A Very Deep Dive Into Japanese Fiscal and Monetary Actions (with more than a hint of MMT)

From Professor William Mitchell's Billy Blog:

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....

....MUCH MORE