Japan: Where MMT goes to die

Japan used to be a favored talking point of MMT proponents - not anymore

The US and many other advanced economies did massive fiscal stimulus during COVID. At the time, one of the preferred talking points was Japan. The logic went that if Japan could sustain its huge debt load without any problems, then surely there couldn’t be any meaningful downside to aggressive fiscal stimulus. This argument was especially popular among proponents of MMT, who are fond of saying that monetary sovereigns can issue as much debt as they like as long as inflation stays low.

Flash forward a few years and Japan has become a serious challenge for MMT. Yields on government bonds have risen to unprecedented levels, even as the Yen is almost as weak as the Turkish Lira in real effective terms. In my view, this shows that inflation isn’t what constrains debt run-ups. After all, inflation in Japan is still low. Instead, it’s depreciation of the currency, which can run out of control when debt gets too high. A sharp fall in the currency has serious distributional consequences. It helps exporters, but hurts consumers and importers. The political economy of all this is much more complex than simply boiling things down to inflation and means that a monetary sovereign like Japan can run out of fiscal space way before inflation picks up.

Stephanie Kelton yesterday published a nice post pushing back - from an MMT perspective - on my point that Japan is in a de facto fiscal crisis. I think this kind of back and forth is incredibly important and useful, so this post lays out what in my opinion has gone wrong in Japan and why this is a serious challenge to MMT.

There’s basically two stages to the unravelling of Japan as a favored MMT talking point. The first stage happened in 2022, when - as the chart above shows - central banks everywhere were hiking aggressively to contain inflation. Japan wasn’t able to join in that hiking cycle because - given its debt overhang - this could have led to a debt crisis. Rate differentials moved massively against the Yen, which depreciated sharply as a result. This first stage is about fiscal dominance causing divergent monetary policy, with the Yen bearing the brunt of this.

The second stage kicked in more recently and is a direct consequence of sharp Yen depreciation during the first stage. This depreciation proved politically unpopular and caused severe policy dysfunction. At one point in 2024, the Ministry of Finance was intervening to strengthen the Yen, even as the Bank of Japan was buying government bonds, causing the Yen to fall. Recognizing that its de facto yield caps were politically unsustainable, the Bank of Japan began to allow longer-term yields to rise, but the Yen has continued falling and is currently at its lowest level in trade-weighted terms in more than 20 years, as the chart above shows.

The fact that the Yen has kept falling - even as longer-term yields rose - is puzzling many, but it makes perfect sense. Long-term yields are still much too low given the massive debt pile. The chart above is my favorite illustration of this. Japan’s 30-year yield is basically the same as Germany, which has much lower public debt. That’s a sign that fiscal risk premia in the bond market are being artificially suppressed via ongoing Bank of Japan bond purchases. However, these yield caps don’t cause the fiscal risk premium to disappear. It just manifests in foreign exchange markets, dragging down the Yen.

All this brings us to the here and now. Prime minister Takaichi is running on an end to “excessive” fiscal austerity. Those comments caused long-term yields in Japan to spike and the Yen to fall still further. Markets are telling Japan it’s run out of fiscal space. This is the end of the road for Japan and for MMT.