火曜日, 12月 03, 2019

Q&A Japan style – Part 5a – Bill Mitchell – Modern Monetary Theory

Q&A Japan style – Part 5a – Bill Mitchell – Modern Monetary Theory


Q&A Japan style – Part 5a

This is a discussion about Modern Monetary Theory (MMT) and the bond-issuing options for a currency-issuing government such as Japan and Australia. We will consider the three options that such a government has and discuss each from an MMT perspective. What an MMT understanding allows is a thorough appreciation of the consequences of each option. The conclusions we reach are quite different from those presented in mainstream macroeconomics, mostly due to the fact that we do not consider the bonds to be necessary to fund government spending beyond tax revenue and construct the operations of the central bank and the commercial banks to accord to the way they operate in reality rather than in the fictional world of the mainstream. This discussion also recognises the political dimensions of government rather than the technical way we often consider things in MMT. This is the first-part of a two-part answer which I will conclude on Thursday. Today, we consider the emergence of the so-called ‘reflationists’ in Japan who advocated large-scale, non-standard monetary policy in the late 1990s as a solution to the ‘Great Stagnation’ that had beset the Japanese economy.

There are three main options facing a government in relation to bond-issuance:

1. It can recognise its currency-issuing capacity, which among other things, makes the necessity to ‘fund’ deficits redundant. This leads to an exploration of what other purposes such debt-issuance might serve and the conclusion is that there is no useful purpose, in terms of advancing the well-being of the overwhelming majority of the citizens, of continued issuance.

2. The government can issue bonds to the central bank as an accounting match for the central bank then crediting bank accounts to facilitate government deficit spending. In this option, the central bank accumulates the government debt receives interest payments from the treasury side of government. In a consolidated government accounting, the liabilities and assets, thus net to zero.

3. The government issues bonds under one system or another to the non-government sector. In the current period, this is usually done via an auction process, where selected financial institutions are licensed to ‘make the market’, by placing bids for volume and price (yield), which then determines the overall yield on each bond issue.

These options then led to the following question from a Japanese professor that is worth answering because it involves a number of interesting aspects that will help you achieve an MMT understanding.


In Japan, the political consensus is that Option 3 is preferred. This is a position taken by both the progressive Left parties and the conservative parties on the Right, largely as a result of them being seduced by the mainstream myths about debt.

However, there is disagreement about what the central bank should do in this case.

(A) Should the central bank purchase these bonds in the secondary market which has the effect of transferring the interest return to the consolidated government sector and allows the central bank to control all yields and hold rates at zero if they desire?


(B) Should the central bank refrain from purchasing these bonds in the secondary market and leave the bond holders in the non-government sector to earn interest returns and principal payment on maturity?

Many progressives in Japan oppose Option A because they believe by creating bank reserves the policy approach plays into the hands of the so-called New Keynesian ‘reflationists’ who were prominent in the ‘Great Stagnation’ debate in the late 1990s and early 2000s.

However, a rival view is that under Option (B), the central bank loses control of interest rates, and, ultimately, yields become market determined, which may ultimately lead to rising interest rates.

In this sense, many marginal firms who are just surviving in the present situation, would be adversely affected by interest rate changes, which would have the consequence of reducing investment and overall aggregate demand.

The other observation is that there is recognition that under Option (A), the price of bonds rises (because of the central bank demand pressure in the secondary market), and the bond holders enjoy capital gains, which would reflect the discounted sum of the expected future interest returns.

So the central bank purchases of the debt in the secondary market imply an interest return anyway and an equivalence with Option (B) in this respect.

What does MMT say about this debate?

Given the political reality in Japan that the government must continue to issue bonds to the non-government sector to match its fiscal deficits, would the intrinsic MMT position be to prefer Option (A) rather than Option (B) and maintain a zero interest rate environment?

The New Keynesian ‘Reflationists’ and Japan

The first thing is to understood the meaning of the term ‘reflationist’ in the Japanese context.

In the period after the massive commercial property crash in Japan in the early 1990s, Japan returned to growth under the support of fiscal deficits.

However, the 1990s also saw a period of subdued price movements, with the wholesale price index starting to decline in 1994, followed by a simular fall in the CPI in 1997.

Then, under pressure from conservatives, the Japanese government introduced a consumption tax in May 1997, which caused a slump in economic activity and a period of sustained economic malaise, which has become known as the ‘Great Stagnation’.

The discussion in Japan at the time was focused on countering deflation.

This discussion was conditioned by the experience of Japan during the transition from the Bretton Woods system when the then Minister for Trade and Industry, Yasuhiro Nakasone, advocated using policy to increase the rate of inflation in order to offset the appreciation of the yen, as the currency broke with the peg.

There was a vigorous debate over this in Japan in early 1972, which is documented in the excellent book by the now Deputy Governor of the Bank of Japan, Masazumi Wakatabe – Japan’s Great Stagnation and Abenomics: Lessons for the World (Palgrave Macmillan, 2015).

The Endnotes for the book provide further information:

16. Nakasone suggested it on August 9, 1972. “Yen Saikirisage wo Fusegu tame ni wa Chosei Infure mo” (We may need adjustment inflation to prevent yen’s reap- preciation) Asahi Shimbun, Tokyo, August 10, 1972, 9).

17. The Asahi Shimbun quickly criticized Nakasone’s “Chosei Infure Ron” in its edito- rial titled “Chosei Infure Yonin Ron ni Hantaisuru” (We oppose the adjustment inflation argument) (Asahi Shimbun, Tokyo, August 13, 1972, 5).

The policy, labelled “Chosei Infure Ron (adjustment inflation argument”, resonates whenever reflationary strategies are raised.

Many economists tried to disabuse Japanese policy makers from using expansionary macroeconomic policies, and, instead advocated “deregulation and other structural reform measures” to combat deflation.

The typical neoliberal approach.

Masazumi Wakatabe notes that the deflation debate was really the “first gloablized economic debate for Japan” because it “attracted a considerable amount of attention from abroad”.

While many non-Japanese economists entered the debate, Masazumi Wakatabe considers “The most powerful argument for reflation came from Paul Krugman”, who argued against central banks “aiming for zero inflation”.

So, it was the more moderate New Keynesians that entered the fray as the ‘reflationists’.

In the early 1990s, as the inflation era arising from the OPEC oil crises came to an end (largely due to the 1991 recession), many economists advocated central banks adopting zero inflation targets.

In 1996, Krugman argued that Japan should “adopt as a long-run target fairly low but not zero inflation, say 3-4%”.

His (flawed) logic was that markets desire the capacity to run inflation ahead of nominal wages growth (to cut real wages) and an inflation rate of zero would make this impossible, given the downward rigidity in nominal wages.

Krugman basically claimed that with zero nominal interest rates, if there are deflationary expectations, the real interest rate (difference between the nominal interest rate and the rate of inflation) would remain too high to stimulate investment and end the stagnation.

This is Krugman’s so-called ‘liquidity trap’ argument, which supports his contention that pushing inflationary expectations up with macroeconomic stimulus, will drop the real interest rate towards its full employment level.

Krugman also claimed that QE-type bond purchases would help stimulate the desired inflation.

This is clearly a loanable funds type of argument (the real interest rate issue) with Quantity Theory overtones (the inflation from QE).

It is erroneous and I will come back to that soon.

As Masazumi Wakatabe notes, Krugman was railing against those who considered the ‘Great Stagnation’ to be the result of supply-side factors which needed further deregulation and structural shifts to cure.

His argument, even though it was established on spurious grounds (real interest rates etc), was that:

Japan’s problem was a macroeconomic demand shortage, so the necessary remedy was expansionary macroeconomic policy.

Krugman was joined by a host of New Keynesian economists, including Lars Svensson and Ben Bernanke, in advocating expansionary policies based on driving the inflation rate up.

They were called the “reflationists”.

At the time, this argument was strongly opposed by leading Keynesian economists in Japan (for example, Hiroshi Yoshikawa, a professor at Tokyo University).

His point was:

1. The problem was a lack of effective demand (a la Keynes).

2. Expansionary policy will not work because there is “demand saturation”.

3. Only creating new markets with new goods previously unavailable will spur new spending by households and firms.

4. Krugman’s arguments were based on flawed New Keynesian analysis – loanable funds and Quantity Theory – which Keynes had firmly debunked in the 1930s.

As Masazumi Wakatabe notes, Professor Yoshikawa nonetheless, did support fiscal expansion in the late 1990s, after the meltdown caused by the consumption tax hike in 1997.

The representation of the Japanese problem as a ‘liquidity trap’ by the ‘reflationists’ was spurious and not reflective of the insights of Keynes who analysed the liquidity trap phenomenon in the 1930s.

I wrote about that issue in these blog posts (among others):

1. Whether there is a liquidity trap or not is irrelevant (July 6, 2011).

2. The on-going crisis has nothing to do with a supposed liquidity trap (June 28, 2012).

But, moreover, the New Keynesian or ‘reflationist’ causality, which motivated the likes of Krugman et al. was deeply flawed.

I touched on the problems with the narrative in this blog post – Q&A Japan style – Part 1 (November 4, 2019).

The relevant summary points:

1. The reflationists believed that monetary policy could cause a reflation in Japan because they believe in the validity of the Classical loanable funds doctrine, the Wiskellian real interest rate link, and the Quantity Theory of Money to understand the inflationary process.

None of these concepts, theories are valid in a modern monetary economy and were categorically debunked by Keynes and others in the 1930s and beyond.

2. The natural rate of interest is a central concept in the Loanable Funds theory, where the loanable funds market brought savers together with investors, the natural rate of interest is that rate where the real demand for investment funds equals the real supply of savings.

This remains a core concept in New Keynesian macroeconomics.

Accordingly, when the money interest rate is below the natural rate, investment exceeds saving and aggregate demand exceeds aggregate supply. Bank loans (shifting the savings to investors) create new money to finance the investment gap and inflation results (and vice versa, for money interest rates above the natural rate).

The orthodox position is that the interest rate somehow balances investment and saving and that investment requires a prior pool of saving are both incorrect.

In the modern sense, the New Keynesians construct the narrative in this way – the central bank controls the nominal interest rate by managing bank reserves and the interbank market.

They manipulate the interest rate to target a given inflation rate which then allows them to influence the real interest rate, which is determined outside of the monetary system in the loanable funds market, which mediates saving and investment preferences, which are, in turn, reflective of factors such as productivity and preference for future consumption over current consumption.

If those preferences and real forces are stable, the natural interest rate will be stable. So, the policy regime then tries to target an inflation rate via a nominal interest rate setting that will deliver the appropriate natural rate of interest.

Given the same approach contends that fiscal policy expansion will put upward pressure on interest rates (‘crowding out’), it is considered a destabilising force and eschewed.

The reality is that investment brings forth its own saving through income adjustments.

Saving is a monetary variable dependent on income.

Further, banks will extend loans to any credit worthy customer and are not constrained by the available saving.

Loans create deposits, which, if spent, will stimulate income and saving as a residual after consumption. There is no financial crowding out arising from increased fiscal deficits.

3. The ‘reflationists’ believed that if the Bank of Japan expanded bank reserves through massive bond buying campaigns, this would increase the capacity of the banks to extend loans, which would stimulate economic growth and drive up the inflation rate.

They considered the increased central bank money (bank reserves) would multiply into increased broad money growth and via the Quantity Theory of Money, would drive the inflation rate up.

As expectations of inflation rose, this would start to drive the inflation rate up independently.

A rising inflation rate at low nominal interest rates would drive down the real interest rate, which according to the loanable funds model would stimulate investment and the economy in general.

As above, the supply-side model of banking, where reserves are built up before loans are made, is not representative of reality. It is one of the fictions of the mainstream monetary theory.

Further, the idea of the money multiplier is erroneous.

In the real world, as banks extend credit to borrowers and loans create deposits, the central bank is obliged, as part of its charter to preserve financial stability, to ensure there are sufficient bank reserves to guarantee the integrity of the payments system.

So the reserves adjust to the broad aggregates not the other way around.

The reality is that the central bank does not have the capacity to control the money supply.

The banks then ensure that their reserve positions are legally compliant as a separate process knowing that they can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

What the ‘reflationists’ failed to understand (and still get it wrong) is that quantitative easing involves the central bank engaging in an asset swap (reserves for financial assets) with the private sector.

The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits. This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

Should we be surprised. Definitely not. The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

Building bank reserves does not increase the bank’s capacity to lend. Loans create deposits which generate reserves. Bank lending is not ‘reserve constrained’.

Please read my blog posts for more detailed discussion:

1. Money multiplier – missing feared dead (July 16, 2010).

2. Money multiplier and other myths (April 21, 2009).

3. Bank of England finally catches on – mainstream monetary theory is erroneous (June 1, 2015).

In turn, this failing means that the invocation of the Quantity Theory of Money is spurious.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

In general, to operationalise this identity and create a causal link between M -> P, requires one to assume that V and Q fixed – which in turn, implies the economy is always at full employment (the neoclassical economists assumed that flexible prices would sustain this state).

Under those assumptions, changes in M cause changes in P – which is the basic ‘reflationist’ claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

Keynes departed from his Marshallian (Quantity Theory) roots by observing price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing output rather than prices.

The reason that the commercial banks were reluctant to lend much during the late 1990s in Japan was because the potential borrowers had become risk averse and were not presenting themselves to the banks.

It had nothing to do with a lack of ‘reserves’. Adding more reserves by quantitative easing was never going to alter the pessimistic outlook.

The ‘reflationists’ were correct in suggesting the Great Stagnation was a demand-side problem, which any amount of structural changes (wage cuts, cutting job protection, privatisation, welfare cuts, etc) would not be able to solve.

But they were wrong to believe it had something to do with a real interest rate being too high.

Their belief that non-standard monetary policy (QE, etc) was necessary because the nominal rate had hit zero or thereabouts was also flawed.

Other relevant blog posts that provide more detail are:

1. Investment and interest rates (August 10, 2012).

2. The natural rate of interest is zero! (August 30, 2009).

3. Why investment expenditure is insensitive to monetary policy (June 22, 2015).

4. Monetary policy is largely ineffective (April 8, 2015).

5. Building bank reserves is not inflationary (December 14, 2009).

6. Printing money does not cause inflation (March 17, 2011).

7. Modern monetary theory and inflation – Part 1 (July 7, 2010).

8. Modern monetary theory and inflation – Part 1 (January 6, 2011).


The point is that no MMT economist would support the sort of narrative that the ‘reflationists’ applied during the late 1990s in Japan.

It was clearly spurious and when applied, failed to achieve its stated purpose for reasons discussed above.

However, we do not have surrender to the ‘reflationist’ vision or causality to see the value of Option (A), in the politically constrained environment in Japan.

On Thursday, I will relate this knowledge to the specific question under investigation and further explain that last statement.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.