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Excerpts from Bernanke

Just wanted to pull out a few excerpts from this brilliant paper which crystallizes a lot of my own monetary policy views:
The argument that current monetary policy in Japan is in fact quite accommodative rests largely on the observation that interest rates are at a very low level.  I do hope that readers who have gotten this far will be sufficiently familiar with monetary history not to take seriously any such claim based on the level of the nominal interest rate.  One need only recall that nominal interest rates remained close to zero in many countries throughout the Great Depression, a period of massive monetary contraction and deflationary pressure.  In short, low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease.
A more respectable version of the argument focuses on the real interest rate.  With the rate of deflation under 1% in 1999, and the call rate effectively at zero, the realized real call rate for 1999 will be under 1%, significantly less than, say, the real federal funds rate in the United States for the same period.  Is this not evidence that monetary policy in Japan is in fact quite accommodative?  I will make two responses to the real-interest-rate argument.  First, I agree that the low real interest rate is evidence that monetary policy is not the primary source of deflationary pressure in Japan today, in the way that (for example) the policies of Fed Chairman Paul Volcker were the primary source of disinflationary pressures in the United States in the early 1980s (a period of high real interest rates).  But neither is the low real interest rate evidence that Japanese monetary policy is doing all that it can to offset deflationary pressures arising from other causes (I have in mind in particular the effects of the collapse in asset prices and the banking problems on consumer spending and investment spending).  In textbook IS-LM terms, sharp reductions in consumption and investment spending have shifted the IS curve in Japan to the left, lowering the real interest rate for any given stance of monetary policy.  Although monetary policy may not be directly responsible for the current depressed state of aggregate demand in Japan today (leaving aside for now its role in initiating the slump), it does not follow that it should not be doing more to assist the recovery. 
My second response to the real-interest-rate argument is to note that today’s real interest rate may not be a sufficient statistic for the cumulative effects of tight monetary policy on the economy.  I will illustrate by discussing a mechanism that is highly relevant in Japan today, the so-called “balance-sheet channel of monetary policy” 12 (Bernanke and Gertler, 1995).  Consider a hypothetical small borrower who took out a loan in 1991 with some land as collateral.  The longterm prime rate at the end of 1991 was 6.95% (Table 1, column 3).
Such a borrower would have been justified, we may speculate, in expecting inflation between 2% and 3% over the life of the loan (even in this case, he would have been paying an expected real rate of 4-5%), as well as increases in nominal land prices approximating the safe rate of interest at the time, say 5% per year.  Of course, as Tables 1 and 2 show, the borrower’s expectations would have been radically disappointed.   
To take an admittedly extreme case, suppose that the borrower’s loan was still outstanding in 1999, and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan.  These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments.  The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected.  This example illustrates why one might want to consider indicators other than the current real interest rate—-for example, the cumulative gap between the actual and the expected price level—-in assessing the effects of monetary policy.  It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era.  The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century.  Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree.  Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago. 

The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows:  Money, unlike other forms of government debt, pays zerointerest and has infinite maturity.  The monetary authorities can issue as much money as they like.  Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets.  This is manifestly impossible in equilibrium.  Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero.  This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence.
On legal authority, it is true that technically the Ministry of Finance (MOF) retains responsibility for exchange-rate policy.  (The same is true for the U.S., by the way, with the Treasury playing the role of MOF.  I am not aware that this has been an important constraint on Fed policy.)  The obvious solution is for BOJ and MOF to agree that yen depreciation is needed, abstaining from their ongoing turf wars long enough to take an action in Japan’s vital economic interest.  Alternatively, the BOJ could probably undertake yen depreciation unilaterally; as the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its legally mandated objective. 
Suppose that the yen depreciation strategy is tried but fails to raise aggregate demand and prices sufficiently, perhaps because at some point Japan’s trading partners do object to further falls in the yen.  An alternative strategy, which does not rely at all on trade diversion, is money-financed transfers to domestic households—-the real-life equivalent of that hoary thought experiment, the “helicopter drop” of newly printed money.  I think most economists would agree that a large enough helicopter drop must raise the price level.  Suppose it did not, so that the price level remained unchanged.  Then the real wealth of the population would grow without bound, as they are flooded with gifts of money from the government—-another variant of the arbitrage argument made earlier.  Surely at some point the public would attempt to convert its increased real wealth into goods and services, spending that would increase aggregate demand and prices.  Conversion of the public’s money wealth into other assets would also be beneficial, if it raised the prices of other assets.
The only counter-argument I can imagine is that the public might fear a future lump-sum tax on wealth equal to the per capita money transfer, inducing them to hold rather than spend the extra balances.  But the government has no incentive to take such an action in the future, and hence the public has no reason to expect it.  The newly circulated cash bears no interest and thus has no budgetary implications for the government if prices remain unchanged.  If instead prices rise, as we anticipate, the government will face higher nominal spending requirements but will also enjoy higher nominal tax receipts and a reduction in the real value of outstanding nominal government debt.  To a first approximation then the helicopter drops will not erode the financial position of the government and thus will not induce a need for extraordinary future taxes.  

Perhaps the Bank of Japan Law should be reviewed, to eliminate the possibility that such trivial considerations as the distribution of paper gains and losses between the monetary and fiscal authorities might block needed policy actions.  An alternative arrangement that avoids the balancesheet problem would be to put the Bank of Japan on a fixed operating allowance, like any other government agency, leaving the fiscal authority as the residual claimant of BOJ’s capital gains and losses. 


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