The Federal Reserve announced Oct. 29 that it was ending quantitative easing, its program to keep interest rates low. Two days later and halfway around the world, the Bank of Japan announced that it would do the opposite. Both Washington and Tokyo, having presided over weak economies for several years, are eager to get growth back on a fast track. So why are they pursuing opposite policies?
Quantitative easing involves increasing the money supply to stimulate economic growth. The country’s central bank buys large amounts of government bonds and other securities from banks. In return, the banks get large amounts of newly minted cash. It’s a way of printing money. Banks spread this new money throughout the economy by lending and other financial activity.
It’s a big program. The Fed’s total purchases stand at around $1.66 trillion. Japan’s announced program will increase to $705 billion of new currency a year for the life of the program, however long that is. That is equivalent to 15 percent of the size of Japan’s economy, making Tokyo’s program proportionally far larger than the Fed’s.
Despite their seemingly opposite trajectories — and their are programs having different effects on their economies — the Fed and Bank of Japan are actually pursuing similar policies, rooted in similar philosophies based on an illusion of control. Central banks can manipulate economic indicators in the short run, but long-term prosperity doesn't come from monetary policy. It comes from private sector innovation and entrepreneurship.
Instead of constantly and unpredictably tinkering with interest rates, money supply, exchange rates, and other variables, central banks should pursue a humbler monetary policy. This would emphasize an honest, stable, and predictable price system that creates a better environment for those private sector engines of growth.
Central bankers around the world are famously fearful of a shrinking money supply, and with good reason. America’s Great Depression was largely caused by the money supply shrinking by roughly one-third. At its worst, Depression-era unemployment reached 25 percent. Real gross domestic product per person didn’t recover lost ground until 1939. Today’s monetary authorities have learned that lesson and are hyper-vigilant about deflation.
Keynesian economists in particular are wary of having too few dollars (or yen, or euros) circulating in the economy. Scarcity prompts people to hang on to the money they have, and to spend less. Low spending brings economic stagnation. There is no sense hiring workers to produce something nobody is going to buy. Economists from Nobel laureate Paul Krugman to former Council of Economic Advisers Chairwoman Christina Romer favor quantitative easing as a way to avoid the trap of illiquidity.
Krugman has criticized the Fed for not going far enough. He also argues that monetary expansion needs to be coupled to higher government spending to stimulate economic growth as much as possible. In an interview with the Guardian newspaper, he said, “I wouldn’t say that quantitative easing has been decisive. It is a fragile and fairly weak tool, so to ask it to override fiscal austerity is asking too much.” The paper adds that Krugman “wants more QE and is relaxed about inflation at 4 percent or 5 percent.” Inflation has mostly hovered between 1 percent and 2 percent in recent years.
The risk of inflation is what animates many opponents of easy money. America’s quantitative easing experiment caused little if any inflation because banks sat on their new cash reserves rather than lending them liberally. They did so partially because of new standards being implemented, ironically, by the Fed. The standards, known as Basel III, stem from an international accord passed in reaction to the 2008 financial crisis. They require higher capital reserves, stress-testing, and other preventive measures. This means the Fed’s own regulations actually prevent banks from using much of the easy money windfalls the Fed gave them!
The Fed is famously opaque, so it is hard to tell if this was intentional. Few people outside the Fed know for sure. Memoirs may have to be published before we find out.
The bottom line is that quantitative easing in America, to the surprise of its supporters and detractors alike, turned out to have had almost no impact.
Japan is now officially in recession with its Nov. 17 announcement of a second consecutive quarter of contraction. For two decades, the economy has grown slowly when it has grown at all. The go-go days of frenetic postwar growth are a distant memory from the early 1990s. Seeing this, Prime Minister Shinzo Abe is trying boost the economy and his approval ratings back to the stratosphere. Bank of Japan Governor Haruhiko Kuroda hopes to join him.
It helps that Kuroda knows how to induce an inflationary boom. The key element is surprise. Businesses, suddenly seeing their goods selling for higher prices, react by boosting production and hiring workers. The economy grows faster than it would have without inflation. But if businesses know inflation is coming, they factor it into their decision making. Financial firms adjust their yields and interest rates accordingly, neutralizing any beneficial impact.
An inflationary boom works only if people don’t see it coming, so Kuroda made sure few did. The bank’s policies are voted on by an eight-member board, with the governor holding the ninth vote. Their votes are typically unanimous or close to it, in part to avoid any appearance of division or uncertainty. Kuroda kept his QE proposal secret from all but a few close advisers. Much of the board was taken completely by surprise, and after a tense meeting they split 4-4. Kuroda broke this rare tie. His plan stunned stock markets and the Nikkei index hit a seven-year high.
If all goes to plan, Japan’s inflation rate will jump out of its current range of 1 to 1.5 percent up to 2 percent. The yen will weaken, making Japanese goods cheaper and boosting exports. A minor inflationary boom would help offset an earlier increase in the value-added tax that dampened consumer spending. A further VAT increase has been postponed but is likely at some point, strengthening Kuroda’s case for easy money.
But there are two big problems with inflationary booms. They are temporary, and they are followed by busts. Kuroda and Abe are playing with fire. If the bank is correct that inflation will rise by just 1 percentage point, the fire is a manageable array of small flames. America’s underwhelming experience of easy money bodes well for Japan. But if the Japanese inflation guess is wrong, and if prices rise too fast, Tokyo will have started a forest fire.
Imagine if the money supply magically doubled overnight. Everyone wakes up and finds twice as much money in their wallets and bank accounts. They may well go on a spending binge, which stimulates the economy. But they’d quickly figure out that prices are higher, too. Prices would double to match the currency as soon as people catch on to what’s happened.
The extra cash didn’t actually make people richer; the price level just changed. The amount of actual wealth — goods and services — hasn’t changed at all. The only change is the amount of currency describing that wealth.
The same principle holds in the real world just as it does in the imaginary one. Usually, a surprise spike in inflation triggers a short boom. But it doesn’t make people wealthier. They simply consume more now, and less later.
Worse, distorted prices lead to distorted decision making. If a company ramps up production for a product that people don’t actually want more of, it has wasted labor and resources that could have created more value somewhere else. These ill-judged, inflation-induced investments trigger a bust before long.
A central bank can try to counter a bust with another sudden inflationary boom, but that is only a temporary patch that will lead to another, worse, bust — like drinking heavily to avoid the onset of a hangover. Keep doing it and the hangover is twice as bad. If the central bank keeps repeating the game, the result is hyperinflation — a death sentence for any economy.
Causing a temporary inflationary boom is just one goal of the Bank of Japan’s easy money program. Another is to make the yen artificially cheap to encourage more exports. This also is not a free lunch.
When Japanese manufacturers send more goods abroad, it looks good on their balance sheets. But a weak yen hurts Japanese businesses and workers, who get less money for products they worked just as hard to make. A weak yen also hurts Japanese consumers. Households pay higher prices for everyday purchases, and can afford fewer of them.
It benefits consumers abroad. A deliberately weak yen is a gift to shoppers in other countries, who can buy high-quality Japanese goods at artificially low prices. As an American, I like this subsidy. But in terms of reviving Japan’s economy, I question its wisdom.
An economy cannot function effectively without a stable, predictable, and honest price system. This must be the goal of any sound monetary policy. Countries that lack currency stability — basket cases such as Zimbabwe and Venezuela come to mind — remain poor until they stop printing money. America and Japan are in much better positions, but Kuroda and Fed Chairwoman Janet Yellen can still do harm to their countries’ economies.
Honest prices allow millions of decisions every day to be based soundly on price tags — whether to hire a new employee or install a new machine, whether to buy a new car now or later, whether to buy this brand or that at the grocery store, or simply where to have lunch. Prices distill complicated and diffuse information as nothing else can into a single, easy-to-understand number. Prices guide people’s actions in ways that make them as well-off as possible, even if they know nothing beyond the number on the tag.
Nobel-winning economist Friedrich Hayek used the example of a tin mine that suffers a collapse and ends production. A sudden scarcity of tin will cause the metal’s price to rise. Tin users, such as canned food producers, will be more careful about buying and using tin, and will seek out cheaper substitutes. They don’t have to have heard of the shuttered mine to do this; the higher price of tin tells them all they need to know.
There are plenty of ways to keep a country’s price system stable, predictable, and honest. The key for a country with a central bank is for that bank to behave predictably. It can follow the Taylor rule, named after Stanford University economist John B. Taylor.
The rule’s central equation incorporates inflation and growth. It calls for the Fed to adjust its overnight interest rate counter cyclically. Following the Taylor rule means the Fed will raise interest rates automatically in response to higher inflation, and thus slow price increases. If growth is so fast that there is a risk of economic overheating, interest rates will be raised automatically to cool things off. Weak growth automatically induces the Fed to lower interest rates, helping the economy heat it back up.
Taylor’s point isn’t so much about what the specific numbers should be in his equation, but that the Fed should follow the rule predictably, making long-term planning and investment possible.
The Fed did this for nearly two decades, covering most of Paul Volcker’s chairmanship and the first half of Alan Greenspan’s. The results were good. The Volcker-Greenspan period of monetary predictability accompanied one of the fastest increases in living standards in U.S. history.
Another way to be predictable is to link money supply to growth. Bentley University economist Scott Sumner says that instead of manipulating interest rates, the Fed should focus directly on the money supply, indexing money supply to nominal gross domestic product. If this rises 5 percent in a year, so does the money supply, moving in lockstep.
The result would be near-zero monetary inflation, with nearly all price changes being driven by non-monetary factors such as changes in supply and demand, or productivity increases. This would help keep prices honest. A central bank could also maintain a constant inflation rate — 2 percent, for example — by increasing the money supply 2 percentage points above nominal GDP growth.
There are other such rules that central bank can adopt. But the point isn’t so much which rule is adopted as the fact that one is adopted and consistently followed. This gives entrepreneurs and investors long-term predictability and keeps prices honest. If entrepreneurs and investors know central banks won’t freak out and change course during a crisis, it is much easier for them to make good long-term decisions — and raise living standards for everyone.
Predictability is arguably more important than any other specific central bank policy.
There is one other powerful force that helps bring a stable, predictable, and honest price system, and that is competition. Theoretically, a government could allow foreign currencies to be legal tender, too; you could buy goods in the United States with euros, pounds, or yen. Consumers and investors would choose to use the most stable and predictable currencies and shun volatile or dishonest ones.
There is no iron law that only governments can make currencies. Privately created digital currencies such as Bitcoin are already being used more widely. Some are more popular than others, and each has different built-in rules.
The total number of Bitcoins is set at a maximum of 21 million. This makes Bitcoin inflation-proof, which is one reason for its growing popularity. But the hard limit also makes it subject to long-term deflation as both population and per capita wealth increase over time. If Bitcoin doesn’t prove useful or popular over time, other digital currencies, with different rules, will displace it. One currency could have a Taylor rule built into its algorithm, another could incorporate nominal GDPtargeting, and so on. The possibilities are endless.
Whichever currency people trust the most, whether government or private, will eventually emerge on top if, and it’s a big if, governments don’t step in to quash competition. The perpetual threat of competition gives all currency managers an incentive to stay on their best behavior.
Currency competition is already having an impact around the world. Germany’s government has recognized Bitcoin as legitimate private, and thus taxable, money, while Ecuador’s has banned Bitcoin and is trying to create its own digital currency. (Ecuador’s ban is an implicit admission of weakness; the government clearly believes its currency won’t be as good as its competitors’ and people will not adopt it voluntarily.)
Neither Japan nor the United States gives Bitcoin or any other private currency full legal tender status. But both are closer to Germany than to Ecuador. Both are working to figure out ways of regulating and taxing private currencies, and both are tolerating buyers and sellers using Bitcoins instead of yen or dollars.
Honest price systems can prevail around the world if governments let them, massively benefiting poor people everywhere. Honesty is not just a virtue. It is the driving force behind the price system.
The United States is ending its easy money experiment just as Japan is ramping up its own. It looks like they are pursuing opposite policies, but in truth they are just staring at opposite sides of the same gradually debasing coin.
Both Yellen and Kuroda should move their focus away from stimulus, exchange rates and constant tinkering, and toward stability, honesty and predictability in their price systems. Easing of $1.66 trillion has had almost no effect on the U.S. economy. How reality will stack up against the Bank of Japan’s predictions, no one knows.
If both the Fed and Bank of Japan shifted their considerable energies to developing standard rules, and stuck to them in the face of political pressure, the result in the long run would be more investment, better investment decisions, and lower obstacles to the entrepreneurship and innovation needed to raise everyone’s standard of living.