COMMENT: Keynes theories reborn

As Sims explained, contrary to popular belief, aggregate demand and the price level (inflation) are not dictated only – or even primarily – by monetary policy. Instead, they are determined by the country’s net wealth and the liabilities of the central bank and the government.

When government deficits are lower, investing in government debt becomes more attractive. As the private sector purchases more of that debt, demand for goods and services falls, creating deflationary pressure. If the central bank attempts to spur inflation by expanding its own balance sheet through monetary expansion and by lowering interest rates, it will cause the budget deficit to fall further, reinforcing the cycle. In such a context, Sims argued, monetary policy alone would not be adequate to raise inflation; fiscal policy that increases the budget deficit would also be necessary.

The FTPL provides a clear diagnosis of the Japanese economy’s problems – and points to solutions. When Abenomics was introduced in 2012, a massive injection of liquidity by the Bank of Japan was supposed to offset deflation. But, as both traditional Keynesians and FTPL followers would note, quantitative easing – which amounts to an exchange of money for its close substitutes (zero-interest bonds) – becomes less effective in stimulating demand over time. Add to that Japan’s fiscal tightening – and, especially, its consumption-tax hike – and it is no surprise that demand has remained repressed.

More recently, Japan’s negative-interest-rate policy worked rather well to push down market interest rates. But the policy also impaired the private sector’s balance sheet, because it functioned as a tax on financial institutions. As a result, it has failed to provide the intended boost.

During periods of recession or stagnation, additional interest payments by banks would burden the economy, whereas public debt may enable the economy to reach full employment. (Neo-Ricardians would argue that public debt in the hands of people is worthless, because consumers internalise their children’s future tax payments by holding debt certificates. But, as David Ricardo himself recognised, people are rarely that smart.)

John Maynard Keynes’ The General Theory of Employment, Interest, and Money, which argued for active fiscal policies, was published in 1936. Forty years later, a counterrevolution took hold, reflecting sharp criticism of fiscal activism. After another 40 years, Keynes’ key idea is back, in the form of the FTPL. This may be old wine in a new bottle, but old wine often rewards those who are willing to taste it.

****

Koichi Hamada, Special Economic Adviser to Japanese Prime Minister Shinzo Abe, is Professor Emeritus of Economics at Yale University and at the University of Tokyo.

****

Copyright: Project Syndicate, 2016.
www.project-syndicate.org