Alford: My Nominee for Worst Macro Paper, Ever (Courtesy the Fed’s Ministry of Truth)

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

It is award season and I would like to nominate the 13-author “Preventing Deflation: Lessons from Japan’s Experience of the 1990s” for an award, (International Financial Discussion Paper number 729, June 2002, Research Department Board of Governors of the Federal Reserve System.) It is probably the most alternative reality-driven and misguided piece of macroeconomic research ever published-certainly ever published by the Fed. While purporting to draw useful lessons from the Japanese experience, the paper missed the lessons to be learned and reinforced policy decisions and a mindset which contributed to the financial crisis of 2007 and the subsequent recession.

The authors provided the following background for Japan’s crisis and the lost decade(s):

Japan’s protracted slump can best be understood as the outcome of developments that date from the “bubble economy” of the late 1980s…. between 1986 and 1989, both equity prices and land prices rose precipitously. This, along with relatively low interest rates substantially eased the financing of investment. As a result the ratio of bank loans to GDP soared …

By early 1989, however, as equity and real estate prices continue to soar and inflation moved upward, the BOJ began raising interest rates in a bid to moderate the degree of overheating. In response to monetary tightening and its own unsustainably high level, the stock market collapsed at the beginning of 1990. …The BOJ continue to raise the official discount rate until August 1990. It started lowering rates ashore. Thereafter as GDP growth fell off more sharply, Inflation starts to move down, and land prices began to decline as well.

In many respects, the peaking of the bubble economy and the subsequent slowdown followed a standard pattern for postwar business cycles in industrial economies. Yet, it is apparent, with the benefit of hindsight, the unusually strong forces were at work to hold down growth. First, the high ratio of capital to output accumulate by 1990 which was predicated on expectations of continued high output rose in the future was revealed to be excessive once the economy slowed. In consequence, profits fell and business investment exhibited protracted declines over the 1990s.

Second, the collapse of equity and, eventually, housing prices lead to severe balance sheet problems for households and firms, particularly the latter. Weak stock markets discourage issuance of as a means of financing investment, while declining stock and land prices undercut the value of collateral used to secure new loans. Moreover, with a net worth of many firms, particularly in construction and real estate, substantially reduced by the collapse of the asset price bubble, the demand for investment funds fell off sharply.

As a third and related factor, the balance sheet problems of corporate borrowers led to deterioration in loan performance and in the financial strength of the banking system. Owing to both weaknesses in the Japanese supervisory system and too ingrained practices among Japanese bankers, Japanese banks failed to resolve the nonperforming loans adequately recapitalize themselves. The continued fragility of the banking system, in turn, has limited its ability to extend loans in support economic recovery.

All of these factors weigh heavily on growth…. which decline from nearly 5% (Q4/Q4) in 1990 to nearly zero in both 1992 and 1993.

In response to the slowdown, Japanese economic policy clearly loosened. The overnight call money interest rate declined from a peak of 8.2% in March 1991 to 2% in March 1995, and decline further to 1/2% by October 1995. Fiscal policy also moved toward stimulus, with the structural budget balance moving from a surplus of 1.3% in 1992 a deficit of nearly 5% 1996.

In retrospect, however, it is apparent that the mid-1990s recovery was quite fragile, and with the advent of a hike in the value added tax in 1997 and the Asian financial crisis in 1997-98, economy once more fell into a protracted slump, interrupted only briefly by the high-tech boom in 2000.”

The authors’ most salient conclusions and the arguments supporting them are presented below:

First, notwithstanding the severity of a collapse in asset prices and the vulnerability of the financial sector to this collapse, Japan’s sustained deflationary slump was not anticipated.

This point is well supported by the second major finding of our study: while loosening of monetary policy in the early 1990s by the Bank of Japan (BOJ) seemed appropriate given the expectations of future economic developments held at the time, in light of the weakening of spending and prices that took place subsequently, this loosening prove to be inadequate.

This suggests that… policymakers did not take out sufficient insurance against downside risks to a precautionary further loosening of monetary policy. Simulation of the staffs FRB/Global model suggests that, had the BOJ lowered short term interest rates by a further 200 basis points at any point in time between 1991 and early 1995, deflation could indeed have been avoided.

The third key issue addressed in our study was whether the effectiveness of Japanese monetary policy in influencing the economy might have diminished in the early 1990s. We uncovered, at most, mixed evidence that monetary policy became less effective during this period. ..In the 1992-95 period, the growth of the monetary base rose above that of the broader aggregates, an indication that a “liquidity trap” may have emerged, but this differential in growth rates did not become especially pronounced until the second half of the 1990s. Finally, the collapse in asset prices and the resulting deterioration of balance sheets by making firms more reluctant to borrow and banks more reluctant to lend most likely diminish the ability of monetary policy to stimulate the economy, although by how much is difficult to say. In sum, the effectiveness of Japanese monetary policy may have diminished somewhat in the early 1990s, but probably not to the point of the benefits of earlier sharper easing would have been obviated.

To sum up, analysis of Japan’s experience suggests that while deflationary episodes may be difficult to foresee, it should be possible to reduce the chances of their occurring through rapid and substantial policy stimulus. In particular, when inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As cited earlier, the authors of this piece ran a series of counterfactual simulations that buttressed their argument that an additional 200 basis points of eases would have forestalled deflationary pressures. The counterfactual simulations were carried out in the context of the Federal Reserve staff’s FRB/Global model. Three simulations were run with rate reductions commencing in Q1 1991, Q1 1994, and Q2 1995. The authors report the key finding as:

The key finding is that, had the BOJ loosened monetary policy to the extent modeled in the simulations at any time up to early 1995, inflation would have been positive for the end of the decade.

Another important finding is contained in the charts titled “FRB/Global Simulations of Alternative Japanese Monetary Policies”-Exhibit IV.2. The chart of the actual and simulated output gaps indicates that if the BOJ had reduce interest rates as per the simulations that negative output gaps would have been closed and that the negative output gaps that opened late in the decade due to the increase in the VAT tax would have been small and of short duration.

In short, the authors view Japan’s “lost decade(s)” as a standard pattern downturn that morphed in to a prolonged period of economic stagnation simply because the central bank failed to cut interest rates by enough prior to mid-1995. The paper argues that the economic costs to Japan (in terms of lost output) of burst bubbles (that reflected inappropriate policies and the buildup of massive financial imbalances, resource misallocations over decades) could have been avoided if the BOJ had simply cuts rates faster and 200 bps farther than it normally would have when responding to a standard cyclical downturn.

In particular, the argument and results of the simulations suggest that in the early to mid-1990s in Japan:

200 bps of additional easing could have compensated for an unprecedented decline in equity prices (about 60% between the bubble peak 1989 and mid-1995). (The words “out of sample” come to mind.)

200 bps of additional easing could have compensated for an almost 30% decline in land prices and the implications for credit availability and balance sheets given that credit was generally collateralized by real estate. (The words “out of sample” again come to mind.)

200 bps of additional easing could have compensated for a nearly complete collapse of the banking system. (The words unprecedented in modern Japanese history come to mind.)

200 bps of additional easing could have compensated for the collapse of corporate balance sheets and the crippling of the keiretsu system.

200 bps of additional easing could have compensated for decades of misallocated capital via the keiretsu system and vote-buying-pork-barrel public works projects.

200 bps of additional easing could have compensated for the policy promoted-export-dependent economy for the loss of competitiveness stemming from the growth of the “Asian tigers”.

In fact, the argument and the simulations suggest that 200 bps of additional ease could have insulated the Japanese economy from the costs of all of the above shocks and structural changes.

The argument was fanciful when it was written. The nearly two decade long underperformers of the Japanese economy since the equity and property market bubbles burst and financial system nearly collapsed were more shock and structural change than 200 bps of additional counter-cyclical easing could possibly have offset.

Post the bursting of the bubbles and near collapse of the US financial system, it is also clear that the US did not learn enough from the Japanese experience to avoid repeating major elements of it. In fact, the failure of the precipitous decline in official rates, the quantitative/credit-easing ballooning of the Fed balance sheet, and the explosion of the federal fiscal deficit, to maintain economic growth indicates that the Fed and the authors of the paper learned nothing of value from the Japanese experience.

The major problem with the paper, however, is that it is “spin” of Orwellian Ministry of Truth dimensions. It implicitly assumed that a strategy cleaning up after asset price bubbles and financial crises would be more efficient than one of than leaning against them.

Its Orwellian aspect should not be surprising given that the paper was published in the aftermath of the bursting of the NASDAQ bubble. It was presumably published with an eye to reinforcing the perception that Greenspan was correct in his choice to wait and clean up after rather than lean against the NASDAQ bubble. If additional easing would have insulate the Japanese economy from the collapse of equity prices, the collapse of real estate prices, the near bankruptcy of the financial system, etc, then expedited easing in the US should have no problem offsetting the NASDAQ collapse given that real estate prices, the financial system and household and corporate balance sheets emerged, relatively speaking, unscathed.

The real cost of the “spin” and the underlying mindset that cast interest rate policy as an uber-policy tool was that it gave the Fed pseudo-intellectual license to ignore its regulatory and supervisory responsibilities, asset bubbles, financial innovations, etc.

For example, why should the Fed have concerned itself with a possible real estate price bubble in the US when expedited interest rate cuts could offset any negative effects should the possible bubble burst? In particular, this paper suggests that the effects of a 33% decline in land prices could be easily offset. Why should the Fed have worried about or leaned against the 2001-2007 real estate asset price bubble in the US?

Why should the Fed have considered leaning against a possible equity bubble when any problem arising from the bursting of an equity bubble can be offset by expedited interest rate cuts?

Why should the Fed have let regulatory and supervisory issues distracted it from questions concerning monetary policy when the effects of an almost total collapse of the banking system can be offset by expedited interest rate cuts?

Why should the Fed have concerned itself with possible downside risks associated with new financial instruments or the growth of the “shadow banking system” when the effects of an almost total collapse of a financial system can be offset by expedited interest rate cuts?

Why should the Fed have been concerned about external balance when the effects on income and inflation all erosion of international competitiveness can be offset by expedited interest rate cuts?

Why should the Fed have been concerned with over-investment in real estate (relative to tradable goods manufacture or other forms of business investment) when any associated problem can be offset by expedited interest rate cuts?

Why should financial firms and households limit their use of leverage when the Fed is asserting that it can insulate the economy from financial dislocations by simply cutting interest rates?

Why should financial institutions have been concerned with problems of systemic risk, when the Fed has announced that expedited interest-rate cuts can insulate the economy and presumably financial institutions from the effects of bursting asset bubbles and the misallocation of economic resources?

Post-2001and pre-2007, Fed monetary and regulatory policies were certainly consistent with the policy prescription laid- out in the paper (although the paper undoubtedly reflected attitudes at the Fed rather than was a shaper of them.) Unfortunately, the unemployment rate is 9.7%, despite the expedited interest rate cuts, the quantitative/credit easing reflected in the change in the size of the Fed balance sheet, and the stimulus implied by the Federal fiscal deficit ballooning from 1.17% in 2007 to 9.92% in 2009.

Clearly, the US would be in a much better position today if the Fed had decided that (given the low-levels of inflation and interest rates and the limited room for monetary stimulus) it should direct attention at preventing the asset price bubbles and economic imbalances that gave rise to the crisis in Japan two decades ago and in the US today. The Fed’s misplaced confidence in its ability to use monetary policy to clean up asset price bubbles contributed mightily to today’s problems.

Insofar as the whole point of the paper was to “shed light on a host of questions that potentially could face policymakers in the United States” it failed and contributed to the public’s misplaced confidence in the Fed’s ability to deal with the aftermath of asset price bubbles. It gave a justification for the authorities to ignore their regulatory and supervisory responsibilities; it gave households and financial institutions a misplaced confidence in their ability to deal with leverage. Most of all, it erroneously endorsed the clean-up-after approach to dealing with asset price bubbles by dismissing the lean against approach without so much as a mention.