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Opinion

Japan and the limits of liquidity

Modern monetary theory is too simplistic to solve all today's complex economic challenges

Modern Monetary Theory (MMT) is a macroeconomic doctrine with historical antecedents going back to economists John Maynard Keynes, Abba Lerner and Hyman Minsky.

It has recently had a populist resurgence as a rationale for printing money to pay for more government spending.

The theory's basic premise is that a sovereign nation with its own fiat currency, public debt denominated in that currency and a floating exchange rate cannot go broke. Because the state can service its outstanding domestic-currency debt and can finance any fiscal deficits by printing its own money, there is no reason to worry about the public debt. The only limit on public spending is inflation, and currently this is not a binding constraint for most advanced economies.

If this theory were correct, it would clearly be relevant to Japan. Japan has effectively been in a liquidity trap, with policy rates very near zero, and now below it, since 1996, as shown in the chart. With the interest rate on the 10-year Japanese government bond now also near zero, inflation or the fear of future inflation is certainly not a binding constraint today on government spending and monetizing government deficits in Japan.

But there are elements of Modern Monetary Theory that undermine its validity in modern, globalized, financialized economies. The theory is correct in saying that to understand the overall indebtedness of a country, and the financial options open to it, it is necessary to consolidate the accounts of the central government and the central bank. It is also correct that the state has a monopoly on the issue of base money -- cash in circulation and commercial bank deposits held by the central bank -- and that the profit that can be generated by exercising this monopoly, can loosen the state's budget constraints.

An important implication of this analysis is that the proper measure of how much debt a state can carry is not the gross debt of the general government (238.2% of GDP for Japan at the end of 2018), nor the net debt of the general government (155.7% of GDP for Japan at the end of 2018). It is the monetary debt net of the central bank balance sheet, which was 67.4% of GDP for Japan at the end of 2017.

The monetary liabilities of the state are liabilities in name only because they are irredeemable -- the holder cannot force the issuer (the central bank) to exchange his monetary claim for something else. This does not mean, however, that printing money cannot have important economic consequences.

There are three modern monetary theory (MMT) propositions that are incorrect. The first is that government deficits must precede surpluses because taxpayers have to pay their taxes in government money. This ignores the fact that the state can inject money into the economy without running a deficit, simply by lending to the private sector, that is by purchasing securities from the private sector.

The second error is that public debt is not a burden on the future. This assumes that any previous public debt issued to finance a fiscal deficit stimulates activity in the private sector sufficient to repay the borrowing, with interest. The assumption that deficits financed by public debt are as productive as investments financed by private debt is a strong one, and fraught with fiscal, financial, and private choices. MMT supporters and supply-side economists are odd bedfellows here.

The third error is that the government need only set one nominal price -say 1 unit of currency equals 1 unit of gold -- and then let market forces determine relative prices while printing money at will. Such an approach is inconsistent with monetary equilibrium. But, once you adopt the gold standard (or any other standard), domestic fiat money issuance at will is no longer possible.

The proposition that the state will not default on domestic-currency debt because it can always print money to service the debt in full ignores the case where the inflationary consequences of monetary financing -- hyperinflation, say -- are perceived to be more costly than the costs associated with a sovereign default. The proposition that the U.S. always has the "exorbitant privilege" of borrowing globally in its own currency skips over evidence from both currency and U.S. Treasury markets that this privilege is not immutable. The Suez Crisis ended Britain's exorbitant privilege.

MMT assumes that monetary financing of deficits inevitably yields a liquidity trap equilibrium where the economy is at the effective lower bound, or a zero nominal interest rate. But this is not the inevitable destination of an economy that monetizes the deficit. If investment or consumption respond sufficiently, the result could be either a slowdown or a more robust supply response neither of which end up with zero interest rates. MMT gives short shrift to the role of financial intermediaries, financialization of investment and asset price inflation in the transmission of monetized fiscal deficits into price inflation or growth. Monetized fiscal deficits might finance investment or mergers and acquisitions, and buybacks -- with different implications for growth and well-being. Asset price appreciation will affect inequality through its effect on wealth. Given the interest of MMTers in investment choices and inequality, ignoring the role of financial intermediaries and financial instruments seems odd.

One reason MMT is getting a lot of attention is that the current combination of quiescent inflation and extraordinarily low interest rates is the ideal one for supporting the MMT's arguments in favor of monetizing fiscal deficits. In our view, an economy with zero interest rates and in a persistent liquidity trap is the unique economic environment in which the key prescription of MMT -- spend and print -- is robustly valid.

"Helicopter" money drops distributing shopping coupons with an expiry date might make sense for Japan today. But the U.S. and the U.K. no longer are in a liquidity trap and the eurozone and even Japan are likely at some point to exit from zero interest rates. When that happens, the inflationary consequences of large monetized deficits will become an issue even in Japan.

Helicopter money drops might make sense for Japan.    © AP

Advocates of modern monetary theory in the U.S. have proposed that monetized deficit finance be used to fund a universal state-financed jobs guarantee program and a "Green New Deal." The merits of these two programs are separate, logically and politically, from the merits of MMT. If these programs make sense, from a supply-side or a distributional perspective, they are worth doing even with a balanced budget.

Finally, the amount of fiscal monetization is not as important as the fiscal choices given the amount of monetization. Fiscal choices -- the size and composition of public spending changes and the details of any changes in the tax structure -- more than debt and deficit monetization, determine whether a fiscal stimulus makes good countercyclical or structural economic sense. Clearly, in a liquidity trap it makes sense to monetize a fiscal stimulus that is desirable for countercyclical reasons. Once out of the trap, careful attention must be paid to the maximum amount of resources that can be extracted by printing money without ending up in an inflationary ambush.

Catherine Mann is global chief economist at Citigroup and former chief economist at the OECD. Willem Buiter is special economic adviser at Citigroup and a former founder External Member of the Monetary Policy Committee of the Bank of England.

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