The Absurdity of ‘Abenomics’ and the PM’s ‘Three Bendy Arrows’ (Part 3: Monetary Policy and a Fictitious Can)

In my two previous posts on Abenomics (here and here), I argued that Japan is a post-growth economy. As the OECD explains in its Compendium of Productivity Indicators 2012, growth can be achieved in only three ways:

Economic growth can be increased either by raising the labour and capital inputs used in production, or by improving the overall efficiency in how these inputs are used together, i.e. higher multifactor productivity (MFP). Growth accounting involves decomposing GDP growth into these three components, providing an essential tool for policy makers to identify the underlying drivers of growth.

Therefore, if I am to be proved wrong in my declaration that Japan is post-growth, Abenomics must be able to boost labour inputs, and/or increase capital inputs and/or improve multifactor productivity (innovation and efficiency). By definition, the Abe agenda must encompass one or more of the three—there are no other means of achieving growth.

Against this background, Prime Minister Abe has given top billing to monetary stimulus within his ‘three arrow’ policy agenda. He campaigned and won a general election on a pledge to force Japan’s central bank, the Bank of Japan, to adopt a binding 2% inflation target through unlimited monetary easing and thus slay deflation. Moreover, to execute such a strategy, he backed a new BOJ governor, Haruhiko Kuroda, who took office in March. Kuroda, in turn, has executed Abe’s monetary policy agenda with gusto. (For a fascinating article on how Kuroda deftly manoeuvred the BOJ board into unanimously support the policy shift, see this Reuters’ article here).

In contrast with the speeches of his predecessor, Masaaki Shirakawa, Kuroda’s early utterances have been accompanied by a very thin chart pack dominated by the now famous ‘all the twos’ slide (click for larger image):

BOJ Quantitative Easing jpeg

These measures will give rise to an extraordinary jump in the monetary base over a two-year period from ¥138 trillion at the end of 2012 to ¥270 trillion at the end of 2014. In fiscal 2012, Japan’s GDP was estimated at approximately ¥475 trillion in nominal terms, so the monetary base is targeted to rise from around 30% of GDP to 55% of GDP.

Monetary Base Target jpeg

By contrast, the action by the Federal Reserve Board in the U.S. looks positively cautious (here), with the monetary base a modest 17% of GDP.

US Monetary Base to GDP jpeg

Kuroda expects his unconventional policy actions to have the following effects:

Effects of Monetary Easing jpeg

Let’s backtrack for a second and recall that the components of economic growth are labour, capital and multifactor productivity (innovation and efficiency). In the slides above, do we find any explicit mention of these three? The answer is ‘no’. Accordingly, we have to follow an indirect, implicit path if we are going to move from the monetary policy agenda above to the three growth drivers.

I will start with the third box above which highlights ‘expectations’. These are not any old expectations, these are ‘inflation expectations’. Both Abe and Kuroda are very explicit over this point: the Bank of Japan will conduct aggressive quantitative and qualitative monetary easing until an inflation rate of 2 percent per annum is achieved. Kuroda’s monetary playbook is a direct rendering of Paul Krugman’s ground-breaking policy recommendation back in May 1998. In that paper, Krugman gave this advice:

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

This is exactly what Kuroda is doing. Indeed, if you want to see the theoretical economic underpinnings behind Kuroda’s policy, then I recommend you read Krugman’s more formal paper “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap”.

The above papers require some knowledge of economic theory. However, if you have never taken any courses in economics, then I suggest you read the five page Federal Reserve Bank of Richmond’s “A Citizen’s Guide to Unconventional Monetary Policy” by Haltom and Wolman that provides a non-technical interpretation of current Federal Reserve and, indirectly, Bank of Japan actions. In the opening paragraph of this short paper we see this statement:

Monetary policy became much more complicated in December 2008, when the Fed pushed its main policy rate, the target federal funds rate, as low as it can effectively go. This unusual situation is called the “zero lower bound” (ZLB) on nominal interest rates. Once the Fed confronted the ZLB, it turned to alternative tools to ease monetary policy further. These unconventional monetary policy tools fall into three general areas: increasing the size of the Fed’s balance sheet; altering the composition of its balance sheet; and providing increasingly detailed guidance about the likely future path of policy.

In Japan’s case, we have been at the “zero lower bound” from the late 1990s. Moreover, the BOJ has been engaging in unconventional monetary policy since March 2001. This includes increasing the size of its balance sheet, altering the composition of its balance sheet and guiding policy expectations. With regards to the latter measure, the BOJ announced in the autumn of 2003 that it would keep interest rates low until deflationary pressures had subsided and CPI inflation was projected to be in positive territory. A time line of the measures and the extent to which the BOJ’s balance sheet has expanded can be seen in the following chart taken from a 2012 paper by Kazumasa Iwata and Shinji Takenaka (click for larger image).
Balance Sheet Size of BOJ jpeg
What is new from Kuroda is that he is moving all three policy tools into overdrive (or perhaps more accurately hyperdrive), both quantitatively in terms of balance sheet numbers, and qualitatively, in terms of  detailed guidance that he will do ‘whatever it takes’ to secure and maintain 2% inflation. (Technically, Kuroda’s predecessor, Shirakawa, was first to announce the 2% target, but he was basically bullied into this action. The intellectual midwives of the 2% target are, in reality, Abe and Kuroda, standing on the shoulders of Krugman’s original analysis and lots of Federal Reserve Board support.)
Keeping in mind that both the BOJ’s balance sheet and, consequently, Japan’s monetary base has been on a upward march for 15 years, albeit with a little dip around 2006, let’s have a look how inflation has fared (chart taken from a November 2012 Shirakawa presentation here, click for larger image):
Japan's Output Gap jpeg
We can see that the introduction of unconventional monetary policy through the expansion of the BOJ’s balance sheet and policy guidance has had almost no lasting effect on inflation up until the arrival of Kuroda. Will Kuroda change the game? Advocates of unconventional monetary policy argue that the BOJ just did not do enough to change inflation expectations. In Krugman’s characterisation, they didn’t make a sufficiently credible claim to be irresponsible. This point also comes out in the Richmond Fed’s Economic Brief I referred to above:

Gauti Eggertsson and Michael Woodford, at the New York Fed and Columbia University, respectively, show in a 2003 paper that at the ZLB, it is optimal for the central bank to raise inflation expectations, which it can accomplish by credibly committing to making monetary policy “too easy” in the future. This commitment lowers real interest rates (nominal rates adjusted for inflation), which makes spending today more attractive relative to spending tomorrow.

The Eggertsson and Woodford paper quoted above has also become a central theoretical support for current Fed policy, and Fed Governor Ben Bernanke has not been shy of urging Japan to use it as a model for policy making. Here are some remarks Bernanke made in a May 2003 speech in Tokyo given to the Japan Society of Monetary Economics:

Demand on the part of both consumers and potential purchasers of new capital equipment in Japan remains quite depressed, and resources are not being fully utilized. Normally, the central bank would respond to such a situation by lowering the short-term nominal interest rate, but that rate is now effectively zero. Other strategies for the central bank acting alone exist, including buying alternative assets to try to lower term or liquidity premiums and attempting to influence expectations of future inflation through announcements or commitments to expand the monetary base.

The above discussion makes me think of one of the oldest economist jokes:

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, “Let’s smash the can open with a rock.” The chemist says, “Let’s build a fire and heat the can first.” The economist says, “Let’s assume that we have a can-opener…”

The assumption all the advocates of unconventional monetary policy are making is that Japan has a large output gap: in our case, a fictitious can rather than can-opener! That is, the country is supposed to be awash with unused labour and capital resources. For those not familiar with the term output gap, it refers to the difference between what an economy is producing at a particular moment in time and what it has the potential to produce at that moment in time. Keeping this in mind, let’s look at Japan’s inflation and output gap chart again. The output gap appears to be a modest 0.5% of GDP.

Japan's Output Gap jpeg

All the way back in 1998, Krugman recognised that the published output gap made a big hole in his theory, but his response was to suggest that the reported numbers were wrong:

An economy is in a liquidity trap if aggregate demand consistently falls short of productive capacity despite essentially zero short-term nominal interest rates. Japan certainly more or less meets the interest-rate criterion: at the time of writing the overnight money-market rate was 0.37 percent. The economy also certainly seems to be operating well below capacity. True, the OECD and IMF estimates of output gap are surprisingly modest, given the economy’s lack of real growth since 1991. However, those numbers are based not on economic analysis but on a smoothing procedure that automatically builds any sustained slump into the estimated trend in potential output (using the same procedure on the United States in the 1930s finds the economy at full capacity by 1935). If one uses even a conservative estimate of Japanese potential growth since 1990 – say, 2 percent – the economy now appears to be in a very deep slump indeed.

I don’t buy any of this. For a start, the comparison with the U.S. as regards output gaps appears grossly misleading. Here is a graph of U.S. unemployment in the 1930s (click for larger image):

U.S. Unemployment jpeg

And here is one for Japan:

Unemployment Rate Japan jpeg

So we have unemployment of around 20% in the U.S. during the Great Depression and we have unemployment of a little over 4% currently in Japan. Where is the evidence of a huge output gap in Japan from the labour market?

Bernanke also made the fault of comparing apples and pears in his 2003 speech:

Reflation–that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level–proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt’s reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years.

The Takahashi role model has been cropping up in numerous op-ed pieces in The Financial Times and The Wall Street Journal (for example, Peter Tasker here). I don’t know why: the output gap situation between the two historical periods is completely different. What is more, the 1930s witnessed a stunning rise in technological and organisational innovation-related multifactor productivity. The revolutionary changes that took place over that period have been brilliantly chronicled by the economist Alexander Field in his award-winning book “A Great Leap Forward: 1930s Depression and Economic Growth“. By contrast, current such productivity gains are meagre.

And as for Krugman’s other assertion that Japan’s potential growth rate is 2%, this again is barking mad to me. Let’s get former BOJ Governor Shirakawa’s favourite slide out again:

Labour Force jpeg

As one can see, the slowdown in worker growth was accelerating and labour productivity had slumped. There is a case that there existed a bit of an output gap following the bursting of the bubble economy in the late 1980s and the country’s balance sheet recession of the 1990s. But GDP growth was still a none-to-shody 1.5% per annum. There is no real evidence that a large output gap has persisted until the present day. The Japanese decline in GDP is the product of demographics and diminishing long-term gains in multifactor productivity (innovation), the latter being witnessed worldwide.

At this point, let’s reconnect Kuroda’s policy prescription with growth economics one more time. The unconventional monetary policy he advocates is a response to an economy caught in a liquidity trap; that is an economy operating below full potential with a large output gap due to the fact that at the zero interest rate bound, real interest rates cannot fall sufficiently enough to stimulate demand. Note that the policy prescription to deal with this is a short-term: it aims to bash the economy back to its full potential by stimulating demand. It says nothing about the long-term determinants of growth.

Counter-intuitively, a successful escape from the liquidity trap will show up according to GDP growth accounting methodology as a jump in multifactor productivity (MFP). The OECD Compendium of Productivity Indicators explains this phenomenon:

A number of studies have indicated that MFP behaves cyclically, i.e., it increases in an upturn and declines in a downturn. This has sometimes been interpreted as a paradox, as MFP has traditionally been perceived as exogenous technological change, which should typically not behave cyclically.

Four factors help to explain this cyclical movement. Each of them is related to the definition of MFP as the part of GDP growth that cannot be explained by the rates of change of labour and capital inputs (see also Annex A). First, cycles in productivity growth may relate to imperfect competition and the potential to capitalise on increasing returns to scale during upturns. Second, labour input typically adjusts with a lag in downturns, as firms seek to retain workers even if not needed for current production so as to keep the human capital. Third, adjustment costs prevent an immediate up- or downsizing of production and capital, resulting in lower utilisation of existing capital stock in downturns. Fourth, the reallocation of resources to production of goods and services with higher or lower marginal productivities may be pro or counter cyclical.

An unconventional monetary policy-related escape from a liquidity trap (and resulting closure of the output gap) relates to the second and third factors highlighted above. In other words, it presupposes that there are a lot of workers sitting around drinking coffee and a lot of machines and computers on idle. MFP jumps because employees go back to work and the machines and computers get powered back up. Growth does not jump because labour and capital inputs have increased.

Now there is a possibility that by bringing unemployed workers back into employment then the labour input could increase. However, as of March 2013, Japan had an unemployment rate of 4.1%, roughly the same rate as before the global credit crisis. Back in the late 80s, Japan’s unemployment rate got down to 2%, but it could be argued that at this time the economy had a negative output gap; i.e., it was operating above capacity, hence the bubble. In sum, there is very little leeway for Kuroda’s policies to increase labour input into the economy.

How about capital deepening? If real interest rates go negative, won’t that cause Japanese firms to invest in new plant and equipment? The answer to this is probably ‘no’. As former Governor Shirakawa pointed out in a speech in November 2012. Japanese firms have deleveraged, have plenty of cash and are recording a return on assets comfortably above the average borrowing rate.

Return on Assets jpeg

However, they complain of a dearth of attractive projects, especially in the home market. The Bank of Japan is setting up some specialist lending mechanisms to get credit to parts of the economy that bank lending cannot or won’t reach (in other words, 1970s style MITI picking of winners), but this is nothing really to do with unconventional monetary policy, it is really just statism.

So to conclude, we must remember that Abe’s first, and strongest, arrow—unconventional monetary policy—is not targeted at long-term growth. It is principally a tool to overcome a liquidity trap; that is, an inability of the BOJ to achieve negative interest rates using conventional monetary policy when faced with a large output gap and deflation. Unfortunately, this is obviously premised on  a large output gap being in existence. But the direct evidence for such a claim is not there.

Accordingly, economists such as Krugman have to use an alternative rationale to summon a large output gap into being. The logic goes like this: a large output gap must exist because Japan has operated at far below its long-term potential growth rate for many years. Unfortunately, quite mundane reasons can be found for Japan’s sluggish growth: ageing demographics and a slowing contribution from long-term multifactor productivity growth, (fewer technological and organisations gains). As one of Shirakawa’s charts clearly shows, adjusting for working age population, Japan’s GDP growth rate has actually surpassed those of other nations since the credit crisis broke (click for larger image).

Adjusted Growth jpeg

So there is scant evidence of a shadow output gap existing that is not being caught by the headline data. If therefore, our economist’s can (the output gap) proves to be fictitious, is there any danger that policy is being employed to open it anyway?

This takes me two further gripes I have with the deployment of unconventional monetary policy on the back of poor theory. First, the theory generally aggregates households and consumers into one undifferentiated lump. But Japan, if nothing else, shows us that an economy behaves differently when its population ages. Put differently, the elderly have different consumption preferences through time than the young. Accordingly, if you threaten the elderly with inflation they may react differently than the young. And an aged country may behave differently than a youthful country.

Secondly, the entire debate over monetary policy is conducted as if a massive expansion of the monetary base is neutral in terms of its impact on households. This is barmy. Monetary policy is a method whereby we target a stock (asset prices) in order to influence a flow (GDP). If such a policy is successful in moving asset prices—which it has been to date if we look a Japan’s stock market indices—then it will benefit those who own assets, particularly risk assets. Who owns risk assets? That’s obvious: the rich. This has major implications in terms of wealth distribution, societal welfare and, ultimately, happiness. Does anyone talk about this? Not that I’ve heard.

Among all the clapping-and-cheering op-ed articles I have read on Abenomics, I have yet to see one that deals with the unintended consequence of unconventional monetary policy. Some commentaries talk about the potential for hyperinflation (I am skeptical), but none deal with how hyper aggressive monetary policy will move wealth between generations and classes. I will return to these themes, and Shinzo Abe’s other two arrows, in my next post.

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