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Q&A Japan style – Part 1

This is the first part of a four-part series this week, where I provide some guidance on some key questions about Modern Monetary Theory (MMT) that various parties in Japan have raised with me. The public discussion about MMT in Japan is relatively advanced (compared to elsewhere). Questions are asked about it and answered in the Japanese Diet (Parliament) and senior economics officials in the central bank and government make comments about it. And political activists across the political spectrum are discussing and promoting MMT as a major way of expressing their opposition to fiscal austerity in Japan. The basics of MMT are now as well understood in Japan as anywhere and so the debate has moved onto more detailed queries, particularly with regard to policy applications. So as part of my current visit to Japan, I was asked to provide some guidance on a range of issues. In my presentations I will be addressing these matters. But I thought it would be productive to provide some written analysis so that everyone can advance their MMT understanding. These responses should not be considered definitive and more detail is available via the referenced blog posts that I provide links to.

Monetary policy versus Fiscal policy


Do MMT economists suggest the central bank policy interest rate should be fixed at zero because: (a) investment expenditure is relatively insensitive to interest rate changes; (b) a highly variable interest rate, even it can influence investment, will spread a sense of uncertainty within the private sector?

Mainstream economists believe that the central bank can maximise real economic growth by achieving price stability. Consistent with this view is the belief that when the central bank target interest rate is below the ‘neutral rate of interest’, inflation will break out (eventually) and vice versa.

So the neutral rate is sometimes called the equilibrium interest rate. It has a direct analogue in the labour market in the concept of the natural rate of unemployment that is a central focus of mainstream theory.

The ‘neutral rate of interest’ concept is derived from Knut Wicksell. In his classic book – Interest and Prices – he defined the “natural interest rate” as follows (page 102):

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods.

So consistent with the view held in those times that the loanable funds market brought savers together with investors, the natural rate of interest is that rate where the real demand for investment funds equals the real supply of savings.

This remains a core concept in New Keynesian macroeconomics.

In this view, when the money interest rate is below the natural rate, investment exceeds saving and aggregate demand exceeds aggregate supply. Bank loans create new money to finance the investment gap and inflation results (and vice versa, for money interest rates above the natural rate).

MMT follows on from Marx’s attacks on Say’s Law (Walras’ Law) which considered money to be a veil over the real economy.

It also follows from the attacks from Kalecki and Keynes of the Wicksellian notion.

Keynes wrote in his 1936 – General Theory (Chapter 14, page 189):

… the traditional analysis is faulty because it has failed to isolate correctly the independent variables of the system. Saving and Investment are the determinates of the system, not the determinants. They are the twin results of the system’s determinants … [aggregate demand] … The traditional analysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment.

In other words, the orthodox position that the interest rate somehow balances investment and saving and that investment requires a prior pool of saving are both incorrect.

The reality is that investment brings forth its own saving through income adjustments.

And empirical work trying to link shifts in interest rates with changes in economic activity finds only weak connections.

The 2004 US Federal Reserve Bank Kansas City paper – Estimating equilibrium real interest rates in real time – concluded that “the link between trend growth and the equilibrium real rate is shown to be quite weak.”

Post Keynesians have long held that the link between interest rate changes and capital formation is weak and that monetary policy is not an effective tool for counter-stabilisation.

MMT builds on that view.

Investment decisions are, in the words of Keynes, dependent on the “state of long-term expectation” because it is a forward-looking process, where firms form guesses about what the state of aggregate demand will be in the years to come.

It is necessarily such because the process of creating new capital stock is lengthy and involves a number of separate decisions – type of product to produce, nature of capital required to produce it, design, access supply and ordering, and quantum – are all separated in time.

The investment spending today is the result of decisions taken in some past periods about what the state of the world will be today and into the future. Investment spending is not a tap that is turned on or off when current interest rates change.

Firms are continually making guesses about the future in terms of what the overall state of demand for their products will be, what they are likely to receive by way of revenue if their sales match these expectations, and what it will cost them to produce the output necessary to meet this demand.

Firms also have various choices about what products to produce and how they can produce them (for example, choice of technique).

Firms are driven by the desire to make profit and will thus make choices among different types of productive equipment on the basis of which will contribute the most profit subject to a range of other considerations, many of which are subjective.

For example, a firm that wishes to keep good standing in the community will probably eschew the use of equipment that is damaging to the local environment even if the use was legal and generated more profits than other options.

Whether firms use retained profits to fund future investment or seek funds from the markets there is a cost involved in purchasing new capital.

A firm may have retained earnings to invest. It has the choice of investing them in new plant and equipment, or perhaps, purchasing financial assets which yield a positive rate of return (for example, a bond).

While the firm will be driven by the need to stay in its present business and therefore defend its market share, which means it will usually want to use the funds available to it to purchase best practice, productive infrastructure; it may, at times, hold off from upgrading its productive capital if the circumstances are not conducive.

Investment decisions will thus depend on whether the productive asset being purchased delivers a positive return above the cost.

While business investment is no doubt cost sensitive, what the mainstream economists usually ignore is the fact that expectations of earnings are also important as are assymetries across the cycle.

The cyclical asymmetries in investment spending arise because investment in new capital stock usually requires firms to make large irreversible capital outlays.

Capital is not a piece of putty (as it is depicted in the mainstream economics textbooks that the students use in universities) that can be remoulded in whatever configuration that might be appropriate (that is, different types of machines and equipment).

Once the firm has made a large-scale investment in a new technology they will be stuck with it for some period.

In an environment of endemic uncertainty, firms become cautious in times of pessimism and employ broad safety margins when deciding how much investment they will spend.

Accordingly, they form expectations of future profitability by considering the current capacity utilisation rate against their normal usage.

They will only invest when capacity utilisation, exceeds its normal level. So investment varies with capacity utilisation within bounds and therefore productive capacity grows at rate which is bounded from below and above.

The asymmetric investment behaviour thus generates asymmetries in capacity growth because productive capacity only grows when there is a shortage of capacity.

This insight has major implications for the way in which economies recover and the necessity for strong fiscal support when a deep recession is encountered.

These dynamics are covered in my 2008 book with Joan Muysken – Full Employment abandoned.

The simple investment model, which says that rising market rates of interest lead to lower total investment is also based on an assumption that all other things are equal.

But, in a growing economy, it is likely that aggregate demand conditions will improve at times when the market rate of interest rises. The former will improve the revenue cash flows over time and increase the profitability for each project.

In other words, we would not observe investment falling when the market rate of interest rose because the internal rate of return of each project could also be increasing.

Alternatively, when the economy is in recession, entrepreneurs become pessimistic and this negatively impacts on their assessment of the future returns from different projects.

Further, with substantial excess productive capacity firms are unlikely to expand the capital stock even if new investment projects become cheaper as the central bank cuts the market interest rate to stimulate demand.

The extreme optimism that typically accompanies a boom also would reduce the sensitivity of investment to changes in the market rate of interest. With expected returns high, firms will be prepared to pay higher borrowing costs.

In general, MMT considers monetary policy – the act of varying interest rates – to be an ineffective means for managing aggregate spending.

It is indirect, blunt and relies on uncertain distributional behaviour.

It works with a lag if at all and imposes penalties on regions and cohorts that may not be contributing to the price pressures.

There is also no strong empirical research to tell us about the impact on debtors and creditors and their spending patterns. It is assumed implicitly that borrowers have higher consumption propensities than lenders but that hasn’t been definitively determined.

MMT considers fiscal policy to be powerful because it is direct and can create or destroy net financial assets in the non-government sector with certainty. It also does not rely on any distributional assumptions being made.

MMT also considers that in most cases, fiscal deficits will be the norm to offset the spending drain from the non-government sector (via household saving, corporate saving and/or external deficits).

We also know that fiscal deficits add to bank reserves and create system-wide reserve surpluses.

The excess reserves then stimulate competition in the interbank market between banks who are seeking better returns unless there is a support rate offered by the central bank.

The interbank competition cannot eliminate the system-wide surplus (all transactions net to zero), so, without a support rate for the excess reserves, the overnight rate will fall to zero.

Thus, in pursuit of the desired policy goal of full employment, fiscal policy will have the side effect of driving short-term interest rates to zero. It is in that sense that MMT considers the zero rate to be the norm.

If the central bank wants a positive short-term interest rate for whatever reason then it has to either offer a return on excess reserves or drain them via bond sales.

An MMT understanding does not lead to support for either strategy.

Further reading:

1. Investment and interest rates (August 10, 2012).

2. The natural rate of interest is zero! (August 30, 2009).

3. Why investment expenditure is insensitive to monetary policy (June 22, 2015).

4. Monetary policy is largely ineffective (April 8, 2015).


Is this fixed rate the nominal rate? Would it be sensible to maintain interest rates fixed (at zero or any level) if there was accelerating inflation due to excessive spending on capital formation?

The central bank adjusts the nominal rate of interest and the real equivalent is then determined by the inflation rate.

MMT advocates a macroeconomic state of full employment and price stability, which means that the real interest rate will largely be stable and set by whatever policy rate the central bank chooses to target.

Consistent with the view that monetary policy is ineffective, MMT proposes to use fiscal policy, employment buffer stocks (the Job Guarantee) and other policy tools (regulation, procurement policies, etc) to achieve price stability and discipline inflationary spirals.

MMT considers that all spending components – household consumption, business investment, export demand and government spending – carry an inflation risk.

So, as an example, if growth in private capital formation (investment) was running at such a rate that the government felt it was pushing nominal demand ahead of the real capacity of the economy to absorb it, then clearly, the government has a choice to make.

Cut back other components of spending or target lower rates of investment. In the case of investment, many projects are of a large-scale, infrastructure type and usually have to gain planning and other approvals from authorities before they can proceed.

In an inflationary environment, such processes could be staggered.

The point is that MMT economists consider there are much more effective ways of ensuring nominal demand in the economy keeps pace with real capacity than trying to hike interest rates with all the uncertainty that that process brings.

Further, MMT economists point out that it is not clear that rising interest rates are anti-inflationary. Given they boost incomes for a range of asset holders, they increase spending capacity. They also increase costs for firms exposed to the changes, which may provide further impetus for price rises.

Further reading:

1. Building bank reserves is not inflationary (December 14, 2009).

2. Printing money does not cause inflation (March 17, 2011).

3. Modern monetary theory and inflation – Part 1 (July 7, 2010).

4. Modern monetary theory and inflation – Part 1 (January 6, 2011).


It is my understanding that MMT asserts that the currency issued by government is the government’s IOU, in the sense that it can be used by the non-government sector to extinguish their tax obligations. Does this presume that everyone must have a tax obligation? Are there differences of opinion among the MMT economists about this?

First, we need to be clear that their is an ordering in the pedagogy that MMT economists use to introduce our work to the general public.

In some cases, we use simple conceptual vehicles (heuristics) to begin a discussion with those interested in MMT who have no prior background.

Representative of these heuristics are these blog posts:

1. A simple personal calling card economy (March 31, 2009).

2. Barnaby, better to walk before we run (February 8, 2010).

3. Some neighbours arrive (February 15, 2010).

There is no sense that these ‘models’ can represent reality as we know it. Reality is much more complex and multilayered.

But these heuristics allow us to explore some intrinsic characteristics of the monetary system, the capacity of the currency issuer and the options that such a government might have to advance its policy agenda.

As an example, in a highly simplistic, logical model, we might show how a new currency achieves its status by requiring all people to pay their taxes in that currency and then we show that that capacity doesn’t exist in the non-government sector until the government spends that currency into existence.

So we are able to establish a clear causality that taxes cannot intrinsically fund government spending. In that simplistic world, it is the other way around.

Government spending provides the currency in which the non-government sector can pay its taxes and any outstanding debt that such a government might issue just represents previous fiscal deficits, which haven’t been taxed away yet.

As it stands, that simplistic model serves a purpose.

But it should never be the end of the story. The academic MMT economists certainly don’t hold this sort of reasoning as the definitive MMT statement, even if others might.

The point is that once we layer that simple heuristic with real world institutional insights and reality then the simple heuristic quickly becomes inadequate for analysis.

For example, to say that MMT says that taxes cannot be paid before spending is obviously an incorrect statement on two counts.

First, MMT doesn’t say that beyond our simple heuristic models, which are highly stylised and the assumptions used are transparent and deliberate abstractions of reality.

Second, in the real world, I can walk into a bank and borrow funds to pay my tax obligations without having built up any prior financial assets. Abstract from the financial record I might have had to demonstrate in order to access the loan from the bank.

But it is clear, in that instances, taxes can be paid without government’s spending the money into existence first. That is because there are real world institutions such as commercial banks that create deposits when they make loans, and which are absent from the simple heuristic models.

This doesn’t invalidate the insights in the simple models. It just adds layers of complexity that have to be augmented with deeper insights.

In a pedagogical sense, we need to walk before we run. So the simple heuristic models allow us to start thinking in terms of MMT concepts – currency-issuance, government/non-government, flows and stocks, income and wealth, etc – which then allow us to make the next steps as we layer the analysis with more real world complexity.

But hanging onto the simple logic and denying the real world complexity is a dangerous strategy and not one that the academic MMT economists adopt.

In this specific tax payments case, how we extend the complexity of understanding is to note that while it is obvious that banks can create deposits (and liqudity) everytime they create a loan, the transactions associated with that loan (in this case, me paying my taxes) have to ‘clear’. The funds have to come from somewhere.

And that then takes us into a deeper analysis of the role of bank reserves and central bank funds. We then note that ultimately, claims on that deposit at my bank, must be backed by reserves, which is a different to to saying that the loan was made possible by the prior existence of reserves.

But clearly, when I tell the government I am paying my taxes and transfer funds from the deposit the bank has created as part of my loan, the government instructs the central bank to debit the reserve accounts of the bank in question and credit its own account with the amount of the tax payment.

If the bank in question has insufficient reserves or there are insufficient reserves within the banking system at that time, then the only place those reserves can come from is the central bank (which in MMT is considered to be part of the consolidated government sector).

In that sense, the correct statement is not that taxation requires prior spending but that the solvency of the non-government financial system ultimately rests on government making loans to the non-government sector in the currency that the government issues and that these loans allow the banks to always meet the demands on them for bank reserves.

Now, it is clear that not everyone who uses (and demands) the currency pays taxes, as the question notes.

But, the tax-driven currency argument that underpins MMT reasoning does not require everyone to be ‘taxpayers’. Once a currency is established then their are many reasons why it becomes broadly acceptable to the population, not the least being that transaction costs are lower if everyone uses the same currency.

The way in which MMT represents taxation is also rather simplistic. In our simple heuristics, it appears as a lump sum that everyone has to pay (although we represent it as a total non-government sum to simplify matters).

We can clearly introduce complexity into the tax system, with progression in the income tax structure, an array of non-income taxes (such as GST or VAT), and other complexities (death duties, wealth taxes, expenditure taxes, etc).

That has never been a necessity in my view, although I acknowledge that a government has to contend with those complexities when it is operating the tax system in the real world.

But introducing such complexity will not alter the fundamental insight that if you require a significant proportion of the population to extinguish their tax liabilities in the currency that only the government issues then that will elicit a demand for that currency, irrespective of whether you can get that currency by working for the government, working on contracts paid for by the government, or borrowing that ‘currency’ from commercial banks who have reserve accounts at the central bank denominated in that currency, or from other financial institutions that ultimately have to work through banks that have such reserve accounts.

Further reading:

1. Deficit spending 101 – Part 1 (February 21, 2009).

2. Deficit spending 101 – Part 2 (February 23, 2009).

3. Deficit spending 101 – Part 3 (March 2, 2009).

4. Will we really pay higher taxes? (April 7, 2009).

5. Taxpayers do not fund anything (April 19, 2010).


I will continue to answer the questions in Part 2.

Today, I am Kyoto, Japan, for the second event in this week-long speaking Tour. I am speaking at a Rose Mark Campaign workshop today at the Kyoto City International Foundation House.

Tomorrow, I will be speaking in Tokyo.

It has been a great trip so far and I have met some really nice people, all committed to ending austerity and the neoliberal hold on economic policy.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.

This Post Has 11 Comments

  1. This is a keeper Bill.

    Simply superb !

    Every MMT activist should file this under important and bring it out when debating with the ” sound finance” priests.

  2. Of course, those who cherry pick MMT and own the parts of MMT they like and discard the bits they don’t.

    Write their blogs and explain to their followers that they knew this all along and it was them who came up with this lens. Refuse to admit they are standing on the shoulders of giants and keep falling off.

    It’s perverse.

  3. The level of detail makes this a wonderful read to me. I deeply enjoyed reading this.

  4. Let me heartily second the sentiments expressed in praise of this particular post. I especially benefited from the clarity contained in the follow observation: “But, the tax-driven currency argument that underpins MMT reasoning does not require everyone to be ‘taxpayers’. Once a currency is established then their are many reasons why it becomes broadly acceptable to the population, not the least being that transaction costs are lower if everyone uses the same currency.” I had always felt (like I’m sure did many others) that national custom and usage were also crucial factors in currency validation, and not merely or solely as necessary consequences of tax obligations. Thanks, Bill, for pointing out that the MMT axiom concerning the primacy of the tax obligation calls for elaboration by additional real world considerations, and for indicating that the same is the case with virtually all of MMT’s axioms. For those who would go deeper into economic things, the obvious truths of the axioms wind up drawing you into a much more complex, nuanced, and interesting game. Thus, of course, those mind-stretching weekend Q & A’s.

  5. Great piece. One comment : Bill says “Investment brings forth its own saving through income adjustment”
    My understanding is that the investment/saving identity simply means that investment creates non-financial saving (machines, software, housing, etc). That is, as Bill indicates, the mainstream idea that interest rates equilibrate financial saving and investment is nonsense. Indeed, overall financial saving (at initial face values) is always zero regardless of the level of interest rates. My only point is that Bill’s statement is not clear as to the type of saving is created by investment. Many will think it means investment creates financial saving. wWhich, if my understanding is correct, is not true. Investment creates and, indeed, IS, saving (non-financial). Thanks.

  6. Dear Bill,

    One question: you say that ultimately citizens can get the currency by getting it from a bank, who in turn can get it by borrowing from the Fed (if it does not have the required reserves). Doesn’t this mean precisely that the Fed does indeed “inject” new money into the system when it lends to banks, so there can be stimulative effects from Fed operations?


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