May 30, 2003

Stephen Roach on the Limits of Monetarism

Stephen Roach on the limits of monetarism:

Morgan Stanley: ...The monetarist cure is a final comparison worth making -- especially in light of the debate now raging in the US over the efficacy of the Fed?s coming assault on deflation.† The monetarist diagnosis and prescription is straight-forward: Inasmuch as fluctuations in the price level are believed to be first and foremost a monetary phenomenon, an injection of massive liquidity should stop deflation dead in its tracks.† Yet if it was all that simple, it?s hard to believe that the Bank of Japan wouldn?t have tried this recipe some time ago.† In fact, that?s exactly what happened.† Since early 1997, Japan?s broad money has increased by about 20%, its monetary base has surged by 84%, and the BOJ?s balance sheet has expanded by 122%.† Yet over that same six-year period, Japanese nominal GDP has actually contracted by 6%.† In other words the monetarist prescription has failed miserably in Japan -- hardly a comforting result for other central banks as they now face the perils of deflation...

Posted by DeLong at May 30, 2003 06:44 AM | TrackBack

Comments

Is " nominal GDP" a good measure of "Deflation" ? Or inflation,
for that matter? The "P" part of
the acronym stands for "product"...
If prices were stable and productivity
down, wouldn't the GDP fall?

Posted by: Melcher on May 30, 2003 07:59 AM

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Roach does not mention that it took the BOJ some time to entertain the idea of loosening monetary policy. The 1990-97 period, if anything, seems to confirm that monetarists do indeed have something useful to say about how Japan got in to its deflationary mess; the BOJ was routinely criticized then for its conservatism.

On the other hand, perhaps the Japan experience does illustrate that, once you have launched a deflationary regime, a monetary policy shift will not be sufficient to get you out, even if accompanied by expansionary fiscal policy. This is the scary part.

Posted by: Jim Harris on May 30, 2003 08:32 AM

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the dallas fed just put out a primer on Monetary Policy in a Zero-Interest-Rate Economy

http://www.dallasfed.org/htm/research/hot/bd0503.html

"If standard policy options are exhausted, the Fedís quiver is by no means empty. But the arrows that remain are less familiar and, perhaps, not quite as straight as the ones that have already been fired."

Posted by: kenny on May 30, 2003 08:45 AM

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Japan might not make a good test case. If the domestic market is so structurally stagnant that it destroys wealth and Japan's growth is totally tied to export markets as some have claimed, the BOJ would not really have that much control. Japan's growth potential would be limited to the possible increased absorbtion rates of other economies. Since exports are small compared to overall economic activity, there would be political constraints to the type of major exchange rate movements needed to boost exports enough to offset even minor internal declines.

Posted by: Stan on May 30, 2003 09:03 AM

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Melcher,

I suspect the reason for choosing nominal GDP is that the monetarist policy prescription anticipates that central banks can manipulate the nominal level of output. Aim nominal growth at trend real growth, plus whatever inflation rate you choose, and that tells you how fast money supply should grow. Japan's case is offered as evidence that nominal GDP fell even as money supply rose - the monitarist model ain't working. Pointing out the rate of decline in nominal GDP (which is faster than the rate of decline in real GDP) is a backhanded way of pointing out that Japan is experiencing deflation.

Posted by: K Harris on May 30, 2003 09:54 AM

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"The bottom line: Investors are all fascinated with the great inflation debate. But when push comes to shove, the broad consensus is still leaning the other way when putting real money to work."

Well now, what an interesting laboratory experiment. I suppose within a year or two we'll be able to see whether the dismal science or instinct colored by experience was more accurate in perceiving the current state of affairs.

Posted by: Russell L. Carter on May 30, 2003 10:34 AM

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Well, if monetarism isn't working perhaps structural problems are the reason?

All those econ textbooks do say "in the long run monetary policy is neutral", and 12 years seems a pretty long run. So if those textbooks aren't all wrong, perhaps Japan is running where it is because policy decisions that result from the politics of one-party-government are structurally misallocating resources to constrain growth?

After all, there have been no shortage of one-party governments that have constrained the growth of their economies to the point of collapse in spite of easy money.

For "structural trap" or "statism trap" analysis, Arnold Kling at http://econlog.econlib.org/archives/000144.html
references papers by...

Edward Prescott (his 2002 AEA Ely lecture), which notes a 17% drop in productivity relative to trend in Japan over the last decade, while also reviewing growth and depression in various countries
http://research.mpls.frb.fed.us/research/wp/wp618.pdf

And by Dugger and Ubide about Japan specifically, with IS/LM analysis, etc. (given to the Central Bankers Symposiun in Kyoto last year)
http://www.newamerica.net/Download_Docs/pdfs/Doc_File_131_1.pdf

The latter points out that while a liquidity trap and structural trap may look much the same, they have significantly different policy implications, for monetary policy and otherwise.


Posted by: Jim Glass on May 30, 2003 10:44 AM

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I had to laugh when Victor Canto recently explained why GDP growth was weak even though the money supply grew rapidly: you see, "velocity fell". Since velocity = GDP/money, this has to be true by definition. I laughed only because this is not the first time GDP growth in a nation was weak even as the money supply grew. And it would seem others have "explained" this by saying velocity fell. So I once asked the monetarist who said this: "whose behavior does velocity describe anyway". His response was simply velocity is a definition and not a behaviorial equation - which was precisely my point.

Posted by: Hal McClure on May 30, 2003 12:05 PM

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I had to laugh when Victor Canto recently explained why GDP growth was weak even though the money supply grew rapidly: you see, "velocity fell". Since velocity = GDP/money, this has to be true by definition. I laughed only because this is not the first time GDP growth in a nation was weak even as the money supply grew. And it would seem others have "explained" this by saying velocity fell. So I once asked the monetarist who said this: "whose behavior does velocity describe anyway". His response was simply velocity is a definition and not a behaviorial equation - which was precisely my point.

Posted by: Hal McClure on May 30, 2003 12:08 PM

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Steve Roach makes a rookie mistake when assessing prospects for deflation in the United States. He confuses monetarism with the proposition that monetary policy can affect the general price level. Monetarism is the very strong claim that there is a usefully predictable relationship between the rate of growth of some monetary aggregate and the rate of inflation or nominal demand. Few people in Ameican policy circles are attracted to monetarism because they recognize that the demand for money is extremely unstable and unpredictable. Accordingly, the evidence that Roach presents to the effect that monetarism would not have worked in Japan is irrelevant to the question at hand in America. (This is not to say that Japan's entire experience is irrelvant.)

Proponents of inflation targeting in the USA may be contributing to the confusion experienced by Dr. Roach and others. For example, Fed Governor Bernanke often motivates his discussions of monetary policy efficacy by reminding us that P is the relative price of money and output and that the Fed has ultimate control over the former. I think that comment is meant to make our minds receptive to the notion that the Fed can ultimately control the general price level.
But within the Fed at least, the case for monetary policy efficacy does not really rely on a monetarist transmission mechanism. It relies instead on the notion that the central bank has the ability to depress term (real) interest rates through a combination of open-mouth and open-market operations.

In the very near term, the Fed's intention is to manipulate Treasury yields only. But if conditions were to deteriorate further, the Fed could operate directly on credit and liquidity spreads in agency, mortgage and conceivably even corporate debt. Admittedly, this appraoch could fail if the equilibrating nominal yields on private sector debt instruments were to fall generally below zero or if the Fed were to move too slowly. So I am not making the case for naive optimism here. I am saying only that Roach's discussion of monetary aggregates is entirely irrelevant to the discussion that is right now happening within the Fed.

I noticed an earlier poster suggested a primer from the Dallas Fed. Roach could read that. Or he could go back to the Bernanke speeches of last fall. I am not suggesting that Roach abandon this debate. But people playing a prominent role within the debate should focus on the issues actually at stake.


Posted by: Gerard MacDonell on June 1, 2003 07:45 AM

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GM

Why then has the Bank of Japan not been more effective in spurring moderate inflation? What do you make of the approach of deflation in Germany, where the European Bank is not likely to be even as responsive as the BOJ? Does the deflation in Hong Kong teach us anything relevant?

Posted by: anne on June 1, 2003 10:46 AM

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Folks, I am no economist but this is what I see.

1) Too many factories and suppliers of the same old stuff.

2) Too many machines making too much stuff thus driving down the components and the products sold by all those in #1.

3) A tapped out population that has no more money to spend.

4) A population that has already too much junk and really has nothing else to buy.

5) An exhausted population tired of all the news, politics, wars, SARS, aids scares, muslims,etc. A population that is being bombarded with news, advertisements, etc to the point they all just want to get away from people, malls, shopping, Disney World. They are exhausted.

5) And a world wide shift that says enough is enough....a desire for simplicity.

Thus, prices will drop as producers and sellers realize the consumption economy is no longer the dominant force in the life of the population. We are exhausted. WE have entered a new world and the adjustment is now beginning. Here comes deflation.

Posted by: Al on June 27, 2003 11:49 AM

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Folks, I am no economist but this is what I see.

1) Too many factories and suppliers of the same old stuff.

2) Too many machines making too much stuff thus driving down the components and the products sold by all those in #1.

3) A tapped out population that has no more money to spend.

4) A population that has already too much junk and really has nothing else to buy.

5) An exhausted population tired of all the news, politics, wars, SARS, aids scares, muslims,etc. A population that is being bombarded with news, advertisements, etc to the point they all just want to get away from people, malls, shopping, Disney World. They are exhausted.

5) And a world wide shift that says enough is enough....a desire for simplicity.

Thus, prices will drop as producers and sellers realize the consumption economy is no longer the dominant force in the life of the population. We are exhausted. WE have entered a new world and the adjustment is now beginning. Here comes deflation.

Posted by: Al on June 27, 2003 11:50 AM

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In his errors a man is true to type. Observe the errors and you will know the man.

Posted by: Peck Amy on December 10, 2003 04:23 AM

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I believe that all government is evil, and that trying to improve it is largely a waste of time.

Posted by: Gray Neil on December 20, 2003 03:44 PM

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Suits and religions rupture if you force them on.

Posted by: Mitra Kanchan on January 9, 2004 03:56 AM

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