Abstract
In the past quarter century, Japan’s economy has seen rates of interest, including those on long-term public bonds, remain quite low despite colossal accumulation of public debt, while the price level has been mildly deflationary or almost constant despite rapid monetary expansion. In this chapter, these puzzling phenomena are interpreted using a simple disequilibrium analysis framework. The major reasons for adopting disequilibrium analysis are that (1) Japan’s economy often fell into excess supply in both goods and labor markets after short-term rates of interest were controlled below 0.5% in mid-1995, and (2) public bond markets were clearly in serious excess supply given the expectation that the primary fiscal balance was not going to turn into surpluses in the future relevant to those bonds being issued. In the proposed disequilibrium model, excess supply in goods, labor, and public bond markets is absorbed by excess demand in money markets, induced by strong money demand at near-zero interest rates. In particular, strong money demand absorbs public bonds not as investment instruments, but as money substitutes. This chapter also demonstrates that excess demand in money markets in disequilibrium analysis can be interpreted as public bond price bubbles in equilibrium analysis. Given the analogy between the two approaches, as far as the bubble is sustained, mild deflation and near-zero interest rates continue in spite of massive issues of public bonds and rapid expansion of money stocks. On the other hand, once the bubble bursts, money demand shrinks drastically, a wide range of interest rates rise suddenly, and the price level jumps abruptly. With the government’s credible commitment to future fiscal reforms, a one-off price surge would stop immediately at a level two or three times higher than before, but without the reforms, the price process would be hyperinflationary.
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Notes
- 1.
See Wray (2015) and others for detailed descriptions of MMT and its policy recommendations.
- 2.
Armstrong and Okimoto (2016) survey the literature on fiscal sustainability in Japan. Imrohoroglu et al. (2019) update Imrohoroglu et al. (2016), and present detailed simulations of the sustainability of Japan’s fiscal conditions. The Fiscal System Council, MOF (2018) reports the long-term prospects for Japan’s fiscal policies.
- 3.
The theoretical framework presented in this section is out of the context of mainstream modern macroeconomics, where all markets are assumed to be in equilibrium simultaneously. Even within modern economics, however, some schools of thought have taken disequilibrium phenomena in money markets seriously. Yeager (1986) surveyed orthodox monetarists, showing that they always considered monetary disequilibrium to be responsible for a systematic relationship between the general price level and monetary aggregates. On the other hand, Zahringer (2012) showed that in Austrian economics, disequilibrium in plural money markets was thought to cause business cycles in a complicated manner. Of course, the orthodox monetarists and the Austrians had sharp disagreements on disequilibrium approaches. In contrast to the orthodox monetarists, Austrian economics took relative prices, not the general price, seriously, and were extremely reluctant to aggregate individual variables to construct macroeconomic variables.
- 4.
Another drastic departure from equilibrium analysis is disequilibrium dynamics, proposed by Iwai (1981). In the so-called Wicksellian case with flexible prices, the price level continues to fall heavily once aggregate demand runs short of aggregate supply. However, this model may not be applied to the current Japanese economy, in which the present price process is not in a deflationary spiral, but only mildly deflationary.
- 5.
Ono (2001), Ono et al. (2004), and others adopt a rather different assumption on utility from real money balances to derive a strong liquidity preference. That is, \(\mathop {\lim }\nolimits_{{\frac{M}{P} \to \infty }} v^{\prime } \left( \frac{M}{P} \right)/u^{\prime } \left( c \right) > 0\). Such strong demand for money and assets, induced by this unconventional assumption, yields the same predictions as those in this chapter, such as stagnant aggregate demand, high unemployment, and downward pressures on the price level. A major difference between their model and the model presented in this chapter is that in the former any wealth including public bonds are always close substitutes for money in generating liquidity conveniences, but in the latter public bonds and money are close substitutes only at near-zero interest rates. Consequently, the two models make very different predictions once interest rates take off from the zero level; that is, the former is still Keynesian, but the latter returns to a neoclassical model.
- 6.
As implied by Eq. (2.6), under the assumption that \(\sum_{i=1}^{N}{B}_{i}^{d}\left(t-1\right)+\sum_{i=1}^{N}{M}_{i}^{d}\left(t-1\right)={B}^{s}\left(t-1\right)+{M}^{s}\left(t-1\right)\), goods and labor markets are ex post cleared; that is, \(\left\{y\left(t-1\right)-\left[inv(t-1)+c\left(t-1\right)+g\left(t-1\right)\right]\right\}+w\left(t-1\right)\left[{l}^{s}\left(t-1\right)-{l}^{d}\left(t-1\right)-{l}_{g}^{d}\left(t-1\right)\right] \left\{y\left(t\right)-\left[inv(t)+c\left(t\right)+g\left(t\right)\right]\right\}=0\).
- 7.
Equation (2.6) is interpreted to share characteristics of both beginning- and end-of-period formulations in assets markets equilibrium, both of which are proposed by Foley (1975) and others. In end-of-period models, the market-clearing conditions of not only goods markets, but also money and bond markets are defined in terms of flow variables. Here, Walras’s law holds for all of goods, money, and bond markets. In beginning-of-period models, on the other hand, the market-clearing conditions of assets markets are defined in terms of stock variables. In the latter formulation, Walras’s law does not hold. Accordingly, the market clearing conditions of goods markets can be separated from those of assets markets as in the IS–LM model. According to Eq. (2.6), the current setup shares the nature of end-of-period formulations in the sense that Walras’s law holds for all of goods, labor, money, and public bond markets, but it has the property of beginning-of-period formulations in that stock variables appear in the market clearing conditions of assets markets.
- 8.
As emphasized in chapter “Central Bank Cryptocurrencies in a Competitive Equilibrium Environment: Can Strong Money Demand Survive in the Digital Age?”, when bond interest coincides with currency interest (equal to zero in this case), public bonds are also equivalent to money in that neither generates any additional currency convenience.
- 9.
Equation (2.3) is rewritten as follows:
$$\begin{aligned} \frac{{B\left( {t - 1} \right) + M\left( {t - 1} \right)}}{{P\left( {t - 1} \right)}} & = \frac{{P\left( t \right)\left[ {tax\left( t \right) - g\left( t \right) - w\left( t \right)l_{g}^{d} \left( t \right)} \right]}}{{P\left( t \right)\frac{{P\left( {t - 1} \right)}}{P\left( t \right)}\left[ {1 + i\left( t \right)} \right]}} \\ & \quad + \frac{{i\left( t \right)M\left( {t - 1} \right)}}{{P\left( {t - 1} \right)\left[ {1 + i\left( t \right)} \right]}} + \frac{B\left( t \right) + M\left( t \right)}{{P\left( t \right)\frac{{P\left( {t - 1} \right)}}{P\left( t \right)}\left[ {1 + i\left( t \right)} \right]}} \\ & = \frac{1}{1 + \rho \left( t \right)}\left[ {tax\left( t \right) - g\left( t \right) - w\left( t \right)l_{g}^{d} \left( t \right)} \right] \\ & \quad + \frac{1}{1 + i\left( t \right)}\frac{{i\left( t \right)M\left( {t - 1} \right)}}{{P\left( {t - 1} \right)}} + \frac{1}{1 + \rho \left( t \right)}\frac{B\left( t \right) + M\left( t \right)}{{P\left( t \right)}} \\ \end{aligned}$$As the above equation implies, the real seigniorage arises on the previous real money balance \(\left(\frac{i\left(t\right)M\left(t-1\right)}{P\left(t-1\right)}\right)\), and is accordingly discounted by the nominal rate of interest. On the other hand, the real fiscal surplus is defined at the current period \(\left(tax\left(t\right)-g\left(t\right)-w\left(t\right){l}_{g}^{d}\left(t\right)\right)\), and is consequently discounted by the real rate of interest.
- 10.
According to chapter “Long-Run Mild Deflation Under Fiscal Unsustainability in Contemporary Japan”, if the transversality condition fails to hold in the equilibrium analysis of Eq. (2.11), then the bubble term, which is finitely positive at asymptotically zero rates of interest, contributes to appreciation of the real balance of public bonds \(\frac{{B}^{s}\left(t\right)}{P\left(t\right)}\) and yields deflationary pressure on the current price level. Kobayashi (2019), Sakuragawa (2019), Murase (2020), and Brunnermeier et al. (2020) also demonstrate that deflationary pressure is generated by the unsatisfied transversality condition in the consolidated government’s budget constraint. Hagedorn (2018) regards government bonds as net wealth in the sense that the bond valuation exceeds the present value of future fiscal surpluses, and presents a similar monetary model.
- 11.
If both the nominal rate of interest and the price level converge to zero in the limit, \(B\left(t\right)-B\left(t-1\right)\) also converges to zero in Eq. (2.3).
- 12.
Estimates for the output gap are from Kawamoto et al. (2017), and their updates.
- 13.
According to Nakayama et al. (2004), rapid rises in long- and ultra-long-term yield spreads in mid-2004 were triggered by an increase in US long-term yields, and the market participants’ expectation that QE would be terminated quite soon (though it actually ended in March 2006).
- 14.
Chapter “Long-Run Mild Deflation Under Fiscal Unsustainability in Contemporary Japan” explores in a theoretically rigorous manner how longer-term yields decline toward zero slowly given the expectation that the public bond price bubbles will burst in the (far) future.
- 15.
However, the Public Finance Act allows the BOJ to underwrite and refund T-bills for the government directly.
- 16.
Note that the BOJ’s taxes and payments on the government accounts [(5) in Fig. 18] are excluded from net changes in the TFs.
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Appendix: How Did the BOJ de facto Refinance Its Own JGBs at Maturity?
Appendix: How Did the BOJ de facto Refinance Its Own JGBs at Maturity?
In this appendix, we show that strong money demand, together with rapidly declining yields on long-term JGBs, helped the BOJ to refund de facto its own JGBs at maturity, without violating any strict restriction imposed by the Public Finance Act. Under the Public Finance Act, the BOJ is prohibited from directly refinancing long-term JGBs for the government.Footnote 15
The BOJ usually finances a purchase of T-bills, long-term JGBs, and other bonds through either increments to the BOJ’s current accounts (CAs), which are largely reserve deposits, or additional issues of BOJ notes. Accordingly, the BOJ’s net purchases of JGBs almost match increases in the monetary base, which consists of the BOJ notes and CAs. As Fig. 17 shows, however, the BOJ’s net purchases of JGBs and other government liabilities (dotted line) has exceeded changes in the monetary base (solid line) considerably since FY1999. In particular, the former surpassed the latter by more than 100 trillion yen from FY2013. As shown below, these differences have contributed to the BOJ’s de facto refinancing of its own JGBs at maturity.
Changes in the monetary base and the BOJ’s net purchase of JGBs and other assets, 1985–2018 (unit: trillion yen). Note (1) The MOS, which are compiled by Financial Markets Department, BOJ (2003–2019), report the sources of changes in current accounts at the BOJ
What was happening to the above transactions among the BOJ, government, and private banks is explained as follows:
-
(1)
The government issued new JGBs to private banks to raise funds for redemption of the BOJ’s own JGBs at maturity.
-
(2)
The BOJ received funds from the government as a result of redemption of its own JGBs, and appropriated those funds for purchases of newly issued JGBs from private banks.
The above transactions among the BOJ, government, and private banks meant that a net purchase of JGBs by the BOJ was recorded positive in the Market Operations Statistics (MOS), which is compiled by the Financial Markets Department of the BOJ, but changes neither in the BOJ CAs nor in the balance of the BOJ’s own JGBs appeared in the MOS. Here, withdrawals from the CAs, which are accompanied by new issues of JGBs to private banks by the government, are cancelled out by payments on the CAs, which results from purchases of the same amount of JGBs by the BOJ. In addition, the JGBs maturing at the BOJ were replaced by those purchased from the private banks by the BOJ. Consequently, the BOJ’s net purchases of JGBs were positive in spite of no change in the BOJ CAs under the BOJ’s de facto refinancing of its own JGBs at maturity.
Why did the private banks participate in such an irregular refunding of JGBs by the BOJ? Again, strong money demand, driven by near-zero interest rates, helped substantially. The private banks could temporarily absorb newly issued JGBs as money substitutes. In addition, given that long-term yields on JGBs were expected to decline quickly toward zero, the private banks could enjoy capital gains by holding long-term JGBs for an even brief period.
Let us describe more precisely how the above de facto refinancing by the BOJ was recorded in the MOS using Fig. 18. The MOS records transactions among the BOJ, government, and private banks in terms of changes in the BOJ CAs.
Relationship between the Treasury and the private sector, which is intermediated by the BOJ. Note (1) The author constructed this figure based on Policy Research Institute, MOF (1981–2018), and Financial Markets Department, BOJ (2008)
An increase in BOJ notes (ginko-ken yoin in Japanese) is recorded negative because the BOJ notes are withdrawn from the BOJ CAs by the private banks [(8) in Fig. 18]. The BOJ’s net purchases of T-bills, JGBs, and other bonds (kin-yu chosetsu), on the other hand, are recorded positive because the BOJ makes payments on the CAs ((1), (1′), and (1″)).
An increase in the Treasury Funds (TFs), caused by payments of taxes and public insurance premiums by private agents, and funds raised by issuing JGBs to the public including the private banks ((2)), is recorded negative as a result of withdrawals from the CAs by private banks, while a decrease in the TFs, caused by fiscal expenditures, and redemption of JGBs held by private agents ((3)), is recorded positive as a result of payments on the CAs by the government.
Usually, net changes in the TFs (zaisei tou yoin) are almost zero because an increase in the TFs is approximately cancelled out by its decrease during a given fiscal year.Footnote 16 However, when the government issues JGBs to redeem the BOJ’s own JGBs at maturity, (1) net changes in the TFs need to be positive, (2) most of the increase in TFs goes to the BOJ’s own accounts to facilitate redemption ((5)), (3) the remainder is put into government deposits at the BOJ ((6)), and (4) the BOJ finally finances its purchase of JGBs from the private banks by the above increases in its own accounts and government deposits. As shown in Fig. 19, the BOJ’s net purchases of JGBs minus increases in the BOJ CAs (black thick line in Fig. 19) are matched exactly by increases in the TFs plus increases in the BOJ note issues, the sum of which is recorded negative in the MOS (grey thick line).
BOJ’s market operations, 1985–2018 (unit: trillion yen). Note (1) See Financial Markets Department, BOJ (2003–2019) for the MOS
Let us now explain the same transactions using the Treasury Funds Statistics (TFS), which are compiled by Policy Research Institute, Ministry of Finance (MOF). The TFS record transactions between the government and BOJ in terms of changes in the TFs.
Payments on the BOJ’s accounts for the redemption of the BOJ’s own T-bills and JGBs by the government are recorded negative in the TFS. Regarding T-bills, however, the BOJ is allowed to underwrite T-bills for the government directly, and this is recorded positive as a result of payments on the TFs by the BOJ. As shown in Fig. 20, the redemption of T-bills from the TFs by the government was dominated by the refinancing of T-bills on the TFs by the BOJ up to FY1997.
The TFS cover not only the BOJ’s transactions with the general account of the government, but also those with its various special accounts. Redemption of the BOJ’s own JGBs by the special accounts is also recorded negative, whereas sales of JGBs to the BOJ by the special accounts are recorded positive. As shown in Fig. 20, the redemption was sometimes dominated by the sales of the transactions between the BOJ and the special accounts.
Transactions between the Treasury and the BOJ’s own accounts, 1985–2018 (unit: trillion yen). Note (1) See Policy Research Institute, MOF (1981–2018) for the TFS
How had the BOJ expanded holdings of T-bills and JGBs, and refunded them at maturity, given the extremely strong money demand? As demonstrated above, the BOJ usually finances an increase in T-bills and JGBs by an increase in the monetary base, while it de facto refinances its own JGBs at maturity by the redemption-purchase operations, where purchases by the BOJ immediately follow redemption by the government in de facto refunding JGBs.
According to the MOS (Fig. 19), the BOJ had expanded its holdings of JGBs by an increase in the CA (more precisely, excess reserves in the CA), which amounted to about 70 trillion yen from FY2013. On the other hand, the BOJ had refunded its own JGBs by the redemption-purchase operations. The scale of the operations, which can be measured by changes in the TFs, amounted to 30 trillion yen from FY 1999, and exceeded 100 trillion yen from FY2013.
On the other hand, according to the TFS (Fig. 20), the BOJ’s own T-bills and JGBs had been aggressively redeemed from FY2001 to FY2005, and even more aggressively since FY2013. Such large-scale redemptions allowed the BOJ to refund its own JGBs de facto by the redemption-purchase operations. In addition, the BOJ partly refinanced its own JGBs with government deposits, which increased from FY1999 to FY2000, and from FY2015.
Tables 1 and 2 report changes in T-bills and JGBs holdings as well as the scale of their refinance, the latter of which is measured by the BOJ’s net purchases of T-bills and JGBs minus changes in its holdings of T-bills and JGBs. The scale of refinance relative to the balance at the previous year is also reported in both tables. An inverse of this relative scale can be interpreted as the redemption period. For example, if this relative scale is 25%, its inverse implies a four-year rollover period.
As shown in Table 1, the BOJ’s own T-bills were aggressively refinanced from FY2002 to FY2005, and from FY2013, while the BOJ reduced its holdings of T-bills. Note that the relative scale of refinance was often larger than 100% because T-bills were usually refinanced in less than one year.
As shown in Table 2, however, the BOJ greatly expanded its holdings of long-term JGBs since FY2013. Before FY2012 when the BOJ’s holdings of long-term JGBs were less than 100 trillion yen, the relative scale of refinance ranged between 20 and 50%, implying that the BOJ’s own long-term JGBs were refinanced in two to five years. This implied rollover period is consistent with the fact that the BOJ purchased only long-term JGBs with shorter than three-year duration before FY2012.
While the BOJ expanded holdings of long-term JGBs from 91.3 trillion yen at the end of FY2012 to 459.6 trillion yen at the end of FY2018, the scale of refinance grew comparatively slowly. Accordingly, the relative scale of refinance declined from 26.5% in FY2012 to 11.9% in FY2018, implying that the BOJ’s own long-term JGBs were refinanced in about nine years. This extended redemption period suggests that the BOJ held JGBs with duration much longer than three years since FY2013.
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Saito, M. (2021). Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Current and Future Japanese Economy. In: Strong Money Demand in Financing War and Peace. Advances in Japanese Business and Economics, vol 28. Springer, Singapore. https://doi.org/10.1007/978-981-16-2446-9_4
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