20 April 2016

Japan in NOT a Market Monetarist Success Story

Annoyingly (starting a post with that word is strangely entertaining), Scott Sumner has once again claimed that the increase in Japanese inflation that we have seen over the last few years provides vindication for Market Monetarism. Perhaps most infuriating was his magical ability to know that the thing that has caused the increase in inflation (which is really very modest, which I will address shortly) is the Bank of Japan's monetary stimulus program: "and monetary stimulus did get [Japan] out of deflation."

The real question here is what would actually enable Sumner to reasonably make this claim (news flash, it is not the evidence, which in this case agrees with both the Keynesian and Market Monetarist view). This is where I once again delve into philosophy of science, but don't worry, this is very general. As economics is quasi-experimental in that policy experiments can be conducted, but the system can never be closed, a good method for testing a hypothesis is something along the lines of what Jason Smith has suggested: "any system can become an effective closed system if your instrumental variables move faster (move a greater magnitude in a shorter period of time) than your unobserved variables."

That is, all we need to do is have Japan engage in a massive monetary stimulus in order to see if monetary stimulus works in liquidity trap conditions. Oh, wait... Yes, as it turns out, Japan has been doing massive monetary stimulus, so I guess we have our ideal (if not perfect) experiment. Evidently the massive expansion of the monetary base in Japan has led to inflation. Market Monetarists win!

No. It's extremely important to note that the lukewarm response of inflation to the monetary stimulus is completely consistent with a Keynesian analysis in which the improved labor market has increased inflation via the Phillips curve and that the inflation has little or nothing to do with the monetary stimulus. How do we know which one of these models is more accurate in this case? We can easily use one of Scott Sumner's pet models and see if it squares with his predictions -- then we could have a slightly more testable prediction than 'increasing monetary base growth leads to increased inflation' which doesn't actually specify how structural the supposed relationship is (and allows Scott to get away with his terrible declaration of victory).

It must first be understood that Scott can claim his prediction is correct even though the increase in the Japanese monetary base has been much quicker than the increase in nominal GDP, which is evidence in and of itself against monetary policy effectiveness. However, because Sumner's prediction was simply that the monetary stimulus would cause an increase in inflation (never mind the magnitude), the apparent failure of Market Monetarism to explain Japan can be ignored.

Fortunately for those of us who aren't trying to be dishonest (I'm growing tired of giving people the benefit of the doubt), Sumner has given us a model. Namely, he has frequently argued that velocity is a positive function of the nominal interest rate. With this, we can look at the nominal interest rate in Japan (noting that it has been relatively constant since the Bank of Japan began monetary easing) and the velocity of the monetary base in Japan (noting that it has fallen precipitously since Abenomics began) and see if Sumner's model, which predicts relatively constant velocity at constant interest rates, fits with reality.

Evidently it doesn't. Now, Scott will likely defend himself by saying he doesn't pretend to have an explanation for why real money demand would have risen so sharply in Japan since the nominal money supply began increasing sharply, but the fact remains that the nominal and real monetary base should not track each other so closely if market monetarism were indeed correct. In fact, Sumner has repeatedly said that expectations of more NGDP growth (in this case equivalent to more inflation) would make demand for the monetary base fall. I agree with this theory, but this is evidently not what has happened in Japan -- the Japanese situation is simply incongruous with his position.

Of course, Scott only predicted that inflation and monetary base growth would be positively correlated, not that the degree of correlation would be somewhat constant. Any positive inflation response is thus a positive result for Market Monetarism!

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