Here is Part 2 of my analysis of the claim that Japan is not a good demonstration of what happens when macroeconomic policies are pushed beyond their usual limits. I have long argued that trying to apply a mainstream macroeconomics (New Keynesian) framework to the Japanese situation yields nonsensical predictions about rising interest rates, accelerating inflation, rising bond yields and government insolvency. Nothing like that scenario has emerged since Japan has introduced economic policies that ran counter to the mainstream consensus since the 1990s. Japan demonstrates key Modern Monetary Theory (MMT) principles and those that seek to deny that are really forced to invent a parallel-universe version of MMT to make their case. That version is meaningless. In Part 2, we extend that analysis to consider trade transactions, the fear of inflation, and the argument that the current generation are selfishly leaving their children higher tax burdens while we party on.
Here is – The Japanese denial story – Part 1 (January 3, 2022) – which you should read prior to Part 2 for context.
We ended Part 1, with the observation that it is always possible for a nation to experience a sudden change in its external circumstances if the positive net exporting countries decide they no longer want to accumulate financial assets in the local currency.
Sudden changes rarely happen and advanced nations have run permanent external deficits for decades without experiencing the adverse consequences from global financial markets.
In order to fully understand how trade occurs and why it does not particularly matter who holds the debt issued by a currency-issuing we begin Part 2 by tracing the actual transactions that coincide with an international trade transaction.
You will learn that the funds never leave the local currency financial system unless the holder ultimately converts them through the foreign exchange market.
Following our example yesterday, here is a transactional account of how this works which starts off with a US citizen buying a Chinese product:
- US citizen buys a Chinese manufactured car from a local dealer.
- If the US consumer pays cash, then his/her bank account is debited and the car dealer’s account is credited – this has the impact of increasing foreign savings of US dollar-denominated financial assets. Total deposits in the US banking system, so far, are unchanged.
- If the US consumer takes out a loan to buy the car, then his/her bank’s balance sheet now records the loan as an asset and creates a deposit (the loan) on the liability side. When the US consumer then hands the cheque over to the car dealer (representing the Chinese firm – ignore intervening transactions) the Chinese car company has a new asset (bank deposit) and my loan boosts overall bank deposits (loans create deposits). Foreign savings in US dollars rise by the amount of the loan.
- So the trade deficit (1 car in this case) results from the Chinese car firm’s desire to net save US dollar-denominated financial assets and sell goods and services to the US in order to get those assets – it is the only way they can accumulate financial assets in a foreign currency.
What if the Chinese car company owners then decided to buy US Government debt instead of holding the US dollar-denominated bank deposits?
Some more accounting transactions would occur:
- The Chinese company would put in an order for the bonds which would transfer the bank deposit into the hands of the central bank (US Federal Reserve) who is selling the bond (ignore the specifics of which particular account in the Government is relevant) and in return hand over a bit of paper called a bond to the Chinese car maker’s lawyers or representative.
- The US Government’s foreign debt rises by that amount.
- But this merely means that the US Government promises, on maturity of the bond, to credit the Chinese car firm’s bank account (add reserves to the commercial bank the car firm deals with) with the face value of the bond plus interest and debit some account at the central bank (or whatever specific accounting structure deals with bond sales and purchases).
If you understand all of that then you will clearly understand that this all merely amounts to substituting a non-interest bearing reserve balance for an interest-bearing Government bond.
That transaction can never present any problems of solvency for a sovereign government.
The US consumers get all the real goods and services and the Chinese have bits of paper.
I know some so-called progressives worry about the stock of debt that the Chinese are holding.
But the US government holds all the cards. The debt, in our example, is in US dollars and they never leave the US system.
The Chinese may decide they have accumulated enough and will seek to alter the real terms of trade (that is, reduce its desire to export to the US).
In that situation the US will no longer be able to exploit the material advantages and the adjustment might be sharp and painful.
But that doesn’t negate that while the situation is as described the material benefits are flowing in favour of the US citizens (overall).
So the fact that the Japanese government debt is held by Japanese residents or resident companies and other nations have their debt held by foreigners is largely irrelevant from the perspective outlined above.
What foreigners do with those local currency financial assets leads to different narratives.
If the asset holders are allowed by government, for example, to use those local currency assets (say, an account balance at a local bank) to speculate in local real estate markets, then we might reasonably be alarmed and seek ways to prevent such transactions.
Some nations have foreign investment review processes which seek to regulate what a non-resident can and cannot purchase.
But if the local currency funds derived from the export surpluses are used to purchase government bonds then there are no particular issues as we saw above.
The cries that China funds the US government, as part of some sinister narrative that implies that government is beholden to a foreign power, are meaningless.
The government can spend whenever it chooses – given it issues the currency – and the servicing and repayment of the debt liabilities are the same, irrespective of whether the holder of the debt is a resident or a foreigner.
The debt is repaid by crediting bank accounts in the local currency.
The situation is different, however, if the government issues debt denominated in a foreign currency. That is a path to trouble. It relies on the nation being able to generate sufficient export revenue to ensure it has the foreign currency reserves necessary to service and repay the debt.
But, of course, that is not a distinction that applies to either Japan nor the US.
The hyperinflation is just around the corner and about to get us story
Takatoshi Ito argues that:
… the Japanese government need not, and should not, default on its debt. Even if there are no buyers for it, the Bank of Japan can continue to purchase new and rolled-over bonds with cash injections. This may invite very high inflation. But MMT advocates would say that bond issues can be stopped if and when the inflation rate exceeds 2%.
The first part is correct.
And the Bank of Japan can always control yields and/or just buy all the debt.
In the last decade or more, all new debt issued by the Japanese government and a substantial portion of debt previously issued has ended up being held by the Bank of Japan as a deliberate policy.
This ‘may’ do a lot of things, but high inflation is not one of them.
For more than two decades, the Bank of Japan has been effectively funding the treasury side of government – don’t be mislead by the optics of primary issue auctions that put an institutional smokescreen over what is happening.
The Japanese government issues an instruction to spend X yen on something and the Bank of Japan ensures the appropriate accounts are credited to allow the funds to be transferred.
So where is the inflation?
New Keynesians predicted it in the 1990s.
They had another go in the 2000s.
Now in late 2021 (when the Op Ed was published) they are still predicting it – although the wording is now ‘may’ rather than will.
Any global inflationary pressures at the moment are pandemic-related and will eventually dissipate (if we solve the pandemic and/or adjust our behaviours).
Further, MMT economists do not say that “bond issues can be stopped if and when the inflation rate exceeds 2%”.
If anyone says that they are not being faithful to our work.
We say – there is no need to issue government debt any time! Full stop.
There is no conditionality there.
So the rest of his analysis based on the 2 per cent rule is barking up the wrong tree.
But let’s consider the argument he makes that debt matters?
He claims that given the large outstanding stocks of government debt, the government would have to impose “massive and sudden” fiscal austerity “to pay for the redemption of existing maturing bonds”.
Not in any world I inhabit!
The Bank of Japan would just mark up one account (debt repayment and reserves) and mark down another (bonds outstanding).
No austerity needed – just some typing.
If there was sudden and massive fiscal austerity imposed, then, of course, there would be a “sharp recession”.
Any other option?
The don’t you get it – inflation is coming story
Well, Takatoshi Ito says that:
The only other option would be for the BoJ to continue to buy up the debt, which would result in still higher inflation, if not hyperinflation.
Like, all the inflation Japan has experienced since 1990, that is!
It becomes comical when we have had around 3 decades of a nation struggling to record positive inflation rates (that is, above zero) and regularly has recorded deflationary outcomes, for the mainstream economists to keep saying that when the central bank purchases government debt, issued to match (not fund) a fiscal deficit, that inflation, or hyperinflation will result.
It is time to give up on that one.
It is interesting how these sorts of Op Eds start modestly and by the time we are getting to the end, the hype expands – not just inflation but hyperinflation is Japan’s destiny – or mass unemployment.
And now our kids will have to pay the piper story
Having dropped the inflation thing into the mix, Takatoshi Ito turns to the intergenerational burden thing:
Cash transfers, such as the one just approved, and other programs benefit current generations, whereas the tax burden of eventual bond redemption will be borne by future taxpayers – many of whom may not yet be alive. And even when existing bonds are rolled over indefinitely, interest payments for debt-financed current consumption will be borne by future generations.
Each generational vintage (comprising the voting public) chooses its own tax burden through the governments it elects.
The previous generation cannot impose upon the current generation any particular tax schedule, although inertia does militate against change.
For my generation, the tax burden is much lower than it was for my parent’s generation.
And that is a common element around the world.
But the public infrastructure I have access to as a result of large public investments in education, health care, transport, utilities, etc made before I was born have provided me with a much higher quality lifestyle than my parents enjoyed.
So where is the burden?
My parent’s generation encouraged governments to invest in nation-building so that their children would be better off in material terms.
The neoliberal generation of adults (me) are trying to do exactly the opposite, which will undermine the future amenity that we leave behind.
More on that soon.
Further, governments do not pay back their debt liabilities by increasing taxes at some point in time.
They mark up and mark down accounts.
Clearly, at some point in history, tax burdens can rise and fall.
But that has little to do with the trajectory of fiscal policy and debt issuance in the past.
I talked about future amenity above.
The actual burden that the current generation places on the future generation relates to real resource use and exhaustion.
If we destroy the planet now, then our future generations will have a depleted outlook.
That is the intergenerational challenge and it will need much larger fiscal deficits into the future to solve it – through green transitions and the like.
Further, the ageing society in Japan, that Takatoshi Ito considers will “soon” lead to a collapse in the Japanese old age pension scheme, is a problem.
But the problem is not that the government will soon run out of money and not be able to pay the pensions etc.
The reason it is a problem is that there will be less producers of material goods and services and more consumers. The real value of the pensions – what is available for them to purchase – may be depleted.
Which means the next generation will have to be more productive than the last, or else society will have to seriously downgrade its material aspirations – both will be desirable of course.
Balancing that material imperative with the environmental imperative is the biggest challenge facing humanity once the pandemic abates.
And trying to impose ‘sound finance’ principles now on Japanese fiscal policy (along the lines advocated by Takatoshi Ito) will likely undermine the very institutions that will enhance that future productivity – education, training and health institutions – and create technological and other solutions to the climate challenge.
The Japanese government has just proposed in its supplementary fiscal statement a cash transfer of ¥100,000 (around $A1200) to residents under 19 years of age.
The likes of Takatoshi Ito think this is scandalous and will drive the country broke.
I would rather predict it will help Japanese families cope with future education and training demands to ensure their kids maximise their potential.
It certainly won’t send the government broke.
The point of the intergenerational debate is that it is based on false principles.
The intergenerational transfer is about real resources not $ or yen and not whether the gross public debt ratio is 250 or 251 per cent.
Takatoshi Ito presented a very curious argument which urged Japanese politicians not to give:
… a blanket endorsement of MMT and its policy implications …[which] … is the last thing Japan needs.
The fact is that many senior members of the government in Japan are becoming familiar with our work and are seeing the opportunities that a better understanding of how the monetary system operates and the consequences of different policy actions gives them to improve well-being and retain electoral popularity.
The approach taken by Takatoshi Ito which involves (a) Build a straw house; (b) burn it down – is a very conventional approach when there is no substance in the perspective adopted and where history has shown it to be errant.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.