The Federal Reserve Has Been Following in the Shadow of the Bank of Japan by Mimicking Its Policies Since the 2000s

Since the 2000s, Federal Reserve officials have been following in the shadow of the Bank of Japan, mimicking its policies to no avail. For reasons we examine in the paper, Federal Reserve officials have largely ignored the Japanese experience. Yet the results of Federal Reserve policy have been disappointing. The bursting of the dot-com bubble was followed by a period of then-extraordinarily low interest rates. Those rates inflated a housing bubble, which also burst, resulting in the Great Recession. The Federal Reserve then engaged in rounds of large-scale asset purchases, or quantitative easing policy (QEP). That was part of a zero interest rate policy (ZIRP). 

Like the Japanese experience, the US recovery has been weak by almost any measure. To name just one, the US economy has gone a decade without one year of at least 3 percent real GDP growth. That is a historical record of economic weakness. There are proposals for institutional redesign of the central bank (e.g., Cochrane and Taylor 2016; Fed Oversight Reform and Modernization Act of 2015, H.R. 3189). These discussions and legislative proposals would benefit from considering the Federal Reserve in the shadow of the Bank of Japan. Though not well known, many fundamental issues of Federal Reserve policy and institutional redesign, as well as the political economy of constraints on central bank policy, have been experienced by the Bank of Japan well before they became issues in the United States. In fact, the policy discussion in Japan about central bank policy in the context of other policies has been far more transparent than discussion in the United States. . . .  

Hence, the bubble economies in both Japan and the United States have common ground. Both bubbles were the outcome of easy monetary policy in the context of a flawed financial system that directed imprudent lending to specific economic sectors supported by government guarantees and incentives. In both cases, financial regulators and supervisors failed to appreciate the feedback between increasing asset prices and lending. And, in both cases, central bank officials failed to appreciate the interaction between the structural flaws of the financial system and monetary policy. 

As long as government financial policy and the structure of the financial system go unchanged, central bank policy errors are amplified. The asset bubbles, their bursting, and the subsequent economic and financial distress illustrate the problems central banks face. When their respective governments use the financial system to pursue industrial and social policies, central banks cannot pursue price stability without inflating asset bubbles. The behavior of spot prices no longer provides reliable information about economic stability (Leijonhufvud 2007). 

—Thomas F. Cargill and Gerald P. O’Driscoll Jr., “The Federal Reserve in the Shadow of the Bank of Japan,” Journal of Private Enterprise 33, no. 1 (Spring 2018): 47-48, 53.

The Central Issue in Macroeconomic Theory Is the Extent to which the Economy May Be Regarded as a Self-Regulating System

The central issue in macroeconomic theory is the extent to which the economy, or at least its market sectors, may properly be regarded as a self-regulating system. While the general belief in the superiority of self-regulating, polycentric, market-based economic systems had undoubtedly been intensified since the collapse of the former Soviet Communist system, now two decades ago, in the field of money and banking authoritative economists still adopt a radically different stance, and go on developing proposals for what are essentially new variants of central planning in monetary matters. 

While it is today seldom contested that we can rely on self-regulating, decentralized, market-based systems as far as the production and allocation of commodities in general — such as automobiles, computers etc. — is concerned, in the field of money and banking the monocentric presupposition still almost universally prevails: in order to function properly the monetary and banking system has to be constantly monitored by a central agency, viz. by the central bank. A number of economists have nevertheless recognized the inconsistency implicit in this special treatment of the monetary and banking sectors as contrasted with economic issues in general, and have developed models of decentralized monetary and banking systems which are supposed to function as polycentric, self-regulating orders. While the general direction of this branch of research can be welcomed with some enthusiasm, the ways in which the “details” of some of the better known proposals for “free banking” have been elaborated until present, remain subject to a certain amount of well-founded criticism. The recent republication by the Ludwig von Mises Institute of Larry Sechrest’s Free Banking offers an opportunity to draw special attention to two particular claims revealed by the argumentation off the free bankers which struck this author as rather questionable. 

—Ludwig van den Hauwe, “Free Banking, the Real-Balance Effect, and Walras’ Law,” Procesos de Mercado: Revista Europea de Economía Política 7, no. 1 (Spring 2010): 242-243.

Keynes Transformed Fractional Reserve Bankers from Economic Villains Who Cause Depressions into Economic Heroes Who Enrich Society

Many critics of John Maynard Keynes attribute the success of his ideas to political appeal. No doubt, politicians are attracted to Keynesian economics because it can be used to justify profligate government spending. While important, political appeal alone cannot totally explain his triumph. Since Keynes’s theory is purportedly an economic theory, it could have never prevailed without the economists. So why does Keynes’s theory attract so many economists, and the most influential economists in particular? The answer is that influential economists in the banking system are attracted to Keynesian economics because it can serve as an economic justification for fractional reserve banking. The Keynesian interpretation of fractional reserve banking is an important reason Keynes’s theory conquered the economics profession.

Economists were becoming increasingly critical of fractional reserve banking in the years before Keynes published his theory. Even Alfred Marshall, the founder of the Cambridge school of economics, argued fractional reserve banking amplifies the business cycle. In 1912, Ludwig von Mises showed that fractional reserve banking is the fundamental cause of the business cycle. The Great Depression led many eminent American economists, including Irving Fisher, Frank Knight, Henry Simons, and Jacob Viner, to advocate abolishing fractional reserve banking. In fact, it was the American backlash against fractional reserves in the early 1930s that led directly to the formation of the Chicago school of economics. During the Great Depression, Senator Bronson Cutting and other politicians in the United States introduced legislation to abolish fractional reserve banking. 

Keynes’s theory was a godsend for the defenders of fractional reserves. Pre-Keynesian economics showed fractional reserve banking causes the business cycle and thereby makes society poorer than it otherwise would be. Before The General Theory of Employment, Interest and Money (1936), the defenders of fractional reserve banking had no answer to the pre-Keynesian analysis. But Keynes gave defenders of fractional reserves a weapon with which to combat the pre-Keynesian analysis. While the pre-Keynesian theory shows fractional reserve banking destroys wealth, the seemingly scientific New Economics purports to show that it is good for the economy. Rather than impoverishing society, fractional reserve banking actually creates prosperity in Keynes’s system. In short, Keynes transformed fractional reserve bankers from economic villains who cause depressions into economic heroes who enrich society. It is no wonder so many influential economists in the banking system have enthusiastically adopted Keynes’s theory.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 40-41.

Hayek’s “Profit, Interest and Investment” (1939) Is a Theoretical Explanation of the High and Persistent Unemployment of the 1930s

It is usually assumed that, while John Maynard Keynes developed a theory of chronic unemployment, Friedrich August Hayek did not. Indeed, a theory like this one was never explicitly explained by Hayek. 

However, we defend “Profit, Interest and Investment” (1939a) was written as a theoretical explanation of the high and persistent unemployment of the 1930s. We believe that the assumptions chosen by Hayek reveal that intention: “We shall start here from an initial situation where considerable unemployment of material resources and labor exists, and we shall take account of the existing rigidity of money wages and of the limited mobility of labor. More specifically, we shall assume throughout this essay that (. . . ) money wages cannot be reduced (. . . )and finally, that the money rate of interest is kept constant.” These assumptions are similar to the institutional and macroeconomic conditions of the British economy in the late 1930s. Besides, these assumptions are radically different from those chosen in Prices and Production (1931). In that book, Hayek assumed as a starting point in his discussion, a) full employment, b) labor mobility, c) flexible wages and d) flexible rate of interest. Thus, we believe that Hayek tried to adapt his model to the new circumstances. 

We will argue in this paper that this essay could be interpreted as a theory of chronic unemployment and economic stagnation. Also, it will be defended that this phenomenon has its explanation in a dynamically inefficient design of some of the institutions that rule the market.

—David Sanz and Juan Morillo, “The Hayekian Theory of Chronic Unemployment,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 14.

Keynes Suppresses the Study of the Production Structure in the Concept of Aggregate Investment and Excludes Time as a Relevant Variable

From Hayek’s point of view, the major deficiency in The General Theory is that it is not based on a theory of capital. According to Hayek, the market is a network of millions of companies that complement and coordinate with each other intertemporally and synchronically, forming an extremely complex production structure. In order to understand how and why this structure is coordinated or discoordinated, we need to apply a theory allowing us to study the way it works. However, Keynes does not study this production structure, but suppresses it in the concept of aggregate investment. This is why Hayek thought that Keynes was not able to understand the causes of and the solutions to economic fluctuations. 

According to Hayek, the absence of a theory of capital meant that in the model developed in The General Theory, time is not considered as a relevant variable. In the Keynesian world, when demand increases, a parallel increase in the supply of goods appears almost instantaneously. Therefore, for Keynes, the structure of production does not need a significant amount of time to produce the necessary additional final goods to meet additional consumer demand. Thus, The General Theory never considered that a shortage of supply may occur. In Hayek’s opinion, this approach is wrong.

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 214-215.

The Microeconomic Approach Shows that the Belief in a Direct Relationship between Aggregate Spending and Employment Is WRONG

 The microeconomic approach shows that the belief that there is a direct relationship between aggregate spending and employment is wrong. Hayek explains that unemployment is usually concentrated in certain sectors, industries and production stages (for example, let us assume that unemployment is mainly concentrated in sectors A, B, C, D and E). For the Keynesian employment policies to be able to create new jobs in those specific sectors of the market, it would be necessary for entrepreneurs and consumers to voluntarily decide to spend the additional revenue received from these Keynesian policies in those sectors that are in crisis. However, Hayek explains that “[i]f expenditure is distributed between industries and occupations in a proportion different from that in which labour is distributed, a mere increase in expenditure need not increase employment.” Hayek thinks that it is an illusion to believe that these policies would solve the unemployment problem, as the holders of the additional money will spend their money where they consider it most appropriate and not necessarily in areas where there is unemployment (for example, they might decide to spend their money in sectors O, P, Q, R, S and T). Indeed, Hayek points out that it is very unlikely for individuals to choose to spend their money in the specific sectors that are in crisis, since these sectors are in crisis precisely because entrepreneurs and consumers are not willing to buy the output offered by these sectors at current prices. 

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 216-217.

The Change in Relative Prices Caused by Keynesian Demand Policies Will Encourage a Spontaneous Process of DISINVESTMENT

The second reason [for why there is not a direct connection between aggregate demand and employment] is what Hayek termed the “Ricardo effect”: the permanence of a productive structure requires the permanence of a parallel structure of relative prices. Hayek noticed that Keynesian demand policies have the special feature of modifying the pricing structure so as to promote investments with reduced maturity periods (i.e., less intensive capital investments). Hayek explains that, after applying Keynesian demand policies, this peculiar modification takes place in relative prices, and as a result, many entrepreneurs will modify their production strategies and will try new, less capital intensive (and therefore more profitable in relative terms given the new pricing structure) production strategies. This change in production strategies will result in a change in the composition of the demand for capital goods of those entrepreneurs, and will also reduce the aggregate amount of money devoted to buying higher-order capital goods in the market. Therefore, Hayek notes, many entrepreneurs will stop buying capital goods from their usual suppliers. As a result, these suppliers will lose part of their market and many will be forced to lay off workers or even to cease business. Hayek named this phenomenon the Ricardo effect. Thus, the change in relative prices caused by Keynesian demand policies will encourage a spontaneous process of disinvestment and, therefore, many of the business firms and jobs that were needed before to produce these specialized capital goods (which now will have significantly lower demand) will become useless. Hayek concludes that the demand policies proposed by Keynes will lead to an absolute reduction in the volume of employment. 

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 216.