Fearing the Japan Scenario

There is a major underlying fear among US policymakers: that the US will suffer the same longtime stagnation that Japan has suffered since the bubble burst in the early 1990s. This useful op-ed by Larry Summers in the Washington Post is a prime example of this concern.

In fact, many of the current crop of senior officials spent a decade loudly advising the (unreceptive) Japanese on the necessity to stimulate their economy, and telling themselves that the US would never make the same policy errors. Hubris has been followed by dismay.

In fact, there are three major historic analogies that often play in policy minds. Japan is one. Another is 1937, when the Fed arguably prolonged the depression by prematurely raising interest rates. And another is the experience of the 1970s, when the Fed likely overestimated slack in the economy, leading to the Great Inflation.

Athanasios Orphanides, at the time a Fed researcher (and later Governor of the Bank of Cyprus) wrote a series of papers on the later argument. He argues that the Fed (and others like CBO) suffered from very serious misperception of the output gap and natural rate of unemployment at the time.

Consistent with the natural rate hypothesis, maintaining the unemployment rate slightly above the perceived “natural” rate was meant to be the optimal approach for restoring price stability. The “optimum feasible path”, of course, became the Great Inflation. Accepting that this activist policy was optimal, the policy disaster of the 1970s cup deb attributed to bad luck – an adverse shift in the “natural” rate of unemployment that could not have reasonably been expected to be correctly assessed for some time. But a more fundamental flow can be readily identified – concentrating policy efforts towards targeting the economy’s elusive full employment potential.

If that also eerily sounds like recent Fed talk about optimal policy and the need to pay close attention to employment potential… it is.

So what do we make of this? First, many current Fed officials would argue that if they had their choice of bad outcome, inflation is likely preferable to endless stagnation or depression. At least the Fed can raise interest rates to head off inflation. But it also suggests that there is usually a balance to be struck between, and trusting completely in one particular analogy can produce huge policy errors. People have a remarkable tendency to “fight the last war”, or repeat the mistakes of the past. We naturally reason in terms of historic analogies, and naturally commit patterns of errors as a result. We have to be careful about which “last” analogy we evoke – Japan in the 1990s, or the US in the 1970s or 1930s.

The other point is that people also tend to cherry-pick analogies to fit with their preconceived policy views, and usually fail to explore similarities and differences in historic situations in any depth. For foreign policy hawks, every foreign crisis is Chamberlain at Munich all over again. For doves, it is Dr Strangelove and the Vietnam War.

So Larry Summer’s piece is an excellent analogy by a Democratic economist to Japan. But it is always worth asking what is left unsaid or overlooked in policy analogies. Japan has also engaged in massive fiscal stimulus for twenty years, so much so its debt/GDP ratio is almost 230% of GDP. And stagnation endured.

The most relevant differences are more likely the structural flexibility of the two economies.



All that glitters is not golden

Gold's amazing fall of 9.3% yesterday is in the zone central bankers call “disorderly markets”. It is a brutal adjustment, and there are rumors some big funds could be distressed.

It is possible to point to some short-term triggers, as this Bloomberg story does. But I think it is more than just a reaction to Chinese growth numbers or less fear of QE-induced inflation, or Cypriot gold sales. There are renewed concerns over the strength of global recovery, signaled by broader falls in commodities, but the data has been tuning softer for weeks, and doesn't explain a massive adjustment in a single day.

I suspect a deeper reason is it is a chain reaction from the Bank of Japan shock two weeks ago, which has caused major adjustments in JGBs and the yen. Losses in one market often trigger forced sales in other markets.

The rout in gold apparently started with a very large sell order on Friday. That can only be one of two things: a flagrant attempt to manipulate the market down, conjoined with a massive short; or a sudden, urgent need to meet a massive margin call. Normal sellers are going to dripfeed into the market to avoid moving it against them.

I'd bet it was distressed selling. Suddenly people become much more aware of fundamental arguments that the commodity cycle may be turning or central banks may sell gold.

Usually a fall in gold is a sign of retreating market fear, but in this case it points to deeper technical dislocation rather than fundamental change in outlook. I don't think gold bugs changed their mind yesterday.

It should burn out after a few days, so long as it doesn't spread into violent adjustments in the US Treasury market. That could cause its own cascade of problems, including the return of counterparty risk fears. When the US bond avalanche eventually starts, it will bury some banks.


2017-05-11T17:32:57+00:00 April 16, 2013|Bonds, Central Banks, Current Events, Japan, Market Behavior|

Frankenstein #economic #policy only buys time for natural resilience

Sometimes a cluster of major events happens all at once in just a few days. We had the significant Bank of Japan announcement, a bad payrolls number in the US,  nuclear theatrics in North Korea, nerves about Portugal,  and Obama is about to release his budget. I didn’t have time to fully update things on the blog, but it’s been a very interesting weekend.

But this has to be said: we really are near the point where normal monetary and fiscal policy is exhausted.  This is the end game.

It is good news that the Japanese are taking such decisive action. It is bad news that it is necessary. They have tried fiscal expansion on a scale that few others have ever dared, and it has not worked. Now they are trying to do a Dr Frankenstein on their economy with an unprecedented monetary jolt. It is a brave act, but also smells of desperation. Normal medicine has not worked so the surgeon is jumping up and down with electrodes and clamps and a mad-scientist air.  If the economy gets off the operating table, it may be hard to like the ugly outcome.


The direct quantitative impact of monetary (and fiscal) measures is almost beside the point,  for all the person-years that have been spent on constructing models to quantify the impact of QE, or debating multipliers in fiscal policy, or pondering blockages in the transmission mechanism.

Sure, we can talk about whether the BoJ can keep control of inflation, whether 10-year JGBs continue to gap and trade in a disorderly way, or whether we are on the way to disguised currency war. This is going to be a major subterranean crack in bond markets.

However, the real objective of policy here is to reset expectations so the economy can generate its own momentum. As I’ve said before, economics does have a very good empirical understanding of expectations formation. The fundamental question now is whether  the average person on the street comes to believe things are going to get better. That will be the real thing to watch in Japan, not inflation or JGBs (unless you hold the bonds).

That’s why the labor number in the US is also important. One bad number could be a blip. The next one will matter, however, because consumer confidence is fragile.

I still think US recovery is on track, because modern economies have a natural tendency to adjust and recover despite policy mistakes. It’s the base rate.

Central bankers (and government spending) can at best buy time for natural healing to take place. The Fed and BoJ and others are doing their best (despite criticism from the likes of David Stockman) but at some point the patient has to get up off the operating table and walk for himself, without the drip feed of QE. The central banks can’t themselves cure the sickness.

What happens if the latest policy jolts do not work? The economy will still cure itself, but through something more like a burning fever of brutal adjustment than a slow recovery.

2017-05-11T17:32:57+00:00 April 8, 2013|Current Events, Cyclical trends, Economics, Japan, Monetary Policy|