The Japan story: a lesson for central bankers everywhere

A James Alexander & Marcus Nunes post

It´s a simple story of failure, but one that fits the facts.

It´s also based on a simple premise: An inflation obsession that took hold in 1974.

It´s also a story that gives credence to Market Monetarists’ recommendation that central banks should level target NGDP.

It teaches us Abe´s latest move is one that goes in the right direction.

The story is told through 3 charts.

The trigger of the process that defined the Japanese economy was the domestic inflationary impact of the first oil shock. Inflation in 1974 climbed above 20% and worries about inflation and its effects on the real economy, including the worst bout of labor unrest since the war, quickly turned price stability into a priority of economic policy. More than a “priority”, price stability became an “obsession”. This is consistent with the reaction to the introduction of the consumption tax (CT) in 1989 and the CT increase in 1997.

We should put “price stability” in scare quotes too. The Fed and other central banks increasingly seem happy to interpret this as zero inflation is acceptable, but anything over 2% a precursor to hyperinflation at worst and a return to stop-go monetary policy chaos at best.

Japan Story_1

What central bankers should recognize are that labor unrest and consumption taxes are supply shocks and the best the BoJ could have done was keep NGDP on the level path it had been on since the early 50s. The BoJ monomania on price stability led to them wanting to “eradicate” inflation, not keep it in the 0% – 5% range that held in the 20 years before the oil shock. To do that, the BoJ strongly reduced the trend growth of NGDP. Did they think that crushing inflation would somehow teach labor a lesson? Perhaps.

The new trend held until 1990, when the “tax shock” gave a very short term uptick to inflation. Thereafter NGDP trend growth has remained close to zero. Competent central banks should stay loyal to long-term inflation expectations, but seem unable to do so only when headline inflation (even if due to CT increases) is above target. If headline or even core inflation is below target they all too easily fall back on those long term, well-anchored, expectations to justify doing nothing, or worse and tightening.

The BoJ´s goal of price stability (“zero” inflation) was attained, but real growth all but disappeared as monetary strangulation took place.

Japan Story_2

Abenomics, introduced with the election of Abe in late 2012, has improved things somewhat but it´s still tied the self-defeating inflation target (not “zero” but 2%), and as the recent experience of many developed countries with targets for inflation has shown, you can easily get into a “stagnation trap”!

Japan was the first country to (implicitly) pursue an inflation target. Now it looks on the verge of being the first to pursue an (explicit) NGDP level target. Maybe it will not take as long for present day inflation targeting countries to follow suit.

Who said there´s no irony in economic policy!

PS: The Economist makes exactly that suggestion:

A target for nominal GDP (or the sum of all money earned in an economy each year, before accounting for inflation) is less radical than it sounds. It was a plausible alternative when inflation targets became common in the 1990s. A target for NGDP growth (ie, growth in cash income) copes better with cheap imports, which boost growth, but depress prices, pulling today’s central banks in two directions at once. Nominal income is also more important to debtors’ economic health than either inflation or growth, because debts are fixed in cash terms.

Abe has to provide an ETA

From the news:

Japanese Prime Minister Shinzo Abe said Thursday that he would seek to expand the nation’s economy by around a fifth, pivoting away from a month’s long fight over security legislation that hurt his popularity among voters.

“Creating a strong economy will continue to be my top priority,” Mr. Abe said during a news conference at the headquarters of the ruling Liberal Democratic Party, where he was officially appointed to another three-year term as party leader.

Mr. Abe said he would aim at increasing the size of Japan’s economy to ¥600 trillion ($5 trillion), from around ¥490 trillion in the latest fiscal year. He didn’t say exactly how or when that growth would be achieved.

As the chart shows, nominal spending in Japan has remained bottled-up for more than twenty years. The 2008 crisis depressed it further. It is also clear in the chart that Abenomics, introduced when Abe assumed the premiership in December 2012, has helped lift-up the economy, but certainly not enough to “crank” the growth engine.


Market Monetarists have for long proposed that central banks, instead of targeting inflation should establish a level target for nominal spending, or NGDP. Abe has “broken the spell”, but to be successful he has to do it right. And that means providing an estimated time of arrival (ETA) at the new target. If that is specified, the route becomes known and that provides the best guidance for all types of economic agents, allowing the Bank of Japan to closely monitor the process and enabling it to undertake timely corrective measures, i.e. quickly reset the “rudder” as soon as deviations from the path are identified.

One small step for supply-siders, a giant leap for Wren-Lewis?

A James Alexander post

Market Monetarists have often been a bit frustrated with Simon Wren-Lewis’ Keynesian over-concern with the obstacle of the Zero Lower Bound. Having flirted  with NGDP Targeting a few years ago he went off the idea. It is great to see him both attacking  the idea of raising rates, in fact suggesting a cut in rates, and also returning to support NGDP Targeting:

“Good policy should not just look at the most likely outcome, but also at risks. At the moment there is a significant risk that we may be losing a huge amount of resources because of a tepid recovery. To cover that risk, we should cut rates now. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2 per cent target. Inconvenient, but not very costly.

If we fail to cover that risk, there is a non-trivial probability that in three years’ time inflation will still be well below target and we will all be asking why on earth everyone in 2015 was talking about an interest rate increase.”

“If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.”

Unfortunately, there is still little room for the UK to cut rates as they are obviously very close to the the ZLB, unless the MPC goes down the negative rate road. Perhaps Wren-Lewis is just paving the way for a reopening of his campaign for more big government fiscal policy – he has never proposed tax cuts as a form of fiscal policy as far as I have read. Is this because his anti-market, anti-supply side, bias blinds him? I don’t know. But this bias needs to be overcome for NGDP Targeting to be really effective.

At or around the ZLB central banks have to be very clear just how far they will go with unconventional monetary policy in order to achieve their targets. But the key issue is how the markets, and thus the wider economy, understand what the central bank is really targeting.

Actual NGDP is a tricky thing to target as the numbers inevitably come out after the event, and accurately many months after the event. It could be too little, too late if central banks only look at incoming data. They must look forward, to set the flight path they want to be on.

Better to work with the market and target the market’s expectations for future NGDP. At the moment these expectations can only be seen indirectly through market implied inflation rates, longer term bond yields, equity markets and exchange rates. Consensus macro forecasts are almost worthless with their constant reversion to mean, usually using the same discredited macro models used by the central bank’s themselves. Market prices are far more reliable as a guide to the future as real money is at stake rather than just the reputations of a lot of rent-a-mouths.

It would be best for central banks to help launch an NGDP Futures market as Scott Sumner has argued. This small but imaginative step by a supply-side macroeconomist brought together Friedman’s classic monetarism with the new insights of rational expectations.

It would be even greater if Wren-Lewis too could make this step and work with rational expectations to achieve successful monetary policy and growth, rather than being so skeptical about the market all the time. For a Keynesian like Wren-Lewis this would be a giant leap, but it is a necessary one.

When your mind´s made up…there´s no point trying to change it!

From The Telegraph:

Turmoil in China and slower UK growth will not blow the Bank of England’s plans to raise interest rates off course, policymakers are expected to signal this week.

While economists said there was “little doubt” that rates would be kept at a record low of 0.5pc for a 78th consecutive month, minutes of the September meeting, which will be published alongside the Monetary Policy Commitee’s (MPC’s) rate decision, are expected to highlight the strength of the domestic economy, even as the nine member panel remains split over the timing and path of rate rises.


Michael Saunders, chief UK economist at Citi, said even a sharp slowdown in China would only exert a “modest” drag on UK growth and inflation, while stronger pay growth meant increases in real income were on course to reach 3.5pc this year, a level that has not been seen over the past decade.

“The UK suffered several mini-slowdowns during the long pre-crisis expansion from 1993-2007. But, when one looks back at the period as a whole, what stands out is the economy’s resilience and the expansion’s ability to shrug off minor setbacks. Unless global conditions or UK credit availability worsen markedly, we suspect the same will apply in coming years,” he said.

Exactly, but why? Is a repeat performance guaranteed as he suspects?

The charts indicate the reason for the UK´s economy “resilience” from 1993 to 2007. That´s because NGDP growth was kept “right on top” of a trend level growth path of 5.4%. With that, RGDP was also kept stable, “shrugging off minor setbacks”!

When your minds made up_1

The growth chart shows the result of the lost NGDP stability. Given that NGDP growth has remained substantially below the previous trend path and has been somewhat volatile, I believe Michael´s “suspicion” is not warranted!

When your minds made up_2

Title song

Please be serious: Put the toys away and just change the policy target

A James Alexander post

Eric Lonergan takes Bank of England blogger Fergus Cumming to task for not being up to speed with the very latest in the helicopter drop debate. This arcane dispute is beyond me. It is not going to happen. Central banks will never act “irresponsibly”, as the helicopter drop requires – it is not in their DNA and nor should it be. They want “serious” policies with “serious” goals – not mere illustrative thought experiments, no matter how smart.

However, Lonergan misses the core problem, one that Cumming alludes to:

“For helicopter money to work, households and firms have to believe that all future central bankers and governments want to abandon inflation targeting.  That seems implausible given current institutional set-ups.”

A central bank cannot do helicopter drops if they are tied to fixed Inflation Targeting. Central banks cannot get the public to believe the helicopter drop is serious, and the money to be spent, because of IT. The central bank would have to temporarily abandon fixed IT, and that’s hard to do credibly.

And there’s the rub.

The central bank should change it’s target. It could move to flexible inflation targeting, a distinct and much more successful policy proven in many countries. Or, even better, price level targeting. Best of all, nominal GDP level targeting.

The central banks and their political masters who set the banks’ goals should abandon strict IT and its suffocation of the real economy with low nominal growth. It really is that simple. IT works to control inflation, great, but controlling inflation is the wrong target. Targeting nominal growth is the right target and central banks should simply adopt it instead.  (Not least if adoption could also put an end to these interminable debates about monetary vs fiscal policy or helicopter drops.)

It´s good when something works both in practice and in theory!

For the past several years, market monetarists have promoted the change from inflation targeting to NGDP level targeting. The analysis was mostly empirical, a fact that made some “wrinkle their nose”. A new model based paper arrives at the same conclusion:

The design of monetary policy has been the subject of a voluminous and influential literature. In spite of widespread discussion in the press and policy circles, the normative properties of nominal GDP targeting have not been subject to scrutiny within the context of the quantitative frameworks commonly used at central banks and among academic macroeconomists.

The objective of this paper has been to analyze the welfare properties of nominal GDP targeting in comparison to other popular policy rules in an empirically realistic New Keynesian model with both price and wage rigidity. We find that nominal GDP targeting performs well in this model. It typically produces small welfare losses and comes close to fully implementing the flexible price and wage allocation. It produces smaller welfare losses than an estimated Taylor rule and significantly outperforms inflation targeting.

It tends to perform best relative to these alternative rules when wages are sticky relative to prices and conditional on supply shocks. While output gap targeting always at least weakly outperforms nominal GDP targeting, the differences in welfare losses associated with the two rules are small.

Nominal GDP targeting may produce lower welfare losses than gap targeting if the central bank has difficulty measuring the output gap in real time. Nominal GDP targeting always supports a determinate equilibrium, whereas output gap targeting may result in indeterminacy if trend inflation is positive.

Overall, our analysis suggests that nominal GDP targeting is a policy alternative that central banks ought to take seriously.

There are a number of possible extensions of our analysis. Two which immediately come to mind are financial frictions and the zero lower bound. Though our medium scale model includes investment shocks, which have been interpreted as a reduced form for financial shocks in Justiniano et al. (2011), it would be interesting to formally model financial frictions and examine how nominal GDP targeting interacts with those.

Second, our analysis abstracts from the zero lower bound on nominal interest rates. It would be interesting to study how a commitment to a nominal GDP target might affect the frequency, duration, and severity of zero lower bound episodes.

On the last sentence, MM´s have little doubt that, when undertaken, the study will also corroborate their view that the frequency, duration and severity of ZLB episodes would essentially disappear!

Brad DeLong misses the “put”

In “Why Small Booms Cause Big Busts”, DeLong writes:

As bubbles go, it was not a very big one. From 2002 to 2006, the share of the American economy devoted to residential construction rose by 1.2 percentage points of GDP above its previous trend value, before plunging as the United States entered the greatest economic crisis in nearly a century. According to my rough calculations, the excess investment in the housing sector during this period totaled some $500 billion – by any measure a tiny fraction of the world economy at the time of the crash.

The resulting damage, however, has been enormous. The economies of Europe and North America are roughly 6% smaller than we would have expected them to be had there been no crisis. In other words, a relatively small amount of overinvestment is responsible for some $1.8 trillion in lost production every year. Given that the gap shows no signs of closing, and accounting for expected growth rates and equity returns, I estimate that the total loss to production will eventually reach nearly $3 quadrillion. For each dollar of overinvestment in the housing market, the world economy will have suffered $6,000 in losses. How can this be?


Today, we recognize that clogged credit channels can cause an economic downturn. There are three commonly proposed responses. The first is expansionary fiscal policies, with governments taking up the slack in the face of weak private investment. The second is a higher inflation target, giving central banks more room to respond to financial shocks. And the third is tight restrictions on debt and leverage, especially in the housing market, in order to prevent a credit-fueled price bubble from forming. To these solutions, Keynes would have added a fourth, one known to us today as the “Greenspan put” – using monetary policy to validate the asset prices reached at the height of the bubble.

Just rewrite the underlined sentence as “keeping nominal spending on a stable level path” (a.k.a. NGDP-LT)!

So, it appears even Keynes knew that to be the best option!

Keynes Put


Denying the monetary solution

Noah Smith has an interesting piece in Bloomberg View: Big Economic Discovery! Booms Might Cause Busts:

Paul Beaudry and Franck Portier are two such researchers. They are famous for a 2006 theory saying that news about future changes in productivity could be what cause recessions and booms. That model never really caught on — it always had some issues with the data, and it definitely didn’t seem to be able to explain the Great Recession. But it inspired further research, and it was an interesting and novel idea.

Now, Beaudry and Portier, along with co-author Dana Galizia, are going after bigger fish. They want to resurrect the idea that booms cause recessions.

In a new paper called “Reviving the Limit Cycle View of Macroeconomic Fluctuations,” Beaudry and Portier try to think of reasons why booms might cause busts. The mechanism they come up with is pretty simple. You have a whole bunch of people — basically, companies — who invest in their businesses. The amount other people invest affects the amount I want to invest, but I can only adjust my investment slowly. When you have feedback effects like this, you’re going to get instability in your model economy, and that’s exactly what the authors find — the economy experiences booms and busts in a chaotic, unstable way. To reproduce the randomness found in the real economy, the authors simply add in some random “shocks” to productivity

BP&G´s latest seem to be a variant of RBCT, where the “trend is the cycle”, or where growth and fluctuations are one and the same.


“For the past half-century, the academic macro story has gone something like this: There is a general trend of rising growth and prosperity in the U.S. economy, caused by steady improvements in technology. But this steady course is disturbed by unpredictable events — “shocks” — that temporarily slow growth or speed it up. The shocks might last for a while, but a positive shock today doesn’t mean a negative shock tomorrow. Recessions and booms are like rainy days and sunny days — when you look back on them, it looks like they alternate, but really, they’re just random.”

I find the fact that economists tend to move away from monetary explanations of cyclical fluctuations hard to explain .In a recent paper by Roger Backhouse and Boianovsky – “Secular Stagnation: the History of a Macroeconomic Heresy” – we read on page 5 that:

The economist who introduced this idea into economic theory was Alvin Harvey Hansen. Born in 1887 in rural South Dakota to immigrants from Denmark, he came from the frontier that according to Jackson was ending. After majoring in English, he moved to the University of Wisconsin to study economics and sociology, before moving to Brown and writing a thesis on business cycle theory, in which he became a specialist. His early work, Cycles of Prosperity and Depression (1921) was empirical. Believing the British economist, John A. Hobson, to have rebutted the charge that under-consumption was impossible, Hansen explained cycles of prosperity and depression as the result of changes in money and credit.

However, on the next page we read:

During the 1920s, turning to the ideas of Albert Aftalion, Arthur Spiethoff and other continental European writers, he began to see fluctuations in investment, driven by population changes and waves of innovations, as the root cause of the cycle. He still thought monetary factors played a role, but they merely served to magnify other forces rather than being an independent factor.

Recently, Brad DeLong went “ballistic” in his critique of Friedman´s monetary view of the Great Depression:

These questions can be debated. But it is fairly clear that even in the 1970s there was not enough empirical evidence in support of Friedman’s ideas to justify their growing dominance. And, indeed, there can be no denying the fact that Friedman’s cure proved to be an inadequate response to the Great Recession – strongly suggesting that it would have fallen similarly short had it been tried during the Great Depression.

The dominance of Friedman’s ideas at the beginning of the Great Recession has less to do with the evidence supporting them than with the fact that the science of economics is all too often tainted by politics. In this case, the contamination was so bad that policymakers were unwilling to go beyond Friedman and apply Keynesian and Minskyite policies on a large enough scale to address the problems that the Great Recession presented.

Admitting that the monetarist cure was inadequate would have required mainstream economists to swim against the neoliberal currents of our age. It would have required acknowledging that the causes of the Great Depression ran much deeper than a technocratic failure to manage the money supply properly. And doing that would have been tantamount to admitting the merits of social democracy and recognizing that the failure of markets can sometimes be a greater danger than the inefficiency of governments.

I find those arguments untenable. The Great Depression only ended when FDR intervened by delinking from gold. Nominal spending (NGDP) immediately turned around (the follow-up government intervention – NIRA – only retarded the process).

The “Great Recession” only bottomed-out when the Fed adopted QE1, and subsequent doses of QE have managed only to keep the economy humming along a depressed path. A target level for spending (or even prices) would have been a better monetary solution.

The spending target level path is ancient. In the Backhouse paper I found out that Evsey Domar, before Clark Warburton, Leland Yeager, James Meade, Bennett McCallum, Mankiw & Hall, among others, had already “been there”:

“Capital expansion, rate of growth and employment” (Domar 1946). This focused on the relationship between productive capacity and national income. Investment was related to both of these, for it generated aggregate demand, which determined income, and it added to productive capacity. Because investment was linked to the growth rate of productive capacity and the level of income, Domar could show that there was an equilibrium rate of growth, at which income would grow at the same rate as productive capacity. Secular stagnation was what happened when investment grew more slowly than this, for in that case there would be an increase in unused capacity and unemployment. However, if, somehow, the growth rate of income could be guaranteed, the result would be sufficient investment to achieve growth without resorting to a government deficit.

Even a Great Stagnation requires planning!

In a recent post, Nick Rowe gives a short reply to DeLong´s long post:

Suppose you lived in a world where, whenever the price level fell/rose by 1%, the central bank responded by decreasing/increasing the base money stock by the same 1%. A world like that would not have a long-run Omega point, from which some present equilibrium can be pinned down by back propagation induction.

That’s the sort of world we live in, under the inflation targeting regime. A drunk doing a random walk does not have a destination, from which we can infer his route by working backwards. His long run variance is infinite.

Stop arguing about whether a market macroeconomy is or is not inherently ultimately self-equilibratingIt’s a stupid question. It depends. It depends on the monetary regime.

Instead, let’s solve the stupid question by adopting a nominal level path target.

It´s even worse. If you don´t plan, i.e. provide a “destination” for it, even a “Great Stagnation” becomes “random”!

The charts illustrate.

Destination Required_1

Destination Required_2

The first shows why the “Great Moderation” happened. The “destination” was the trend level path, to which the economy returned after monetary policy mistakes dislodged it. Observe what many called a period of “too low for too long” rates doesn´t look like that at all!

In the second chart, we note that after the Fed pulled the economy down, it has been satisfied in keeping it down, i.e. “depressed”. It could come out and say that that´s the path (“destination”) it wants it to follow. But no, by saying it´s about time to “tighten” policy, it is implying that the path might be even lower. Is it A? Is it B? The truth is no one knows!

It certainly does not appear to be X!

Related: David Glasner, Scott Sumner

A “solution” to DeLong´s “back-propagation induction-unraveling” problem

Brad DeLong has a (way too) long post. But the end gives the gist of his argument:

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980.

That is the framework that Marty is using now, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well. You need to explain why the back-propagation induction-unraveling worked at its proper time scale in the 1970s and the 1980s, but is nowhere to be found now.

And so I am much less confident that I have solid theoretical ground under my feet than Paul Krugman does.

The “solution” (or “explanation” for the absence of the “back-propagation induction-unraveling”), towards which even Brad´s pal Larry Summers is warming up to is….NGDP-Level Targeting. In fact, the Fed has (implicitly) established a much lower level target for NGDP, a level that is consistent with Summers´ “Great Stagnation” thesis.

So I hope that when Summers says “I didn’t quite endorse NGdp targeting. I said that I would prefer a shift to NGdp targeting to a shift up in inflation targets”, I also hope he has a level target at the back of his mind!

HT Scott Sumner