Japan’s 4th quarter torpedoes Market Monetarism

Japan’s GDP fell 0.4 percent from the third to fourth quarters, which translates into an annual rate of -1.4 percent as it is commonly reported. The shrinkage dealt another blow to Abenomics, the term the press invented for the Prime Minister Shinzo Abe’s economic plan to boost the Japanese economy through massive money printing. Last month, and before the latest data, the central bank of Japan drove interest rates into negative territory in further hopes of jump starting the economy.

"The latest data show that it is difficult to say that the Abe government has achieved of its goal of a 'virtuous cycle' of rising incomes, wages, and investment," said Tobias Harris, political risk analyst at US-based consultancy Teneo. 

"It's getting clearer that Abenomics is a paper tiger," said Seiya Nakajima, chief economist at Office Niwa, a consultancy, referring to Prime Minister Shinzo Abe's policy mix of monetary easing, spending and reform. 

This second collapse of GDP in a year not only tarnishes the image of Abenomics. Growth for the full year of 2015 was a mere 0.4 percent, following a year of zero growth in 2014. Japan’s economy, as well as the continuing malaise in Europe and the US, should kill hope among economists that monetary policy alone can fix anything that is wrong with an economy, including those of the very popular market monetarism that preaches to central banks to target the nominal GDP instead of inflation, or “NGDP” targeting. It might improve slightly over inflation targeting, but the results will not be anything near the panacea its promoters predict.

Economists elevated monetary policy to the throne only after their previous monarch, fiscal policy, had suffered decapitation in the stagnation war of the 1970s. Fiscal policy, they reasoned, had failed and its death was justified because of three lags that made it impotent – recognition, creation and implementation. In other words, Congress takes a long time to recognize that a problem exists; it takes a long time to debate and formulate a plan; and it takes longer to implement the plan. As a result, fiscal policy tended to be pro-cyclical, which means it makes the business cycle buck more violently.

Mainstream economists thought that monetary policy was free from those constraints. It wasn’t. The Fed cannot predict sharp downturns in the GDP. That’s why economists call recessions “shocks”; the downturn is so sharp and unexpected it shocks them. So the Fed is in no better position than was the government to see recessions coming. Janet Yellen told Congress that she is watching inflation and employment to guide her decision making, but both are lagging indicators in all models of the business cycle because the respond to changing business conditions several months afterwards.

Monetarists deny that any lags exist in monetary policy; prices, they say, change instantly. They are correct that the prices of stocks and bonds react very quickly to changes in monetary policy, but other prices, those that indicate price inflation, do not. Some econometric studies of the effects of money printing on price inflation show that the lag between policy change and the appearance of price inflation can take five years. Milton Friedman warned fellow monetarists not to try to manipulate the money supply because of the dangers of those long and variable lags. But no one listened. The Fed simply cannot see five years into the future.

Market Monetarism suffers from these same flaws in spite of what the salesmen claim. The Fed has asked Santa for a robust econometric model for decades, one that can provide useful forecasts of GDP beyond the next quarter. But the economic elves have failed to construct one. That has persuaded Scott Sumner to propose a GDP futures market that would average the models of thousands of GDP forecasters.

But why would an average of bad forecasts prove more useful? Besides, the US already has a futures market for predicting GDP in the stock market. In spite of its occasional failures, the stock market has beaten the Fed and mainstream economists at predicting recessions for over a century. If they need a rule for the Fed to follow, target the stock market.

But the main problem with Market Monetarism is that it ignores microeconomics, as do all mainstream macroeconomists. A simple way of explaining the difference between Austrian and mainstream economics would be to say that Austrian economics takes micro seriously; mainstream pretends it doesn’t exist.

The chief principle that Market Monetarists ignore is that of diminishing marginal returns. The principle states that any effect, such as printing money, has its largest effect immediately. Then as the process continues the effects shrink rapidly until they disappear. That applies to money printing. Mises and Hayek expressed the principle as it applies to money by saying that to maintain a certain growth rate the central bank would have to increase the money supply exponentially. Some Japanese understand the principle well:

"The impact of monetary easing is similar to currency intervention. The first time they do it, there's a huge impact. But as they repeat it, the impact will wane," said Nakajima.

Market Monetarists instruct us that if the NGDP falls below target, the Fed needs to print money and keep printing it until NGDP rises to embrace the target. However, as we have seen in the US, Europe and Japan, the initial jolt of new money does a little bit of good, but not enough, so the central bank tries again. This time the effect is smaller, so it tries again and accomplishes even less. That happens because, as Mises, Hayek and the principle of diminishing marginal returns have shouted for decades, the growth in the money supply must be exponential in order for later rounds of money printing to have the same effect as earlier ones. Otherwise diminishing marginal returns take control.

Sumner has proposed something similar by suggesting that the Fed buy all of the debt that exists in the nation, including all credit card debt. That may or may not work. Again, it ignores what is happening in the micro economy. If people hoard the cash they get, use it to buy gold, or invest it overseas, it will not work to create the inflation that mainstream economists so desperately crave.

Market Monetarists assume that the desire for more cash on the part of businesses and consumers is an irrational act that hits people on rare occasions, like a flu epidemic, and that lust for cash plunges the economy into recession. But they’re wrong. The desire for cash is a symptom of the recession, not the cause. The recession caused people to lose their jobs and strike fear in the hearts of those who haven’t. They want more cash to pay down debt and provide for greater uncertainty about their future. The initial phase of money printing after the Fed has recognized a recession can help supply that demand, but any further printing does more harm than good.

Market Monetarists assume that money printing has no bad effects other than rising inflation in the long run. But as Austrians have shown, and most people can see today, it has devastating effects. The low interest rates for the past six years have nearly destroyed pension funds, insurance companies and the incomes of retired people. Continuous money printing launches unsustainable expansions that end in recessions. The real sector of goods and services, the micro economy, ends recessions because poor investment decisions, caused by the central bank’s money printing and distortion of prices, destroy businesses. Once the recession has begun, the Fed might as well try to stop an earthquake by papering over the cracks in the earth with dollar bills.

Investors should expect a surge in the stock market as investors fooled by monetarism anticipate that the Fed will rescue them. But like the troop surge in Iraq, it won’t last long. At some point the market will be forced to join the real economy. And even if the Fed introduces negative interest rates, people will merely buy gold and silver.