Last year, I lost my teacher, friend and
most valued research colleague, and the world lost a brilliant economist.
Richard Cooper was one of my supervisors
when I was pursuing my Ph.D. at Yale. As a doctoral candidate, I benefited from
a veritable “dream team” of economists, each of whom enriched my life and work
tremendously. James Tobin pushed me toward deep and creative insights with
empirical relevance. Edmund Phelps sharpened my analytical skills. And Cooper
made sure that I applied my ideas to policymaking, so that they would have a
real-world impact. For that, I will be forever grateful.
Cooper led by example: his work examined
the interdependence of countries’ economic policies. He developed his ideas
mainly within the Keynesian framework, in which fiscal policy is the primary
policy tool, and showed how carefully planned international coordination of
fiscal policies would improve outcomes for everyone.
Notably, Cooper developed the “locomotive
theory,” according to which the United States, Germany and Japan — the three
“locomotives” — would “pull” the global economic train to safety following a
recession in the 1970s. The theory was put into practice at the G7 summit in
1978.
Inspired by Cooper’s work, I proposed a
similar approach to monetary policy, drawing on Harry Johnson’s monetary
approach to the balance of payments, where central banks’ policies are the
tools and inflation targets are the guiding objectives. Given the
interdependence of the global monetary system — then operating under a regime
of fixed exchange rates — policy coordination among countries was essential to
maintain stability.
After the Bretton Woods system collapsed
in 1971, this approach was no longer appropriate, as Jeffrey Sachs and others
pointed out. Under a global system based on flexible exchange rates, a
laissez-faire approach to monetary policy was the right one.
Even without the need for coordination,
however, macroeconomic policy remained interdependent, with a crucial
difference. With fixed exchange rates, an increase in macroeconomic stimulus in
one country would call for a reduction of stimulus in its main trading
partners. With flexible exchange rates, by contrast, monetary expansion in one
country should be met with monetary expansion elsewhere, though on a smaller
scale than in the first country.
This is a wisdom Japan failed to internalize.
After the U.S. investment bank Lehman Brothers collapsed in 2008, triggering a
global financial crisis, the U.S., the United Kingdom and the eurozone expanded
their monetary bases enormously — a policy that weakened their respective
currencies.
But the Bank of Japan, under Gov. Masaaki
Shirakawa, failed to expand its monetary base in line with its counterparts. As
a result, the yen appreciated significantly and Japan suffered a much sharper
economic downturn than the countries at the epicenter of the crisis. Jeffrey
Frankel has cautioned about precisely this type of “coordination confusion.”
Then, in 2013, then-Prime Minister Shinzo
Abe appointed Haruhiko Kuroda as the new BOJ governor. Kuroda implemented
aggressive quantitative easing (QE), like his counterparts at the other
advanced-economy central banks, and the Japanese economy began to recover.
Between 2012 and the beginning of the
COVID-19 pandemic, Japan’s economy added about 5 million new jobs. (In a 2014
commentary, Cooper and his co-author, Richard Dobbs, praised this approach,
noting that “if central banks had not acted decisively to inject liquidity into
their economies, the world could have faced a much worse outcome,” before
urging countries to prepare for the end — or continuation — of QE.)
After 2016, the link between Japan’s
monetary base and the yen exchange rate (relative to the U.S. dollar) —
captured in the so-called Soros Chart — was broken, and the effect of the BOJ’s
monetary expansion weakened. But the rule of monetary-policy interdependence in
a flexible-exchange-rate system remained unchanged — and Japan had learned its
lesson. So, during the pandemic, when the U.S. again ramped up monetary
expansion, the BOJ followed suit, expanding Japan’s monetary base
significantly.
To be sure, amid ultralow and even
negative interest rates, the link between monetary bases and exchange rates
remains impaired, so monetary expansion alone will not be enough to deliver a
strong and sustained economic recovery. But expansion was essential to ensure
that Japan was not left behind.
The challenge now is to devise a recovery
strategy that recognizes the implications of today’s global economic
interdependence. Such a strategy must acknowledge that this era of secular
stagnation has blurred the division between monetary and fiscal policy.
Moreover, it should account for the fact that, though exchange rates are
flexible, common inflation targets among the major economies limit the likely
scale of currency fluctuations.
This means that, as long as there is no
major uptick in inflation, central banks would do well to sustain their
expansionary monetary policy, but with the goal of supporting effective — and
coordinated — fiscal-policy interventions. In other words, the world needs to
follow Cooper’s advice.
Japantimes