Monday, November 8, 2010

Is the US More like Italy or Japan?

The great folks at e21 have a piece up arguing that repeated comparisons of the US to Japan may be inapt; and rather that Italy might be a better comparison. The lesson is that quantitative easing might not be a cure all:

Just as Italy went from one financial crisis in 1974 to another in 1976, is the U.S. poised to follow its 2008 financial crisis with another in 2011 or 2012? Maybe. Just as Italian easy monetary policy boosted domestic demand, which could not be satisfied by domestic production even as it reduced the value of the lira, the Fed’s policy has stimulated domestic consumption and reduced the trade-weighted value of the dollar without materially closing the current account since 2008.

I understand this point of view and appreciate the role that skeptics are playing here. I'm also still trying to think through these issues. At the same time, there are a number of reasons why the lessons from Italy might not apply.

First -- the 70s were a tough economic decade for many countries. High energy prices, unions and structural problems in Italy's economy drove prices higher and deficits up. This was a time of great political instability. In particular, the pressures in maintaining both a fixed exchange rate while paying more for oil imports seems to have been a huge driver in Italy's current accounts. But let's accept for a moment the monetarist idea that changes in inflation were ultimately due to monetary issues.

To the left is a graph of Italy's growth in M2, taken from an article linked to in the e21 piece (their big crisis was 1975). As the authors of that note -- the problem was not political pressure to monetize debt, but rather a general desire to pursue expansionary policies. This led to a quite substantial growth in the money supply, at least in M2 (Friedman's favorite monetary unit), which in turn seems to be associated with inflation and currency depreciation.

At the same time, there is also evidence that wages were growing steadily as well, in part due to pressure by unions. To the extent that real wage increases faster than productivity led to inflation, the lesson from Italy that "quantitative easing can be bad" might be less applicable; especially given how weak wage increases have been lately. But, again, let's take purely the monetarist point of view for the moment. How does America compare?

David Beckworth provides a graph for the US, here:

Clearly, M2 growth lately has been below both historical averages and Italy. It appears at 2-3 percent here. Meanwhile, other measures of monetary bases -- like M3 -- are actually declining. As Gary Gorton has suggested, M3 may be a better indication of what "money" means in today's economy. It includes, for instance, at least some repurchase agreements, which operate today as "money" in the market for financial assets.

Japan has had figures that looked much more like the US today than Italy. Milton Friedman observed that during Japan's "troubled times," money (which he defined as M2 + CDs) grew at just 2%. For Friedman, this was not just unacceptably low, but was causally linked to their terrible economic performance as well. Since interest rates on short-term government debt were close to zero; he recommended quantitative easing as a matter of course. He would have been shocked if you suggested to him that in fact he was recommending an unproven idea as risky as geoengineering -- for him, as well as many other Japan experts, the only plausible explanation for the Bank of Japan's failure was their complete ineptitude.

And, of course, the fact that Japan and the US suffered banking crises means that velocity in these countries (rate at which money turns over) was much lower. As Friedman has argued; central banks ought to adjust the monetary base to keep pace with movements in velocity and output. So the tepid growth in monetary bases in both the US and Japan can be really destructive.

By the way, here's a comparison of Japan and US along inflation:

It's difficult to judge what the lessons from Italy are. Monetarist skeptics like Modigliani will presumably argue that Italy only shows that union-brokered wage increases in the face of a stagnant economy and oil shocks can be inflationary. Monetarists might instead argue that double-digit growth in M2 eventually results in inflation. However, it's not clear why that result should give us pause given that money growth in the US now is an order of magnitude lower.

Finally, if the results from Italy represent the worst possible result of quantitative easing -- it doesn't look that bad. Italy, after all, recovered and grew fairly rapidly afterwards; passing the British economy by 1987. Meanwhile, the only sorpasso that Japan experienced was their being lapped by China. I think they'd happily trade their problems for the post-1975 experience in Italy, and I think in a few years we'd like to take that trade as well.

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