It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy through the Lens of the Great Depression

Field: Economics, Econometrics and Finance (Social Sciences)

Previous article FreeIt Takes a Regime Shift: Recent Developments in Japanese Monetary Policy through the Lens of the Great DepressionChristina D. RomerChristina D. RomerUniversity of California, Berkeley, and NBER Search for more articles by this author University of California, Berkeley, and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreLast week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. It took dramatic actions and pledged convincingly to do whatever it takes to end deflation.The theoretical reasons why this regime shift may be important are well understood by economists. Japan's slow growth over the past two decades surely reflects a mixture of structural and cyclical problems. But persistent deflation in recent years suggests that Japan continues to suffer from a shortfall of demand. Unfortunately, the Bank of Japan's policy interest rate is already at the zero lower bound. Riskier, longterm rates are also very low—suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates.In such situations, the main tool that a central bank has to stimulate demand is expectations management. As discussed by Paul Krugman (1998), Gauti Eggertsson and Michael Woodford (2003), and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. This, in turn, can raise aggregate demand by stimulating interest-sensitive spending.Perhaps even more important, as discussed in a recent paper by Iván Werning (2011), if aggressive monetary policy actions can cause expectations of real growth, this may have an even greater impact on consumer spending and investment. Consumers who expect to have a job are far more likely to buy cars and remodel their kitchens than those who do not. And firms that expect to have customers are far more likely to build new factories and buy new machines than those that do not.The regime shift we are seeing in Japan is just the kind of bold action that might actually succeed in changing both inflation and growth expectations a substantial amount. As a result, it may be an effective tool for encouraging robust recovery and an end to deflation.My support for that conclusion is based less on theory and more on economic history. In the last century, there have been three times when major countries have hit the zero lower bound on safe, short-term rates: the United States in the 1930s, Japan in the 1990s and 2000s, and many advanced countries since 2008. The only true success story is the United States in the 1930s.1 Neither Japan nor the United States and Europe in recent years have managed to use monetary policy to jump-start a robust recovery at the zero lower bound. But, in the mid-1930s, we did.Through a combination of actions, the most important of which were monetary, Franklin Roosevelt managed to turn our ocean liner of an economy on a dime. Industrial production climbed 57 percent in the first four months of the Roosevelt administration. And real GDP continued to grow at an average rate of nearly 10 percent per year between 1933 and 1937.The fundamental feature of Roosevelt's policy was a regime shift. This is the conclusion of an old paper by Peter Temin and Barry Wigmore (1990), which I failed to appreciate when it was published back in 1990, but which I now think is not just right, but prescient. Roosevelt's actions were bold enough and different enough from what had been done before that people had no choice but to notice.In my talk, I want to discuss the evidence that economic historians and macroeconomists have accumulated that suggests that a regime shift really was important to the recovery from the Great Depression. I then want to discuss the implications of that evidence for monetary policy today. I will argue that it can help us to understand why the Fed's actions since 2009 have done relatively little to spur recovery. Exactly what the Federal Reserve has not been willing to do is have a regime shift. I will also discuss why I think the new Japanese monetary policy really is an important break with the past, and as a result, just might work.I. Roosevelt's Regime ShiftRoosevelt came into office on March 4, 1933. The country had been through nearly four years of crushing depression. What exactly did the new president do?A. Nature of the ShiftTemin and Wigmore suggest that Roosevelt's most dramatic and consequential action was going off the gold standard. The United States had been on some form of a gold standard since the late 1800s. During the early 1930s, it was widely perceived to limit what monetary and fiscal policies the United States could pursue (Eichengreen 1992). Going off the gold standard was therefore a powerful signal that Roosevelt intended to focus on the domestic economy and take very different policies.Figure 1, which replicates one from Temin and Wigmore, shows the dollar/pound exchange rate and the American price of cotton in the early 1930s. The dollar had appreciated relative to the British pound when Britain devalued in September 1931. Technically, what the United States did in early April 1933 was suspend convertibility of the dollar and allow it to float. When that happened, the dollar depreciated greatly. And you can see it had a large and immediate impact on the price of tradable goods—particularly agricultural commodities. The price of cotton rose almost 90 percent in just a few months.Fig. 1. Dollar devaluation and the price of cottonSources: Replication of figure 3 of Temin and Wigmore (1990, 496). Data on the price of cotton are from US Department of Commerce (1932, 23; 1936, 11; 1938, 11). Data on the exchange rate are from US Board of Governors of the Federal Reserve System (1943, 681).View Large ImageDownload PowerPointThough devaluation was the most dramatic sign of the regime shift, it was backed up by aggressive monetary expansion. Figure 2 shows the behavior of M1 in the Depression. You certainly can't miss the collapse of the money supply in the early 1930s emphasized by Milton Friedman and Anna Schwartz (1963). But what's important to the regime shift story is the enormous increase under Roosevelt. I have drawn in a line in March 1933 so you can see the timing of the change.Fig. 2. Money supplySource: Friedman and Schwartz (1963, table A1, 712–15).View Large ImageDownload PowerPointIn a paper I wrote many years ago, I described the source of this monetary expansion (Romer 1992). It was not the result of the Federal Reserve finally seeing the error of its ways. Rather, it was arguably the one time in modern US history when we had monetary expansion by the executive branch. In January 1934, the United States went back on the gold standard, at a price for gold in terms of dollars not quite double what it had been when Roosevelt took office. The revaluation of gold caused a large gold inflow, which the Treasury chose not to sterilize.Then, by a lucky-for-us, unlucky-for-Europe coincidence, mounting political tensions in Europe caused gold to continue to flow to the United States in large quantities. Figure 3 shows these gold inflows. Importantly, the Treasury continued to monetize the inflow. The result was a dramatic increase in the money supply. This was an essential part of the regime shift. A true regime shift is not just a change in words, but action. Roosevelt backed up devaluation with rapid monetary expansion.Fig. 3. Gold flows to the United StatesSource: US Board of Governors of the Federal Reserve System (1943, table no. 157, 538).View Large ImageDownload PowerPointAs many people have emphasized, Roosevelt also switched to fiscal expansion (see, for example, Eggertsson 2008). Figure 4 shows a rough estimate of the change in the federal high-employment surplus in the 1930s. You can see that the high-employment surplus fell in 1934, indicating fiscal expansion. However, the size of the fiscal expansion was fairly modest—only about a percent and a half of GDP.2Fig. 4. Change in the high-employment surplusSources: US Bureau of Economic Analysis (2013, tables 1.1.5 and 3.2) and author's calculations. A negative change in the high-employment surplus corresponds to fiscal expansion.View Large ImageDownload PowerPointFinally, Roosevelt also backed up his regime shift with a consistent and effective communications policy. He spoke often of the need to return prices and incomes to their pre-Depression levels. For example, his second fireside chat in May 1933 was focused on devaluation and reflation. He said: The Administration has the definite objective of raising commodity prices to such an extent that those who have borrowed money will, on the average, be able to repay that money in the same kind of dollar which they borrowed. . . . That is why powers are being given to the Administration to provide, if necessary, for an enlargement of credit.3A wonderful old video, described in a recent book by Robert Hetzel, suggests that these ideas were getting through to ordinary Americans.4 It was made in June of 1933 and ran in theaters before feature films. It sings the virtues of Roosevelt's inflationary policies, and explains clearly how such policies could spur both consumer and business spending. This suggests to me that the changes Roosevelt undertook were bold enough and consequential enough that they were noticed.B. Evidence of an ImpactThe case for believing there was a regime shift in 1933 is very strong. What about evidence that the shift had an expansionary impact on the economy? Here, I will be the first to admit that the evidence is largely circumstantial—but it is pretty good circumstantial evidence.One fact that suggests the regime shift mattered is just the sheer speed of the turnaround. Figure 5 replicates a graph of industrial production from Temin and Wigmore. The low point was March 1933. Industrial production started to grow rapidly in April and May. As I mentioned, overall IP rose 57 percent between March and July of 1933. You can see that iron and steel production, arguably a leading indicator of other industrial production, grew even more rapidly.Fig. 5. Industrial and steel production indexes, 1932–1933Sources: Replication of figure 4 of Temin and Wigmore (1990, 498). Both series are from US Board of Governors of the Federal Reserve System (1940, 765 [industrial production]; 768 [iron and steel production]).View Large ImageDownload PowerPointPart of what makes this turnaround so remarkable is that the US economy was in the midst of a terrible financial panic at the time of Roosevelt's inauguration. This last wave of the financial crisis was finally stopped by the national bank holiday Roosevelt declared two days after the inauguration. That output nevertheless soared in the spring of 1933 suggests to me that something other than just the ordinary forces of recovery was at work.Perhaps more persuasive is the fact that indicators of expectations turned roughly coincidently with Roosevelt's actions. One such indicator is stock prices. Figure 6, which graphs the monthly Dow Jones Industrial Average, shows a stark change in stock prices starting in March 1933. After falling almost continuously for four years, stock prices jumped 70 percent between March and June of 1933 (though, admittedly, the large percentage change is partly a consequence of the painfully low starting level).Fig. 6. Stock pricesSource: Federal Reserve Bank of St. Louis, FRED Economic Data, Series M1109BUSM293NNBR.View Large ImageDownload PowerPointOne reason why this turnaround in stock prices is significant is that it may indicate that expectations of real growth turned around. As I described earlier, such changes in growth expectations may be even more important than the inflationary expectations economists usually emphasize.However, inflationary expectations also turned around. James Hamilton (1992) has put together a series on inflation expectations deduced from commodity futures prices. Most of the interest in his series has been with the expectations earlier in the 1930s, and the question of whether the deflation in 1930 and 1931 was expected. Figure 7 shows Hamilton's expected inflation series. There was an extraordinary change in inflation expectations in 1933. According to these data, which are for thirds of a year, there were still deflationary expectations in the middle third of 1933. But then in the last third, they swung strongly to expected inflation. And the change was enormous—from expected deflation of 7 percent in the first third of 1933 to expected inflation of 6 percent in the last third of the year.Fig. 7. Expected inflation as measured using commodity futures pricesSource: Hamilton (1992, table 7, 171).View Large ImageDownload PowerPointTo understand just how extraordinary that change was, recall that output was about 50 percent below the pre-Depression trend in 1933 and unemployment was 25 percent (Romer 1992). Why was anyone expecting inflation? The most plausible explanation is that Roosevelt's actions were having a powerful impact on the public's psyche.In a recent paper, David Romer and I (2013a) looked at expectations of deflation in 1930 and 1931 through the eyes of the business press. We found that monetary contraction played a central role in causing expectations of deflation early in the 1930s. This makes it plausible that monetary expansion had the opposite impact after 1933. Something that I think would be very helpful is to look for narrative evidence of a change in inflation expectations in the spring of 1933. It might help to solidify or contradict the empirical estimates. More important, it could help identify why expectations changed when they did.Further circumstantial evidence on the importance of Roosevelt's regime shift is provided by the composition of the increase in production. Figure 8 shows industrial production in durables and nondurables manufacturing. Durables manufacturing turned around much more strongly—which could reflect a surge in interest-sensitive spending. That would be consistent with the regime shift having an impact on inflationary expectations and lowering real interest rates.Fig. 8. Index of industrial production by manufacturing typeSource: US Board of Governors of the Federal Reserve System (1940, 764–65).View Large ImageDownload PowerPointTemin and Wigmore point out that price expectations may have had a particularly direct impact on farmers and their spending. If devaluation and monetary expansion raised expectations of farm prices, this would have directly affected expected farm incomes. And it is indeed the case that farm spending rose quickly and dramatically. Figure 9 shows that truck sales took off in April 1933. A Berkeley graduate student, Joshua Hausman, is working on the recovery of 1933 in his dissertation. One of his new findings is that the change in car sales by state in the spring of 1933 was very positively related to the fraction of the population of the state employed in agriculture (Hausman 2013).Fig. 9. Truck productionSource: Federal Reserve Bank of St. Louis, FRED Economic Data, Series M0144AUSM607NNBR.View Large ImageDownload PowerPointThe bottom line is that there is suggestive evidence that Roosevelt's largely monetary regime shift was an important source of recovery. More work is needed, but the evidence is already pretty strong. If this were a clinical trial, one might stop it early and start treating patients.II. Implications for Policy TodayThis brings me to the implications for policy today. The evidence from the Great Depression may help us to understand why monetary policy actions over the past few years have not been particularly effective. More important, it may provide a potential road map for what could be done to rescue troubled economies at the zero lower bound today.A. Policy in the United StatesLet me start by talking briefly about recent monetary policy in the United States. Like just about everyone, I believe the Fed's response to the financial crisis and its initial efforts at unconventional policy were effective. The extraordinary measures taken to unfreeze financial markets in the fall of 2008 helped to prevent an even worse meltdown of the economy. And the first round of quantitative easing, which included purchases of more than $1 trillion of agency debt and mortgage-backed securities, was both bold and powerful.5 It not only helped push down mortgage rates, but likely improved expectations and helped further stabilize financial markets.But from early 2010 until last September, the Federal Reserve was fairly cautious. Though American monetary policymakers took additional actions during this period, the measures were practically designed in such a way as to minimize their effect on expectations. Both the size and the duration of actions in the second round of quantitative easing and Operation Twist were specified in advance—so they were inherently limited.Moreover, additional moves were justified by explicit references to deteriorating conditions or grim forecasts. For example, the Federal Reserve's press release from 2010 the second round of quantitative easing shows the It since the Federal in September that the of recovery in output and continues to be . . . spending on and is though less rapidly than earlier in the year . . . the a return to of in a of price its has been may have helped to of the but it did painfully little to raise expectations of real growth or inflation. And these actions were to have September the changed its and actions It undertook a third round of asset purchases and did not the an end or The to such a was by more And went out of his way to that very monetary policy would likely continue even after conditions to in the was The that the federal rate would not be raised until unemployment hit percent or inflation rose percent was a more expectations the is even these moves were pretty the of the Fed's but they did not change The has been to do something more such as a for the of the price or nominal And even the changes that have been made have had their expectations impact by about the and the size and duration of the bottom line is that the Federal Reserve has been to do a regime shift. And of monetary policy has not been able to a role in recovery. conclusion about fiscal policy in the Great monetary policy has not been a recovery tool in recent years not it did not work but it was not not on the and in the form that was to have a large Policy in me back to I my a of As is well Japan has with low growth for more than two And as figure 10 prices have been falling in Japan for most of the past this is not the to the policies of the Bank of Japan since But, the is that for much of this period, Japanese monetary policymakers have been about their to end and have not taken to do Index inflation in Federal Reserve Bank of St. Louis, FRED Economic Data, Series Large ImageDownload PowerPointThe to be very A new was in with a large And it ran on a of demand. It the that Japan's were the policies the new were fiscal structural and exchange rate the monetary the of the Bank of Japan to raise its inflation from percent to 2 and to there fairly more important, the of the bank to office so that could put in a new and two at the same new was to be to rapid monetary expansion going in to office. But the recent policy were even more expansionary than almost anyone expected. 9 The Bank of Japan changed its focus from the policy interest rate to the monetary and pledged to double the by This change may not be as dramatic as Roosevelt's going off the gold standard, but it is getting Bank of Japan also to asset purchases on a far more significant than the has per is almost as large as the Fed's an economy the size of the United most important of were the communications around the action. The central bank were almost And has emphasized that the Bank of Japan will do it to end initial indicators are consistent with Japan's actions being perceived as a regime shift. Figure shows that the has about percent since It fell 5 percent just after the monetary policy last The has of more than percent since an impact on expectations of real exchange Federal Reserve Bank of St. Louis, FRED Economic Data, Series Large ImageDownload done by the Bank of Japan before its recent that the of expecting prices to from percent in to percent in More direct on inflationary expectations can be from the between nominal and real Figure shows the rate of inflation in suggest that expected inflation has about a percentage point since the Japanese Expected inflation in inflation rate from the between real and nominal Large ImageDownload there are of this regime shift could could of the policymaking of the Bank of which could cause the expansion to be It is also very that the impact of the monetary actions will be slow in policy taken after more than a of deflation is some pretty expectations. One I have is that if conditions do not the political in of monetary expansion could if Japanese policymakers with the new it with structural think there is a good that there will be a break in the of the Japanese economy. that is the from the Great is a for both policymakers and economists to that is a in a central I that it is to admit that there is much we do not about monetary policy and its on the economy. 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