MMTed - Home Page of Public Education in Modern Monetary Theory

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One of the things that economists do is deal with data because data tells us about the real world. Now, why is that important?

Well, if you're sitting in the ivory tower, then you want to be able to build theories and explanations about the real world, particularly in economics. And so, in a way, the data that we can assess and look at is a test of how well we're doing in theory and building frameworks for explanation.

Now, Japan's are great example. Let's have a little look at it. The first graph here is showing us the Japanese government fiscal position - it's deficit. In the late 1980s, Japan had a huge credit boom and that fuelled the property markets. And in the early 90s, the property markets collapsed. And from then on, Japan has run very large fiscal deficits.

And the reason we talk about Japan is because it has pushed the policy parameters to relative extremes.

Now, as part of the running the deficits, they also built up a lot of debt, as you can see in the next graph. And the economics is taught in most universities around the world and the economics that you read in the paper and watch on TV and finance reports, etc., the economists will say that Japan would seriously struggle with these policy extremes - that debt would become too large and the investors would stop lending the Japanese government money and that the deficits would squeeze interest rates up. And we'll explain that in more detail later.

And also, the other part of the story was that the Bank of Japan, which is Japan's central bank, was also buying a lot of that increasing debt and holds about 45% of all government debt now. So it's sort of the government buying its own debt. And economists of the mainstream variety also said - that's taboo and that would drive inflation and risk hyperinflation.

And this is the sort of predictions that come out of learning mainstream economics and so the reality check is what actually happened.

And here you can see that inflation was has been extremely low for 30 years. Interest rates have been near zero for 25 years. Bond yields have been steadily falling and in some cases now they are negative.

Now, what does that mean? Well, an economic framework has to be able to explain that reality and the mainstream economic approach can't possibly understand that its predictions are systematically wrong all the time when we're dealing with, say, that data set.

And so what we'll do in this course is be building up a body of explanation that can embrace the real world. That's the use of MMT.

End of Transcript

Study Notes:

Any macroeconomic theory should help us understand the real world and provide both explanations of historical events and reasonable forecasts as to what might happen as a consequence of set events, for example, changes in policy settings.

A theory doesn’t stand or fall on its absolute predictive accuracy because it is recognised that forecasting errors are a typical outcome of trying to make predictions about the unknown future. However, systematic forecast errors (that is, continually failing to predict the direction of the economy) and catastrophic oversights (for example, the failure to predict the 2008 Global Financial Crisis) are indications that a macroeconomic theory is seriously deficient.

The facts provide a benchmark against which any macroeconomic theory can be assessed. If a macroeconomic theory generates predictions which are consistently at odds with what we subsequently observe, then we can conclude that it doesn’t advance our understanding of the real world and should be discarded.

Consult almost any mainstream macroeconomics textbook and you will find the following propositions stated, in some form or another, as inalienable fact:

Persistent fiscal deficits push up short-term interest rates because the alleged need to finance higher deficits increases the demand for scarce savings relative to its supply.
These higher interest rates undermine private investment spending (the so-called ‘crowding out’ hypothesis).
Persistent fiscal deficits lead to bond market investors demanding increasing yields (returns) on government debt.
Rising government debt-to-GDP ratios associated with the persistent fiscal deficits will eventually lead bond market investors to withdraw their lending to the government and the government will run out of money.
Persistent fiscal deficits lead to accelerating inflation and potentially hyperinflation, which is highly detrimental to the macroeconomy.

In the video, I talked about Japan because it has pushed the policy parameters to relative extremes over the last 30 years and so is a good candidate to assess competing macroeconomic theories.

Following its reconstruction after the Second World War, Japan enjoyed spectacular growth in the 1960s. It is now the third largest economy behind the United States and China.

However, things came unstuck in the early 1990s. A massive build-up of private indebtedness accompanied a real estate boom, which crashed spectacularly in 1991 and to avoid a major recession the government started to run higher deficits. Since 1992, Japan has run persistent and relatively large government deficits.

We also saw that public debt levels relative to GDP have risen significantly since the 1990s and are now among the highest in the world and that the Bank of Japan, the central bank, has been purchasing significant volumes of the government's debt.

As a result of these trends, mainstream economists predicted rising interest rates, increasing bond yields, and accelerating inflation in Japan. On all counts, these predictions have been seriously deficient. Government bond yields remain low and recently investors have been prepared to accept negative yields on long term government bonds. Further, interest rates have been close to zero and the inflation rate has been low and often negative. There is clearly no inflationary bias in the modern Japanese economy, as persistently predicted by the mainstream economic theories.

It is clear that the mainstream macroeconomic explanation of the relationships between fiscal deficits, interest rates, bond yields and inflation rates is unable to adequately capture the real-world dynamics in Japan. This significant data set runs entirely counter to the expectations of mainstream economic theories.

As we progress through the course, we will see that the MMT framework can provide convincing explanations for these developments in Japan.

1.6 The stylised facts in macroeconomics

Study Notes: