Thus far, Powell’s plan for containing inflation, pivoting from quantitative easing to quantitative tightening, pushing up interest rates, and generally breaking various bits of the US economy, has been an abysmal failure.
While few will argue that reining in inflation is good monetary policy, that does not make every plan instituted in furtherance of reining in inflation a good plan. At the present time, constantly raising the Federal Funds rate shows no indication of being a productive plan, in that it is having only minimal impact on inflation if even that.
Yet, had Powell merely looked around the world at other countries grappling with problematic economies, he would have seen more than enough object lessons on the foolishness of government trying to rescue an economy from itself.
Japan, in particular, with its ten-year experiment known as “Abenomics”, is a study of the ultimate impotency of government action in restoring economic vitality. Even extreme economic measures, when executed by the all-too-visible hand of government, are prone to failure.
While Powell apparently lacks the curiosity to study the efforts of other nations, choosing to remain stuck on a strategy that has failed him at every turn, we do well to look closely at Shinzo Abe’s radical plan to revive the Japanese economy—and to understand how it ultimately failed to restore vitality to a moribund economy mired for decades in deflation.
In these days when all eyes look to China as the rising economic Asian power, it is perhaps easy to forget that in the 1980s it was Japan that was the world’s second largest economy, and Japan that many presumed would at some point dethrone the United States as the world’s largest. That upward trajectory ended abruptly in the early 1990s, as Japan’s economy went from boom to bust, and entered a deflationary spiral known as “the Lost Decade”1.
Japan’s economy rose meteorically in the decades following World War II, peaking in the 1980s with the largest per capita gross national product (GNP) in the world. Japan's export-led growth during this period attracted capital and helped drive a trade surplus with the U.S.
To help offset global trade imbalances, Japan joined other major world economies in the Plaza Agreement in 1985. In accord with this agreement, Japan embarked on a period of loose monetary policy in the late 1980s. This loose monetary policy led to increased speculation and a soaring stock market and real estate valuations.
In the early 1990s, as it became apparent that the bubble was about to burst, the Japanese Financial Ministry raised interest rates, and ultimately the stock market crashed and a debt crisis began, halting economic growth and leading to what is now known as the Lost Decade. During the 1990s, Japan's gross domestic product (GDP) averaged 1.3%, significantly lower as compared to other G-7 countries. Household savings increased. But that increase did not translate into demand, resulting in deflation for the economy.
At first glance, this seems somewhat counterintuitive, given the near religious conviction among most western economists (and US-based economists in particular) that loose monetary policy and money supply growth leads to inflation, not deflation. Certainly, this has been a long-standing criticism of Jay Powell’s various views on consumer price inflation in the US.
Federal Reserve Chairman Jerome Powell still believes that inflation and the money supply are unconnected. He first made this remarkable assertion in his Semiannual Monetary Policy Report to Congress last February, saying that “the growth of M2 . . . doesn’t really have important implications for the economic outlook.” Since then, the U.S. annual inflation rate has climbed to 7.5% from 1.7%, but Mr. Powell hasn’t changed his mind. He doubled down during congressional testimony in December, arguing that the connection between money and inflation ended about 40 years ago. The nearby chart shows otherwise.
However, a closer inspection of what actually happened provides the first important lesson to be learned from Japan. When assessed by economist and Nobel laureate Milton Friedman, he put the cause of Japan’s deflationary crisis as clamping down on the money supply too quickly2.
Then, at the Louvre conference in February 1987, the assembled leaders agreed to stabilize the foreign exchange value of the dollar. Japan, as its part of the deal, bought dollars, in the process creating yen. The resulting acceleration in monetary growth led to higher inflation and, initially, to higher real growth. The most notable result was the "bubble economy," an explosion in the prices of land, stocks, and other assets; the Nikkei stock index more than doubled in three years.
The Bank of Japan reacted belatedly in 1990, reducing monetary growth from 13 percent to less than 3 percent in the first year of the new policy and to negative rates in the second--too much of a good thing. Tight money was spectacularly effective; the stock market, and also nominal income growth, plunged. Low inflation turned into actual deflation by 1994. Monetary growth has recovered since but remains at the lowest level of the postwar period.
This is the relationship between money supply and prices Friedman asserts is controlling. The supply of money in an economy defines the price level in that economy.
However, this is not the relationship Jay Powell and the economists at the Federal Reserve infer. Rather, their monetary policies presume a relationship between money supply growth and inflation, which is not the case and which Friedman does not assert to be the case. Indeed, owing to the concurrent influence of money velocity, it is not possible to establish a clear correlation between money supply growth and inflation. Velocity becomes a confounding factor that invariably disrupts all such calculations.
When the BoJ responded to Japan’s bubble economic conditions by clamping down on money supply growth, inflation turned to deflation—substantially for the inverse of why too large a money supply drives inflation3—instead of consumers looking to unload excess money stocks, they opted to hold onto money stocks. As the BoJ tightened monetary policy, Japanese consumers saved rather than spent, thus causing prices to fall…and fall…and fall.
Could this happen here in the US? Absolutely. Given that Powell’s program largely revolves around manipulating interest rates to discourage consumer spending, if he succeeds “too much”, today’s high consumer price inflation could easily become tomorrow’s consumer price deflation. If consumers become overly focused on savings rather than spending, a deflationary spiral could very easily emerge.
Friedman’s take on Japan’s situation was largely echoed by economist and fellow Nobel laureate Paul Krugman, who concluded that Japan became enmeshed in a liquidity trap4.
Increasing the money supply can now increase output, up to a point - specifically, up to point 2. But what if productive capacity is at a point like 3? Then the same argument as in the previous section applies: since the nominal interest rate cannot go negative, any increase in money beyond the level that drives the rate to zero will simply be substituted for bonds, with no effect on spending. And therefore no open-market operation, no matter how large, can get the economy to full employment. In short, the economy is in a classic liquidity trap.
Under what conditions will a liquidity trap occur? One possibility is that P is high compared with P* - that people expect deflation, so that even a zero nominal rate is a high real rate. The other possibility, however, is that even if prices are expected to be stable, yf is high compared with the future - or to put it differently, peoples' expected future real income is low compared with the amount of consumption needed to use today's capacity. In that case, to persuade people to spend enough now may require a negative real interest rate, and with downwardly inflexible prices that may not be possible.
Or to put it yet another way, one that is closer to the language of applied macroeconomics: if people have low expectations about their future incomes, then even with a zero interest rate they may want to save more than the economy can absorb. (In this case, of course, the economy cannot absorb any savings - but I will come to that point below). And in that case, no matter what the central bank does with the current money supply, it cannot reflate the economy sufficiently to restore full employment.
Simply put, Krugman’s thesis is that, when the BoJ tightened monetary policy in the 1990s, it was so successful at tamping consumer expectations that it overshot the mark, so that subsequent episodes of looser monetary policy were ineffective.
What we can definitely see is what happened in Japan’s economy, and in particular to consumer price inflation.
While the headline PCE Price Index value has risen and fallen—and is now rising again—the core metric has remained in the same range around 5% ±0.5% since November of 2021. Since a full five months before the Federal Reserve began pushing the federal funds rate up, core consumer price inflation has not appreciably changed.
We see the same pattern in core consumer price inflation per the CPI metric as well. Core inflation per the CPI has remained at 6%±0.5% since well before the Federal Reserve began hiking the federal funds rate.
In order for the Federal Reserve to claim it has had any effect on consumer price inflation, there has to be…well…some demonstrable effect to be claimed. There is none.
In December 2012, the Liberal Democratic Party won a general election, making Shinzo Abe prime minister of Japan, a post that he had held in 2007. “Abenomics” refers to the economic policies advocated by the prime minister after the election, which were designed to revive the sluggish economy with “three arrows”: (i) fiscal consolidation, (ii) more aggressive monetary easing by the Bank of Japan, and (iii) structural reforms to boost Japan’s competitiveness and economic growth. By the end of February 2013 these measures had resulted in a 22% rise in the Tokyo Stock Price Index (Topix) since the election win. The Bank of Japan settled on an inflation target of 2%.
Abe’s program consisted of three “arrows.” The first was printing additional currency – between 60 trillion yen to 70 trillion yen – to make Japanese exports more attractive and generate modest inflation—roughly 2%.
Unlike earlier policy easings, however, Abe combined the money printing with a more aggressive fiscal policy (the “second arrow”), and a series of economic reforms to revitalize the private sector, (the “third arrow”).
The second arrow was new government spending programs to stimulate demand and consumption—to stimulate short-term growth, and to achieve a budget surplus over the long term.
The third component of Abenomics was more complex—a reform of various regulations to make Japanese industries more competitive and to encourage investment in and from the private sector.
While Abenomics did push consumer price inflation briefly up above 3%, it did not remain there, soon falling back well below Abe’s 2% inflation target, where it would remain until last year.
Some economists have argued that Abenomics was, in fact, broadly successful. At a minimum, the plan has been credited with ending deflation in the Japanese economy.
In normal circumstances, real GDP growth trends below nominal growth—the difference is the impact of consumer price inflation. However, in Japan, deflation inverted the two charts, with real GDP growth trending above nominal growth.
What Abenomics did not do was restore robust economic growth to Japan. Again comparing the Japanese economy to the US, from 1994 through this year, we see that economic growth even on nominal terms has been nearly nonexistent. increasing by just under 12% over the past 29 years.
The US economy, by comparison, has more than tripled over that same period.
The overarching teachable moment arising from Abenomics is to illustrate the severe limitations of monetary policy as a means of stimulating economic growth.
Abenomics ultimately proved Krugman’s thesis about a “liquidity trap”, where monetary policy beyond a certain point becomes ineffective. Even though Abenomics is credited with ending deflation in Japan, it was not until after the COVID lockdowns that inflation approached 2% in Japan.
Japan’s experience with deflation was a strong proof of Friedman’s views on inflation and the economy even before Abenomics.
Yet despite validating these monetarist theories and models, what Abenomics has never managed to do has been to reverse the stagnation that has set in within Japan’s economy. Abenomics arguably ended deflation within the Japanese economy, but only just barely. It would take the external shock of the COVID pandemic and the resultant government lockdowns worldwide before Japan experienced sustained inflation at or above the 2% mark.
Abenomics thus highlights the reality that government policy is a poor substitute for healthy, free, and unfettered markets. Government policies can tank an economy, as the BoJ’s careless whiplash from loose to tight monetary policy did in the 1990s, but government policy cannot resurrect an economy once it has tanked.
Jerome Powell and his colleagues at the Federal Reserve would do well to remember this as they attempt to corral consumer price inflation in the US without tanking the US economy. Doing too much is a far more dangerous outcome than doing too little.
Yoshino , N., and F. Taghizadeh-Hesary. “Three Arrows of ‘Abenomics’ and the Structural Reform of Japan: Inflation Targeting Policy of the Central Bank, Fiscal Consolidation, and Growth Strategy”, ADBI Working Paper Series. Aug. 2014, https://www.adb.org/sites/default/files/publication/156347/adbi-wp492.pdf.
First, you’ve succinctly answered my questions about Japan’s deflationary era - thank you!
Second, this is a truly brilliant analysis! I’ll bet not one person in ten million could piece together and comprehend the intricate, convoluted interactions of all these factors - money velocity, liquidity traps etc. - as you have. This should be published in an important economic journal.
Third, you’ve shown how our economic near-future depends, in large part, on hard-to-quantify cultural aspects. Will the American culture of 2023 respond in the same way to savings and spending decisions as the culture of Japan in the 1990s? Not likely, but because it’s hard to quantify, the Fed and government agencies are more likely to guess wrong and compound their mistakes. The Fed seems to already be walking a real tightrope; now it seems alarmingly certain that they will fall. I think we are in trouble.
Wow. Three comments, Mr. Kust:
First, you’ve succinctly answered my questions about Japan’s deflationary era - thank you!
Second, this is a truly brilliant analysis! I’ll bet not one person in ten million could piece together and comprehend the intricate, convoluted interactions of all these factors - money velocity, liquidity traps etc. - as you have. This should be published in an important economic journal.
Third, you’ve shown how our economic near-future depends, in large part, on hard-to-quantify cultural aspects. Will the American culture of 2023 respond in the same way to savings and spending decisions as the culture of Japan in the 1990s? Not likely, but because it’s hard to quantify, the Fed and government agencies are more likely to guess wrong and compound their mistakes. The Fed seems to already be walking a real tightrope; now it seems alarmingly certain that they will fall. I think we are in trouble.