Japan refutes old Keynesianism
Over at TheMoneyIllusion I have a post lamenting the recent revival of old Keynesian ideas. It occurred to me that Japan is an almost perfect refutation of these theories. In particular, Japan shows that:
1. Inflation is not caused by a tight labor market.
2. There is no permanent tradeoff between inflation and unemployment.
3. Even massive fiscal stimulus has almost no impact on aggregate demand.
In Japan, the unemployment rate continues to fall and is now 3.0%, well below the levels prior to the Great Recession:
And yet inflation is slightly negative:
And even if one excludes food and energy, Japan’s inflation rate is roughly zero.
Some might argue that the unemployment rate is not the right measure of labor market slack. Maybe lots of Japanese have become discouraged, and dropped out of the labor force. Not so, the employment to (15-64) population rate keeps soaring to new highs:
(Unfortunately Fred data ends in early 2015—does anyone have more recent data?) Notice that this is almost a mirror image of what happened in the US. In Japan, the employment ratio rose from just below 70% in the mid-1990s, to about 73% today. In America it dropped from about 73% in the mid-1990s to just below 69% today.
Update: Commenter Michael Makdad informed me that the Japanese ratio has increased another 1.4 points over the past 19 months—to the highest rate since 1974. That’s an extremely strong job market.
And there is also lots of anecdotal evidence that Japan has a very tight labor market:
Send us your construction workers, your care givers, your store clerks — but for a limited time only.
That’s the message from Japan, where the number of foreign workers, though still relatively small, has nearly doubled over the past eight years, and Prime Minister Shinzo Abe’s ruling party is considering policies to speed up arrivals. . . .
A 2015 Manpower Survey found that 83 percent of Japanese hiring managers had difficulty filling jobs, compared with a global average of 38 percent.
Low and falling unemployment, a record high employment population ratio, and lots of anecdotal evidence of an extremely tight labor market. And what’s the evidence against my claim? And what’s the Keynesian explanation for the lack of inflation in Japan?
Market monetarists don’t believe inflation is caused by tight labor markets; they believe that NGDP growth causes inflation. A good example occurred in the US during 1933-34, when the WPI rose about 20%, and even consumer price indices increased significantly despite the highest unemployment rate in American history. The cause? Extremely rapid NGDP growth.
Japan has had almost no NGDP growth in the past 23 years. So the old Keynesian model has no explanation for the strong Japanese labor market. None.
You might wonder how the market monetarists explain this pattern. After all, don’t we emphasize the link between NGDP growth and employment? Yes we do, but the Natural Rate Hypothesis (NRH) is also a part of market monetarism (and New Keynesianism.) Over time, workers’ expectations adjust to slow NGDP growth, and the labor market gradually returns to the natural rate. According to the NRH, it is sudden unexpected changes in NGDP growth that destabilize labor markets.
In the US, a sudden fall in NGDP in 2008-09 pushed unemployment up to 10%, and then unemployment fell back to 5% as workers gradually adjusted to the unexpectedly low level of NGDP. The recovery took longer than usual, as workers are especially averse to nominal wage cuts. Cuts were needed because NGDP declined during the recession, whereas usually there is just a slowdown in the rate of growth. In addition growth in NGDP was unusually slow during the recovery.
In Japan, unemployment rose in the late 1990s and early 2000s, as NGDP fell unexpectedly. Then labor markets started to recover, as NGDP stopped falling and then rose slightly. Once again, unemployment rose sharply in 2008-09 when NGDP plunged, and recovered once NGDP stopped falling. After 2012, Abenomics caused NGDP to start rising, but even if it had been flat, the Japanese unemployment rate would have kept falling.
(BTW, this does not mean Abenomics was useless; it’s main purpose is (or should be) to reduce Japan’s dangerously high debt/NGDP ratio, by boosting NGDP. The BOJ needs to adopt a more expansionary monetary policy.)
Speaking of the deficit, fiscal policy is probably the area where Keynesian theory has failed most spectacularly in Japan. Despite running massive budget deficits in the 1990s and 2000s, which pushed the debt/GDP ratio to well over 200%, Japan has had essentially no growth in aggregate demand since 1993. This isn’t just a slight miss; it’s one of the most expansionary fiscal policies in all of history coinciding with the worst performance of aggregate demand ever observed in a major economy, over an extended period of time.
And as if that’s not bad enough, the recent pickup in Japan (since 2012) was accompanied by a modest tightening of fiscal policy, mostly due to a rise in the national sales tax from 5% to 8%. (The following shows the deficit/GDP ratio):
I’m trying to imagine what it would be like to be an economics grad student in Japan, learning old Keynesian ideas. Each theory that was presented would predict almost the exact opposite of what actually happens in Japan. I don’t doubt that the Japanese are very polite when visiting (western) Keynesians present their advice, but just imagine what they are thinking in private.