Archive for May, 2013

Is Japan a Currency Manipulator?

In his Wednesday column (“Japan’s bumpy road to recovery“) in the Financial Times, the estimable Martin Wolf provided a sober assessment of the recent gyrations of the Japanese bond and stock markets and the yen. I was especially struck by this passage.

[C]riticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, “the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable.” In a letter to the FT, Takashi Ito from Tokyo responded: “I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen”. This does begin to look like a currency war.

In a couple of posts last November about whether China was engaging in currency manipulation, I first gave China a qualified pass and then reversed my position after looking a bit more closely into the way in which the Chinese central bank (PBoC) was imposing high reserve requirements on commercial banks when creating deposits, thereby effectively sterilizing inflows of foreign exchange, or more accurately forcing the inflow of foreign exchange as a condition for expanding the domestic Chinese money supply to meet the burgeoning domestic Chinese demand to hold cash.

So to answer the question whether Japan has been manipulating its currency to drive down the value of the yen, the place to start is to look at what has happened to Japanese foreign-exchange holdings. If Japan has been manipulating its currency, then the reduction in the external value of the yen would be accompanied by an inflow of foreign exchange. The chart below suggests that Japanese holdings of foreign exchange have decreased somewhat over the past six months.


However, this item from Bloomberg suggests that the reduction in foreign exchange reserves may have been achieved simply by swapping foreign exchange reserves for different foreign assets which, for purposes of determining whether Japan is manipulating its currency, would be a wash.

Japan plans to use its foreign- exchange reserves to buy bonds issued by the European Stabilitylity Mechanism and euro-area sovereigns, as the nation seeks to weaken its currency, Finance Minister Taro Aso said.

“The financial stability of Europe will help the stability of foreign-exchange rates, including the yen,” Aso told reporters today at a briefing in Tokyo. “From this perspective, Japan plans to buy ESM bonds,” he said. The purchase amount is undecided, Aso said.

The move may help Prime Minister Shinzo Abe temper criticism of Japan’s currency policies from trading partners such as the U.S. The yen has fallen around 8 percent against the dollar since mid-November on Abe’s pledge to reverse more than a decade of deflation as his Liberal Democratic Party won an election victory last month.

“The Europeans would be happy to see Japan buy ESM bonds, so Japan can avoid criticism from abroad and at the same time achieve its objective,” said Masaaki Kanno, chief economist at JPMorgan Securities Japan Co. and a former central bank official.

So I regret to say that my initial quick look at the currency manipulation issue does not allow me to absolve Japan of the charge of being a currency manipulator.

It was, in fact, something of a puzzle that, despite the increase in Japanese real GDP of 3.5% in the first quarter, the implicit Japanese price deflator declined in the first quarter. If Japan is not using currency depreciation as a tool to create inflation, then its policy is in fact perverse and will lead to disaster. It would also explain why doubts are increasing that Japan will be able to reach its 2% inflation target.

I hope that I’m wrong, but, after the high hopes engendered by the advent of Abenomics, I am starting to get an uneasy feeling about what is happening there. I invite others more skillful in understanding the intricacies of foreign exchange reserves and central bank balance sheets to weigh in and enlighten us about the policy of the BoJ.

What’s with Japan?

In my previous post, I pointed out that Ben Bernanke’s incoherent testimony on the US economy and Fed policy last Wednesday was followed, perhaps not coincidentally, by a 2% intraday drop in the S&P 500 and by a 7% drop in the Nikkei average. The drop in the Nikkei was also accompanied by a big drop in long-term bond prices, and by a big jump in the yen against all major currencies (almost 2% against the dollar).

For the past six months or so, ever since it became clear that Shinzo Abe and his Liberal Democratic party would, after two decades of deflation, win the December elections on a platform of monetary expansion and a 2% inflation target, the Nikkei average has risen by over 50% while the yen has depreciated by 25% against the dollar. The Japanese stock-market boom also seems to have been accompanied by tangible evidence of increased output, as real Japanese GDP increased at a 3.5% annual rate in the first quarter.

The aggressive program of monetary expansion combined with an increased inflation target has made Japan the poster child for Market Monetarists, so it is not surprising that the tumble in the Nikkei average and in the Japanese long-term bonds were pointed to as warning signs that the incipient boom in the Japanese economy might turn out to be a flop. Scott Sumner and Lars Christensen, among others, effectively demolished some of the nonsensical claims made about the simultaneous drop in the Japanese stock and bond markets, the main point being that rising interest rates in Japan are a sign not of the failure of monetary policy, but its success. By looking at changes in interest rates as if they occurred in vacuum, without any consideration of the underlying forces accounting for those changes – either increased expected inflation or an increased rate of return on investment – critics of monetary expansion stumble into all sorts of fallacies and absurdities.

Nevertheless, neither Scott nor Lars addresses a basic problem: what exactly was happening on Black Thursday in Japan when stock prices fell by 7% while bond prices also fell? If bond prices fell, it could be either because expectations of inflation rose or because real interest rates rose. But why would either of those be associated with falling stock prices? Increased expected inflation would not tend to reduce the value of assets, because the future nominal value of cash flows would increase along with discount rates corresponding to the expected loss in the purchasing power of yen. Now there might be some second-order losses associated with increased expected inflation, but it is hard to imagine that they could come anywhere close to accounting for a 7% drop in stock prices. On the other hand, if the increase in interest rates reflects an increased real rate of return on investment, one would normally assume that the increased rate of return on investment would correspond to increased real future cash flows, so it is also hard to understand why a steep fall in asset values would coincide with a sharp fall in bond prices.

Moreover, the puzzle is made even more perplexing if one considers that the yen was appreciating sharply against the dollar on Black Thursday, reversing the steady depreciation of the previous six months. Now what does it mean for the yen to be appreciating against the dollar? Well, basically it means that expectations of Japanese inflation relative to US inflation were going down not up, so it is hard to see how the drop in bond prices could be attributed to inflation expectations in any event.

But let’s just suppose that the Japanese, having experienced the positive effects of monetary expansion and an increased inflation target over the past six months, woke up on Black Thursday to news of Bernanke’s incoherent testimony to Congress suggesting that the Fed is looking for an excuse to withdraw from its own half-hearted attempts at monetary expansion. And perhaps — just perhaps — the Japanese were afraid that a reduced rate of monetary expansion in the US would make it more difficult for the Japan to continue its own program of monetary expansion, because a reduced rate of US monetary expansion, with no change in the rate of Japanese monetary expansion, would lead to US pressure on Japan to prevent further depreciation of the yen against the dollar, or even pressure to reverse the yen depreciation of the last six months. Well, if that’s the case, I would guess that the Japanese would view their ability to engage in monetary expansion as being constrained by the willingness of the US to tolerate yen depreciation, a willingness that in turn would depend on the stance of US monetary policy.

In short, from the Japanese perspective, the easier US monetary policy is, the more space is available to the Japanese to loosen their monetary policy. Now if you think that this may be a bit far-fetched, you obviously haven’t been reading the Wall Street Journal editorial page, which periodically runs screeds about how easy US monetary policy is forcing other countries to adopt easy monetary policies.

That’s why Bernanke’s incoherent policy statement last Wednesday may have led to an expectation of a yen appreciation against the dollar, and why it also led to an expectation of reduced future Japanese cash flows. Reduced expectations of US monetary expansion and US economic growth imply a reduced demand for Japanese exports. In addition, the expectation of US pressure on Japan to reverse yen depreciation would imply a further contraction of Japanese domestic demand, further reducing expected cash flows and, consequently, Japanese asset prices. But how does this account for the drop in Japanese bond prices? Simple. To force an increase in the value of the yen against the dollar, the Bank of Japan would have to tighten money by raising Japanese interest rates.

PS Lars Christensen kindly informs me that he has a further discussion of Japanese monetary policy and the Nikkei sell-off here.

How Did Bernanke Scare the Markets?

On Wednesday Ben Bernanke appeared before the Joint Economic Committee of the US Congress to give his semi-annual report to Congress on the Economic Outlook. The S&P 500 opened the day about 1% higher than at Tuesday’s close, but by early afternoon had already given back all their gains, before closing 1% lower than the day before, an interday swing of 2%, pretty clearly caused by Bernanke’s testimony. The Nikkei average fell by 7%. Bernanke announced no major change in monetary policy, but he did hint that the FOMC was considering scaling back its asset purchases “in light of incoming information.” So what was it that Bernanke said that was so scary?

Let’s have a look.

Bernanke began with a summary of economic conditions, giving himself two cheers for recent improvements in the job market. He continued by explaining how, despite some minimal and painfully slow improvements, the job market remains in bad shape:

Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.

Bernanke then shifted to the inflation situation:

Consumer price inflation has been low. The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Nevertheless, measures of longer-term inflation expectations have remained stable and continue to run in the narrow ranges seen over the past several years. Over the next few years, inflation appears likely to run at or below the 2 percent rate that the Federal Open Market Committee (FOMC) judges to be most consistent with the Federal Reserve’s statutory mandate to foster maximum employment and stable prices.

In other words, the job market, despite minimal improvements, is a disaster, and inflation is below target, and inflation expectations “continue to in the narrow ranges seen over the past several years.” What does that mean? It means that since the financial crisis of 2008, inflation expectations have consistently remained at their lowest levels in a half century. Why is any increase in inflation expectations above today’s abnormally low levels unacceptable? Bernanke then says that inflation appears likely to run at or below the 2% rate that FOMC believes is most consistent with the Fed’s mandate to foster maximum employment and stable prices. Actually it appears likely that inflation is likely to run below the 2% rate, perhaps by 50 to 100 basis points. For Bernanke to disguise the likelihood that inflation will persistently fail to reach the Fed’s own nominal 2% target, by artfully saying that inflation is likely to run “at or below” the 2% target, is a deliberate deception. Thus, although he is unwilling to say so explicitly, Bernanke makes it clear that he and the FOMC are expecting, whether happily or not is irrelevant, inflation to continue indefinitely at less than the 2% annual target, and will do nothing to increase it.

You get the picture? The job market, five and a half years after the economy started its downturn, is in a shambles. Inflation is running well below the nominal 2% target, and is expected to remain there for as far as the eye can see. And what is the FOMC preoccupied with? Winding down its asset purchases “in light of incoming information.” The incoming information is clearly saying – no it’s shouting – that the asset purchases ought to be stepped up, not wound down. Does Bernanke believe that, under the current circumstances, an increased rate of inflation would not promote a faster recovery in the job market? If so, on the basis of what economic theory has he arrived at that belief? With inflation persistently below the Fed’s own target, he owes Congress and the American people an explanation of why he believes that faster inflation would not hasten the recovery in employment, and why he and the FOMC are not manifestly in violation of their mandate to promote maximum employment consistent with price stability. But he is obviously unwilling or unable to provide one.

Why did Bernanke scare the markets? Well, maybe, just maybe, it was because his testimony was so obviously incoherent.

Scott Sumner, Meet Robert Lucas

I just saw Scott Sumner’s latest post. It’s about the zero fiscal multiplier. Scott makes a good and important point, which is that, under almost any conditions, fiscal policy cannot be effective if monetary policy is aiming at a policy objective that is inconsistent with that fiscal policy. Here’s how Scott puts it in his typical understated fashion.

From today’s news:

The marked improvement in the labor market since the U.S. central bank began its third round of quantitative easing, or QE3, has added an edge to calls by some policy hawks to dial down the stimulus. The roughly 50 percent jump in monthly job creation since the program began has even won renewed support from centrists, raising at least some chance the Fed could ratchet back its buying as early as next month.

I hope I don’t have to do any more of these.  The fiscal multiplier theory is as dead as John Cleese’s parrot.  The growth in jobs didn’t slow with fiscal austerity, it sped up!  And the Fed is saying that any job improvement due to fiscal stimulus will be offset with tighter money.  They talk like the multiplier is zero, and their actions produce a zero multiplier.

This is classic Sumner, and he deserves credit for rediscovering an argument that Ralph Hawtrey made in 1925, but was ignored and then forgotten until Sumner figured it out for himself. When I went through Hawtrey’s analysis in my recent series of posts on Hawtrey and Keynes, Scott immediately identified the identity between what Hawtrey was saying and what he was saying. So up to this point, I am with Scott all the way. But then he loses me, by asking the following question

Has there ever been a more decisive refutation of a major economic theory?

What’s wrong with that question? Well, it seems to me to fly in the face of another critique by another famous economist whom, I think, Scott actually knows: Robert Lucas. Almost 40 years ago, Lucas published a paper about the Phillips Curve in which he argued that the existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation. That simple point, dressed up with just enough mathematical notation to obscure its obviousness, helped Lucas win the Noble Prize, and before long became widely known as the Lucas Critique.

The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions. Observed relationships between economic variables are useless for policy makers unless they understand those deep structural relationships and how they are affected by expectations.

But now Scott seems to be turning the Lucas Critique on its head by saying that the expectations that result from a particular policy regime — a policy regime that has been subjected to withering criticism by none other than Scott himself – refutes a structural theory (that government spending can increase aggregate spending and income) of how the economy works. I don’t think so. The fact that the Fed has adopted and tenaciously sticks to a perverse reaction function cannot refute a theory in which the Fed’s reaction function is a matter of choice not necessity.

I agree with Scott that monetary policy is usually the best tool for macroeconomic stabilization. But that doesn’t mean that fiscal policy can never ever promote recovery. Even Ralph Hawtrey, originator of the “Treasury view” that fiscal policy is powerless to affect aggregate spending, acknowledged that, in a credit deadlock, when expectations are so pessimistic that the monetary authority is powerless to increase private spending, deficit spending by the government financed by money creation might be the only way to increase aggregate spending. That, to be sure, is a pathological situation. But, with at least some real interest rates, currently below zero, it is not impossible to suppose that we are, or have been, in something like a Hawtreyan credit deadlock. I don’t say that we are in one, just that it’s possible that we are close enough to being there that we can’t confidently exclude the possibility, if only the Fed would listen to Scott and stop targeting 2% inflation, of a positive fiscal multiplier.

With US NGDP not even increasing at a 4% annual rate, and the US economy far below its pre-2008 trendline of 5% annual NGDP growth, I don’t understand why one wouldn’t welcome the aid of fiscal policy in getting NDGP to increase at a faster rate than it has for the last 5 years. Sure the economy has been expanding despite a sharp turn toward contractionary fiscal policy two years ago. If fiscal stimulus had not been withdrawn so rapidly, can we be sure that the economy would not have grown faster? Under conditions such as these, as Hawtrey himself well understood, the prudent course of action is to err on the side of recklessness.

The Reinhart-Rogoff Rally

In the current issue of the New York Review of Books, Paul Krugman explains “How the Case for Austerity Has Crumbled,” focusing at length on the infamous Reinhart-Rogoff 90% debt-to-GDP threshold, and how it became a sort of banner, especially in the US and Europe, for the worldwide austerity caucus. Aside from some quibbles, I don’t have much to criticize in Krugman’s treatment, though I am puzzled by his Figure 1, showing, insofar as I can understand it, that government spending increased sharply in 2008 and tapered off thereafter. But Krugman asserts:

[A]fter a brief surge in 2009, government spending began falling in both Europe and the United States.

In his Figure 1 (reproduced below), Krugman identifies his zero year as 2007 (“zero year is the before global recession (2007 in the current slump) and spending is compared with its level in that base year.”) But government spending equals 100 in year -1 and increases sharply in year 0. So his figure indicates that spending increased in 2008 not 2009. It therefore seems to me that the horizontal axis in Figure 1 was mislabeled.


The 90% debt-to-GDP threshold was derived from a paper, “Growth in Time of Debt,” by Reinhart and Rogoff. After other researches had repeatedly failed to replicate its results, Thomas Herndon, Michael Ash, and Robert Polin identified a coding error, missing data, and an unconventional weighting of summary statistics by Reinhart and Rogoff, the three together accounting for the existence of the otherwise inexplicable 90% threshold in the paper.

Despite several attempts Reinhart and Rogoff to minimize the misleading implications of their paper, the 90% threshold, which never had any theoretical credibility, is now thoroughly discredited; any citation of  it as authoritative would rightly invite scorn and ridicule.

Krugman comments:

At this point, then, austerity economics is in a very bad way. Its predictions have proved utterly wrong; its founding academic documents haven’t just lost their canonized status, they’ve become the objects of much ridicule. But as I’ve pointed out, none of this (except that Excel error) should have come as a surprise: basic macroeconomics should have told everyone to expect what did, in fact, happen, and the papers that have now fallen into disrepute were obviously flawed from the start.

What has not yet been commented on as far as I know is the extent to which the discrediting of the Reinhart-Rogoff 90% threshold has had tangible economic consequences.

When the Herndon, Ash, and Pollin paper was posted on the internet about 5 weeks ago on April 15, the S&P 500 closed at 1552.36. The S&P 500 began 2013 at 1426.19, surpassing1500 on January 25. From January 25 until April 15, the S&P 500 fluctuated in the 1500 to 1550 range, only occasionally rising above or falling below those limits. On April 16 and 17, the S&P 500 rose and then fell by about 20 points, closing at 1552.01 on Wednesday April 17. On Thursday April 18, Krugman wrote his New York Times column “The Excel Depression,” the S&P 500 fell to an intraday low of 1536.03 before closing at 1541.61. The S&P 500 has subsequently risen 17 of the next 21 trading days, closing at 1667.47 on last Friday, an increase of almost 126 points, or more than 8%.

I suggest that the most important economic news since April 15 may have been the collapse of the austerity caucus following the public exposure of the Reinhart-Rogoff 90% threshold as a fraud, so that the markets are no longer worried (or, at least, are less worried than before) about the risks that further fiscal tightening will offset the Fed’s modest steps in the direction of monetary ease.

Another positive development has been the decline in the CPI in both March and April, reflecting fortuitous supply-side expansions associated with declining energy and commodity prices. With falling inflation expectations caused by positive supply-side (as opposed to negative demand-side) forces, real interest rates have risen sharply, the 10-year TIPS yield rising from -.69% on April 15 to -.31% on May 17. That increase in real interest rates presumably corresponds to an increase in expected future real incomes. So the economic outlook has gotten a little less bleak over the past month. Call it a reverse Reinhart-Rogoff effect.

Wherein I Try to Help Robert Waldmann Calm Down

Brad Delong kindly posted a long extract from my previous post (about Martin Feldstein) on his blog. The post elicited a longish comment from Robert Waldmann who has been annoyed with me for a while, because, well, because he seem to think that I have an unnatural obsession with monetary policy. Now it’s true that I advocate monetary easing, and think monetary policy, properly administered, could help get our economy moving again, but it’s not as if I have said that fiscal policy can’t work or shouldn’t be tried. So I don’t exactly understand why Waldmann keeps insisting that he won’t calm down. Anyway, let’s have a look at Waldmann’s comment.

After making a number of very cogent criticisms of the Feldstein piece that I criticized, Waldman continues:

On the other hand I also disagree with Glasner. This is the usual and I will not calm down.

Well, you maybe you should reconsider.

Then, quoting from my post on Feldstein,

“does he believe the Fed incapable of causing the price level to increase?” Obviously not (it made no sense to type the question) as he fears higher inflation.

That’s true, I started by asking why Feldstein believed a 20% increase in commodity prices was a bubble. I pointed out in my next sentence that if the Fed was causing inflation, then the increase in commodity prices was not a bubble.

I wish for higher inflation, but, unlike Glasner, I don’t hope for it. the Fed has made gigantic efforts to stimulate and inflation is well below the 2% target. What would it take to convince Glasner that the Fed can’t cause higher prices right now ? It seems to me that his faith is completely impervious to data.

OK, fair question. My point is that the Fed is still committed to a 2% inflation target. If the Fed said that it was aiming to increase the price level by 10% within a year and would take whatever steps necessary to raise prices by 10% and failed, that would be a fair test of the theory that the Fed can control the price level. But if the Fed is saying that it’s aiming at a 2% annual increase in the price level, and its undershooting its target, but isn’t even saying that it will do more to increase the rate of inflation, I don’t see that the proposition that the Fed can control the price level has been refuted by the evidence. The gigantic efforts that Waldmann references have all been undertaken in the context of a monetary regime that is committed to not letting the rate of inflation exceed 2%.

Continuing to quote from my post, Waldmann writes:

“Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets”

Note the clear assumption. QE is the only possible cause of any change in asset prices. Glasner assumes that nothing else changes or that nothing else matters. He basically assumes that there is nothing under the sun but monetary policy.

I think I am being entirely fair to him. I think that, in fact, he assumes not only that monetary policy affects macroeconomic developments but that it is the only thing which affects macroeconomic developments. He has made this very clear when debating me. I think his identifying assumption is indefensible.

Sorry, but where is that clear assumption made? I said that rising asset prices could be attributed to an expectation that QE would increase the rate of inflation. My empirical study showed a strong correlation between inflation expectations and asset values, a correlation not present in the data before 2008. I didn’t say and my empirical study never suggested that asset prices depend on nothing else but inflation expectations, so I am at a loss to understand why Waldmann thinks that that is what I was assuming. What I do say is that monetary policy can affect the price level, not that monetary policy is the only thing that can affect the price level.

Waldmann concludes with a question:

I am curious as to whether there is another possible interpretation of Glasner.

The answer, Professor Waldmann, is yes! Why won’t you take “yes” for an answer? I hope that helps calm you down. It should.

PS I am sorry that I have not responded to comments recently. I have just been too busy. Perhaps over the weekend.

Martin Feldstein Is at It Again

Martin Feldstein writes in the Wall Street Journal (“The Federal Reserve’s Policy Dead End”)

Quantitative easing . . . is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

What Feldstein fails to ask, much less answer, is why anyone is willing to pay more for the stocks than they are worth (based on expectations of the future net cash flows generated by the underlying assets) just because they have excess cash in their pockets. Feldstein is covertly attributing irrationality to investors, although to be fair, he intimates, and has previously asserted explicitly, that the increase in stock prices since QE started was a bubble. And to be fair one more time, he is accurately characterizing Ben Bernanke’s explanation of how QE is supposed to work.

But despite the Fed’s current purchases of $85 billion a month and an accumulation of more than $2 trillion of long-term assets, the economy is limping along with per capita gross domestic product rising at less than 1% a year. Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

Again, all that is irrelevant, because the portfolio balance rationale for QE misrepresents the mechanism whereby QE can have any effect. That mechanism is primarily by preventing inflation expectations from dropping. Each one of the QE episodes has been initiated when expectations of inflation were dropping. In each instances, the announcement or even the expectation of QE succeeded in reversing the downward drift of inflation expectations, thereby contributing to expectations of increased profits and cash flows and thus allowing stock prices to recover from their deeply depressed levels after the 2007-09 downturn and panic. I explained the underlying theory in my paper “The Fisher Effect under Deflationary Expectations,” which also provided supporting empirical evidence showing of a strong positive correlation since 2008 between inflation expectations as measured by the TIPS spread and stock prices, a correlation not predicted by conventional theory and not observed in the data until 2008.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Earnings per share of the Standard & Poor’s 500 stocks rose 50% in 2010 and a further 9% in 2011, driving the increase in share prices. The S&P price-earnings ratio actually fell to 17 at the start of 2013 from 21 at the start of 2010, showing the importance of increased earnings rather than an increased demand for equities.

In other words, QE helped to improve earnings, thus validating the expectations that caused the increase in stock prices.

In short, it isn’t at all clear that the Fed’s long-term asset purchases have raised equity values as the portfolio balance theory predicted. Even if it did account for the entire rise in equity values, the increase in household equity wealth would have only a relatively small effect on consumer spending and GDP growth.

Feldstein continues to attack a strawman, albeit one presented to him by Ben Bernanke.

Mr. Bernanke has emphasized that the use of unconventional monetary policy requires a cost-benefit analysis that compares the gains that quantitative easing can achieve with the risks of asset-price bubbles, future inflation, and the other potential effects of a rapidly growing Fed balance sheet. I think the risks are now clear and the benefits are doubtful. The time has come for the Fed to recognize that it cannot stimulate growth and that a stronger recovery must depend on fiscal actions and tax reform by the White House and Congress.

Feldstein’s closing comment reminded me of a piece that he wrote two and a half years ago in the Financial Times entitled “QE2 is risky and should be limited.” Here are the first and last paragraphs of the FT contribution.

The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress: to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. Any QE should be limited and temporary.

I was not yet blogging in 2010, but I was annoyed enough by Feldstein to write this letter to the editor.

Sir, Arguing against quantitative easing, Martin Feldstein (“QE2 is risky and should be limited“, Comment, November 3) asserts that Federal Reserve signals that it would engage in QE, having depressed long-term interest rates, are fuelling asset and commodities bubbles that will burst once interest rates return to normal levels.

In fact, since Ben Bernanke made known his intent to ease monetary policy on August 29, longer-term rates have edged up. So rising asset and commodities prices are due not to falling long-term rates, but to expectations of rising future revenue streams. Investors, evidently, anticipate either rising output, rising prices or, most likely, some of both.

Why Mr Feldstein considers the recent modest rise in commodities and asset prices (the S&P is still more than 20 per cent below its 2007 all-time high) to be a bubble is not clear. Does he believe that with 15m US workers unemployed, expectations of increased output are irrational? Or does he believe the Fed incapable of causing the price level to increase? It would be odd if it were the latter, because Mr Feldstein goes on to insist that QE is dangerous because it may cause an “unwanted rise in inflation”?

Perhaps Mr Feldstein thinks that expectations of rising prices and rising output are inconsistent with expectations that interest rates will not rise sharply in the future, so that asset prices must take a hit when interest rates finally do rise. But he acknowledges that expectations of future inflation may allow real rates to fall into negative territory to reflect the current dismal economic climate. Since August 29, rates on inflation-adjusted Tips bonds have fallen below zero. Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets, presaging increased real investment and a pick-up in recovery.

Why then is inflation “unwanted”? Mr Feldstein maintains that it would jeopardise the credibility of the Fed’s long-term inflation strategy. But it is not clear why Fed credibility would be jeopardised more by a temporary increase, than by a temporary decrease, in inflation, or, indeed, why credibility would be jeopardised at all by a short-term increase in inflation to compensate for a prior short-term decrease? The inflexible conception of inflation targeting espoused by Mr Feldstein, painfully articulated in Federal Open Market Committee minutes, led the Fed into a disastrous tightening of monetary policy between March and October 2008, while the US economy was falling into a deepening recession because of a misplaced concern that rising oil and food prices would cause inflation expectations to run out of control.

Two years later, Mr Feldstein, having learnt nothing and forgotten nothing, is urging the Fed to persist in its earlier mistake because of a neurotic concern that inflation expectations may soar amid massive unemployment and idle resources.

Well, that’s my story and I’m sticking to it.

A Newly Revised Version of My Paper (with Ron Batchelder) on Hawtrey and Cassel Is Now Available on SSRN

This may not be the most important news of the day, but for those wishing to immerse themselves in the economics of Hawtrey and Cassel, a newly revised version of my paper with Ron Batchelder “Pre-Keynesian Monetary Explanations of the Great Depression: Whatever Happened to Hawtrey and Cassel?” is now available on SSRN.

The paper has also recently been submitted to a journal for review, so we are hoping that it will finally be published before too long. Wish us luck. Here’s the slightly revised abstract.

A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman. Designed to counter the Keynesian notion that the Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an ill-conceived monetary policy pursued by an inept Federal Reserve Board. More recent work on the Depression suggests that the causes of the Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed. We document that current views about the causes of the Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who independently warned that restoring the gold standard risked causing a disastrous deflation unless the resulting increase in the international monetary demand for gold could be limited. Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored or forgotten. This paper explores the possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.

Hawtrey Reviews Cassel

While doing further research on Ralph Hawtrey, I recently came across a brief 1933 review written by Hawtrey in the Economic Journal of a short book by Gustav Cassel, The Crisis in the World Monetary System. Sound familiar? The review provides a wonderfully succinct summary of the views of both Cassel and Hawtrey of the causes of, and the cure for, the Great Depression. The review can still be read with pleasure and profit. It can also be read with wonder. It is amazing that something written 80 years ago about the problem of monetary disorder can have such relevance to the problems of today. Here is the review in full. And pay special attention to the last paragraph.

The delivery of a series of three lectures at Oxford last summer has given Professor Cassel an opportunity of fulfilling his function of instructing public opinion in the intricacies of economic theory, especially of monetary theory in their application to current events. This little book of just under 100 pages is the result. As admirers of Professor Cassel will expect, it is full of wisdom, expressed with an admirable clarity and simplicity.

He points out that so long as the policy of economising gold, recommended at the Genoa Conference, was carried out, it was possible to prevent any considerable rise in the value of gold. “The world reaped the fruits of this policy in an economic development in which most countries had their share and which for some countries meant a great deal of prosperity” (p. 27).

Progress up to 1928 was normally healthy; it was not more rapid than was usual in the pre-war period. It was interrupted in 1929 by the fall of prices, for which in Professor Cassel’s view the responsibility rests on the central banks. “The course of a ship is doubtless the combined result of wind, current and navigation, and each of these factors could be quoted as independent causes of the result that the ship arrives at a certain place.” But it is navigation that is within human control, and consequently the responsibility rests on the captain. So a central bank, which has the monopoly of supplying the community with currency, bears the responsibility for variations in the value of the currency (pp. 46-7).

Under a gold standard the responsibility becomes international, but “if some important central banks follow a policy which must lead, say, to a violent increase in the value of gold, the behaviour of such banks must be regarded as the cause of this movement” (p. 48).

Professor Cassel further apportions a heavy share of the responsibility for the breakdown to war debts and reparations. “The payment of war debts in conjunction with the unwillingness to receive payment in the normal form of goods led to unreasonable demands on the world’s monetary stocks; and the claimants failed to use in a proper way the gold that they had accumulated” (pp. 71-2).

Just as a reminder, if you have made it this far, don’t stop without reading the next and final paragraph.

Finally, for a remedy, “the best thing that the gold standard countries could do for a rapid economic recovery would be immediately to start an inflation of their currencies. If this inflation were the outcome of a deliberate and well-conceived policy it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts” (p. 94).

Let’s read that again:

If inflation were the outcome of a deliberate and well-conceived policy, it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts.

The Vampire Theory of Inflation

The FOMC issued an opaque statement yesterday observing that the economy is continuing to expand at “a moderate pace,” though unemployment remains too high while inflation is falling. The statement attributes the weakness of the recovery, at least in part, to fiscal tightening, perhaps suggesting that the Fed would not, under these circumstances, tighten monetary policy if fiscal policy were eased.

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Notice despite the neutral, matter-of-fact tone of the statement, there are two factually inaccurate, or at least misleading, assertions about inflation. First, while the assertion “inflation has been running somewhat below the Committee’s longer-run objective,” is not objectively false, the assertion ignores the steady downward trend in inflation for the past year, while sewing confusion with a gratuitous diversionary reference to “temporary variations that largely reflect fluctuations in energy prices.” By almost any measure, inflation is now running closer to 1% than to the Fed’s own 2% target.

Second, the statement asserts that longer-term inflation expectations have remained stable. Oh really? If we take the 10-year TIPS spread as a proxy for long-term inflation expectations, inflation expectations have been falling steadily since the mid-January to mid-March time frame, when the breakeven rate fluctuated in a narrow range between 2.5% and 2.6%, to a spread of 2.3% yesterday, the lowest since early September of last year.

The FOMC continues:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee continues to see downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2% objective.

Well, here is my question.  If the FOMC “seeks to foster maximum employment and price stability,” and the FOMC itself anticipates that inflation over the medium term will likely be less than 2%, why, under the FOMC’s own definition of price stability as 2% inflation, is the FOMC proposing to do nothing — not a single wretched thing — to hit its own inflation target?

Under both elements of its dual mandate, the FOMC is unambiguously obligated to increase the rate of monetary accommodation now being provided. The FOMC asserts that unemployment is elevated; it also asserts, notwithstanding a pathetic attempt to disguise  that obvious fact, that inflation is below its target. Both conditions require increased monetary expansion. There is now no trade-off between inflation and unemployment, and no conflict between the Fed’s two mandates. So why can’t the Fed do what it is plainly obligated to do by current legislation? Pointing a finger at the President and Congress cannot absolve the Fed of its own legal obligation not to tolerate an inflation rate below that consistent with price stability when unemployment is elevated. Is there no one capable of extracting from the Chairman of the Federal Reserve Board an explanation of this dereliction of duty?

Interestingly enough, I happened to catch a piece (“Should we bring inflation back from the dead?”) on American Public Radio’s “Marketplace” last evening. After asking David Blanchflower of Dartmouth College and Kevin Jacques of Baldwin Wallace University about the potential benefits of moderate inflation in the current environment, reporter David Gura turned to Marvin Goodfriend, formerly of the Richmond Fed, and now at Carnegie-Mellon, for a contrary view. Here is how Goodfriend explained why more inflation would not be a good thing.

Of course, resurrecting inflation is not risk-free. Economist Marvin Goodfriend says this kind of thinking could lead the economy to overheat: “If a little inflation is good, maybe a little more inflation is better.” It is something that is hard to control.

Goodfriend tells his students at Carnegie Mellon University to remember something.

“Inflation doesn’t die,” he says. “It’s like a vampire.”

You can vanquish it with “determined policy,” Goodfriend explains. Inflation will creep back into its coffin. And then, when you least expect it, it can come back with a vengeance.

Whew! Talk about sophisticated economic analysis. But then again, Goodfriend’s students at Carnegie-Mellon are super bright, aren’t they? Could this be what Bernanke and his colleagues are thinking? The vampire theory of inflation? Say it ain’t so, Ben.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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