Monetary policy works just fine – Exhibit 14743: The case of Japanese earnings

The graph below shows the ratio of upward to downward revisions of equity analysts’ earnings forecasts in different countries. I stole the graph from Walter Kurtz at Sober Look. Walter himself got the data from Merrill Lynch.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads – or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.


Answering Tyler’s question on Japan with old blog post

Here is Tyler Cowen on Twitter:

Still not seeing much discussion of 4.1% unemployment rate in Japan, would love to see “jump start” defined.

What Tyler is basically saying is that there really is not an argument for “jump starting” the Japanese economy with fiscal and monetary stimulus when unemployment is this low. I many ways I share Tyler’s skepticism about “stimulus” in the case of Japan.

I have long argued that Japanese story is a lot more complicated than it is normally said to be (my first post on the topic was: “Japan’s deflation story is not really a horror story” from October 2011). It is correct that Japan’s lost decade was not a story of two lost decades and in my view quantitative easing ended the “lost decade” in 2001. This is what I said in my post “Japan shows that QE works”

In early 2001 the Bank of Japan finally decided to listen to the advise of Milton Friedman and as the graph clearly shows this is when Japan started to emerge from the lost decade and when real GDP/capita started to grow in line with the other G7 (well, Italy was falling behind…).

The actions of the Bank of Japan after 2001 are certainly not perfect and one can clearly question how the BoJ implemented QE, but I think it is pretty clearly that even BoJ’s half-hearted monetary easing did the job and pull Japan out of the depression. In that regard it should be noted that headline inflation remained negative after 2001, but as I have shown in my previous post Bank of Japan managed to end demand deflation (while supply deflation persisted).

And yes, yes the Bank of Japan of course should have introduces much clearer nominal target (preferably a NGDP level target) and yes Japan has once again gone back to demand deflation after the Bank of Japan ended QE in 2007. But that does not change that the little the BoJ actually did was enough to get Japan growing again.

This graph of GDP/capita in the G7 countries illustrates my point:


As I said in my earlier post: “A clear picture emerges. Japan was a star performer in 1980s. The 1990s clearly was a lost decade, while Japan in the past decade has performed more or less in line with the other G7 countries. In fact there is only one G7 country with a “lost decade” over the paste 10 years and that is Italy.”

Hence, Japan came out of the crisis from 2001. However, it should also be noted that Japan has once again fallen into crisis and more importantly Japan’s monetary policy certainly is not based on a rule based framework so the risk that Japan will continue to fall back into crisis remains high. This in my view is a discussion about securing Japan a “Monetary constitution” rather than about stimulus. Unfortunately Prime Minister Abe’s new government do seem to be more focused on short-term stimulus rather than on real institutional reform.

There is no such thing as fiscal policy

– and that goes for Japan as well

The Abe government is not only pursuing expansionary monetary policies, but has also announced that it wants to ease fiscal policy dramatically. This obviously will scare any Market Monetarist – or anybody who are simply able to realise that there is a budget constrain that any government will have to fulfill in the long-run.

This is what I earlier have said on the fiscal issue in the case of Japan:

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.

My advise: Target an 3% NGDP growth level path and balance the budget 

My advise to the Abe government would therefore be for the Bank of Japan to introduce proper monetary policy rules and I think that an NGDP level targeting rule targeting a growth path of 3% would be suiting for Japan given the negative demographic outlook for Japan. Furthermore, if the BoJ where to provide a proper framework for nominal stability then the Japanese government should begin a gradual process of fiscal consolidation by as soon as possible to bring the Japanese budget deficit back to balance. With an NGDP growth path of 3% Japanese public debt as a share of GDP would gradually decline in an orderly fashion on such fiscal-monetary framework.

So what Japan needs is not “stimulus” – neither fiscal nor monetary – but rather strict rules both for monetary policy and fiscal policy. The Abe government has the power to ensure that, but I am not optimistic that that will happen.

Earlier posts on Japan:

There is no such thing as fiscal policy – and that goes for Japan as well
The scary difference between the GDP deflator and CPI – the case of Japan
Friedman’s Japanese lessons for the ECB
There is no such thing as fiscal policy – and that goes for Japan as well
Japan shows that QE works
Did Japan have a “productivity norm”?
Japan’s deflation story is not really a horror story

PS even though I am skeptical about the way Shinzo Abe are going about things and I would have much preferred a rule based framework for Japan’s monetary and fiscal policy I nonetheless believe that the Abe government’s push for particularly monetary “stimulus” is likely to spur Japanese growth and is very likely to be good news for a global economy badly in need of higher growth.

Update: Scott Sumner also comments on Japan and it seems like we have more or less the same advise. Here is Scott:

“Just to be clear, my views are somewhere between those of Feldstein and the more extreme Keynesians.  I agree with Feldstein that Japan has big debt problems and big structural problems, and needs to address both.  And that fiscal stimulus is foolish (as even Adam Posen recently argued.)  Unlike Feldstein I also think they have an AD problem that calls for modestly higher inflation and NGDP growth.  At a minimum they should be shooting for 2% to 3% NGDP growth, instead of the negative NGDP growth of the past 20 years.”

Ambrose on Abe

Here is our friend Ambrose Evans-Pritchard in the Daily Telegraph:

Japan’s incoming leader Shinzo Abe has vowed to ram through full-blown reflation policies to pull his country out of slump and drive down the yen, warning Japan’s central bank not to defy the will of the people.

…The profound shift in economic strategy by the world’s top creditor nation could prove a powerful tonic for the global economy, with stimulus leaking into bourses and bond markets – a variant of the “carry trade” earlier this decade but potentially on a larger scale.

…”It is tremendously important for global growth, and markets are starting to take note,” said Lars Christensen from Danske Bank.

Mr Abe’s Liberal Democratic Party (LDP) won a landslide victory on Sunday, securing a two-thirds “super-majority” in the Diet with allies that can override senate vetoes.

Armed with a crushing mandate, Mr Abe said he would “set a policy accord” with the Bank of Japan for a mandatory inflation target of 2pc, backed by “unlimited” monetary stimulus.

“Its very rare for monetary policy to be the focus of an election. We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision,” he said.

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

Did I just say that NGDP hasn’t grown for 15 years in Japan? Yes, I did…it is actually worse – Japanese nominal GDP is 10% lower today than in 1997.

NGDP Japan

The ECB is the only one of the major central banks in the world that is not at the moment taking decisive steps in the direction of getting out of the deflationary scenario. I hope we don’t have to wait 15 years for the ECB to do the right thing. The Japanese experience should be a major warning to European policy makers.

If you don’t think you can compare Europe today and Japan in 1997 then maybe you should should take a look at this post.

PS a friend of mine who once spent time at the BoJ is telling me not to get overly optimistic…

PPS Matt Yglesias also comments on Abe.


Previous posts on Japan:

Japan shows that QE works
Did Japan have a “productivity norm”?
There is no such thing as fiscal policy – and that goes for Japan as well
Friedman’s Japanese lessons for the ECB
The scary difference between the GDP deflator and CPI – the case of Japan

BoJ might become the first central bank in the world to introduce NGDP targeting

I stole this from Britmouse (who got it from Bloomberg):

Abe advocates increased monetary easing to reverse more than a decade of falling prices and said he would consider revising a law guaranteeing the independence of the Bank of Japan. (8301) In an economic policy plan issued yesterday, the LDP said it would pursue policies to attain 3 percent nominal growth.

Talk about good news! Shinzo Abe of course is the leader of Japan’s main opposition party the Liberal Democratic Party (LDP). LDP is favourite to win the upcoming Japanese parliament elections – so soon Japan might have a Prime Minister who favours NGDP targeting.

So how could this be implemented? Well, Lars E. O. Svensson has a solution and I am pretty sure he would gladly accept the job if Abe offered him to become new Bank of Japan governor. After all he does not seem to happy with his colleagues at the Swedish Riksbank at the moment.

PS I would love to get in contact with any Japanese economist interested in NGDP targeting – please drop me a mail (

PPS I can recommend vacation in Langkawi Malaysia – this is lunch time blogging in the shadow of the palms

Update: Oops – Scott also comments on this story.

Patri Friedman on Market Monetarism

Here is Patri Friedman on his blog “Patri’s Peripatetic Peregrinations”:

“I sent a friend an intro to market monetarism (a modern, blogosphere-inspired adjustment to the traditional monetarism my grandfather helped create). He was surprised I believed that printing money could be good, rather than agreeing with the Austrians.”

I am happy to see that Patri has read my paper on Market Monetarism.

There is of course nothing wrong in thinking that “printing money could be good” (under certain circumstances). In fact this is completely in line with what Patri’s grandfather Milton Friedman argued in terms of the Great Depression and the Japanese crisis.

Patri in his post also discusses how a “helicopter drop” could happen in a world of digital cash. Interestingly enough this discussion is similar to a recent internal Market Monetarist debate between Nick Rowe, Bill Woolsey and Scott Sumner about whether money is a medium of exchange or a medium of account. See for example here, here and here. Kurt Schuler also has contributed to the discussion. Finally Miles Kimball similarly has a very interesting post on the case for electronic money.

Patri’s discussion of digital cash to some extent also relates to my own discussion of monetary reform in Africa and the development of mobile based money (See for example here, herehere and here).

Anyway, I am happy to Patri seems to be showing some sympathy for Market Monetarism.

HT Lasse Birk Olesen

The ECB is turning into the BoJ

This is ECB Chief Mario Draghi:

“Well, let me first just point out that I never mentioned deflation. Deflation is a generalised fall in the price level across sectors and it is self-sustaining. And so far we have not seen signs of deflation, neither at the euro area level nor at country level. We should also be very careful about not mixing up what is a normal price readjustment due to the restoration of competitiveness in some of these countries. They will necessarily have to go through a re-adjustment of prices. We should not confuse this readjustment of prices, which is actually welcome, with deflation. Basically, we see price behaviour in line with our medium-term objectives. So, we see price stability over the medium term. Also consider that monetary policy is already very accommodative, consider the very low level of interest rates and that real interest rates are negative in a large part of the euro area…”

When I read Draghi’s comments the first thing I came to think of was how much this sounds like comments from Bank of Japan officials over the last 15 years.

Maybe Mario Draghi would be interested in this graph. It show the growth of broad money in the euro zone and Japan. I have constructed the graph so the growth of money peaks more or less at the same time in the graph for Japan and the euro zone. M2 growth peaked around 1990 in Japan and 2008 in the euro zone. The graph clearly shows both the boom and the bust and for Japan a very long period – more than a decade – of very low money supply growth.

I basically hate this kind of graph but the similarity is hard to miss. If Mario Draghi thinks euro zone monetary policy is “accommodative” today then he would also have to think Japanese monetary policy was accommodative in 1994-94.

BUT worse if the ECB continues on it’s present path it will likely repeat the mistakes of the BoJ and then we might be in for years of deflation. I know that this is not what Draghi wants, but the ECB’s present policy is unfortunately not giving much hope that a Japanese scenario can be avoided.

By the way that is the real reason for the slump we are seeing in global stock markets these days and it likely has very little to do with Obama’s reelection and the fear of the “fiscal cliff”. It is mostly about the escalation of bad news out of Europe. I hope Draghi will soon realize that unless he shows some Rooseveltian Resolve then the bad news will continue for another decade.

The scary difference between the GDP deflator and CPI – the case of Japan

Most inflation targeting central banks in the world are targeting inflation measured by the Consumer Price Index (CPI). However, if you want to target inflation CPI is probably the worst possible measure to focus on. Why? Because CPI includes both indirect taxes and import prices – something the central bank can certainly not control.

If the central bank targets CPI it would in fact have to tighten monetary policy in response to negative supply shocks such as rising oil prices. Similarly the CPI targeting central bank would effectively be “forced” to tighten monetary policy in response increases in indirect taxes. Do you think this is foolish? Well, the ECB is doing it all the time…just think of the catastrophic rate hikes in 2011 in response to higher oil prices and austerity induced indirect tax increases across the euro zone.

A much better measure to target – if you want to maintain an inflation targeting (I don’t…) – would be to target the so-called GDP deflator as this measure of prices by definition excludes import prices and indirect taxes. Targeting the GDP deflator therefore would reduce the problem of monetary policy reacting to positive and negative supply shocks.

You might think that the difference between CPI and the GDP deflator is small and frankly speaking that used my view. However, the difference is far from trivial, which the case of Japan’s deflationary experience over the past 15-17 years clearly illustrates. The graph below shows the development in the Japanese price level measured by both CPI and the GDP deflator.

While CPI indicates that the Japanese price level today is around 2% lower than in 1995 the GDP deflator is telling us that prices have dropped nearly 20% in the last 17 years. The difference is stunning and is certainly not something that should be ignored, but unfortunately I doubt that most central bankers are aware about just how great these differences are.

It should of course be stressed that it is not normally so that CPI will be upward biased compared to the GDP deflator, but if tight monetary policy is leading to long periods of low or no growth and that forces the government to increase indirect taxes to improve public finances – as it has been the case in Japan – then there very likely will be an upward biased in the CPI compared to the GDP deflator.

This conclusion obviously is highly relevant for the conduct of monetary policy in the present situation – particularly in the euro zone, where governments around Europe are increasing indirect taxes in a more or less desperate attempt to improve public finances. With the ECB’s focus on consumer prices (the HICP in the euro zone) rather than on the GDP deflator higher indirect taxes implicitly leads to tighter monetary policy – something which is hardly warranted in the present situation.

Therefore if central banks want to continue targeting inflation they should at least change from CPI targeting to GDP deflator targeting – that would be a small, but important step away from repeating the Japanese scenario.

PS This discussion is less relevant for the Federal Reserve as the Fed is targeting a the PCE core inflation measure, which is much closer to the GDP deflator than to CPI.

Related posts:

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Failed monetary policy – the one graph version

Paul Krugman warns against fiscal stimulus

This is Paul Krugman on the effectiveness on fiscal policy and why fiscal “stimulus” will in fact not be stimulative:

“The US is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; USA now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.

Is this likely? The phrase “self-sustaining recovery” trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea. The purpose of this note is to expose this hidden exoticism – to show that anyone who believes that temporary fiscal stimulus will produce sustained recovery is implicitly endorsing a rather fancy economic model, the sort of model that finance ministries would under normal circumstances regard as implausible and disreputable…

…What continues to amaze me is this: USA’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.”

Wauw! What is this? What happened to the keynesian Krugman? Isn’t he calling for fiscal easing anymore? Well yes, but I am cheating here. This is Paul Krugman, but it is not today’s Paul Krugman. This is Paul Krugman in 1999 – and he is talking about Japan and not the US. I simply replaced “Japan” with “the US” in the Krugman quote above.

Read the entire article here.

HT Tyler Cowen and Vaidas Urba.

Friedman’s Japanese lessons for the ECB

I often ask myself what Milton Friedman would have said about the present crisis and what he would have recommended. I know what the Friedmanite model in my head is telling me, but I don’t know what Milton Friedman actually would have said had he been alive today.

I might confess that when I hear (former?) monetarists like Allan Meltzer argue that Friedman would have said that we were facing huge inflationary risks then I get some doubts about my convictions – not about whether Meltzer is right or not about the perceived inflationary risks (he is of course very wrong), but about whether Milton Friedman would have been on the side of the Market Monetarists and called for monetary easing in the euro zone and the US.

However, today I got an idea about how to “test” indirectly what Friedman would have said. My idea is that there are economies that in the past were similar to the euro zone and the US economies of today and Friedman of course had a view on these economies. Japan naturally comes to mind.

This is what Friedman said about Japan in December 1997:

“Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”

So Friedman was basically telling the Bank of Japan to do quantitative easing – print money to buy government bonds (not to “bail out” the government, but to increase the money base).

What were the economic conditions of Japan at that time? The graph below illustrates this. I am looking at numbers for Q3 1997 (which would have been the data available when Friedman recommended QE to BoJ) and I am looking at things the central bank can influence (or rather can determine) according to traditional monetarist thinking: nominal GDP growth, inflation and money supply growth. The blue bars are the Japanese numbers.

Now compare the Japanese numbers with the similar data for the euro zone today (Q1 2012). The euro zone numbers are the red bars.

Isn’t striking how similar the numbers are? Inflation around 2-2.5%, nominal GDP growth of 1-1.5% and broad money growth around 3%. That was the story in Japan in 1997 and that is the story in the euro zone today.

Obviously there are many differences between Japan in 1997 and the euro zone today (unemployment is for example much higher in the euro zone today than it was in Japan in 1997), but judging alone from factors under the direct control of the central bank – NGDP, inflation and the money supply – Japan 1997 and the euro zone 2012 are very similar.

Therefore, I think it is pretty obvious. If Friedman had been alive today then his analysis would have been similar to his analysis of Japan in 1997 and his conclusion would have been the same: Monetary policy in the euro zone is far too tight and the ECB needs to do QE to “rejuvenate” the European economy. Any other view would have been terribly inconsistent and I would not like to think that Friedman could be so inconsistent. Allan Meltzer could be, but not Milton Friedman.


* Broad money is M2 for Japan and M3 for the euro zone.

Related posts:

Meltzer’s transformation
Allan Meltzer’s great advice for the Federal Reserve
Failed monetary policy – (another) one graph version
Jens Weidmann, do you remember the second pillar?

Tight money = low yields – also during the Great Recession

Anybody who ever read anything Milton Friedman said about monetary policy should know that low interest rates and bond yields mean that monetary policy is tight rather than easy. And when bond yields drop it is normally a sign that monetary policy is becoming tighter rather than easier.

Here is Friedman on what he called the interest rate fallacy in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Unfortunately the old fallacy is still not dead and it is still very common to associate low interest rates and low bond yields with easy monetary policy. Just think of the ECB’s insistence that it’s monetary policy stance is “easy”.

In my previous post I demonstrated that all the major changes in the S&P500 over the past four years can be explained by changes in monetary policy stance from either the ECB or the Federal Reserve (and to some extent also PBoC). Hence, it is not animal spirits, but rather monetary policy failure that can explain the volatility in the markets over the past four years.

What holds true for the stock market holds equally true for the bond market and the development in the US fixed income markets over the past four years completely confirms Milton Friedman’s view that tighter monetary policy is associated with lower bond yields. See the graph below. Green circles are monetary easing. Red circles are monetary tightening. (See more on each “event” in my previous blog post)

I think the graph very clearly shows that Friedman was right. Every time either the ECB or the Federal Reserve have moved to tighten monetary policy long-term US bonds yields have dropped and when the same central banks have moved to ease monetary policy yields have increased.

Judging from the level of US bond yields – and German bond yields for that matter – monetary policy in the US (and the euro zone) can hardly be said to be  easy. In fact it is very clear that monetary policy remains excessively tight in both the US and the euro zone. Unfortunately neither the Fed nor the ECB seem to acknowledge as they still seem to be of the impression that as long interest rates are low monetary policy is easy. I wonder what Friedman would have said? Well, I fact I am pretty convinced that he would have been very clear and would have been arguing with the Market Monetarists that monetary disorder is to blame for this crisis and we only will move out of the crisis once the Fed and the ECB move to fundamentally ease monetary conditions and adopt a rule based monetary policy rather than the present zig-zagging.

PS See also my early post on the connection between monetary policy and the bond market: Understanding financial markets with MV=PY – a look at the bond market
Update: Scott Sumner just made me aware of one of his post addressing the same topic. See here.

Update 2: Jason Rave has kindly reminded me of this Milton Friedman article, which also deals with the interest rate fallacy.

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