The third option
By Scott Sumner
Last week I attended the Cato Monetary conference in Washington. Jim Dorn always does a good job of finding interesting speakers.
I couldn’t help contrasting the event with the Peterson Institute conference that I attended last month. At the Peterson Institute, most speakers correctly noted that insufficient AD was a key problem over the past decade, but also argued (wrongly, in my view) that monetary stimulus was relatively ineffective at the zero bound. At Cato it was almost the exact opposite. I don’t recall anyone doubting the effectiveness of monetary policy (I attended 3 of the 4 panels), but there was almost no concern about insufficient nominal spending. Indeed a number of speakers seemed worried that policy was too expansionary.
This makes me feel really good about the prospects for market monetarism. Both logic and facts are overwhelming on our side. It seems absurd to claim a fiat money central bank could not debase its currency. Are the Zimbabweans really that much more talented than we are? And when countries like Japan have changed policy the yen has fallen sharply, even at the zero bound. That doesn’t happen in the Keynesian model. As for the level of AD, during most of the past decade both inflation and employment have been well below the Fed’s targets. It’s the (conservative) opponents of monetary stimulus who have a difficult argument to make, not us.
This recent article gives a good sense of the weakness of the arguments of our opponents:
TOKYO (Reuters) – Premier Shinzo Abe’s victory in last month’s election may make it difficult for the Bank of Japan to dial back its radical stimulus next year despite the rising cost of prolonged monetary easing, former BOJ board member Sayuri Shirai said on Friday. . . .
Shirai said the BOJ should start withdrawing stimulus by hiking its yield target and slowing asset purchases next year, given the rising cost and diminishing returns of its policy.
“When the economy is in good shape like now, the BOJ needs to normalise monetary policy so it has the tools available to fight the next recession,” Shirai told Reuters.
“But the election result has made that difficult,” she said.
Raising the BOJ’s 10-year government bond yield target could trigger an unwelcome yen rise by narrowing the interest rate differentials between Japan and the United States, Shirai said.
This quote exhibits a basic lack of understanding of monetary economics. The speaker implies that tightening monetary policy gives the BOJ more “tools” to fight the next recession, whereas the exact opposite is true. When the BOJ tightens monetary policy the natural rate of interest falls. The speaker presumably believes that what matters is the gap between the actual rate of interest and zero, whereas what really matters is the gap between the natural rate of interest and zero. When the BOJ raises the actual interest rate with a tight money policy, the natural interest rate falls.
If Shirai were correct, then the Fed could have raised interest rates to 20% in 2008, giving them lots of “tools” to later cut rates and spur the economy when the recession got severe. But that’s about as effective as trying to pick yourself up by your bootstraps. This is why I insist that people appointed to the Fed should be experts on monetary economics. I don’t care about credential—it makes no difference if they have a PhD—but they need to understand the basic principles of monetary economics.
Does Japan need higher interest rates to pop asset prices bubbles? Consider the Japanese stock market, which is about 40% below the peak value in 1991, while the US market has risen almost 10-fold. Or take housing, where prices in Japan are down about 40% since 1990 (lavender line), while they have risen 140% in the US (blue) and 360% in Australia (light blue).
Australia’s had the highest interest rates over that period (among developed countries), and Japan has had the lowest. So no, rapid asset price increases are not caused by low interest rates, indeed asset prices tend to rise more rapidly in countries with very high nominal interest rates. Japan doesn’t have to worry about asset price bubbles.
Japan would benefit from higher nominal interest rates, but only if brought about by a more expansionary monetary policy.
PS. I should emphasize that there was plenty that I agreed with at the Cato conference. A number of speakers were critical of the war on cash (as am I), and Charles Calomiris was skeptical of the view that China was a currency manipulator.
PPS. David Beckworth presented me with a coffee mug.
Market monetarism is right on target to becoming the dominant view in macroeconomics; just give us another 10 or 20 years.