96.9% over 1969-2011) during 1994-2000,  and again from 2003-2007, there’s no obvious relationship between non-financial corporate net worth and non-financial corporate financial surplus.

Fortunately we don’t have to guess, we can always check for a statistical correlation. Here’s the graph of non-financial sector financial surplus regressed on liabilities as a percent of assets:

And here is non-financial corporate sector financial surplus regressed on net worth as a percent of GDP:

Needless to say neither of these relationships is even remotely statistically significant.

So since the state of non-financial corporate balance sheets doesn’t seem to explain the degree of non-financial corporate sector financial surplus very well, is there another explanation for this phenomenon that works somewhat better? Well, most of the non-government sector financial surplus is simply a residual of the government sector financial deficit. And since government revenue tends to fall and expenditures tend to rise in recessions it should come as no surprise that the government sector financial deficit is highly correlated to the output gap. Here’s the government sector financial surplus regressed on the output gap (as estimated by the IMF) from 1980 to 2012:

This is statistically significant at the 1% level. And it’s of greater statistical significance than the correlation between the non-government sector financial surplus and the output gap (which is only one of two residuals):

This is in turn is of far greater statistical significance than the correlation between the rest of the world financial surplus and the output gap (not shown). The regression of the government financial surplus on the output gap is also of far greater statistical significance than the regression of non-financial corporate sector surplus on the output gap (which has a p-value of 9.7%):

Bottom line: All of this is highly suggestive of the fact that Japan’s non-government sector financial surplus, which includes the non-financial corporate sector financial surplus, is far 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.

In Part 2 I’ll discuss Koo’s opinions concerning Japan’s monetary and fiscal policy during the Lost Decades.

put pressure on governments to revamp their economies and shrink debt burdens, warning political leaders they may be “punished” by investors if they use the relative calm in markets compared with recent years as an excuse to delay overhauls.

“The plea here is don’t get too optimistic about the present market condition” and interpret it as permitting “protracted relaxation” on fiscal and economic overhauls, Mr. Draghi said after the ECB’s monthly meeting. Officials kept their key lending rate unchanged at 0.5%, a record low, as expected.

And said dismissively:

The bank sees no deflation, nor risk of deflation in any eurozone country.  And lower inflation was not of itself a big problem. “With low inflation, you buy more stuff.”

Now we have this report from Ambrose Evans-Pritchard:

Crucial hearings on the Eurozone’s bail-out policies at Germany’s top court this week could set in motion events that force Germany’s withdrawal from the euro, a leading judge has warned.

Berenberg Bank said the case was now “the most important event risk” looming over the eurozone, with concerns mounting over an “awkward verdict” that may constrain or even block ECB action.

Dr Di Fabio said the court, or Verfassungsgericht, does not have “procedural leverage” to force the ECB to change policy but it can issue a “declaratory” ultimatum. If the ECB carries on with bond purchases regardless, the court can and should then prohibit the Bundesbank from taking part.

The Bundesbank’s Jens Weidmann needs no encouragement, say experts. He submitted a report to the court in December attacking the ECB head Mario Draghi’s pledge on debt as highly risky, a breach of both ECB independence and fundamental principles. The ECB does not have a legal mandate to uphold the “current composition of monetary union”, he wrote.

The UK really best keep out of the so-called EU altogether.

And it´s always useful, as a reminder, to note that the EZ crisis is not a debt crisis but one that has a clear monetary nature.