Still fresh after his performance as the lone dissenting dove on the UK’s Monetary Policy Committee, Adam Posen has now used the expertise for which he is perhaps best known — Japan’s lost decade(s) — to argue in a speech that easy monetary policy doesn’t lead to asset bubbles. Not inevitably, anyway.
Posen’s targets in the speech are the world’s surplus countries, which he believes should embrace more accomodative monetary policy to stimulate domestic demand.
We’ll give you his conclusion first, and then work back through some the argument:
In particular, I want to argue that accommodative monetary policy does not cause asset price bubbles. This argument is based on the empirically supported premise that it is private capital flows and differences in productivity that determine current accounts (and asset prices) for the most part. Barring the self-destructive subjugation of all macroeconomic goals to a fixed exchange rate, the instruments available to central banks of short-term interest rates and bank reserves are of little lasting impact on current accounts …
Posen worries that policymakers in these countries are wrongly drawing analogies to Japan’s experience of the late 1980s, during which the yen’s appreciation against the dollar coincided with low interest rates and bubbles both in real estate and equities — and followed, of course, by the bursting of said bubbles.
But Posen says there are problems with using the Japanese experience to argue against looser monetary policy now. One is simply that land prices had already started climbing by the time the Bank of Japan started lowering rates in January 1986. But more fundamentally, he questions the extent to which asset prices are relevant to discussions about what the BoJ should have done. Emphasis ours:
The debate among monetary economists over this period usually is cast as whether or not a central bank can read asset prices any better than financial markets and can assess the evaluation of equities. As the Japanese case of the late 1980s illustrates, this debate is misfocused. Whatever the state of asset prices, central banks have to assess the potential growth rate of the economy they oversee, and this macroeconomic assessment can be done largely independently of any specific relative prices in the economy. For Japan in 1987–91, output was 2 percent a year above trend, and 1988 showed the highest growth rate (7 percent) seen since the mid-1970s. …
Meanwhile, just looking at overall market averages, the stock and bond prices implied either 15 or more years of low interest rates or a massive drop in the risk premium. Could a significant drop in the risk premium be held credible for aging Japanese savers, given well-known demographic trends and savings behavior? Alternatively, how could interest rates be expected to stay low indefinitely if the boom’s euphoria was based on a real increase in the potential rate of output—and therefore of the economy’s natural rate of interest—over the long run? The apparent surge in Japanese labor productivity in the late 1980s was something to be suspicious about. Given limited deregulation before the 1990s, the end of catch-up growth, and the absence of any new technological revolution, what would justify a near-doubling of productivity growth from its around 3 percent average of 1979–87? What precedent was there for a 2 percent jump in trend productivity anywhere except emerging markets making the great leap as Japan already had in the 1950s? …
In short, the BOJ could have decided to tighten policy in the 1980s without any reference to asset prices beyond the most general evaluation of interest rate expectations. It was not lack of explicit attention to rises in asset prices that led monetary policy astray, no expectations based on a reasonable evaluation of monetary policy could have supported these macroeconomic assumptions embodied in the overall asset market.
What, then, does Posen blame for the Japanese asset bubbles?
Non-monetary domestic factors, including unrealistic investor expectations and, especially, partial deregulation of the financial sector:
There is a consensus view among economists on how partial financial deregulation in Japan in the 1980s led to a lending boom: Japan’s banks lost their best corporate customers after liberalization of securities markets allowed large firms to reduce their cost of capital by seeking direct financing. The banks’ ability to move into new lines of business was still partially constrained by regulation, and their franchise value was declining, yet they retained the same large amount of loanable funds due to deposit insurance. The ‘Convoy’ system of financial supervision, which equated banking system stability with no closure of banks, kept overcapacity in the system, leading to low profits and undercapitalization, increasing the desire to take risks with taxpayer insured deposits. [Hoshi and Kashyap (2003)] …
As a result, Japanese banks made a huge shift into lending to small and medium enterprises (SMEs), increasing that share of their loan portfolios from 42 percent in 1983 to 57 percent in 1989, while their loan portfolios expanded by more than half. The banks nearly doubled their overall lending in selected sectors favorable to the SMEs. Companies hold substantial real estate in Japan, and used this as collateral of rising worth to borrow more; households also took advantage of rising home prices and declining lending standards (mortgage limits rose from 65 percent of home value on average to 100 percent on the assumption that land prices would go up).
Posen closes by mentioning a paradox of the current situation. On the one hand, some emerging markets loudly worry that excess capital inflows will inflate domestic asset bubbles. So they undertake capital controls and simultaneously intervene in currency markets to prevent their currencies from appreciating.
But these actions work against each other, as allowing their currencies to appreciate would have a deflationary impact:
If anything, the degree to which some major emerging market economies have spoken out about their fear of capital-inflow induced bubbles shows the relative impotence of monetary policy in open economies to offset asset price movements. According to the ‘lean against the wind’ proponents, this should be simple for these countries’ central banks: raise interest rates significantly, and the bubble will pop, it is claimed. … I think central bankers in emerging markets are too smart to fall for such monetary snake oil, no matter how slick the salesmen. If not, we will soon have a demonstration of how raising interest rates in an open economy will fuel bubbles further by attracting more capital inflows, rather than popping bubbles.
So again, Posen’s prescription: surplus countries should use monetary policy to help stimulate domestic demand, and allow their currencies to appreciate to keep inflation tame. Or at least they shouldn’t use the possibility of future asset bubbles as an excuse not to try.