Righting Rogoff on Japan’s monetary policy

Carmen Reinhart and Ken Rogoff’s 2010 academic paper “Growth in a Time of Debt” was influential in giving policy-makers the impression that higher levels of government debt would lead to slower economic growth. In Spring 2013, University of Massachusetts Amherst graduate student Thomas Herndon and his faculty coauthors Michael Ash and Robert Pollin announced that they had discovered a spreadsheet error marring Reinhart and Rogoff’s work. News of that error led to a broader reevaluation of Reinhart and Rogoff’s claims. My own embarrassment at having relied on Reinhart and Rogoff’s claims led me to examine their claims closely myself, in two Quartz columns coauthored with University of Michigan undergraduate Yichuan Wang. We found no evidence in Reinhart and Rogoff’s data that national debt slows down economic growth at all. Indeed, after taking into account past growth rates, many economies have grown surprisingly fast despite high levels of government debt.

As Reinhart and Rogoff’s claims fell apart, they came under particular criticism for allowing policy-makers to believe they had conclusive evidence that higher government debt slowed down growth at the same time their more cautious words to their fellow economists indicated that they knew the evidence at best only suggested such a view, pending further analysis. Between Reinhart and Rogoff, it was clear this criticism was directed primarily at Rogoff, in view of his greater stature and influence with policy-makers.

Despite his mistakes in badly overstating the evidence that government debt retards growth, Ken Rogoff is a brilliant economist, who has greatly advanced many areas of economics and has a deep concern for real-world economic policy. So it is disappointing to see his analysis of Japanese economic policy limited so sharply by conventional wisdom in his recent Project Syndicate article “Can Japan Reboot?” Indeed, Rogoff makes an unforced error in that article that is every bit as consequential for economic policy as his errors in relation to debt and economic growth.

Rogoff writes:

My own view is that the “three arrows” of Abenomics 1.0 basically had it right: “whatever it takes” monetary policy to restore inflation, supportive fiscal policy, and structural reforms to boost long-run growth. But, though the central bank, under Governor Haruhiko Kuroda, has been delivering on its side of the bargain, the other two “arrows” of Abenomics have fallen far short.

This is wrong. Both the Bank of Japan and Ken Rogoff know that “whatever it takes” monetary policy goes beyond anything the Bank of Japan has done. Governor Kuroda has not been delivering on his side of the bargain. “Whatever it takes” monetary policy would involve cutting the interest rates determined by the Bank of Japan below zero. The fact that paper currency, according to current practice, earns a zero interest rate causes serious complications, but the Bank of Japan knows, at a detailed level, how to implement a negative interest rate on paper currency, too. I know the Bank of Japan knows how to do it because I went to the Bank of Japan in June 2013 to explain the details in an official seminar, to both staff economists and high Bank of Japan officials, and returned in August 2014 to remind them.

On this, my second visit, I spoke about “Portfolio Rebalancing in General Equilibrium” in my official seminar, but I used that visit as an opportunity to talk about negative interest rates in side conversations. And before the financial crisis that precipitated the Great Recession, I spent enough time in residence at the Bank of Japan that I have many friends among the staff economists at the Bank of Japan who have followed my work on negative interest rates closely.

I know that Ken Rogoff appreciates the power of negative interest rates to provide economic stimulus because he has advocated adding negative interest rates to the monetary policy tool kit for exactly that purpose himself. And when I realized from his May 2014 Financial Times opinion piece in that vein of his advocacy of negative interest rates, I emailed him to let him know of my efforts to work out details of implementing negative paper currency interest rates to make deep negative interest rates practical now, instead of a decade or two from now. Thus, Ken Rogoff’s characterization of current Japanese monetary policy being willing to do “whatever it takes” is not just an error, but an unforced error.

The most likely reason Rogoff made the error is because he is too quick to assume the existence of political constraints on monetary policy in Japan. While they may exist today, they could be swept away tomorrow, if Japan’s economy falls deeper into the mire. To my mind, it is the responsibility of an economist giving serious advice to point out what can and should be done even if that may not be politically feasible at the moment. Of course, one should then go on to give the best advice one can within whatever political constraints exist at the moment, as I did when I gave my opinion to the Bank of Japan that quantitative easing would be more powerful if they focused their asset purchases on risky assets.

But progress is ill served if economists fail to point out areas where a government should try to expand the range of what is politically possible. Many economists explain the benefits of free trade, for example, even when the tide of politics is running toward greater protectionism. And many economists explain the benefits of dramatically more open immigration, even when the tide of politics is running toward greater immigration restrictions.

Indeed, while Ken Rogoff has not yet shown the courage of his convictions in his public advice to Japan about monetary policy, he does show the courage of his convictions in tough words about Japan’s immigration policy. He writes:

There has been no significant progress on supply-side reforms, especially on the core issue of how to expand the labor force. With an aging and shrinking population, Japan’s government must find ways to encourage more women to work, entice older Japanese to remain in the labor force, and develop more family-friendly labor policies. Above all, Japan needs to create a more welcoming environment for immigrant workers.

That is all good advice.

While immigration policy can, for the most part, be cleanly separated from monetary policy, monetary policy and fiscal policy are unavoidably intertwined. Rogoff has this to say about Japan’s recent and possible future increases in its consumption tax:

The timing of the April 2014 consumption-tax hike (from 5% to 8%) was also unfortunate. It would not have been easy for Abe to postpone the move, given that it had been locked in place by broad-based political agreement before he took office. But the government could have engaged in more aggressive fiscal stimulus to counteract the hike’s short-term effects. Instead, two successive quarters of negative growth have had a dispiriting psychological impact. …

Mind you, Japan’s outsize government debt and undersize pension assets are a huge problem …

It is clear from these passages that Rogoff wants lower taxes to stimulate the economy (or to keep from creating a drag on the Japanese economy), but worries about the effect of lower taxes on the already supersized national debt of Japan. But if Japan supercharged its monetary policy with negative interest rates, the fiscal drag from higher consumption taxes would be overwhelmed by the monetary stimulus, so that Japan’s tax policy could be focused on the long-run issue of stabilizing its debt level.

In “Can Japan Reboot,” Ken Rogoff presents himself as someone despairing of the potential for better monetary policy to dramatically improve the situation in Japan, and therefore turning to supply-side measures as the main hope for getting the Japanese economy back on track. In my view, Japan can dramatically improve both its monetary policy and its supply-side policies. I have heard the argument that tight monetary policy can foster supply-side reform by holding an economy hostage until politicians enact the supply-side reforms they know their economy needs, but I don’t believe it. (Fortunately, Rogoff makes no such claims.)

Instead, good monetary policy, by keeping the economy at the level of output consistent with stable prices reveals and highlights supply-side issues that need to be addressed. When people believe, with good reason, that bad monetary policy is part of what ails the economy, it is not surprising that they underestimate the need for supply-side reforms such as loosening immigration restrictions and making it easier for new, innovative firms to enter old, jaded markets. Repairing monetary policy clears the way for repairing the underlying ability of an economy to produce the goods and perform the services that enrich people’s lives with material abundance.

In both the reinforcement he gave to policy makers more worried by the effects of debt on economic growth than by the disastrous human consequences of the persistent worldwide slump, and in his current advice to Japan, Ken Rogoff has erred in the direction of making it easy for people who believe a questionable conventional wisdom to continue in that belief. Economists concerned with real-world economic policy should aim higher. It is all well and good to give a verdict on current policy controversies, as they have been framed by politics as usual. But those who know there is a better way need to say so, with patience and tenacity.

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