Japan, Europe and mainstream monetary theory are out of gas

When a sailor hits a dead spot where the wind refuses to blow he cays he is “in irons.” Japan’s economy sailed into the irons this past quarter when its GDP declined for the second quarter in a row and officially signaled a recession. GDP fell 0.8% in the third quarter after shrinking 0.7% in the second on an annualized basis. This marks the fourth recession Japan has endured since the global crisis hit in 2008.

Following so soon on the heels of massive stimulus, the recession should strike a death blow to mainstream monetary theory. Abenomics, the economic recovery plan that Prime Minister Shinzo Abe launched in 2012, was the poster child for mainstream monetary theory. Japan would wash away deflation and decline with a torrent of new money.

Europe isn’t technically in a recession, but inflation has fallen and growth is so low that the difference between growth and recession may be difficult for the average European to grasp. The inflation rate in the Big EZ is currently 0.1%. Frightened by deflation, the European Central Bank’s head Mario Draghi promised to open the monetary spigot even further.

The top mainstream economists, all Nobel-Prize winners, declared the end of the business cycle in the late 1990s after nearly a decade of the “Great Moderation.” They announced that the US would never face major downturns in the economy again because they had figured out how to use monetary policy effectively. They took credit for creating the “Great Moderation” and announced that monetary policy would quickly smother the fires of any minor downturns in the economy.

The mild recession of 2001 did little to dent the confidence of mainstream economists, but the Great Recession should have. Now Japan has suffered another recession after the most complete implementation of their policies outside of the US and Europe.

Of course, they have argued that the sales tax increases in Japan derailed the monetary policy. But a reasonable person can be forgiven for thinking that monetary policy must be awfully timid if a small sales tax increase can frighten it away.

The real problem with modern monetary theory is that its inventors have defined it in such a way that it’s impossible to test it. They use Milton Friedman’s analogy of a car. Friedman said that monetary policy is like a driver using the gas pedal to cause the car to speed up. On a flat road in the desert, pushing on the gas pedal will cause the car (the economy) to accelerate and releasing it will cause the car to slow down.

But in the mountains, pushing on the gas pedal may not cause the car to speed up if it’s driving up a steep grade. The car may continue to slow down as the driver pushes harder on the gas pedal but he isn’t pushing hard enough to provide enough gas to the engine to make the car go faster. The lesson is that the only way to tell if the Fed is providing enough gas to the economy in the form of new money is if the nominal GDP is speeding up. No matter what the Fed has done in the past, if nominal GDP is not accelerating then the Fed has a tight monetary policy.

The analogy is great if one assumes that monetary policy is omnipotent. But what if it’s not? What if monetary policy doesn’t work the way mainstream economists claim? What if it causes more harm than good as Austrian economists assert? How can we who have not drunk the Kool-Aid of mainstream monetary theory test it?

Clearly, we can’t if we accept their analogy. It assumes its conclusion, which is called circular reasoning in logic. It also assumes that all economic growth comes exclusively from creating new money.

Another way to look at the economy is to compare pre-Fed business cycles with post-Fed cycles. Pre-Fed we see that the economy suffered recessions about as often as the post-Fed period but recovered must faster and more robustly than post-Fed recessions. The pre-Fed economy never suffered a Great Depression and no slow recoveries like the current one. They were almost all V-shaped.

The pre-Fed economy never enjoyed massive monetary printing or government spending as the post-Fed economy has, and yet it always recovered from recessions with enthusiasm. That teaches an important lesson: a free economy has a natural impetus to recovery that is very strong. It comes from mankind’s natural tendency to truck, barter and trade, to paraphrase Adam Smith.

One recovery in the post-Fed era proves the point. If we combine the 1981 and 1982 recessions, separated only by six months, into one recession, then that one was almost as deep as the Great Recession of 2008, the worst since the Great Depression. The 1981-82 recession went so deep because the Fed had raised interest rates very high in order to squash inflation. But the Fed never lowered rates to boost the economy. Neither did the federal government spend massive amounts. Business people (the micro economy) were on their own, as they had been pre-Fed, and they lifted the US out of a deep recession into strong growth that lasted for almost a decade.

History should cause mainstream economists to rethink their monetary theories. Doing more of the same will not produce better outcomes. They’re out of gas and their economies are “in irons.”