Modern Monetary Theory and the Case of Japan

The Japanese public debt to GDP ratio is now in excess of 200%, yet the sovereign long term bond yield has remained below 2% since January 2000, and a credit downgrade a month ago to AA- appears to have had little impact on financial markets. Japan still runs deficits (9.6% of GDP in 2010) and the unemployment rate remains below 5%. Briefly outline a macroeconomic history of Japan since the oil shocks, focussing on GDP growth, unemployment and inflation. Carefully explain why Japan appears to contradict orthodox economic views about the need for fiscal sustainability.

This essay explores why Japan does not follow the orthodox theory for government budget constraints. Orthodox theory dictates that governments are bound in the scope of deficits which they can run by the private sectors preference for debt and that fiscal policies effectiveness is ultimately limited because of rising interest rates which crowds out private investment and increases the cost of debt servicing. Due to the flaws in the conventional wisdom of explaining the experiences of the Japanese economy, the essay focuses on the Modern Monetary Theory to explain the Japanese situation. MMT is founded in the belief that governments which operate under a flexible fiat currency cannot be financially constrained. An overview is provided on how government conducts spending and taxation under MMT, as well as the role the central bank plays in maintaining the interest rate. The implications for fiscal sustainability under this paradigm are discussed with alternative proposals made as to what economic objectives the government should focus on. A comparison between sovereign and non sovereign governments is provided to assess the impact that non sovereignty has on a governments ability to realise its economic goals. Lastly, it aims to draw inference from the Japanese national accounting identities to illustrate how a government's budgetary position can fluctuate in line with private sector savings and net exports to safeguard employment.

The Japanese economy grew on average 5% through the 1980s, a growth rate far higher than the 3.8% of the United States. Japan's unemployment which had been extremely low since the post war period appeared to be immune to the economic cycle and external shocks according to Nokimura (2006). The vast amount of money readily available for investment, combined with financial deregulation, overconfidence and euphoria about the economic prospects, and monetary easing implemented by the Bank of Japan in late 1980s resulted in aggressive speculation in the stock and property markets (Bank of Japan 2003). This eventually proved unsustainable and the asset price bubble burst in 1990 with the combined crashing of the Tokyo stock exchange and property markets coinciding with the beginning of what has been marked " the lost decade", Kenchi (2003) in which Japan endured a growth rate of nearly zero and slipped in and out of recession and experienced price deflation. This period was characterised by stagnant wages and prices, zero interest rates and critically for the long-term economic situation, it meant many Japanese firms were burdened with massive debts, affecting their ability for capital investment. In 1995, the jobless rate exceeded 3% for the first time after World War I and currently stands at 5% following a slight increase in the GFC.

Modern Monetary theory's key assertion and reason which is most relevant to the Japanese situation is that sovereign governments which operate under a flexible fiat currency system cannot become insolvent. Modern Monetary theorist reject that sovereign governments operate in the same fashion as households, that is to say that if governments wish to run a budget deficit where government spending exceeds taxation revenue then they must borrow money through bond issues to fund the shortfall. Orthodox theory uses this to show the Government budget constraint (GBC) arguing that the government is ultimately limited in its spending by the private sectors preference to hold government securities. Modern monetary theory on the other hand asserts that governments are not inherently fiscally constrained but ideology has lead to some governments creating political barriers which may limit their capacity to spend.

In the Modern Monetary hypothesis the Treasury, central bank and the government are seen as the same entity. In its role as "banker to the government" the treasury carries out tax collection and spending by crediting and debiting bank accounts in the private sector so when governments spend, by issuing fiat currency, a cheque is drawn against the treasury. In the same way as when governments spend, taxation revenue collection is carried out by the treasury by debiting private sector bank accounts. The debiting and crediting of bank accounts is conducted all electronically, under this system government spending can be conducted quite independently of prior taxation revenue. Mitchell (2010) states that once this is realised the notion that government's prior surpluses are kept and hoarded is non-sensical. The aggregated total of the Treasury's debiting (taxation) and crediting (spending) transactions determines the net budgetary position of the government, namely whether it is in surplus or deficit. This poses the obvious question then why do governments issue bonds if expenditure is entirely independent of taxation revenue and need not be funded through bond issuances. Governments or the central bank of sovereign nations can issue government securities as a means to control and manipulate the target interest rate to ensure it stays between predetermined levels in line with those specified by the monetary authority. The central banks of most OECD countries have a responsibility under their respective charters to protect the short term interest rate. The short term interest rate determines the levels at which financial institutions can lend to each other from their exchange settlement accounts (in Australia) and through this can establish the structure for longer term interest rates such as mortgages. The central bank requires financial institutions to keep their ESA accounts in surplus, meaning it cannot go into overdraught. Exchange settlement Accounts are used by financial institutions at the end of each trading day to honour their financial obligations with other institutions.

As the treasury conducts crediting and debiting of private sector bank accounts on a constant basis, it follows that the amount of funds held in the exchange settlement Account with the central bank will fluctuate. In the event that the treasury was spending more than it collected through taxation excess reserves will begin to gather in the ESA accounts of the banking sector putting downward pressure on the short term interest rates. The central

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