Magical Monetary Theory

This article appeared in The Wall Street Journal on June 4, 2019.
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"Modern monetary theory" is the latest craze to circulate among the chattering classes. It is a fuzzy, post-Keynesian theory that has caught on in antiausterity circles. The MMT doctrine states that fiscal deficits don’t matter as long as countries borrow in their own currencies and inflation stays in check. This is like manna from heaven for proponents of more government spending and larger fiscal deficits.

Not surprisingly, MMT has reared its head in Japan, where debt is denominated in yen, inflation is nowhere to be found, and the ratio of government debt to gross domestic product has gone to the moon. MMT advocates claim Japan provides proof for their theory, but nothing could be further from the truth.

Separate, potent forces have given rise to two seemingly strange trends in the Japanese economy: dramatic changes in the savings-investment balances in the public and private sectors, and the failure of monetary policy. MMT doesn’t explain either one.

At the outbreak of the global financial crisis in 2008, Japan’s government deficit was only 2% of GDP, while the combined corporate and household surplus amounted to 5.1%. Within a year, a massive contraction of private investment and consumption occurred in Japan. By the fourth quarter of 2009, the private-sector surplus had surged to 12% of GDP. At the same time, the government deficit exploded to 9.9% of GDP. The resulting net savings surplus has fueled capital outflows. Today, these outflows amount to 2.1% of GDP and finance a stream of Japanese foreign investment.

This pattern of large private savings surpluses offset in part by large public deficits continues. The result has been a massive increase in the size and role of the Japanese public sector. Government debt has risen from 60% of GDP in 1990 to an astounding 235% today. But contrary to MMT, this fiscal extravagance has done nothing to boost the economy.

Separate from Japan’s overall savings surpluses, its broad-money metrics have grown at a snail’s pace. Since Japan’s bubble burst in 1990-91, broad money has grown at a paltry 2.6% a year, as measured by M2. In addition, since the 1950s money velocity has been negative, decreasing at an average rate of close to 2% a year. This is one of the most striking and consistent macroeconomic relationships on record. Japan’s slow broad-money growth mixed with a contracting money velocity has held down nominal GDP growth.

Faced with a contracting money velocity, Japan would have to increase its M2 money supply at a minimum of 5% a year, which is double its trend rate, to hit its inflation target of 2% a year and reach its potential annual growth rate of 1%. In practice, inadequate M2 growth over nearly three decades, combined with a declining money velocity, has translated into average real growth of just 0.9% a year. This has put Japan into a deflationary straitjacket, with prices decreasing by an average of 0.6% a year, as measured by the GDP deflator.

As long as M2 growth in Japan remains minimal, low inflation—or outright deflation—will prevail regardless of whether the public and private sectors are running savings surpluses or deficits. As Milton Friedman counseled, “Inflation is always and everywhere a monetary phenomenon.” The same is true of deflation. Money dominates.

Understanding Japan and other economies requires classical monetary theory, not MMT nostrums. From 1974-84, Japan enjoyed a golden period with generally stable broad-money growth, steady real GDP growth, and low inflation. Then monetary policy was derailed by the 1985 Plaza Accord and the 1987 Louvre Accord. The Bank of Japan dropped monetary targets and began to focus on interest-rate targets. The result was Japan’s disastrous bubble from 1987-90, followed by a so-called lost decade, which has turned into a lost generation.

According to the Bank of Japan, the basic idea of interest-rate targeting is that if interest rates can be pushed low enough, sooner or later companies or households will start spending. But as Irving Fisher showed a century ago, interest rates follow inflation; they don’t precede it. That is why economies experiencing high rates of inflation, like Argentina and Turkey, have high interest rates, while Japan and the eurozone have very low or even negative rates.

For Japan (and the eurozone), this circle can be broken only by increasing broad-money growth. The best way to do that would be for the central bank to purchase securities from nonbank institutions such as insurance companies and pension funds, creating new deposits. But the vast bulk of the Bank of Japan’s securities purchases currently come from banks. That’s why broad-money growth in Japan remains anemic.

Recent U.S. history also demonstrates the superior explanatory power of classical monetary theory. From 1971-82, M3 money-supply growth averaged 11.6% a year, while the average level of government debt was only 40.1% of GDP. This combination of rapid monetary growth and low government debt resulted in relatively high inflation. Money dominated.

Today the U.S. faces the opposite: low broad-money growth with high government debt. Since 2009, M3 growth has averaged 4.5% a year, while federal, state and local government debt today is more than 100% of GDP. This combination has resulted in relatively low inflation. This is no mystery. As always, money dominates.

MMT advocates would have us believe that governments can run deficits without limit as long as they are financed by securities denominated in their own currencies—at least until inflation takes off. What they fail to understand is that budget deficits have nothing to do with inflation, unless they are financed by rapid broad-money growth. Money dominates economic trends, and classical monetary theory tells us why. Beware of those peddling MMT snake oil.

John Greenwood and Steve H. Hanke

John Greenwood is chief economist at Invesco in London. Steve H. Hanke is a professor of applied economics at the Johns Hopkins University.