Applying FTPL to Japan
Can the Fiscal Theory of Price Level be applied to Japan?
In view of the persistence of deflation and the apparent inability of the monetary policy to address the problem, there is growing interest in the fiscal theory of price level (FTPL) and its application to Japan. Professor Christopher Sims of the Princeton University, who is one of the scholars that established the theory and who is a strong advocate of applying the theory to Japan, has recently visited Japan. He argued that fiscal policy determines the price level, and what the Japanese government can do to stop deflation is to link fiscal policy to inflation target. In particular, the government can announce that consumption tax rate hike would be postponed until inflation rate (or level) target is achieved (for a Japanese summary of the seminar held in Tokyo, see https://www.jcer.or.jp/info/index20170202.html).
It is an attractive argument in that it proposes a new policy mix that would provide a theoretical background to the expansionary fiscal policy which always has to fight with the fear of being seen as irresponsible about the fiscal situation. Professor Sims does not argue that fiscal consolidation is unnecessary. Achieving inflation target will allow you to reduce real debt somewhat. However, it is bound to be modest unless a rapid inflation is allowed, which is undesirable. Therefore, Professor Sims recommends that after reaching the inflation target, fiscal policy could change gears to consolidation.
If we try to apply the argument to Japan, there are some features of the economy that would make it difficult for it to be successful. I will mention only two of them in the following.
Difficulty in applying: Households do not hold government bonds
First is related to the way the theory works (the transmission mechanism). When FTPL argues that expansionary fiscal policy financed by government bonds would affect price level, it assumes that households who find that they have more government bonds (more wealth) start to spend more. Increased spending on goods and service, in turn, would raise prices.
The problem with this argument is that we don’t know how households end up with having more government debt to start with. Unless they receive them through a helicopter drop (“helicopter bonds”), the households should be holding the government bonds because they purchased them. However, if they had purchased the bonds, it is difficult for them to be “surprised” by having more wealth. Furthermore, if they purchased them in the market, the prices of government bonds supplied extensively should have fallen leaving the households with less wealth, rather than more.
This is crucial because Japanese households are known to be non-holders of government bonds. As Figure shows, of the total outstanding stock of government bonds at end-September 2016 worth 1091 trillion yen, households hold only 13 trillion yen, or 1.2 percent of the total. Even if we see it from the households’ point of view, it is also only 0.7 percent of their total financial assets of 1752 trillion yen.
Figure: Holders of Central Government Bonds
(at end-September 2016)
Increase in government bonds may stimulate household spending if households held more money as a result. That would be the case if extra revenue from issuing the government bonds is used for “helicopter money” dropped in the form of direct transfers (or tax rebates) from the government to households.
To reinforce the argument of FTPL, especially in the context of Japan, it seems that the way that the extra government resources are spent needs to be spelled out.
Difficulty in applying: Households are becoming less Ricardian
Second is related to the policy recommendation as to how stock of outstanding government bonds should be managed. As it has already been mentioned, the government is requested to postpone fiscal consolidation until inflation rate reaches the target, from which the government would start to stabilize the real government bonds.
The argument should look strange from those who argue for “helicopter money” because their concern was that any expansionary fiscal policy would face offsetting reaction by the Ricardian household that anticipates future tax increases and thus suppress consumption. In order to avoid this offset from taking place, Ben Bernanke argues for government debt held by the central bank to be rolled-over forever. Adair Turner goes further to assert that central banks should convert the government bonds to non-interest bearing perpetuities¹.
From the point of view of such advocates, just saying that the government is just postponing fiscal consolidation for the time being clearly would not be enough to stop these households prepare for the future burden they have to bear.
One may be able to support the sequencing of fiscal consolidation à la Sims by the studies showing that Ricardian equivalence does not hold in Japan². If that is still the case, we may not need to worry much about the behavior of Ricardian households.
However, recent analysis reveals that Japan is becoming less Ricardian and more myopic because of the ageing of the population, and that the number of liquidity constraint households is increasing³.
If that is the case, postponement of fiscal consolidation may face a worse situation than not postponing and embarking on fiscal consolidation immediately. That is because, in such a kind of situation, the negative impact on the economy coming from introducing measures for fiscal consolidation (reducing expenditures and raising taxes) will be aggravated as the consolidation extends far into the future.
Looking for a solution to a very difficult problem
In spite of such difficulties in applying, FTPL does raise some interesting points that we need to consider. In particular, it raises the need to understand the interconnection of monetary policy and fiscal policy with prices more carefully and deeply. In due course, it may need to merge further with “helicopter money” theory because there seems to be much complementarity between the two.
What we hope to see at the end is a solution to a very difficult problem: A workable policy recommendation that allows Japan to get out of deflation while, at the same time, avoid fiscal crisis and make fiscal situation sustainable.
¹ For Ben Bernanke’s argument, see, for instance, “What tools does the Fed have left? Part3: Helicopter money,” Brookings Institution blog, April 11, 2016. For Adair Turner’s argument, see, for instance, “The Case for Monetary Finance? An Essentially Political Issue,” IMF, November 5, 2015. I have discussed the implications of their arguments on fiscal consolidation in my column in Japanese. See https://www.jcer.or.jp/j-column/column-saito/20170123-2.html.
² See, for instance, Hiroki Kondo and Arata Ito, “Testing the Neutrality Theorem,” in Toshihiro Ihori (ed.) Fiscal Deficit in Japan, Iwanami Shoten, 2004 (in Japanese).
³ See “Fading Ricardian Equivalence in Ageing Japan,” in Selected Issues, International Monetary Fund, August 2016.