Saturday, June 10, 2006

How do you say NAIRU in Japanese?

Having posted an unpleasant philosophical rant (possibly offensive to conservatives, liberals, Christians, Muslims, Jews, Buddhists, and atheists all at once) as the obligatory non-NAIRU-related post, I now return to the Master of All Topics.

In a comment to a Battlepanda post (acknowledged by Angelica in a subsequent post), I argued that Japan’s experience argues strongly for the pragmatic value of the NAIRU theory:

…if Japan had paid more attention to the unemployment rate, and the fact that it was rising above its historical norm (guesstimated NAIRU), they would have made an earlier and more aggressive policy response to what eventually became deflation, and might have avoided it.

and again:

If you believe in the NAIRU theory, and you observe that unemployment is at or near a historical high, and that the inflation rate is already near zero, then there should be deflation alarms going off all over the place. You should go absolutely wild with the economic stimulus. That was the situation in Japan in 1994-1996, but I don’t think anyone could say they went wild with the stimulus.

I wasn’t sure just how strongly the data supported my contention until I looked, more recently, at the exchange rate series. As Raymond’s dad would say, holy crap! The value of the yen (against the dollar) set a new record high in the exact same month (April 1995) as the Japanese unemployment rate. Was there a shortage of printing presses at the Bank of Japan, or what?

I guess this is what led economist Rudi Dornbusch to say that Japan was shooting itself in the foot. To which Alan Abelson of Barron’s later replied (forecasting a recovery of the dollar, I think) that Japan might shoot itself in the foot, but it wouldn’t shoot itself in the head. Subsequent experience, however, seems to indicate that Japan had already completed its act of economic hari-kari. I think it’s fair to say, if Larry Meyer had been there, it wouldn’t have happened.

The difficulty, though, is that Japan’s Phillips curve has never been very well-behaved, so maybe the Japanese had reason to think that the NAIRU didn’t apply. I tried fitting a “dumb” Phillips curve (i.e., without any control variables) to the pre-1995 Japanese data. While the parameter values look reasonable (and imply that Japan was already far above its NAIRU by mid-1993), the parameters are not statistically significant. In other words, there is so much noise in the Japanese data that you can’t trust the signal. I suspect, though, that a more sophisticated analysis, including controls like, say, oil prices and exchange rates, would result in a much better fit. It’s a shot in the dark, but I wonder if anyone who reads this might know of a better analysis that might have been done (prior to the late 90s, when the Japanese unemployment rate rose well into uncharted territory).

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Blogger TStockmann said...

An overall comment on NAIRU and monetary policy rather than specific to this post: in practical terms raising interest rates on the explicit grounds that too many people have jobs would be the quickest way to end central bank independence, which is, after all, a political artifact. Even assuming this is the best leading ndicator for the economic conditions to which monetary policy should manage (your argument), you're going to have to propose a surrogate measure.

Sat Jun 10, 08:19:00 PM EDT  
Blogger knzn said...

TStockmann, I don’t think that’s true. That’s essentially exactly what the Fed did in 1994 (even after promising Bill Clinton that cutting the deficit would mean lower interest rates), and if anything, the Fed seemed to get even more independence thereafter. Of course, it would be undiplomatic for Ben Bernanke to come right out and say, “Too many people have jobs,” but there are more politic ways of explaining that type of action, ways which I don’t think are entirely inconsistent with transparency.

Sat Jun 10, 10:27:00 PM EDT  
Blogger TStockmann said...

I see a marvellous opportunity for a a demagogic "Cross of Gold 2" in an explicit unemployment target. For that matter and to a lesser extent, the Fed would have political difficulties in taking measures explicitly and specficially against asset rather than consumer inflation, as the folks at The Econmist once urged. Since taking away the punchbowl tends to annoy the partygoers and caterers alike, only the clear and present danger of a commonly acknowledged Bad Thing such as inflation allows them to continue to do it.

Perhaps I'm wrong and I certainly don't remember how the 1994 strategy was presented, but I also don't ever remember a Fed Chairman facing political pressure from members of Congress or administration officials for an overly loose monetary policy.

Sat Jun 10, 11:20:00 PM EDT  
Blogger knzn said...

I’m not suggesting an explicit unemployment target. In fact, even if the Fed were fully committed to a NAIRU-based approach (and I don’t recommend such complete commitment), I believe that some degree of agnosticism as to the specific level of the NAIRU would be critical. An explicit inflation target is one thing: we know that the costs of choosing the wrong target are not all that high. But the costs of choosing the wrong unemployment target could be extremely high (about which, see my upcoming post, “Walking with Keynes”).

Also, there is a problem with the punchbowl metaphor (and with the “slamming the breaks” metaphor used by Angelica at Battlepanda): very rarely does the Fed actually undertake a very rapid shift toward a tight policy; it’s really more like watering down the punch until it loses its kick. By the time people notice that something big has happened (like today), most of the desired impact is already in the system.

Sun Jun 11, 12:27:00 AM EDT  
Blogger TStockmann said...

Of course this is not a stealthy watering of the punch, but ceremonial and public, and between announced dilutions anxious ears are pressed to the kitchen door to catch the possible telltale of a cut glass decanter being readied at the sink.

Sun Jun 11, 09:23:00 AM EDT  
Blogger knzn said...

It’s like every 15 minutes or so, the host takes a tiny sip, declares, “This is just a touch too strong,” and weakens it a bit. Initially, guests agree; later they stop noticing so much; by the time (right about now) someone yells out, “Holy crap! This is freakin’ water!” the extra rum has already been given away to the party next door, and it’s too late to do anything about it.

Sun Jun 11, 10:28:00 AM EDT  
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