The Right Advice for the Pandemic Recovery

Originally published at Project-Syndicate | July 1, 2021

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 the late Richard Cooper’s sound counsel.

NEW HAVEN – 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 US investment bank Lehman Brothers collapsed in 2008, triggering a global financial crisis, the US, the United Kingdom, and the eurozone expanded their monetary bases enormously – a policy that weakened their respective currencies.

But the Bank of Japan, under Governor 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 five 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 US 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 US again ramped up monetary expansion, the BOJ followed suit, expanding Japan’s monetary base significantly.

To be sure, amid ultra-low 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.

Koichi Hamada: Professor Emeritus at Yale University, was a special adviser to former Japanese Prime Minister Shinzo Abe.

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