Keynes reborn By Koichi Hamada December 28, 2016 – Project Syndicate

In the fourth century, Japan’s emperor looked spending. Making matters worse, governments out from a small mountain near his palace and can be tempted to inflate their debts away – a noticed that something was missing: smoke power that has been abused since the age of rising from people’s kitchens. While there monarchs, resulting in a uniform inflation tax were some faint trails here and there, it was on asset holders. clear that people were facing such harsh But large public debts are not always bad for economic conditions that they could barely an economy, just as efforts to rein them in are purchase any food to cook. Appalled at the not always beneficial. The focus on a balanced circumstances of the Japanese people, who budget in the United States, for example, has were largely peasants, the emperor decided to led some elements of the Republican Party to suspend taxation. block normal functions of state and even Three years later, the palace gates were in federal authorities, supposedly in the name of disrepair and the stars shone through leaks in fiscal discipline. Likewise, the eurozone’s the roof. But a glimpse from the same recovery from the 2008 financial crisis has mountain revealed steady plumes of smoke been held back by strict fiscal rules that limit rising from the peasants’ huts. The tax member countries’ fiscal deficits to 3% of moratorium had worked. The people were so GDP. grateful to the emperor – who became known To understand the relationship between public as Nintoku (Emperor with Virtue and debt and economic performance, we should Benevolence) – that they volunteered to repair look to the fiscal theory of the price level his palace. (FTPL), a macroeconomic doctrine that has Almost two millennia later, the Japanese lately been receiving considerable attention. In people are, again, under economic pressure. A August, at the annual conference of central steep hike in the consumption tax in 2014, bankers in Jackson Hole, Wyoming, together with another hike expected in the near Princeton’s Christopher Sims provided a lucid future, has undermined household spending. explanation of the theory. As in the Nintoku story, it is the wealth of the As Sims explained, contrary to popular belief, people – not that of the government – that aggregate demand and the price level dictates consumption. (inflation) are not dictated only – or even Of course, the wealth of the government does primarily – by monetary policy. Instead, they play a role in economic performance. But are determined by the country’s net wealth and excessive concern about government’s the liabilities of the central bank and the solvency can cause the private sector to be government. reluctant to spend. That is what has happened When government deficits are lower, investing in Japan. in government debt becomes more attractive. Excessive government debt can be highly As the private sector purchases more of that damaging. In inflationary periods, high debt, demand for goods and services falls, outstanding government liabilities impair creating deflationary pressure. If the central fiscal policy, because higher taxes are needed bank attempts to spur inflation by expanding to finance the same level of real government its own balance sheet through monetary expansion and by lowering interest rates, it will functioned as a tax on financial institutions. As cause the budget deficit to fall further, a result, it has failed to provide the intended reinforcing the cycle. In such a context, Sims boost. argued, monetary policy alone would not be During periods of recession or stagnation, adequate to raise inflation; fiscal policy that additional interest payments by banks would increases the budget deficit would also be burden the economy, whereas public debt may necessary. enable the economy to reach full employment. The FTPL provides a clear diagnosis of the (Neo-Ricardians would argue that public debt Japanese economy’s problems – and points to in the hands of people is worthless, because solutions. When Abenomics was introduced in consumers internalize their children’s future 2012, a massive injection of liquidity by the tax payments by holding debt certificates. But, Bank of Japan was supposed to offset as David Ricardo himself recognized, people deflation. But, as both traditional Keynesians are rarely that smart.) and FTPL followers would note, quantitative John Maynard Keynes’ The General Theory of easing – which amounts to an exchange of Employment, Interest, and Money,which money for its close substitutes (zero-interest argued for active fiscal policies, was published bonds) – becomes less effective in stimulating in 1936. Forty years later, a counterrevolution demand over time. Add to that Japan’s fiscal took hold, reflecting sharp criticism of fiscal tightening – and, especially, its consumption- activism. After another 40 years, Keynes’ key tax hike – and it is no surprise that demand has idea is back, in the form of the FTPL. This may remained repressed. be old wine in a new bottle, but old wine often More recently, Japan’s negative-interest-rate rewards those who are willing to taste it. policy worked rather well to push down market Koichi Hamada, Special Economic Adviser to Japanese interest rates. But the policy also impaired the Prime Minister Shinzo Abe, is Professor Emeritus of private sector’s balance sheet, because it Economics at Yale University and at the University of Tokyo.