I had some graphics problems with my previous post on this subject — it turns out that what looks like a permanent link at the BOJ website isn’t; plus I had some more to say about the subject.

So: David Wessel quoted what Milton Friedman said about Japan in 1998, and interpreted it as meaning that Friedman would favor quantitative easing now. I think that’s right. And just to be clear, I also favor QE — largely because it might help some, and seems to be just about the only policy lever still available in the face of political reality.

But I think it’s also important to note that Friedman was all wrong about Japan — and that you can argue that he was also wrong about the Great Depression, for the same reason.

For what Friedman argued, both for Japan in the 1990s and America in the 1930s, was that all the central bank needed to do was more — push out those reserves into the banking system. This would raise the money supply, and a higher money supply would have the usual effects.

But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation. Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:

Bank of Japan

So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply! This is why I’m so skeptical of people who say that all the Fed has to do is target higher nominal GDP growth — in liquidity trap conditions, the Fed doesn’t even control money, so how can you blithely assume that it controls GDP?

And this also calls very much into question Friedman’s famous claim that the Fed could easily have prevented the Depression, which gradually got transmuted into the claim that the Fed caused the Depression. Yes, M2 fell — but why should we believe that the Fed had any more control over M2 in the 30s than the BOJ had over M2 more recently?

Again, that doesn’t mean that I oppose having the Fed engage in unconventional asset purchases. I’m just trying to be realistic about the likely results. We really, really need expansionary fiscal policy along with Fed policy; and we’re not going to get it.

David Wessel has an article asking what Milton Friedman would say about quantitative easing, and concludes that he would have been in favor. But I was struck by Friedman’s 1998 remarks about Japan, in which he basically said that increasing the monetary base would do the trick:

“The Bank of Japan can buy government bonds on the open market…” he wrote in 1998. “Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately.”

Well, they did that: staring in 2000, the BOJ nearly doubled monetary base over a period of 3 years.

And the money just sat there. Banks did not, in fact, expand loans.

In fact, Japan’s experience is a key element of the case against monetarism. Just printing notes does not work when you’re in a liquidity trap.

When I read the Mitch McConnell quote that’s been getting so much attention:

The single most important thing we want to achieve is for President Obama to be a one-term president.

my immediate concern was whether it was taken out of context. And if you read the full National Journal interview (subscription required), the nuances are a bit different from those you might take from the quote in isolation.

But not in a good way.

If you read the whole thing, what you get is that McConnell is taking a very different lesson from the events of 1995 than the one most pundits take, and expect Republicans to take. The whole attempt to bully Clinton into slashing Medicare by shutting down the federal government was a political failure for the GOP; but McConnell doesn’t see this as evidence that Republicans were too confrontational.

No, he sees it as evidence that they weren’t confrontational enough; they were too focused on their policy agenda, and neglected the necessary work of destroying Clinton:

We suffered from some degree of hubris and acted as if the president was irrelevant and we would roll over him. By the summer of 1995, he was already on the way to being reelected, and we were hanging on for our lives.

So this time around they won’t bother much with trying to get actual legislation passed; they’ll focus on the important thing: undermining the man in the White House.

On a lighter note, I’ve been traveling a lot lately, and I found myself wondering why so many countries — or to be more specific, so many countries’ airports — have failed to adopt an important productive device widely used in America.

It’s called a table.

You see, when you’re passing through security, you have to put your coat, your liquids, and your computer into trays to pass through the scanner. And in every non-US airport I’ve been through lately, here’s how it worked: you came up to the conveyor belt, and there were trays right there to disgorge your stuff. Of course, this meant that the time taken to clear each person through security includes the time that person spends spent emptying his or her carry-ons of the aforementioned materials, with everyone else waiting idly in line behind while this takes place.

What we have in high-tech America — or at least at Newark — is the following device: a table just in front of the conveyor belt, so that several people at a time can fill their trays, slide them over when the time comes, and pass quickly through the detector.

I know this may be beyond the technological capacity of some countries ….

In my first WEITW post, I went after the claim that quantitative easing, by weakening the dollar, could actually hurt recovery — because, you see, a weaker dollar leads to higher commodity prices. As I tried to explain, a weaker dollar is also a stronger euro (and other currencies), so what raises prices in terms of one currency lowers them in terms of others, and the whole thing makes no sense.

What I didn’t do at the time was take on a related argument — which wasn’t made in that article, but I knew was out there — which said that expansionary monetary policy in general leads to higher commodity prices, and therefore hurts recovery. Sure enough, we’ve got a senior official at the International Energy Agency saying

QE2 could inflate prices in nominal terms and bring about inflation and could derail the recovery

So, how hard is this? Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.

What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales.

Amazing stuff, and further evidence of the Dark Age of economics now descending.

In his article today, Wolf offers just about the same economic analysis I’ve been presenting: the Obama economic plan was a move in the right direction, but too small to generate a visible improvement given the scale of the economic crisis. Wolf also offers what is, in effect, an answer to those who say that Obama got all he could — namely, that even if that’s true, which is arguable, he made a fatal error by pretending that what he got was enough:

The president’s willingness to ask for too little was, it turns out, a huge strategic error. It allows his opponents to argue that the Democrats had what they wanted, which then failed. If the president had failed to get what he demanded, he could argue that the outcome was not his fault.

I guess we can argue about whether that would have worked — I know that I’m constantly accused of having claimed that the Obama stimulus would work, despite having written many, many articles and blog posts pointing out that it was inadequate. Still, the long effort to claim that the ARRA was just right hasn’t worked at all.

Wolf concludes bleakly:

With a political stalemate expected, further action will now be blocked. A lost decade seems quite likely. That would be a calamity for the US – and the world.

Yep.

One confusion I often run into is the belief that there’s some contradiction between times when I and others argue that markets are wrong — as I did when diagnosing a housing bubble, and now in questioning the market’s optimistic beliefs about inflation — and my point that low interest rates undermine the argument for immediate fiscal austerity.

What people don’t get is that in all cases I’m starting from the fundamentals. It’s the austerity types who are appealing to market psychology to reject those fundamentals — and the point then is that this market psychology is all in their imagination.

The key argument against fiscal austerity now is that it’s bad economics: it would depress the economy, while doing very little to improve the long run budget position (and might even make that long-run position worse.) I’ve done the math repeatedly on this blog.

But the austerians argue that the numbers don’t matter — we have to cut now now now or the bond vigilantes will attack.

And then the question is, where are those vigilantes? I guess they’re suckering us in by lending to the US government at negative real interest rates.

So the point isn’t that market are always right; it’s that if you’re going to claim that appeasing the markets trumps rational economic analysis, you really should have some evidence that the markets care at all about what you’re demanding.

I haven’t written at all about HAMP — the administration’s disastrously failed home mortgage modification program, which was supposed to be the modern version of FDR’s Home Owners Loan Corporation. My excuse, such as it is, is that I don’t presume to know the legal ins and outs well enough to devise an alternative.

But still: this is a case where the administration had (and still has) the money, $50 billion from TARP. That should be enough to dangle some pretty big carrots in front of lenders. And it could have had sticks, too: it could have advocated cramdown, it could have taken advantage of the popular anger to put pressure on the banks at any time — and especially as the foreclosure scandal has broken.

And HAMP’s failure isn’t news: it has been obvious for more than a year that the thing wasn’t working. I mean, the money wasn’t even being spent, which is a scandal in itself at a time when the economy so desperately needed help. And tales of the Kafkaesque process have been spreading for many months; read David Dayen’s series at Firedoglake.

But there has been nothing; no significant changes, no major rethinks, just excuses.

I really don’t understand the passivity here.

The 5-year TIPS spread

Financial markets seem convinced that quantitative easing will be highly effective at solving at least one problem: inflation running well below the Fed’s 2-percent-or-so target. The chart above shows the difference between interest rates on 5-year inflation-protected bonds (which are now negative) and rates on unprotected bonds; implicitly, the market forecast of inflation over the next five years has risen half a point.

But I really don’t understand this. Granted that QE2 will probably have some positive effect, hopefully bigger than analysis based on the debt-maturity equivalence suggests. Still, the prospect remains that we’ll face multiple years of high unemployment — or, if you prefer, a protracted large output gap (PLOG). And history is clear on what that means: declining inflation:

My guess, then, is that the markets are overreacting; they’re thinking, “The Fed is printing money!”, while forgetting that this ultimately matters, even for inflation, only to the extent that it seriously reduces unemployment.

A new memo from Goldman Sachs (no link) looks at quantitative easing by treating it as equivalent to a shortening of the maturity of federal debt; among other things, the memo answers the question of where I got it from: work by Jim Hamilton and Cynthia Wu.

So, what GS estimates is that a trillion dollars of QE amounts to a one-year reduction in the average maturity of federal debt. How many people think that would be enough to have a transformative effect on the economy?

I’m finding the foreclosure issue difficult to write about; it’s clear that there has been massive malfeasance on the part of the banks (again), but it’s less easy to say what should be done. One thing is clear, however: the main argument being made for turning a blind eye to the situation, and avoiding anything like a temporary freeze on foreclosures, is wrong.

I’m referring to the argument that we need to let foreclosures proceed, never mind the doubts, because it’s important to get those properties seized and sold, so that we clean up the mess. That’s the argument you’ve been hearing from administration officials — and it sounds reasonable if you don’t look at what actually happens to foreclosed homes.

For the fact is that a startling number of those homes aren’t being sold: there’s a huge “shadow inventory” of homes that have been seized, but not yet put on the market.

If servicers really wanted to get homes sold and the issue resolved, they’d be doing short sales: letting the current owners sell the homes for whatever they can get, hand the proceeds over, and call it quits. And there are a lot of short sales out there — but there are also many cases in which short sales are being refused, and foreclosures take place instead.

The official reason for aversion to short sales is the potential for fraud: the homeowner sells the house cheap to his cousin, or whatever. But how hard is it to police that fraud, at least sufficiently to avoid gross abuses? Remember, a house sold somewhat too cheaply is still a better deal for the lender than a house not sold at all.

An alternative explanation for the preference for foreclosure and the willingness to sit on foreclosed homes for long periods of time is that it’s a game of extend and pretend: a short sale means that lenders have to acknowledge their losses, while an empty foreclosed home can be kept on the books at an unrealistic value.

If this is the right way to look at the situation, then the paperwork crisis presents an opportunity to help fix a major market failure — an opportunity to prod lenders into either short sales or workouts with homeowners, and to stop the socially harmful buildup of shadow inventory.

And it’s an opportunity that is, as usual, going to waste.

Wow. I guess I lead an intellectually sheltered life. Until I followed a link from Yves Smith, I had been blissfully unaware that the investment airwaves were full of people yelling that Bernanke is debasing the dollar because the dollar has fallen modestly in recent weeks.

Is it really possible that the CNBC-watching crowd doesn’t understand that right now a weak dollar is good for America? Have the usual suspects turned their backs not only on the insights of Keynes, but on basic monetary economics as well? Is goldbuggism triumphant?

Guess so. Just for reminders: in the 1930s, the French were the diehard defenders of the gold standard. Here’s what they got:

Industrial production, 1929=100

One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. (Sam and Janet who? If you’d grown up in my place and time, you’d know the answer: Sam and Janet evening / You will see a stranger … But actually, I’m thinking of the two kinds of agent in the Kiyotaki-Moore model.)

Read more…

A brief further note on the equivalence of quantitative easing and shifts in the maturity composition of federal debt, raised here.

Some people have quarreled with my statement of this equivalence. It’s true, they say, that monetary base and Treasury bills both yield near-zero interest rates. But monetary base is money — it provides liquidity in a way that T-bills, no matter how negotiable, don’t. To which the answer is yes, but no — and right now it’s no.

The point is that we’re now in a liquidity trap. What does that mean? It means that the Fed has pushed short rates down to zero, so that at the margin T-bills are no better than cash — and correspondingly, that means that at at the margin people and banks are holding some of their cash purely as a store of value. Liquidity is now free, and as a result the market’s demand for liquidity is satiated; adding more potentially liquid assets makes no difference. So issuing short-term debt and printing monetary base are equivalent.

But, you say, it won’t always be thus: at some point the economy will recover to the point where the zero lower bound is no longer binding; and at that point monetary base and short-term debt will no longer be the same thing. Indeed. But at that point the Fed will be seeking to reduce the monetary base — by definition: it’s only once the Fed is trying to curb the size of the base that the zero lower bound ceases to be binding.

And how will the Fed reduce the monetary base? Through open market operations — that is, by selling T-bills.

And what that means is that as soon as monetary base and short-term debt start to become non-equivalent, the Fed will start swapping base for short-term debt. In the end, then, by increasing the monetary base the Fed was in effect selling short-term debt.

So QE really is just like a shift in the maturity of federal debt.

I’m tempted to end with a Greenspanism: if you think you understood all that, you weren’t reading carefully.

I’ve been getting a lot of correspondence lately that runs something like this:

You’re an idiot. Give me one example in all of history of a country that spent its way out of a depressed economy

Ahem. There’s this country — people may not have heard of it — called the United States of America:

The blue line is total debt, public plus private, in billions of dollars; the red line debt as a percentage of GDP (both on left scale).

But that was different, you say — it was a war! To which I reply, you think it’s better if we spend all that money on useless things?

Sigh.