| A Reality Check for the Conventional Wisdom |
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| By Allan H. Meltzer |
| Posted: Monday, August 18, 2003 |
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| ARTICLES |
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Financial Times
(London)
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| Publication Date: August 17, 2003 |
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To the surprise of most Japan-watchers, the Japanese economy continues to recover. Growth reached a 2.3 percent annual rate in the second quarter, far better than the consensus forecast of 0.6 percent just before the announcement. Annual growth continues to run above 2 percent, about as fast as the recent U.S. growth rate. The recovery is all the more impressive because current growth is above Japan's long-term growth rate of 1 to 1.5 percent.
Japan's recent experience carries four big lessons for contemporary policy in Japan and elsewhere. First, its recovery came despite continued deflation. Second, there was no liquidity trap. Despite a short-term interest rate of zero, monetary policy made an important contribution to the expansion. Third, monetary policy provided stimulus despite continued disarray in the banking system. Fourth, there is no sign of a twin deficit problem in Japan. A budget deficit equal to 7.5 percent of gross domestic product co-exists with a projected 2.5 percent current account surplus.
Current concern about deflation incorrectly interprets experience from the Great Depression in the U.S. and recent Japanese experience as evidence that it necessarily destroys real growth and employment. Most deflations have not had that effect. Despite continued deflation, Japan's real growth has been positive for six quarters and has recently increased. This is consistent with the experience of many countries in the 1880s, when incomes rose at above average rates, while prices fell in the gold-standard countries. Many would dismiss that experience because 19th-century economies were very different, predominantly agricultural and on the gold standard. But recovery and real growth also ended deflations in the U.S. in 1920-21 when deflation reached 17 percent and continued into the 1922 recovery. Deflations occurred in the 1937-38 and 1948-49 U.S. recessions. Consumer prices rose about 1 percent a year during the strong expansion from 1961 to 1964. Corrected for biases in the price index, prices probably fell modestly during much of that recovery.
Overly restrictive monetary policy distinguishes the two deflations that are remembered as destructive--1929-33 and the 1990s in Japan--from those that were not. In the U.S. deflations of 1937-38 and 1948-49, as in Japan, a key short-term interest rate remained at zero. As in Japan, there was no sign of the liquidity trap that many claim makes monetary policy useless. Expanding the monetary base and money lowered long-term interest rates and changed the relative prices of assets and output. In fact, interest rates on Japanese long-term corporate bonds fell from more than 3.5 percent to 1.5 per cent within the past year, suggesting a very strong response from the markets once monetary policy turned expansive.
Proponents of the idea that Japan would face a liquidity trap thought they found support in the massive accumulation of current account balances (bank excess reserves) at the Bank of Japan. Old metaphors about "pushing on a string" had a rebirth. Like many Japanese officials, these analysts were looking in the wrong place and drawing the wrong conclusion. Exchanging zero-yielding bank reserves for zero-yielding short-term securities accomplished nothing. Banks were in the same position before and after. That changed when the BoJ finally, and reluctantly, began to buy longer-term securities and other "un-conventional" assets. Now the expansion of the monetary base mattered; interest rates on many securities fell and, later, stock prices began what appears to be a sustained recovery.
The error in the conventional view was the belief that once short-term interest rates reached zero, monetary policy was powerless. Critics repeated that view in Japan and later in the U.S. Many err by claiming the Federal Reserve, with its short-term rate at 1 percent, is nearly powerless. Japan's current expansion shows that is not true.
Japan's banking system remains troubled and bank loans continue to decline. Although the government delays fundamental banking reform, economic expansion did not wait. Central banks should learn the important lesson about the transmission of monetary policy. Although bank lending is an efficient way to transmit monetary impulses, it is not the only way.
Monetary policy works by changing relative prices. The much-discussed wealth effect is a tiny part of the process. Rising prices of existing homes stimulate the production of new homes. Rising stock prices increase the cost of purchasing existing capital, signalling that new production of capital has become attractive. Falling long-term interest rates signal that purchases of housing, cars or other durables can be made on better terms. Private domestic demand and exports pushed up the second-quarter growth rate in Japan. Government spending declined. More important was the fact that the new leadership at the BoJ promised that monetary expansion would continue, instead of repeating the mistake it made in 2000 when the BoJ raised its short-term rate to avoid "sloppy" money market conditions.
The lessons from Japan were not new, but they were painful and valuable. The liquidity trap can only occur when all interest rates are effectively zero. Despite repeated claims to the contrary, money growth continues to be important for monetary policy.
Allan H. Meltzer is a professor of political economy at Carnegie Mellon University and a scholar at the American Enterprise Institute. |
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| AEI Print Index No. 15634 |
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Asian Outlook
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In the latest edition of Asian Outlook, Michael Auslin lays out a strategy for the United States to serve as a disinterested "third neighbor" to Asian allies in precarious geopolitical positions.
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