America and Japan have dramatically enlarged their monetary bases; they’ve cut interest rates to almost zero. If even that wasn’t enough, just imagine how much monetary stimulus it would take to get a meaningful recovery!
I hear this all the time, and I have to respond to this over and over again in the comment sections. And also to the question of what the Fed should buy, and will those purchases cause major distortions in the economy?
Unfortunately, the worriers have it exactly backwards. They aren’t looking at robust monetary stimulus that failed; they are seeing what ultra-conservative monetary policy looks like, policy which drives NGDP growth to very low levels. The fruits of ultra-tight money just happen to look like what most people (wrongly) think ultra-easy money looks like: near zero rates and a huge monetary base (as a share of GDP.)
The Reserve Bank of Australia is one of the few central banks to keep NGDP growing at a robust rate. It might be interesting to compare their monetary indicators to those of the US and Japan. Let’s consider three indicators of the stance of monetary policy:
1. The monetary base (favored by some conservatives)
2. The interest rate (favored by some Keynesians)
3. NGDP growth (Bernanke’s favorite)
Here is the data for the past 5 years, for three major economies:
Country NGDP growth 5 year Gov bond yield Base/GDP in 2011
Australia 41.3% 3.69% 4.0%
America 12.8% 0.90% 17.9%
Japan -8.3% 0.31% 23.8%
Australia is the only country with an even somewhat normal level of interest rates and monetary base. Does that mean they have tight money? No, just the opposite. Most people are looking through the wrong end of the telescope. They think in terms of the effect of base growth and interest rates on GDP. Obviously there’s a glimmer of truth in that direction of causality, but the reverse causality is far more important.
The table above should be read left to right. Because Australia has much higher NGDP growth than America, they have higher interest rates. And because they have higher interest rates, they have a lower Base/GDP ratio. Ditto for the relationship between America and Japan. So when people ask me how much more base money we’d need to get adequate NGDP growth, I hardly know what to say. The question of interest is: How much less base money would Americans want to hold if our central bank had the same sort of implicit NGDP target as the RBA?
Before the recession our base to GDP ratio was around 6%. It’s normally higher than Australia because the US dollar is especially popular as a store of value in highly unstable economies. Domestic tax evasion also plays a role in international differences in cash/GDP. If we got fast enough NGDP growth to move us above the zero bound, and if the Fed kept the IOR at 1/4%, then the base/GDP ratio would more than fall in half. So the correct answer to the question of how much more money it takes is something like negative 60%!
And all those commenters (usually conservatives) worried about the Fed accumulating all sorts of unconventional assets? You should be praying for a much faster NGDP growth or inflation target. In Australia the NGDP growth rate has averaged about 7% from mid-2006 to mid-2011. That’s how you keep your central bank small and unobtrusive.
But NGDP growth doesn’t even need to be that high if you are doing level targeting, 4% to 5% would be plenty. Australia had a total of 41.0% NGDP growth from mid-2001 to mid-2006, almost identical to the following 5 years. Commenter Declan likes to point out that the Australian data isn’t as good as I make it seem, there’s lots of year-to-year instability. He’s right. There was a sharp slowdown in early 2009 that came close to a recession. But it wasn’t a recession, and I think one reason is the level targeting aspect. The RBA seems reasonably good at steering the economy back toward the trend line when deviations occur. This may be partly due to their higher trend NGDP growth rate, which means they never need fear a zero bound situation, and hence can always rely on conventional monetary policy.
Right now the Fed faces a dilemma, raise the NGDP trend line or switch to non-interest rate targeting. But they don’t seem to understand that they face this choice. As far as I can tell they plan to plow ahead with low levels of trend NGDP growth and interest rates as a policy instrument. That’s a recipe for disaster. One wonders how many times we’ll have to go though this zero bound nonsense before the Fed wakes up. What’s it going to be? Australian levels of trend NGDP? Or market monetarism?
PS. I wrote this post yesterday, before I had read Brad DeLong’s recent post. This post might be viewed as a rebuttal to DeLong. What DeLong sees as ultra-easy monetary policy is actually ultra-tight monetary policy.