Is Japan already dead?

No, I don't think it is. But I think "Is Japan already dead?" is a much better question to ask than "Will the increased interest rates from economic recovery kill Japan?"

This is just a supplement to three posts: by me; by Noah Smith; and by Paul Krugman. (This also harks back to Livio's post and my earlier post). I think I've finally figured out a way to articulate something I couldn't explain very well before.

If Japan pays nominal interest rate i on government debt, and if Japan's Nominal GDP is growing at rate n, then Japan needs to run a primary surplus as a percentage of NGDP equal to (i-n)x(Debt/NGDP) in order to keep the Debt/NGDP ratio constant over time, and therefore sustainable.

If you prefer, we could re-write that formula by subtracting the inflation rate from both i and n to get (r-g)x(Debt/NGDP), where r is the real interest rate and g is the real growth rate of GDP. It's the same thing.

Economic recovery means that n will increase. Partly through higher inflation and partly through higher real growth, though we don't know the exact mix. Theory and observation tell us that economic recovery means that i will increase too.

If economic recovery causes i to increase more than n, so that (i-n) increases, that makes it harder for Japan to service the debt. But if n increases more than i, (i-n) decreases, that makes it easier to service the debt.

Or we could say that if economic recovery causes r to increase more than g, so that (r-g) increases, that makes it harder for Japan to service the debt. But if g increases more than r, (r-g) decreases, that makes it easier to service the debt.

Paul Krugman thinks that looser monetary policy (by raising expected inflation) will cause r to fall. In which case it is clear that economic recovery caused by looser monetary policy must make it easier to service the debt.

I disagree with Paul a bit. I think that if looser monetary policy causes g to rise, that in turn will cause r to rise. (Very briefly, I think the IS curve may slope up, because higher expected future income reduces current saving and increases current investment.) So I think that both r and g will rise, and it is an open question which one rises more, and whether this makes debt service easier or harder.

Let's assume the worst-case scenario. Let's assume that I am right and Paul is wrong, so r increases. And let's also assume that r increases more than g, so (r-g) increases. (Or (i-n) increases, if you prefer.) So economic recovery, by assumption, makes it harder for Japan to service the debt.

Let us also assume that Japan is like an OverLapping Genererations model, where Ricardian Equivalence is false, and where the equilibrium level of (r-g) is an increasing function of the debt/NGDP ratio.

These worst case assumptions mean that there must exist some maximum Debt/NGDP ratio, call it Rmax, such that if the actual debt/NGDP ratio exceeds Rmax, then it would be impossible for Japan to service its debt if economic recovery causes interest rates to rise. Japan would either have to default, or create a big enough unanticipated rise in the price level to inflate away the old debt and bring the debt/NGDP ratio back down below Rmax.

Let us further assume that Japan's current debt/NGDP ratio exceeds Rmax.

In other words, I have deliberately set up a case in which Richard Koo would be right (maybe for the wrong reasons, but let that pass). I have deliberately made worst-case assumptions so that the higher interest rates caused by loosening monetary policy creating economic recovery would cause Japan to default on its debt, either literally or via very high inflation.

Does this mean that "Japan cannot afford recovery"?

No. It means that Japan is already dead. It just doesn't know it yet.

Sure, the Bank of Japan could abandon Abenomics, tighten monetary policy, reduce the inflation target, squash all hopes of recovery, and bring nominal interest rates back down again. But if the past is any guide to the future, this means the debt/NGDP ratio will keep on growing. Because Japan will be scared to tighten fiscal policy in a recession when the Bank of Japan won't offset that tightening by loosening monetary policy. Which means that recovery, when it does finally come, will cause an even bigger default, because the debt/NGDP ratio will be even bigger.

And recovery will come eventually, one way or another. If not by happenstance, then because there is a limit to the debt/NGDP ratio that the young generation in an OLG economy will be willing to buy from the old.

If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.

Now I'm going to cry over spilt milk, and ask: why oh why didn't they do Abenomics earlier, before the debt/NGDP ratio had grown so big? What was all this talk about "balance sheet recessions", where monetary policy was impotent to increase Aggregate Demand, so fiscal policy had to be used to prevent AD from falling? And how did we suddenly switch from "monetary policy is impotent" to "monetary policy is very dangerous because it will increase AD which will only cause inflation and higher interest rates which will cause default because loose fiscal policy has made the debt/GDP ratio so big"?

Comments

[Alex]

Nick, I "intuitively" disagree with you and Krugman and I partially agree with Koo.

My "theory": there is an optimum point. If you pump liquidity less than the optimum point then bond prices increase. If you pump liquidity more than the optimum point then bond price decrease.

I don't have a model to support the "theory" though.

[Frank Restly]

Nick,

"If Japan pays nominal interest rate i on government debt, and if Japan's Nominal GDP is growing at rate n, then Japan needs to run a primary surplus as a percentage of NGDP equal to (i-n)x(Debt/NGDP) in order to keep the Debt/NGDP ratio constant over time, and therefore sustainable."

Debt / NGDP ratio is not a measure of the sustainability of debt. The sustainability of government debt is the current year interest expense as a percentage of current year tax revenue.

[Sandwichman]

"We’re all scared. You hid in that ditch because you think there’s still hope. But Blythe, the only hope you have is to accept the fact that you’re already dead. And the sooner you accept that, the sooner you’ll be able to function as a soldier is supposed to function." -- Lt. Ronald Speirs in Band of Brothers

[Sandwichman]

"Without mercy. Without compassion. Without remorse. All war depends on it."

[Ashok Rao]

And I suppose I can assume a meteor will crash into earth and all this doesn't matter ;-)

It's an interesting post if you're trying to understand what the worst-case looks like. But the way I read it, more than anything, is the likelihood of Abenomics' success. To achieve your desired goal of killing Japan, you've made some pretty harsh assumptions. (Primarily debt/NGDP > rmax).

As we discussed earlier, and I think you agree that there's good reason to believe in non-neutrality in the short and perhaps medium run. This means that Japan *can* reduce its debt burden during whatever the short run is. You have to establish that *at the end of this short run* debt/NGDP is still > rmax. Also note that under all these assumptions Japan is not at the ZLB and can expand its monetary base as needed to implicitly default on debt.

Of course then you can say "oh, hyperinflation" but that assumes there's some nonlinearity after which inflation suddenly bursts. This is why a high NGDP target makes sense, even today. Or maybe I haven't grokked what you said properly and life is a lot scarier than I think it is.

[rsj]

I am glad that you are already giving up on the supposed stimulatory effects of forcing banks to hold more reserves, but it is odd that you would blame fiscal policy for somehow sabotaging monetary policy. Fiscal policy works when you try it, but Japan's problems are really structural in nature. Fiscal policy isn't going to do anything when the main problem in Japan (IMO) is wage repression and declining median wage shares.

[jyp]

All very sound reasoning. Thank you for the post.

Perhaps an idea for a follow-up post, or at least let me blab on for a bit: you have more or less assumed that the Debt/GDP part of the equation is not moving a lot, apart from through an increase in the denominator: NGDP growth at n, which would of course lead to the ratio going down, ceterus paribus. But what about the exogenous influences on the numerator? Ie, the fiscal imbalance that has led to this miserable situation in the first place.

Japan's debt is still growing, and not exactly at a slow pace. Only just over half (JPY 48 trillion) of Japan's JPY 92 trillion government expenditure (FY2013) is financed by tax and a bit of ‘other’ revenue. The other half is financed by... more debt (net new issuance: 44 trillion, the bond dependency ratio is 46%). Apart from not paying off any debt, they are adding to it, and rapidly so. With a GDP of JPY 520 trillion, that 44 trillion of new bond issuance is about 8.4% of GDP. This will be added to the Debt/GDP pile. So apart from the potential problem of ‘i’ (or r) rising in lockstep with ‘n’ (or g), there is also a deeper problem here since Japan is far from balancing its primary budget, and light-years away from balancing its total budget.

Even if r-g is favourable, there remains a problem unless NGDP grows faster than 8.4% (which would be would be... remarkable, but let me get back to that point later), or the debt issuance slows down because of an improving fiscal situation. Unfortunately for Japan, that last option seems unlikely. To improve the fiscal situation, there are only two options (which are not mutually exclusive though): spend less, or collect more taxes.

Let’s tackle the ‘spend less’ prospects first. Abe is hardly talking about tightening the belt in the government’s 90 trillion yen budget. In fact, he is having talk about more stimulus spending, and walking it too. What is the Japanese government actually spending this 90 trillion budget on? Well, there is the staggering 22 trillion on debt servicing costs (we will get back to that in a minute), so that is already a quarter of government expenses. Then there is social welfare (including healthcare) with a whopping JPY 30 trillion, and another 16 trillion goes to the regional and local levels of government, to allow them to do whatever they do (maintain traffic lights and so on I guess). Then there is 5 trillion for education, 5 trillion to defense etc. With government spending at about 20% of GDP, it is actually a fairly middle-of-the road sized government by OECD standards. Just a severely underfunded one. I can’t really see Abe aggressively slashing the government spending. ‘Austerity’ was never one of his arrows. By the way, we haven’t even talked about the fact that that 30 trillion welfare bill may well rise at a rapid pace in the coming years, since Japan is aging fast and furiously, and so national pension and healthcare costs will definitely not decline.

With spending unlikely to be slashed, let’s talk about increasing government revenues then. It is true that tax revenues will grow fuelled by NGDP growth. But even if NGDP growth is a healthy 3~5%, it remains to be seen if that will translate into the same growth rate in tax revenues if Abe indeed reduces corporate taxes as promised. Granted, he did originally plan to increase the consumption tax to 8% and then 10% by 2015 (from 5% now), but has begun talking about delaying that as recent as yesterday. (note: consumption tax makes up about JPY 10 trillion of tax revenue, corporate taxes about JPY 8 trillion).

Either way, even a doubling of the consumption tax to 10% tomorrow (as said, previous plan: 2015, but now likely to be delayed) would see tax revenue rise by 'only' about 20%. Lowering the corporation tax at the same time would further hurt the actual revenue growth rate. In fact, if Abe lowers corporate taxes and does nothing else for now, revenue will obviously fall, not rise. In short, I don’t think we can expect tax revenues to grow at any double digit rate in the coming years. Not unless NGDP growth well exceeds >5% and/or Abe does actually raises taxes significantly, which would really clash with his fiscal stimulus plans. If we see tax revenues grow at, say, 5~7% per year in the coming budgets, fuelled by NGDP growth and some net increase in tax rates, I think Abe should count himself lucky already.

So, looking at this from the other side, how much more tax revenue would they actually need to stop the growth of the debt pile (let alone reduce it)? Well, this is where it gets embarrassing, you may want to cover your eyes. They need a lot. About a quarter (JPY 22 trillion) of the government expenditures exist of debt servicing costs in the first place, and that is at (still) very low interest rates (average interest costs on outstanding debt = around 1.2%, if this would go to a still historically 2% or more in the coming years, then… well, then they will just have to call the IMF). But even without taking debt servicing into account, the primary deficit alone is JPY 23 trillion. (4.1% of GDP) Against tax revenue of JPY 48 trillion... so, tax revenue would have to rise by 48% just to cover the primary deficit. To also cover the total deficit, tax revenue would have to almost double.

And all of that benignly supposes that 1) the debt and hence the debt servicing cost isn't growing (but it is, with 8.4% of GDP this FY alone), and 2) that debt servicing costs aren't going up themselves. Yet, helas, they are. It might be a sign of health from an inflation/recovery perspective that rates have begun to rise, but if I'd be in charge of debt management at Japan's MoF, it would cause me sleepless nights. A doubling of the interest rate (at least with regards to government debt servicing costs, which as mentioned, is now only 1.2%), would mean ALL of the current tax revenue would go to debt servicing. Of course, that can't happen overnight, but with about 1/5th of the national debt being rolled over every year, it will not take too long before the higher bond rates will become painful in the government budget.

With gross MoF debt issuance of about 180 trillion a year, if the average debt interest costs goes from 1.2% pa to 1.5% pa, that will immediately add another 0.5 trillion yen to your their government expenditure. Not nice.

And it would still be a no brainer to me that when you have a central bank aggressively targeting a 2% annual inflation target, you can’t expect nominal bond yields to stay below that for any significant period of time. Or can you…?

Oh yes, you can, but you need a central bank that is buying an amount of debt through QE (ie unsterilized purchases, if not it only warps the curve, it wouldn’t lower rates across the board) that would make Ben Bernanke blush. To keep bond yields under control when/if they actually begin achieving their inflation target, the BoJ will have to buy far more JGB’s than they can currently dream of, and that is not in the last place because government net issuance will increase too (how else are they going to pay for the increasing interest costs, that part is a vicious circle). As illustrated above, it is unlikely that tax revenue will be able to keep pace with the increase of government debt servicing costs.

Which brings me back to the idea of NGDP growing at higher rate than the 8.4% of GDP currently being added to the national debt for this fiscal year. Even if by next year, GDP goes up by 10%, and hence tax revenues rise by 10%, spending remains stable and debt servicing costs don’t rise (both unlikely, but let’s be generous), next year’s deficit will still be 41 trillion yen, or 7.1% of then-(N)GDP. The Debt/GDP ratio will decline and so would the deficit/GDP ratio, true, but hardly at a comforting pace.

And can Japan really achieve >8.4% growth this fiscal year? And if yes, and they do that 10% this year, then can they achieve >7.1% the next year? In short, can they really keep growing faster than the current rate at which the dismal fiscal balance adds to the debt pile? And again: this is with the unrealistically benign assumptions that rates will stay much lower than the growth rate (stable at 1.2% average interest costs), and spending nominally constant too (extremely unlikely, perhaps in real terms, spending can be stable, but definitely not in nominal terms unless you force the whole government sector on negative real wage growth and impose price controls on government supplies).

I doubt it, although the key word may be: nominal. BoJ willing, they can achieve anything they want nominally. Let inflation go well beyond 2% and you will hit your 8.4% NGDP growth in no time. Everybody will be nominally better of. Higher nominal wages, higher nominal asset prices, higher nominal tax revenue, and hopefully a nominally lower deficit. But let’s be crystal clear: Mr Abe can call it Abenomics, warm it up in the microwave and put a fancy ribbon around it, but I just call it internal default through inflation. And quite frankly, I don’t see what other choice they have.

For me, the bottom line is that Japan has never convincingly nor decisively dealt with its post-1989 debt overhang. They didn’t restructure, they didn’t write-off, at least not anywhere near the scale they should have. Instead, they zombied their entire banking sector, and slowly but surely shifted all the debt from the private sector (where the overhang was, and which therefore shifted into excess savings mode) to the government’s balance sheet. It wasn’t even intentional, but just the result of politicians avoiding painful measures, going for way of the least resistance. The government spending kept things bearable, avoiding depression, and only having relatively mild recessions. But debt-financed government spending on one side, means excess savings on the other side, which was conveniently what the private sector had to do anyway.

And if only there has been some normal degree of inflation and/or real growth, they might have gotten away with it. But they haven’t had neither. Instead, deflation expectations took hold, the world economy changed (see: China), and Japan’s demographic dividend expired.

But now the debt overhang still sits there. And it is huge. No, in fact, it is HUGE. Given the nature of Japan’s economy, its geopolitical position, the global conjecture, the country’s demographics and so on, it is extremely unlikely they will now suddenly achieve the real growth that has been elusive for two decades at any sustainable and meaningful rate (per the above, even real growth at a remarkable 3% [5% nominal, assuming 2% inflation) rate would not cut it. So now, they will either have to explicitly default on this pile of debt, or do so implicitly: by inflating it away. Interesting times, except if you are part of the 50% or so of the Japanese population above 50 years old, and are retired or hoping to do so in the coming decade.

[Donte]

Again, capitalism is a faith based system. It all comes down to whether Japan's increased economic activity can increase debt financing.

The US, being the "engine" of the world has a very easy answer for this. Everybody wants a piece of it(including public bond markets). US internal growth it doing pretty good right now.

Abe is trying to boost Japan to investers who will then finance its debt...........and I am not talking about public debt either.

That is what he is really aiming at. Whether investers will want a piece of it, is not my call to make.

"Debt / NGDP ratio is not a measure of the sustainability of debt. The sustainability of government debt is the current year interest expense as a percentage of current year tax revenue"

Yes sir!!!!

[Nick Rowe]

Alex: you could get a theory where a perceived temporary loosening of monetary policy would cause interest rates to fall, but a perceived permanent loosening would cause them to rise. Or where the short run effect is fall and long run effect is rise. Which may be empirically plausible in some cases.

Frank (and Donte): "The sustainability of government debt is the current year interest expense as a percentage of current year tax revenue."

No it isn't. That number doesn't tell you whether the debt/GDP ratio will be rising or falling over time, which is what my number tells you.

rsj: "I am glad that you are already giving up on the supposed stimulatory effects of forcing banks to hold more reserves,..."

You mean like increasing required reserves? I thought that was a tightening of monetary policy?

"... but it is odd that you would blame fiscal policy for somehow sabotaging monetary policy."
Isn't that what Richard Koo is saying? I am trying to make sense of that view, and saying it's wrong.

jyp: Japan's debt/GDP ratio is high and growing. So what it has been doing is unsustainable. I think it's only hope is monetary policy, to escape the recession, and allow it to cut spending and/or increase taxes. And if someone says it's too late for that, because the debt/GDP ratio is already too big, my response is: "Oh well, then Japan is already dead, so no harm in doing it anyway."

[Nick Rowe]

BTW, the UK had similar debt/GDP ratios similar to Japan's a couple of times in history.

[Mayson Lancaster]

Even in this worst case, Japan is not dead, as it could simply resort to printing yen, at which point the ratio starts falling drastically, the yen starts plummeting in value, and exports and real GDP growth go through the roof.

[Max]

It seems like this is one of those cases where the market's prediction will be self fulfilling. As long the market predicts that the debt is sustainable, it will be sustainable. What matters isn't the "true odds", because that is unknown, but whether there will be a catalyst for a shift in sentiment.

I don't know what that might be, but I'm pretty sure that it won't be an economic boom - even if the boom causes the deficit to increase (due to higher interest).

[anonymous]

Here is what I don't understand: if Japan produces more goods and services without borrowing from abroad (i.e., real GDP increases) then how can they be worse off? Yes, they may issue more debt and their debt/GDP may go up but their is more wealth inside Japan and no additional outside obligations. Sure, maybe the debt service numbers could look big but the BoJ can just print more money to finance that regardless of the interest rate. The implicit answer people give to this (usually unstated) argument is that there will be a loss of confidence and everything will collapse.

Confidence is a tricky thing so I suppose it could happen. But if people are willing to lend money (i.e., buy Japanese Government Bonds) to a country that is produce X amount of goods and services, why won't they want to lend money when that country is producing 1.1 * X?

Thanks

[Nick Rowe]

Mayson: yep, but that's just partial default by other means.

Max: yep. But it would be a boom in AD, because if Japanese want to get out of bonds they would presumably want to hold less money too, (if they didn't the BoJ would just print more money and buy bonds).

anonymous: yep! It's like saying "Japan can't afford to get richer"!

But we can *imagine* a case where it might be true. Because if interest rates increased, and so transfers from Japanese taxpayers to Japanese bondholders increased, the higher tax rates might be a problem, because you can't in practice tax all of GDP.

[Ron Ronson]

Looking on the bright side: If Abenomics works then people will clearly see that correct monetary policy can drive economic recovery. Hopefully this will mean not only that no more fiscal stimulus is needed but also that the government can safely run a surplus and start to reduce the debt/gdp ratio over time , using monetary policy to offset any adverse effects.

Even at the current debt/gdp ratio I think i would have to exceed growth in g by quite a lot to cause default, especially within the right monetary policy framework.

[Benoit Essiambre]

I'm not an economists but this is exactly my mathematical intuition on the situation. I'm glad someone smarter than me articulated it so well as the other players in the blogosphere don't seem to see it quite this way.

It seems to me that given Japan's already low unemployment, growth will quickly hit hard limits unless they put retirees back to work or implement an aggressive immigration campaign.

[Majromax]

> Japan would either have to default, or create a big enough unanticipated rise in the price level to inflate away the old debt and bring the debt/NGDP ratio back down below Rmax.

It wouldn't have to be entirely unanticipted. As of 2009, the average maturity of Japan's government debt was about 6.25 years, and I've seen the incidental news report suggesting that the government since then has been focused on longer-term debt instruments. Although that isn't exactly profile duration, it's not too far of. Even if inflation is now wholly anticipated, an increase in nominal interest rates would reduce the value of the government debt profile.

If Abenomics is to be believed, that's one beneficial side-effect. Credibly sticking to a 2% inflation target (up from 0%), even absent real GDP growth, would reduce the government debt liability by upwards of 10%. (Of course, the government has to roll over the debt to realize the gain.)

> But we can *imagine* a case where it might be true. Because if interest rates increased, and so transfers from Japanese taxpayers to Japanese bondholders increased, the higher tax rates might be a problem, because you can't in practice tax all of GDP.

The biggest problem is that any kind of debt solution short of massive real GDP growth will have enormous distributional effects. Taken as a whole, the government debt is an asset to the private sector, and it represents much of the income that the aging population is supposed to live off of. In a sense, the government debt is just an on-the-balance-sheet pension liability. Taking any unconventional means to reduce that government liability -- outright central bank purchases, inflation, or default -- will just replace the explicit liability with a further social problem.

Ultimately, after all, Japan has little external liability; this is a question of distribution rather than level.

> No it isn't. That number doesn't tell you whether the debt/GDP ratio will be rising or falling over time, which is what my number tells you.

As a mathie, I have to point out that debt/GDP is not dimensionless -- it carries units of time (debt is currency; GDP is currency over time). So Japan's debt to GDP level is "two years." Sustainability is really a matter of stability of that ratio, since government debt is just one output of the entire feedback system that is the economy, given a policy and interest rate regime.

Debt*interest/GDP is dimensionless which makes it a better threshold indicator, but the interest rate can change quickly. Using the real interest rate would be a bit more stable, but that's subject to policy as well.

[Alex]

Nick, if you merge your the "short run effect and long run effect" together, you may get my said way of reasoning (which is close to the one expressed in the first part of your sentence addressed to me, btw).

[david]

Isn't this just debt overhang - the government is trapped into being unable to promote growth, because the new growth will be claimed by the creditors faster than the growth increases.

But growth is still Pareto improving, the trick is working out the right bargain. The hypothetical is normally debt restructuring so that the creditor can make the new lending contingent on the government actually promoting growth and pledging to future good behaviour. But this isn't strictly necessary - here, the government can just change the term length of the bonds they are selling, which achieves exactly the same thing. Japan promises to keep servicing the debt at prevailing low rates, as long as investors can't demand a higher price for it once growth bids up the price of deferring consumption.

It's OLG in reverse, with the government asking the households to take on the longer-term commitment. Which one can do, via the banks that are currently powering all that domestic Japanese bond-ownership anyway.

[K]

Presumably, if Japan has a recovery the natural rate will rise with the growth rate, maybe more, maybe less. But at the same time, if they escape the ZLB, the real rate can fall to the natural rate. So whatever the relationship between the natural rate and the growth rate, this is an additional factor which puts a downward bias on the real rate relative to the growth rate.

[wilhelmson]

As someone that works in restructuring --

There is a practical space between recovery and default/formal-restructuring. There is the "informal restructuring" and "recapitalization" world that encompasses amend-and-pretend, below market rate subsidies and others.

Japan doesn't have to be dead .. it could just be very ill. The debate now is will the treatment heal the patient or outright kill it. This is all a very interesting dilemma that we'll get to see unfold over the next few years and decades. I was quite a believer in Keynesian economics -- but that model was predicated on reductions in government spending during booms and increases during busts and it seems like there is a lack of political will to enforce those rough rules in either state. The situation as it is right now is a mixed bag and will likely produce mixed results.

I lament that the technology behind fractional reserve banking, fiat currencies and the like are a technology dangerous to our society at our current level of emotional, political and social development.

Random thought: Can the Keynesian multiplier be negative?

[Nick Rowe]

Majromax: "As a mathie, I have to point out that debt/GDP is not dimensionless -- it carries units of time ..."

Correct. But i and n have the units 1/time. So when we multiply debt/NGDP by (i-n) we get a dimensionless number.

I like looking at dimensions.

[Frank Restly]

Majromax:

"The biggest problem is that any kind of debt solution short of massive real GDP growth will have enormous distributional effects."

Not necessarily. The Japanese government could also alter the risk profile of the securities that it sells - in essence swapping debt that offers a guaranteed rate of return for equity that offers a non-guaranteed rate of return.

[Doug M]

The real interest rate will rise if:
The prospects for Japan look so good that the BoJ feels the need to tighten
or, the prospects of Japan look so bad that default appears to be unavoidable.

[Max]

"Max: yep. But it would be a boom in AD, because if Japanese want to get out of bonds they would presumably want to hold less money too, (if they didn't the BoJ would just print more money and buy bonds)."

Holding interest rates constant, yes. Holding AD constant, one of two things would happen - either a default risk premium appears in government debt, or (more likely) the central bank raises interest rates. The higher rate compensates investors for the risk of unexpected inflation.

The BOJ buying all government debt would make default impossible (well, technically possible, but useless). This is the dreaded monetization. A self respecting central banker wouldn't do that. :-)

[Lord]

Why not earlier? The reason is we have this false separation of monetary and fiscal policy and debt (deficit) is considered fiscal policy, but if monetary policy acts last, it is every bit as much monetary policy as interest rates.

[Rob]

Was the title supposed to be a Fist of The North Star reference?

[PierGiorgio Gawronski]

In an open economy there is always a level of the real effective exrate where you can export your problems away. In other words, if bond vigilantes do not appear and (nominal and real) interest rates go up only because of the recovery, then there must be an exrate level such that g>r and dg>dr by a lot; so for even very high debt levels, ABenomics should stabilize the debt. If bond vigilantes come, the BOJ can insure the JP sovereign bonds so that they will only be pushing down the exrate. So it is not too late to stabilize the debt provided that BoJ manages expectations corrrectly and the Yen falls quickly and by a lot.

[Tom Brown]

Question: Why can't Japan control i (or r) by only issuing short term debt? If the rate on 10 year and above maturity debt is too high, don't issue debt with maturities that long.

Also, can't the BoJ control any part of the yield curve it desires by essentially performing OMOs with whatever maturity debt it targets?

[K]

Tom Brown,

"Why can't Japan control i (or r) by only issuing short term debt?"

Agreed.

"can't the BoJ control any part of the yield curve it desires by essentially performing OMOs with whatever maturity debt it targets?"

If the targeted levels imply absurd forward rates, then the CB is going to get enormous resistance from arbitrageurs. They may not achieve their target before they've mopped up the entire outstanding of bonds in some given sector of the term term structure. So it depends on the degree of sanity of the implied future spot rates.

[Richard H. Serlin]

This is not an area of expertise for me, clearly, but what I was thinking about was suppose inflation expectations go up a lot right now, so the nominal amount that the Japanese government must pay to issue new debt goes up a lot right now. Well, eventually, if the expectations are right, the inflation will come, and then nominal tax receipts will go up commensurately, so the money is there to pay the higher nominal interest.

But what if the actual inflation doesn't come for a while? What if it lags the expectations a lot? Maybe the Japanese government will have severe trouble paying the new higher interest until the actual inflation comes, maybe a lot later, to increase their revenues.

That's what I was thinking could maybe, theoretically, be a problem, an issue of timing, liquidity, and what if the expectations turn out to be wrong and the higher inflation doesn't come later to increase nominal tax receipts.

[A]

All Japan needs to do is formally announce that they'll always sooner print than default (something markets already assume anyway), and then there'd be no level of debt that the Japanese government cannot service, making your whole essay moot.

It's easy to see why: with that promise in play, there's no safer entity that you can loan yen to than the Japanese government. You'd never loan to Nissan, Toyota or a homeowner for a lower interest rate, because printing affects you equally both ways but the latter may default in *addition* to the risk of default.

With that promise in place, regardless of how much debt the government has or how much savings Toyota has, the Japanese government would always get the cheapest lending. Therefore the Japanese government can continue to fund itself with bond sales, even when/if its interest payments exceed revenue. It sounds crazy to a currency-user, but only because we cannot assure our creditors we can pay them back. A currency-issuer can make that assurance however. Insolvency is just not a meaningful term.

Just think. How much interest would you charge the Fed for a 30day loan of USD? The risk-free rate is < 0.5%, you don't have any safer options.. you'd be lucky to not be underbid by some bank offering the loan for a fraction of a percent. Would this change if it turned out the Fed has trillions of these 30 day loans outstanding? If you credibly believed the Fed wasn't going to voluntarily default, of course not. Same story with yen and the Japanese government. If the government just assured people that it'd never do something so daft as to voluntarily default, it'll never have to print *or* default. It could always fund itself with bond sales.

[Knives Nelson]

I agree with Richard! There is no debt:GDP max. The bank of Japan is the sovereign and sole issuer of the yen. Default would be entirely voluntary. However if the most honorable and responsible country in the world voluntarily defaults on its obligations....

[Declan]

If default is death, countries must be phoenices (sp?)

[Max]

A, it's true that the government can obtain the lowest interest rate if its debt is guaranteed by the central bank. But there's still the risk of the interest rate rising above GDP growth, causing a debt explosion which can only be stopped by unexpected inflation (or budget surpluses excluding interest).

Fear of inflation hasn't been a problem recently - quite the opposite. But it could happen.

[A]

Max, short term debt will always trade for exactly what the BoJ wants it to trade for. The Japanese government can sell 30day notes and get exactly that if it wants, 0% interest. It cannot "rise" short of the BoJ lifting rates.

But you are right that if the BoJ decides to lift rates, interest payments could become obscene. The BoJ won't do that unless the economy's bumping up against demand constraints - in which case, a reduction in the deficit or a surplus is completely appropriate anyway. The important thing to note is that this contractionary fiscal policy would be run at a time when the economy's fully employed, and not before. It doesn't cost jobs/growth, it's merely removing demand the economy cannot meet.

In fact, there you have your more general solution: start managing demand through fiscal policy, strong automatic stabilisers and the like, and forget monetary policy. Use fiscal policy to keep monetary policy as close to real 0% as you can. Monetary policy is a flawed tool anyway - real negative interest rates make it impossible to safely store wealth in the currency, real positive interest rates mean people get money for merely having money - exactly the same as a deflationary currency. The sooner we ditch it in favor of far more flexible fiscal policy, the better imo.

[Nick Rowe]

A: "Use fiscal policy to keep monetary policy as close to real 0% as you can."

For most of history, real interest rates have been positive. In order to have kept real interest rates at zero, fiscal policy would need to have been much tighter (higher taxes and/or lower government spending, government surpluses instead of deficits), so instead of positive debt/GDP ratios, we would have negative debt/GDP ratios. Which means we would all be in debt to the government, and/or the government would own a large percentage of the means of production. See where it's leading you? And what's so good about 0% real interest rates anyway? Suppose that farmland paid positive rents of $100 per acre, inflation-adjusted, forever. How much would an acre of farmland be worth, at 0% real interest rates forever? (Answer: $infinity.) Would it be a profitable investment, at 0% real interest rates forever, to use all of our GDP to flatten out the Rocky mountains and convert them into farmland? (Answer: yes.) So consumption would be zero, because everybody would be working to flatten out the Rocky Mountains and no resources would be left over to produce food today.

I just wish the MMT guys would stop and think. Even the Soviet central planners figured out that 0% real interest rates led to some very silly investment decisions.

[Nick Rowe]

Knives: Assume a country had $1 zillion in debt, in its own currency. If it wanted, it could pay off the whole of that debt by simply printing 1 zillion dollar bills. But would people *want* to hold 1 zillion dollar bills, paying 0% interest nominal? Because if they didn't, they would spend them, which would create an excess demand for goods, and a very high level of inflation, so the zillion dollar bills would be almost worthless. Is that default? Well, a lawyer might say "no, because it paid what it promised". But any sane person would say it amounts to the same thing.

[Frank Restly]

Nick,

"I just wish the MMT guys would stop and think." Read what Brad Delong has to say about MMT. It is a tautology, not a policy guide.

[Tom Brown]

"Is that default? Well, a lawyer might say "no, because it paid what it promised". But any sane person would say it amounts to the same thing."

Lawyers or sane people: mutually exclusive groups? Ha! ;)

[Max]

"The BoJ won't do that unless the economy's bumping up against demand constraints - in which case, a reduction in the deficit or a surplus is completely appropriate anyway. The important thing to note is that this contractionary fiscal policy would be run at a time when the economy's fully employed, and not before. It doesn't cost jobs/growth, it's merely removing demand the economy cannot meet."

If the government has to sharply raise tax rates, that has a real cost relative to a policy which keeps tax rates more stable.

We don't want tax rates to swing around wildly while interest rates remain constant. It's better for tax rates to be stable while interest rates swing around wildly.

[A]

Nick Rowe: "And what's so good about 0% real interest rates anyway?"

Let's clarify what interest rates we're talking about. The central bank sets the *risk-free* rate of interest. That is, how much money you get for taking zero risk. I'm arguing that you should never be given free money for taking no risk. You're arguing that we should, and it should be the norm. Why? To me, in a capitalist society you ought have to do something, be it work or take risk, to earn a profit. Not merely have money.

Your "flatten the Rocky's" example is absurd. Nobody's arguing that high-risk loans such as converting the Rocky's into farmland ought go for free interest, only risk-free loans. Try going to a bank and telling them your business plan and they'll laugh in your face - this is anything but a risk-free borrowing. Nobody would loan you the money.

Monetary policy really is inherently flawed, which is why I don't think much of it. When rates are positive it's paying people money for having money, whilst they take no risk themselves. By introducing all spending via loaning, it's always feeding money into the hottest parts of the economy first - those that can absorb spending are the last to receive it. That is, it's constrained by the boom parts of the economy (let's say California) whilst unable to help others that are in outright depression (Detroit). It's additionally powerless to encite demand when demand for credit is low, as we see today. In the absence of a Job Guarantee (a fiscal policy option) it additionally entrenches long-term unemployment (and therefore crime, loss of skills and output) as central bankers cannot ever allow labor to become a scarce resource. I really don't see much to recommend it by.

Max: "We don't want tax rates to swing around wildly while interest rates remain constant. It's better for tax rates to be stable while interest rates swing around wildly"

Strong automatic stabilisers such as a job guarantee allow both to be stable. Keep interest rates stable at zero percent (that is, nobody gets paid money merely for having money) which is where they would be if the Fed and treasury wasn't artificially raising them, and use the JG to anchor prices keeping inflation at zero percent.

If you're unfamiliar with a JG it's essentially this. The government ensures at all times that there's a buffer of people employed at a fixed wage. Let's call it $10/hr. By ensuring that this buffer is kept non-empty, inflation of unskilled wages is non-existent as any firm can hire from this buffer by merely offering more than that fixed wage. It functionally replaces both the unemployed we currently use to manage inflation and the minimum wage.

The JG itself is largely self stabilising, as as employees are hired from it the net injection of spending from the government is reduced - as employees are returned to it, it's increased. Combined with other strong automatic stabilisers (consumption tax etc) the government ought not need to do a *great deal* to keep the buffer non empty.

As for the actions it does take, it *could* alter tax rates to keep this buffer non-empty, it could use monetary policy, or the government could simply alter its discretionary spending. If the JG is not providing sufficient stabilisation in a bust for instance, lower taxes and/or spend on infrastructure. If the JG, consumption taxes etc are not providing sufficient stabilisation in a boom, raise taxes and/or cut discretionary spending. There's a heap of options - it needn't be volatile taxes.

[Nick Rowe]

A: You are ducking the question (and confirming my opinion that MMTers don't understand even the basics of interest rates).

Would you argue that the government should buy and sell apples and bananas to ensure that the relative price of apples and bananas was always equal to one? Presumably not.

Why then would you argue that the government should intervene in the market for current apples vs promises to pay apples one year in the future to ensure that the relative price of those two goods always equals one?

If you were a central planner, deciding on how many resources to devote to consumption vs investment. Would you say that one extra future apple is always as good as one extra apple today? What if that meant you would be consuming zero apples today, and wouldn't be consuming any apples for 1,000 years, because you would be planting all the apples so you could have even more apples in future?

Yes, I know about the JG. I have blogged about it.

[Nick Rowe]

On ducking the question: just suppose I did convince you that I had an investment project that would pay a risk-free return of $1 per year inflation-adjusted forever, even though it would take the whole of world GDP for 10 years to do that investment project. Would you then say "sure, then go ahead!" Because, at a real interest rate of 0%, the present value of $1 per year forever would be infinite, so the investment would be profitable.

I learned this example from my teacher in high school economics. MMT hasn't even caught up with my high school teacher 40 years ago, when it comes to understanding interest rates.

[A]

Nick Rowe:

Apparently further clarification was needed. The Fed manages risk-free **short-term** interest rates. This is monetary policy 101.

Long term interest rates will always be higher, even if the short-term risk rate is 0% and will be forever. This is simply because lenders have a preference for short term IOUs over long term IOUs.

I would agree, manipulating rates such that even 1000yr "risk free" loans (whatever that means over that timescale) are going for 0% interest would be a stupid thing to do.

"If you were a central planner, deciding on how many resources to devote to consumption vs investment"

You're subscribing to an Austrian fallacy there, that "the market" in the absence of the Fed would somehow choose rates based on how much we are "saving".

This is mighty flawed in a free floating fiat money system in many different ways. Ignoring the fact that loans create deposits, the biggest flaw is that in aggregate, we do not decide to save and/or dissave (I highly recommend reading and rereading that PDF until you understand it). We can decide to invest, but "deciding to save" does nothing to alter interest rates.

This is simply because whether we in aggregate try to save/dissave, nothing changes if you view the banking sector as a whole. See, if you decide to lower your savings you do so by consuming.. this is merely income provided to a shopkeeper/pubkeeper etc and if they do not do something about it (like consuming themselves) and their savings will increase accordingly. We cannot clear a surplus of savings amongst ourselves - and the banking sector as a whole always has the full amount that they can draw upon as reserves.

Similarly if you decide to save - you're now depriving someone else of income, draining what would have been their savings. Not that it matters, because once again the banking sector as a whole still has the full amount they can draw upon as reserves.

Once you accept that whether we're trying to save or consume bank reserves are left unchanged, you see that in the absence of the Fed draining liquidity via bond sales and/or paying interest on reserves, interest rates would be zero (for short-term risk free debt). This is perfectly fine - why should someone be paid money for taking zero risk on a short-term basis anyway?

Or, in your apple scenario - if you loan someone an apple overnight, creating a brand new apple from nothing in the process (your flawed analogy is flawed!), and you have a 100% guarantee that they'll pay you back tomorrow, why should they pay you interest on that apple?

Positive interest rates are the distortion, introduced by the Fed, just one more reason why they should be zero.

[Nick Rowe]

A: you are still ducking the question.

Suppose my mountain project were reversible. So I could liquidate my investment at any time and get back the zillion dollars in real resources I had put into it, plus the $1 annual rents. I would then borrow on short term loans, keep rolling those loans over forever, and make a profit.

Here's another example. Suppose the only good produced is wheat. Suppose we have a bad harvest this year, but know we will have a better harvest next year. So we consume little wheat this year, but will be consuming lots of wheat next year. If real interest rates were 0%, everybody would want to borrow wheat and consume more this year, and pay back the loan next year. We would get an excess demand for wheat this year. How does the government decide what rationing scheme to use and so decide who gets the loans? And if the government does ration loans, and a black market springs up, are real interest rates really zero?

[Nick Rowe]

Under what circumstances should apples and bananas always have the same price, so they always trade one-for-one?

1. If they were perfect substitutes in consumption, or

2. If they were perfect substitutes in production.

Under what circumstances should present apples and future apples always have the same price, so they always trade one-for-one?

Same answer as above.

[A]

Nick Rowe: "If real interest rates were 0%, everybody would want to borrow wheat and consume more this year, and pay back the loan next year"

When you borrow wheat, somebody else has to go without wheat. When you borrow money, more money is created, for loans create deposits. Nobody has to go without.

When you go and borrow $50k to buy a vehicle, no one is down $50k. An extra $50k is just created into existence by banks, for that is the nature of fiat money. You're never turned away from a bank because they've exhausted their loaning capacity, nor does anyone see their accounts debited because the bank's made a loan (provided the bank remains solvent at least). Borrowing fiat money is completely different to borrowing wheat, something you really should recognise.

That is, if I borrow wheat, someone's "account" is debited the amount I borrow. If I borrow fiat money however, the bank simply creates a deposit in my account. Nobody has money removed from their account. If at the end of the bank is short of its reserve position it's no big deal - it merely borrows on the interbank lending markets at 0% interest so that its reserve position is met. See the difference between borrowing fiat and borrowing wheat? The former creates more of the thing you're borrowing, the latter just moves it around.

Now if you're borrowing fiat money to buy wheat, and there's a wheat shortage, standard supply/demand dictates that prices of wheat will rise. You can't buy more wheat than is for sale regardless of what the price of credit is. The market allocates who gets the limited resource via prices, as you'd expect.

Your other example is far too bizarre to be taken seriously - if your "project" is completely reversible for zero cost, then you're not really doing any work, are you? You're not consuming anything, the labor is costing you nothing - the project is already zero cost. Why would you expect to have difficulty funding a project that's consuming no real resources?

[Nick Rowe]

A: if you borrow money and sit and look at it, nobody has to go without, provided the central bank prints more money for you to borrow.

But if you borrow money to buy wheat, and buy that wheat and consume it, and if no more wheat is produced, somebody has to go without wheat.

"Now if you're borrowing fiat money to buy wheat, and there's a wheat shortage, standard supply/demand dictates that prices of wheat will rise."

Yep. And if there's a shortage of wheat this year, and no expected shortage of wheat next year, as in my example, the price of wheat this year has to rise, relative to the expected price of wheat next year, to eliminate that excess demand for wheat. Which means the real interest rate (the nominal interest rate minus the expected inflation rate on wheat) has to rise to eliminate that current excess demand for wheat.

You misunderstand my other example. It is costing you real resources, by assumption, but you can close down the project at any time and get those real resources back.

[A]

Nick Rowe: "Which means the real interest rate (the nominal interest rate minus the expected inflation rate on wheat) has to rise to eliminate that current excess demand for wheat"

And now I see where we've come unstuck.

The natural *nominal* rate of interest without the Fed acting to lift rates is 0%. This may very well be real *negative* if there's supply side pressures going unmanaged by fiscal policy leading to inflation. ie in your scenario, you're supposing an absent government, interest rates at zero, and then observing that the wheat shortage is causing prices to rise and therefore real interest rates to be above zero.

What I said earlier though is that I would use fiscal policy to maintain real interest rates near 0%. It's in the bit you quoted A: "Use fiscal policy to keep monetary policy as close to real 0% as you can."

This means that if there is only one good, wheat, and it is undergoing a supply side shock, I would act to reduce overall spending in the economy to a level such that the price of wheat doesn't rise. You would do the same - but your weapon of choice is subsidising savings. Mine would be fiscal policy, reducing spending or raising taxes.

In fact, in this single good economy, a simple buffer wheat system would minimise the amount of fiscal adjustments needed year to year to maintain price stability in much the same way a job guarantee would a real economy.

Anyway, the only reason I said "Use fiscal policy to keep monetary policy as close to real 0% as you can" is so that if the government chooses, for whatever reason, to create 2% inflation (conventional wisdom says this is good) then it should aim to adjust demand such that monetary policy is running 2% interest rates (above the "natural rate"). This was merely to drive home that just as I feel nobody should be paid money for merely having money, nor do I feel people should be unable to store wealth in the currency.

[Nick Rowe]

A: As the current price of wheat rises, relative to the expected future price of wheat (i.e. as the real interest rate rises) people will reduce their demand for current wheat. So too (presumably) should the government reduce its expenditure on current wheat. For example, it should maybe reduce the amount of wheat it pays to the soldiers, and to the poor. But if you wanted to reduce the real rate of interest all the way back down to zero, the government would need to reduce its own expenditure on wheat by a large enough amount so that private consumption of wheat returns to normal. That would mean that (absent storage of wheat from one harvest to the next) the soldiers and the poor (or whoever) would have to cut their consumption by the full amount of the harvest losses. (And in a good year, the soldiers and the poor would eat *all* of the extra harvest.) Because the only way you can keep real interest rates at 0% is if private consumption stays exactly the same from one year to the next (assuming bad harvests are the only shock).

If you want fiscal policy to adjust to keep the real rate of interest at zero, it can (usually) be done. (I say usually, because it might mean making G negative in some years). But it doesn't seem very sensible to have a fiscal policy in which soldiers and the poor starve in lean years and are stuffed in good years, with everyone else eating the same amount of wheat in good and lean years.

[A]

Nick Rowe:

You're talking about a real supply side shock. **Somebody** has to go without. That's the simple reality of the situation.

If you choose to do nothing, inflation will set in, you'd lose price stability of the currency, and the limited wheat would simply go to the wealthiest. If the soldiers are not the wealthiest, they'd go out - just as in your fiscal example.

If you choose to use monetary policy, those willing to save will lose out today - but be granted a *far greater portion* of next year's harvest. Depending on the extent of the price shock, you may not be able to maintain price stability - many countries have seen high inflation despite offering 17%+ interest rates to anyone willing to just save instead.

If you choose to use fiscal policy your options are endless. You could cut the solider's pay, as you suggest. You could increase taxes on any sector of the community. Wealthy consuming so much wheat so that there's not enough to go around? Increase taxes on that sector. You *could*, if you decided, even subsidise savings - for monetary policy is just a subset of the options available to you. Again though, you'll have difficulty maintaining price stability through a large shock by merely giving everyone *more* money, as monetary policy would do.

[Nick Rowe]

A: We agree that in this supply shock case, we have 3 options:

1. Change fiscal policy in a way we might not want to do (because the soldiers and poor would starve)

2. Allow inflation to fluctuate so that real interest rates rise above zero

3. Allow nominal interest rates to rise above zero so that inflation can stay constant.

I prefer options 3.

Now let me change the example away from a supply shock.

The important ingredient in my bad harvest example is that people expect next year's consumption will be higher than this year's consumption. That's what drives real interest rates up above 0%. Lets simply assume that real economic productivity growth causes the wheat harvest to rise by (say) 2% every year. You get the same results. Only now the real interest rate will be above 0% every year, if consumption is rising at 2% per year. And if we wanted to push real interest rates down to 0%, fiscal policy would have to do something very strange. We would have to tell the people that the soldiers and the poor would be eating *all* of the increased wheat production in future years, so that private consumption of wheat would stay constant over time. So government would be taking a larger and larger fraction of total wheat output every year, as the country got richer, while private consumption would stay the same every year.

That doesn't sound like a very sensible fiscal policy.

Yes, fiscal policy has lots of options. There are a lot of different things you might want to do with fiscal policy. But if you constrain fiscal policy, by telling it that fiscal policy must make sure that real interest rates are 0% each and every year, you won't be able to do some of those things, and you will probably end up with a very silly fiscal policy. So maybe you could let monetary policy handle the job of getting aggregate demand right, and let fiscal policy free to do those other things well.

[A]

You're saying some simply bizarre things. Why do the poor/soldiers have to starve? Why can't you simply increase taxes on the rich, reducing their consumption? Why do the poor and soldiers have to eat all excess production in the future? Why can't you simply lower taxes in those times of high wheat yields?

I don't know why you see the expenditure side as having to make up the entirety of the deficit. Soldiers don't have to lose all the food in bad times and absorb it all in boom times - you can just as easily alter taxes, sharing the burden however you want according to your political goals.

Monetary policy is just a tiny tiny tiny subset of the options available, and a blunt weak tool at that. It often can't restrain inflation. It feeds money straight to the boom sectors, an inherently inflationary practice (one reason we aim for 2% inflation) whilst leaving many towns and cities across the continent shrinking. There just really isn't much to recommend it by.

Also, you seem to be making out that the government has to force interest rates down. It's actually quite the opposite. It's not a matter of "allowing nominal interest rates to rise above zero" - what you're referring to is the central bank restraining liquidity such that they do. It's a deliberate action by the central bank to subsidise savings, it's not a simple case of "allowing" interest rates to move.