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.

Even with Idle Resources, There Is a Misallocation of Resources in the Time Structure of Production when a Keynesian Stimulus is Used

Roger W. Garrison (2001) developed a framework to challenge the efforts of John M. Keynes (1936) and his followers, especially those bound to the IS–LM model. Garrison’s main contribution to this type of macroeconomic modeling is adding the time factor with the aid of the Hayekian triangle to represent a “time structure of production.” Garrison follows Hayek’s insight in pointing out that there can be a disequilibrium in the time structure of production even if the macroeconomic aggregates suggest full employment. Garrison’s model is mostly used to illustrate the effects described by the Austrian business cycle theory (ABCT) and to compare, within this model, the ABCT with other business cycle theories like monetarism and Keynesian theories.

Garrison’s framework, however, can be applied to scenarios other than a monetary policy-induced business cycle. In fact, Garrison (2001, chap. 5) remarks on the expected results of a fiscal, rather than monetary, policy. His model has been extended to different applications like the Phillips curve, equilibrium with unemployment, and open economies (Kollar 2008; Ravier 2011, 2013).

Keynesian policies, however, resort to fiscal policy and not only to monetary policy. The fiscal policy tool has remained largely understudied in Garrison’s framework. In this paper, we contribute to filling this gap in two ways. First, we use Garrison’s model to show the effects of fiscal policy rather than the usual effects of an expansionary monetary policy that derives from the ABCT. Second, we assume the presence of idle resources rather than starting from an assumed equilibrium with full employment. The reason for this is that Keynesian policies are assumed to be useful in the presence of idle resources, not in equilibrium, when the problem that Keynesian policies seek to fix is already solved. We demonstrate that Garrison’s model shows that even with idle resources, there is a misallocation of resources in the time structure of production when a Keynesian stimulus is put in place.

—Adrián O. Ravier and Nicolás Cachanosky, “Fiscal Policy in Capital-Based Macroeconomics with Idle Resources,” Journal of Private Enterprise 30, no. 4 (Winter 2015): 81-82.

We Need to Shift the Focus Away from Stages of Production and Back to Average Period of Production

The Hayek-Garrison treatment is missing the Hicksian component. It seems that neither Hayek nor Garrison made the same connection as Hicks did. The Hayek-Garrison framework shifts the emphasis away from the APP [Average Period of Production] toward relative changes in stages of production. However, even though stages of production (the particular order in which production needs to take place—i.e., mining first, retailing last) are a clear conceptual device, they do not have an objective counterpart in reality. Because of this, empirical studies that try to test the ABCT [Austrian Business Cycle Theory] following Garrison’s model face significant difficulties. . . .

To save the structure of production, we need to shift the focus away from stages of production and put it back into the APP.⁶ To do this, we need to follow Hicks’s lead, with the advantage of modern financial analytical tools and mathematics.

⁶While related to each other, APP and stages of production are conceptually different. We can imagine a production process with fewer stages of production but a higher APP and another production process with more stages of production but a shorter APP. This is possible because stages of production have to be arbitrarily delimited. The number of stages of production may or may not shed light on how long a production process is.

—Nicolás Cachanosky and Peter Lewin, “The Role of Capital Structure in Austrian Business Cycle Theory,” Journal of Private Enterprise 33, no. 2 (Summer 2018): 25, 25n6.