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月曜日, 12月 16, 2019

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

Q&A Japan style – Part 5a – Bill Mitchell – Modern Monetary Theory
http://bilbo.economicoutlook.net/blog/?p=43790

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.
Question:
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?
OR:
(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):
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:
2. Money multiplier and other myths (April 21, 2009).
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).

Conclusion

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.

Q&A Japan style – Part 5b – Bill Mitchell – Modern Monetary Theory
http://bilbo.economicoutlook.net/blog/?p=43795

Q&A Japan style – Part 5b

This is the final part of a two-part discussion about the consequences of a currency-issuing government exercising different bond-issuing options. The basic Modern Monetary Theory (MMT) position is for the currency-issuing government to abandon the unnecessary practice of issuing debt (which is a hangover from the fixed exchange rate, gold standard days). Currency-issuing governments should use that capacity to advance general well-being and providing corporate welfare to underpin and reduce the risk of speculative behaviour in the financial markets does not serve any valid purpose. However, when we introduce real world layers (politics, etc) we realise that some pure MMT-type options are not possible. This question introduces just such a case in Japan. Given the political constraints, we are asked to choose between two options for central bank conduct, when the government does issue debt: (A) Buy it all up in the secondary bond markets. (B) Leave it in the non-government sector. In this final part, I go through some of the considerations that might influence that choice.

Recap

In the first part – Q&A Japan style – Part 5a (December 3, 2019) – the proposition was put that in Japan both sides of politics – the progressive Left parties and the conservative parties on the Right – eschew any notion that:
(a) the Japanese government runs deficits but dispenses with the unnecessary practice of matching those deficits with debt-issuance. This is the pure Modern Monetary Theory (MMT) position.
OR:
(b) the Japanese government issues debt, which is then bought on secondary bond markets by the Bank of Japan.
I find this to be a very odd position for progressives to take.
Certainly, a person with an MMT understanding would realise that the first option is desirable and the second option has no fundamental negative consequences, but does allow the central bank to control bond yields (and prices).
We learned that the considered opinion is that the only politically acceptable option is that the government issues bonds to the non-government sector (currently 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.
Under this ‘politically acceptable’ option, we also learned that there is considerable disagreement as to what the central bank should do in this case.
I was asked by my Japanese friends to discuss two options from an MMT perspective:
(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?
OR:
(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?
It transpires that 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’ (such as Paul Krugman) who were prominent in the ‘Great Stagnation’ debate in the late 1990s and early 2000s.
But the 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.
So the question really was about what might an MMT perspective bring to this debate?
In – Part 1 (December 3, 2019) – I dealt with the so-called New Keynesian ‘reflationists’.
These characters correctly understood that the in the period after the first consumption tax hike (May 1997), the Japanese economy went into a recession that lasted for six quarters (from December-quarter 1997 to the March-quarter 1999) and then struggled to resume growth for the rest of 1999.
This was the period that became known as the ‘Great Stagnation’ and attracted the attention of the ‘reflationists’ from within Japan and abroad.
The following graph shows quarterly real GDP growth from 1995 to the September 2019 (using Cabinet data) with the consumption tax hikes impacts shown in the red bars.
It was clearly a recession induced by poorly constructed fiscal policy. There was no need at all to increase the consumption tax. The Japanese government bowed to pressure from conservative economists who spun the story that it was running excessive deficits and building up too much debt, which would eventually create uncontrollable inflation, higher interest rates and bond yields, and ultimately, government insolvency.
All the usual fake narratives about currency-issuing governments.
The May 1997 consumption tax hike caused an almost immediate reaction in real private consumption expenditure, which fell by 0.66 per cent in the June-quarter 1997 – a substantial immediate response.
The decline in consumption expenditure growth resonated for several quarters.
The following graph shows the quarterly growth in real private consumption expenditure from the March-quarter 1995 to the March-quarter 2005.
Similarly, as would be expected, as the collapse in consumption expenditure created excess capacity, business investment also fell sharply as a generalised pessimism set in.
The following graph shows the quarterly growth in real private non-residential investment expenditure from the March-quarter 1995 to the March-quarter 2005.
The negative response was a lagged reaction to the downturn and investment spending didn’t recover as quickly because the renewed growth in late 1998 was accommodated by existing productive capacity.
So trying to suggest that the prolonged recession was due to a ‘mythical’ real interest rate being too high, because the inflation rate was too low relative to the near zero nominal interest rates (the ‘reflationists’ ‘liquidity trap’ fantasy) really missed the point.
And trying to suggest that if the Bank of Japan engaged in large-scale bond-buying in return for bank reserves would lift the inflation rate significantly – via the erroneous money multiplier and Quantity Theory of Money theories – was always going to fail.
The Modern Monetary Theory (MMT) economists made that point at the time and many times since.
The ‘reflationists’ were still trotting out these ridiculous ideas during the GFC.
I remind readers of the analysis one Paul Krugman made of the Japanese situation in May 1998 – Japan’s Trap – which echoed what he was also saying during the GFC and since.
He dramatically failed to understand the nature of the problem in Japan in 1998 and recommended a reliance on monetary policy.
In terms of his prescription he claims that his model was subject to “Ricardian equivalence, so that tax cuts have no effect”.
Further, he claims that government spending stimulus would have some impact in the immediate context but would “would be partly offset by a reduction in private consumption expenditures”.
To understand how ridiculous the notion of Ricardian equivalence is please read these blog posts (among others):
2. Ricardians in UK have a wonderful Xmas (January 24, 2011).
Krugman also said in 1997 that while fiscal policy stimulus might provide some marginal short-term growth, previous government spending:
… has been notoriously unproductive: bridges more or less to nowhere, airports few people use, etc … But there is a government fiscal constraint …
He went on to advocate the ‘reflationist’ strategy and claimed that that monetary policy had been ineffective because:
… private actors view its … [Bank of Japan] … actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs. This sounds funny as well as perverse … [but] … the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.
History tells us he was completely wrong in his diagnosis at the time as were all the ‘reflationists’.
The only thing that got Japan moving again was a renewed commitment to using fiscal policy to support growth.
and so it was no surprise that the QE they were urging the Bank of Japan to engage in as a means of lifting the inflation rate would fail 
In his 2003 book – Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications – Richard Koo wrote:
The reason why quantitative easing did not work in Japan is quite simple and has been frequently pointed out by BOJ officials and local market observers: there was no demand for funds in Japan’s private sector.
In order for funds supplied by the central bank to generate inflation, they must be borrowed and spent. That is the only way that money flows around the economy to increase demand. But during Japan’s long slump, businesses left with debt-ridden balance sheets after the bubble’s collapse were focused on restoring their financial health. Companies carrying excess debt refused to borrow even at zero interest rates. That is why neither zero interest rates nor quantitative easing were able to stimulate the economy for the next 15 years.
While I differ with Richard Koo on other issues, his analysis of the ‘Great Stagnation’ was correct and made Krugman and his fellow ‘reflationists’ look like fools.

Analysing the Options

So what does this all mean for how we should think about the central bank operations under the only ‘politically acceptable’ option that the Japanese government continue issuing debt.
The two options for the central bank in this situation are:
(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?
OR:
(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?
There is no MMT position on this.
What an MMT understanding provides is a framework for assessing the consequences of each choice, which would then reflect the social and political judgement of those consequences.
Option (A) is the current orthodoxy in Japan as is evidenced by the following graphs.
The first shows the Bank of Japan’s Balance Sheet assets from April 1998 to November 2019. The light blue area indicates the Bank’s holdings of outstanding Japanese government bonds (JGBs).
So the rather dramatic increase in the total assets held by the Bank is largely due to the various QE (bond buying) programs it has been pursuing over the last two decades.
The next graph shows the proportion of total outstanding JGBs held by the Bank of Japan from 1985 to September 2019.
The Bank currently holds 42.37 per cent of the total.
What these graphs (and the underlying data) tells us that the Bank of Japan’s strategy to buy JGBs in large volumes in order to, in their words, increase the inflation rate, has failed.
This demonstrates how ineffective monetary policy is in influencing the path of the inflation rate, despite the massive increase in central bank assets.
There is no relationship between the evolution of the monetary base (driven by the Bank’s purchases of JGBS in large volumes) and the evolution of the inflation rate.
The latest data on inflation expectations is also indicative that the QE policies are not having the desired effect.
The New Keynesian mainstream macroeconomics further suggests that prices are adjusted to accord with expected inflation. With rational expectations, the mainstream models predict that inflation will respond one-for-one with shifts in expected inflation.
The Bank of Japan has been trying to manipulate that ‘theoretical claim’ in real space through its QE experiments but has clearly not succeeded.
Please read my blog post – Japan still to slip in the sea under its central bank debt burden (November 22, 2018) – for more discussion on this point.
An MMT understanding provides us with an explanation of why this strategy (independent of fiscal policy) will be ineffective.
Income implications
What we know is that:
1. The QE strategy has been maintain long-term interest rates around zero. Why? In the hope that it will stimulate investment spending. But if the revenue-earning outlook is pessimistic, borrowers will not seek credit even at low interest rates. This is the point the ‘reflationists’ could not grasp.
2. The QE strategy has thus reduced income flows that would normally go to the non-government sector as a result of their bond holdings in the form of interest payments.
3. To offset that impact, central banks pay interest on excess reserves, to assist in maintaining the profitability of the financial institutions in question.
In Japan, there is a complex system known as the Complementary Deposit Facility – which provides a facility where the Bank of Japan can pay interest on excess reserve balances (above required reserves) for financial institutions that have current balances with the Bank.
However, since January 2016, when the QQE program drove interest rates negative, “excess reserves … have been divided into three tiers, to which a positive interest rate, a zero interest rate, and a negative interest rate are applied, respectively.”
The aim is to provide an incentive to banks carrying excess reserves to loan them to other financial institutions in need of reserves – ” as long as the rate exceeds the rate applied to the Policy-Rate Balances” (those that attract the negative interest rate).
The Bank says that “Rather than merely holding surplus funds in current accounts at the Bank, such transactions improve financial institutions’ profits.”
When the “Policy-Rate Balances increase as a whole … this exerts downward pressure on money market rates.” They increase, in part, as a result of the “Bank’s Japanese government bond purchasing operations”.
To protect “the profits of financial institutions”, the Bank makes adjustments to the benchmarks that determine when the negative interest rate (‘tax’) will cut in, “so as to avoid drastic changes in the Policy-Rate Balances”.
The most recent review was on September 19, 2019, see – Review of the Benchmark Ratio Used to Calculate the Macro Add-on Balance in Current Account Balances at the Bank of Japan – which increased the Benchmark Ratio to 37 per cent (from 36 per cent).
But, of course, the payment on excess reserves only flow to the financial institutions that have accounts with the Bank of Japan.
But, that aside, the payment of interest on excess reserves blurs the difference between Option (A) and Option (B).
The difference that remains is the possible capital gains on the assets held.
The outstanding JGBs not held by the Bank of Japan or other government agencies, are mostly held by various City Banks and Long-term Credit banks, Trust Banks, Regional Banks, and other financial institutions.
This graph (created from the Flow of Funds data available from the Bank of Japan) published in the – 2019 Debt Management Report – issued by the Ministry of Finance, shows the breakdown of JGB holders as of December 2018.
Now, ask yourself, why would these holders sell to the Bank of Japan?
Answer: because the demand from the QE programs push the price of the bonds up in the secondary market and create capital gains for the sellers.
The capital gain will reflect the maturity (principle) value of the bond plus the expected discounted flow of the interest payments that the holder would receive adjusted for inflation risk.
If there was a serious shortfall in the realisable capital gain relative to the principle/interest payments from holding to maturity, then why would a holder choose to sell – unless they had short-run liquidity issues that required emergency liquidation.
The point is that Option (A) and Option (B) may, in fact, not be very different in overall outcome.
1. Option (A) shifts liabilities to the non-government at the central bank from an account labelled ‘Outstanding JGBs’ to ‘Reserves’ and the income flows associated from ‘Interest payments on outstanding debt’ to ‘Interest payments on excess reserves’.
2. It also ensures that the secondary markets will be indifferent to selling the asset to the Bank at a price that reflects the return they would expect by holding the asset and earning interest until maturity (Option (B)).
Further, a progressive objection to Option (A) should not be motivated by the fact that the ‘reflationists’ suggested the strategy but rather that it doesn’t actually achieve its stated purposes.
Implications for liquidity management
Under Option (B), the government cedes control of yield determination at the regular JGB auctions to the private bond markets.
Option (A) allows the central bank to control all primary issue yields, indirectly, through influencing bond prices and yields in the secondary bond market.
At the limit, the central bank can set all rates along the yield curve (at all maturities) if it so chooses through QE-type purchases.
That control lapses under Option (B).
If yields are set in the private auction markets and then subject to speculative transactions in the secondary bond markets, then, clearly, there is the possibility that rates will rise over time.
The concern expressed in the original question (see Part 5a) is that this has the potential to damage marginal firms contemplating investment decisions.
While I considered the question of the sensitivity of investment spending in this blog post – Q&A Japan style – Part 1 (November 4, 2019) – and concluded there are solid arguments that can be made to suggest the sensitivity is low, it remains a possibility that such a negative impact would arise.
That concern does not apply under Option (A) because the yield curve always remains under the control of the central bank.
We should also distinguish between QE-type behaviour by the central bank and the more standard Open Market Operations (OMO), which, historically, have formed the basis of the liquidity management function of the central bank.
OMO involves the central bank buying and selling government bonds on the open market to manage bank reserves by influencing the price and yield of certain government bonds.
OMO is part of the strategy central banks use to ensure the short-term interbank rates (and subsequent longer maturity rates) are in line with the policy rate that it chooses.
OMO involves the central bank managing reserves by exchanging government securities for reserves (in either direction) with financial institutions that maintain accounts (current balances in the Japanese context).
The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets.
The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector, whereas, central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.
Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes.
All these transactions net to zero. At the end of each day commercial banks have to appraise the status of their reserve accounts.
Those that are in deficit can borrow the required funds from the central bank, usually at a penalty rate.
Alternatively banks with excess reserves are faced with earning nothing or some support rate on these excess reserves if they do nothing.
Clearly it is profitable for banks with excess funds to offload those reserves via loans to banks with deficits at market rates. Transactions in the interbank market necessarily net to zero and cannot clear the system-wide surplus.
Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.
When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains the excess liquidity by selling government debt.
This is a different motivation to that used to justify QE, which broadens the scope of the standard OMO to more comprehensively control yields and bond prices.
When the government runs a deficit that is matched by bond-issuance, the non-government sector swap reserves for the bonds.
If the deficit spending then stimulates further excess reserves, then the central bank has to drain them or pay the support rate if it is to maintain control of its monetary policy target.
In the case of Japan, the Bank of Japan has effectively maintained zero short-term rates aligned with its policy rate by not draining all excess reserves.
Option (A) is an extreme version of this. Option (B) is not incommensurate with the Bank of Japan maintaining the tools necessary to manage bank reserves.
Some might raise concerns under Option (A) about the Bank of Japan incurring capital losses should yields subsequently rise while they have massive JGB holdings.
Those who do not understand the concept of a currency-issuer cannot also understand why negative capital for a currency-using business is problematic but of no application or relevance to a central bank.
Please read my blog post – The ECB cannot go broke – get over it (May 11, 2012) – for more discussion on this point.

Conclusion

My preference is clearly for the government not to issue debt to match any deficit spending. It is unnecessary and amounts to corporate welfare.
But, when we introduce real world layers (politics, etc) we realise that some pure MMT-type options are not possible.
This question introduces just such a case in Japan.
Given the political constraints, we are asked to choose between two options for central bank conduct, when the government does issue debt.
(A) Buy it all up in the secondary bond markets.
(B) Leave it in the non-government sector.
My preference is for Option (A) because I also have a preference for zero short-term interest rates and Option (B) makes that aspiration difficult to manage.
But, equally, I resent handing out capital gains to bond holders (which makes the corporate welfare even more advantageous) and absorbs the risk of holding the bonds within the government sector.
That is enough for today!
(c) Copyright 2019 William Mitchell. All Rights Reserved.
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