STONY BROOK, NEW YORK – The main thing you have to understand about macroeconomic theory — both of the type used by academics and the type employed by private-sector forecasters — is that it doesn’t really work. Events are constantly taking macro people by surprise, counterexamples to pet theories are a dime a dozen, and the rare theory that can be tested against available data is usually rejected outright. In macroeconomics, your choice of model is usually between “awful” and “very slightly less awful.”
Most macroeconomic theories can be easily tested: all we have to do is take a look at Japan. Japan has a number of unusual traits that make it a very good proving ground for macro models, including a shrinking population, inefficient labor markets, an economy out of sync with the rest of the world and a government willing to engage in dramatic economic experiments. Once we start examining theories used to explain the U.S. economy, and apply them to Japan, we find that these theories usually fail.
For example, take the theory of loanable funds, which is taught in most undergraduate introductory economic classes. According to this model, when the government borrows a lot of money, it pushes up interest rates. That makes a certain logical sense, since interest rates are the price of borrowing, and an increase in demand for credit should push up the price. But even as Japanese government deficits and borrowing have exploded since 1990, interest rates have done nothing but fall. So much for that idea. More demand for loans has been met with falling prices, not rising ones.
Another theory that runs into big trouble in Japan is the New Keynesian Phillips Curve. This curve postulates a relationship between inflation and the output gap — when everyone has a job, competition for workers is supposed to push up wages and prices, thus increasing inflation. Since Shinzo Abe became prime minister at the end of 2012, Japan’s labor force participation rate has soared to record highs. Women have entered the labor force en masse, and unemployment has plunged to 3 percent. But after a brief anemic bout of inflation (excluding food and energy costs), which just managed to reach the government’s official 2 percent target, inflation is back down again.
So a tight labor market hasn’t caused increasing prices. New Keynesian theory, which is the academic idea most beloved of central banks around the world, has failed to explain Japan’s lack of inflation.
Of course, the theory of money demand, promoted by Milton Friedman and taught to most economic undergraduates, also runs into big problems in the land of the rising sun. According to this idea, increases in the money supply are supposed to push up inflation. But Japan’s M2 money supply has risen steadily, despite falling population, and inflation hasn’t kept up. More money is in the economy, but people are spending it less frequently.
These are all mainstream theories. But what about unorthodox ones? A claim that has received a lot of attention in the media, due to its use in an analysis of presidential candidate Bernie Sanders’ economic plans, is Verdoorn’s law. This is the idea that full employment will push up productivity growth. That theory, which has gained support from Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis and now my Bloomberg View colleague, relies on historical correlations for support.
But look at Japan, and we find that full employment hasn’t boosted productivity growth. Since early 2014, Japan’s productivity has decreased, even though essentially everyone in Japan has a job.
How about Lawrence Summers’ theory of secular stagnation? This idea, based on the premise of a permanent shortage of demand, is hard to square with Japan’s extremely high and rising employment rates.
The one theory I know of that seems to do a decent job of explaining Japan — at least, in a rough, basic sort of way — is Neo-Fisherism, the radical monetary theory being promoted by economists John Cochrane and Stephen Williamson. This idea holds that low interest rates, if they continue long enough, cause inflation to fall rather than rise. Japan’s recent experience matches this. Neo-Fisherism has so far been rejected by many mainstream theorists, but Japan could provide support for Cochrane and Williamson’s rebellion.
In any case, Japan offers a clear object lesson that macroeconomic theory is very, very hard to get right. If macroeconomists are always having to explain away Japan as a special case, it should make us that much less confident that they can predict the future of Western economies.
Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications.
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