Why has Fiscal Policy Disappointed in Japan? - Revisiting the Pre-Keynesian View
on the Ineffectiveness of Fiscal Policy
Richard A. Werner
Sophia University, Tokyo andUniversity of Southampton, UK
Tel. +81-3-5573-4771
Fax +81-3-5573-4772
e-mail: werner@profitfund.com
January 2004
Abstract
Fiscal policy has been of significant size in Japan since the early 1990s, propellingJapan to the forefront of fiscally-challenged nations. However, the effect of fiscal policy
has been disappointing. This paper discusses the various explanations provided by theliterature (the argument that fiscal policy was effective; the argument that it was noteffective, because of interest rate-based crowding out; and the argument that it was noteffective, because of Ricardian equivalence). Their empirical record is evaluated andfound to be less than convincing. The paper then discusses an alternative explanation,
which is derived from pre-Keynesian views on the effectiveness of fiscal policy. A
modified Fisher-equation is proposed, which synthesizes aspects of the early monetarist
model with the recent findings in the credit view literature. The alternative explanation
is subjected to empirical tests and found supported. Policy implications are discussed,
especially ways in which the Japanese government could render fiscal policy more
effective.
Keywords: credit, crowding out, equation of exchange, fiscal policy, Japan, monetarism,
monetary policy, quantity equation
JEL Classification: E51, E62, H30, H60, O42
Acknowledgements
The author is grateful for invaluable research assistance from Jenny Alf and Yoko Minami. He is also
grateful for helpful comments by Charles Goodhart, Harald Hagemann, Walter Hatch, Kozo Yamamura
and participants at the seminar at Hohenheim University, Stuttgart, where an earlier version of this paper
was presented. Parts of the earlier version were cited in Werner (2002a). Finally, financial support fromthe Japanese government (research grant on central bank credit policies) and the Profit Research Center
Ltd., Tokyo, is gratefully acknowledged.

“Before Keynes, it was commonplace that government spending and taxation were powerless
to affect the aggregate levels of spending and employment in the economy; they could only redirect
resources from the private to the public sector. … The Keynesian demonstration … changed all this.
Economists began to stress the macroeconomic effects of government spending and taxation. It became
commonplace that not only would a dollar of additional government spending raise national income by
the original dollar but that this expenditure would have multiplier effects of perhaps several dollars
more. The old view that government spending simply crowded out private spending was banished.”
Alan S. Blinder and Robert M. Solow (1973:319).

1. Introduction: Japanese Fiscal Policy in the 1990s
As in other countries, Japanese fiscal policy has been the exclusive domain of thegovernment, which proposes fiscal spending measures to parliament whose funding isdetailed in budgets and supplementary budgets. In principle, the government has been
following a balanced budget policy in the postwar era. The Finance Law of 1947
prohibited the issuance of government bonds. As a result of the 1965 recession, it wasamended and government bonds were issued for the first time.1 Oil shock recessions
and increased spending programmes produced sizeable deficits in the 1970s.2 The
elimination of fiscal deficits (‘fiscal reconstruction’) has been a priority since the late1970s, with the Finance Ministry pursuing a ‘zero [growth] ceiling’ on budget requests
since 1982. Thanks to some tax rises (including the introduction of the consumption tax
in 1989), high nominal GDP growth and asset price rises in the second half of the 1980s,
the target of fiscal reconstruction was achieved in 1991.
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Since 1992, the government has embarked on a series of fiscal stimulation packages toincrease economic growth. Government policy documents stated the view that fiscal
spending needed to be increased, in order to boost domestic demand and stimulate theeconomy.3 The first fiscal stimulation package was implemented in 1992. This wasfollowed with a string of additional packages in every year, except 1996 and 2000.
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See Werner (2003) for an introduction to the political economy of the decision-making process leading to the issuanceof bonds, and the role played by the Bank of Japan in promoting the amendment of the Finance Law.
2
For an overview of the movement of fiscal deficits in the 1970s and 1980s, see Asako et al. (1991). See also Ihori et al.
(2000).
3
See the official statements at the announcement of stimulation packages. For instance: ‘Keikyuu keizai taisaku (youshi),
16 November 1999, Economic Planning Agency (available at: www5.cao.go.jp/98/b/19981116b-taisakuyousi.html).
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Table 1 lists the packages and supplementary budgets. As can be seen, ten fiscal
stimulation packages amounted to Y146trn. Eighteen supplementary budgets werepassed, amounting to Y38.1trn over a decade that often also saw a significant expansion
in the regular budgets.

Table 1. Fiscal stimulation packages and supplementary budgets in the 1990s
FY

91

92

93

94

95

96

97

98

99

00

Total

No.

0

1

2

1

2

0

2

1

1

0

10

stimulation Size

0

10.7

19.2

15.3

21.2

0

40.6

24.5

14.9

0

146.4

Fiscalpackages(Ytrn)

supplm.

No.

1

1

3

2

3

1

3

2

1

1

18

Size

0.3

-0.7

5.1

0.4

7.1

1.1

10.3

7.2

4.8

2.7

38.1

budgets(trn)
Sources: Cabinet Office, Ministry of Finance.

Since the government may have had political motives to overstate fiscal stimulation
packages through double-counting, a more accurate measure of the fiscal stance may betotal government expenditures, as calculated by the national income accounts(aggregating government consumption and investment, as well as inventory data).
Government spending increased from a total of Y705 trn in the 1980s to Y1,136 trn inthe 1990s. As a percentage of nominal GDP, this represented an increase from 20.9% on
average in the 1980s to 22.7% in the 1990s. On a growth basis the more positive fiscal
stance during the 1990s becomes obvious: Table 2 shows the breakdown by contribution
to growth of each GDP component. On average, government spending contributed
almost half of growth in the 1990s, while it only contributed a sixth of growth in the
1980s.

Table 2. Contribution to nominal GDP growth in the1990s
CY

Consumption +

Capex

Net

PrivateGovernment

Government

Total

%

Housing(+Inventories)

Exports

DemandConsumption

Investment

Government

Nominal GDP(+Inventories)

1991

2.6

1.6

1.3

4.9

0.8

0.4

1.2

6.2

1992

2.0

-1.6

0.8

0.8

0.8

1.2

2.0

2.6

1993

1.7

-2.1

0.1

-0.6

0.7

1.2

1.8

1.0

1994

2.1

-1.4

-0.2

0.4

0.5

0.2

0.7

1.1

1995

0.3

0.8

-0.4

0.5

0.7

0.0

0.7

1.2

1996

2.0

0.5

-0.3

1.6

0.5

0.5

1.0

2.6

1997

0.2

1.9

1.4

2.6

0.4

-0.7

-0.4

2.2

1998

-0.7

-1.1

1.2

-1.1

0.3

-0.3

0.0

-1.2

1999

0.4

-1.3

-0.2

-1.4

0.4

0.2

0.6

-0.8

2000

-0.2

1.1

-0.1

0.7

0.6

-0.8

-0.3

0.3

1990s

1.0

-0.1

0.4

0.8

0.6

0.2

0.7

1.5

3.4

1.5

0.3

5.2

0.8

0.2

1.0

6.2

ave.
1980s
ave.
Source: Cabinet Office, December 2001

While the government contribution to growth increased, government revenues fellsignificantly, as the weaker economy reduced tax revenues. 4 As a result, Japan’s
government registered the largest budget deficits of any industrial country in the
postwar era, averaging over 6% of gross domestic product (GDP) during the period
1993-2000.
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Textbooks tell us that there are two options to fund the revenue shortfall: debt-finance ormoney finance. In the former case, the government borrows from the private sector; inthe latter, it either creates money directly, or borrows from the central bank, which paysby creating money.5 In Japan’s case the issuance of legal tender has been delegated to
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There were important tax reductions in 1994 and 1998. However, at other times, fiscal policy tightened. Hoshi and
Patrick (2000) estimate that the 1997 ending of income tax rebates and the rise of the consumption tax from 3% to 5%
increased government revenues by about two percentage points of GDP.
5
Dornbusch and Fischer (1987) emphasise that “the distinction between selling debt to the public and selling it to the
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the Bank of Japan, which, since at least the late 1970s, has in practice acted largely
independently from the government (see monetary policy, below). Moreover, theFinance Law does not allow the central bank to directly underwrite government bonds.6
This has left the government no choice but to fund the public sector borrowing
requirement from the private sector, mainly via bond and bill issuance (Table 3).7
TP

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CY

New

New

Total

Total

¥trn

borrowingborrowing/

Outstanding

Outstanding

nGDP

debt

debt/ nGDP

PT

PT

1991

4.65

1.0%

226.35

47.7%

1992

14.71

3.0%

241.06

49.9%

1993

17.33

3.6%

258.38

53.0%

1994

27.15

5.5%

285.53

58.0%

1995

27.21

5.4%

312.74

62.3%

1996

30.94

6.0%

343.68

66.7%

1997

24.92

4.8%

368.60

70.9%

1998

58.38

11.4%

426.98

83.2%

1999

50.79

9.9%

477.76

92.9%

2000

44.34

8.6%

522.10101.8%

Total

300.4

6.0%

Table 3. Government Borrowing and Debt in the 1990s
Source: Bank of Japan

New government borrowing increased by Y300.4 trn during the 1990s (58.6% of 2000
nominal GDP). This raised total outstanding debt to Y522.1trn by the end of 2000,
amounting to 101.8% of GDP. Adding the new borrowing of Y60.36trn during 2001, thenational debt figures recorded a new high of Y 582.46trn, about 120% of GDP, by thecentral bank is essential. The distinction between money and debt financing can be further clarified by noting that
Treasury sales of securities to the central bank are referred to as monetizing the debt, meaning that the central bankcreates (high-powered) money to finance the debt purchases” (p. 584).
6
The central bank can purchase government bonds in the secondary market one year after issuance. Economically, this isequivalent to primary market purchase. The political circumstances are different, since the government may not be able
to determine the extent to which bonds are purchased by the central bank. Despite legal lack of independence, since the1970s the central bank has independently made this decision. See our discussion of monetary policy below.
7
Indeed, the government’s borrowing is another measure of the stance of fiscal policy.
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end of 2001. The debt continued to rise during 2002 and 2003. At the end of 2003, thegovernment estimated that, with its budgeted new bond issuance of Y30 trillion in fiscal
year 2004, the outstanding balance of government debt will reach over Y700 trn by theend of March 2005.

2. The Literature on the Effectiveness of Fiscal Policy in the 1990s(a) ‘Fiscal Policy was Effective’
The question whether fiscal policy has been effective in stimulating Japan’s economy
has triggered a lively debate. Since many economists in Japan would call themselves
Keynesian, fiscal spending has many supporters.8 The need for and usefulness of fiscal
stimulation has, among others, been argued by Nagatani (1996), Yoshitomi (1996), Koo(1995, 1998, 1999), Posen (1998), Ito (2000).
TPPTThe ‘Fiscalist’ View
The extreme position of a pure fiscalist stance is represented by Koo (1998, 1999, 2003)
and Ito (2000). Koo argues the general case for fiscal policy effectiveness: While moneyis neutral, fiscal policy – and only fiscal policy – is highly effective. However, there has
been no empirical support for this view during the 1990s. In particular, the fiscalist view
cannot explain why the above significant fiscal stimulation failed to stimulate asignificant and lasting economic recovery during the 1990s. As there is no research insupport of this view either, we shall not further concern ourselves with it.
The Keynesian View
The special case for fiscal policy effectiveness was made by Ito (2000), when short-term
nominal interest rates had started approaching zero. He argued at the time that theeconomy was in a liquidity trap, the demand for money perfectly interest-elastic and theLM curve horizontal. Since interest reductions had not stimulated investment, he argued
that investment was perfectly interest-inelastic and the IS curve vertical. Thus monetary
policy would be ineffective and fiscal policy unusually effective, without any crowding
out. Hence Ito advocated further fiscal stimulation as being effective in such a zerointerest environment.9 There is a theoretical problem with this argument, as well as an
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The ineffectiveness of fiscal stimulation has probably rendered many supporters of fiscal spending less vocal by the late
1990s.
9“So far, a straight Keynesian prescription applies” (Ito, 2000, p. 102).
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empirical one. By arguing for a horizontal LM curve, describing the case of short-term
nominal interest rates that have fallen to such low levels that they do not fall further, Ito
restricts his argument to time periods that exclude the entire decade of the 1990s –during this decade interest rates did indeed fall steadily.
An empirical evaluation of the effectiveness of fiscal policy also depends on the size ofthe expected impact of fiscal expenditures. While the Keynesian model implies a‘multiplier’, such that Y1trn of fiscal expenditures would result in a rise in economic
activity larger than Y1trn, many proponents of fiscal policy effectiveness have adopted
a far more cautious approach to fiscal policy effectiveness. Downplaying second andthird-round effects entirely, most proponents emphasized the role of the primary impact:
To estimate the expected impact of fiscal policy, many government and private sector
economists therefore often argued that a public works project worth Y1trn would boost
nominal GDP by Y1trn. A spending package amounting to 2% of GDP was commonly
expected to boost GDP by 2 percentage points.10
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Concerning the empirical evidence, Posen (1998) argues that fiscal policy has beeneffective in Japan during the 1990s. In his view, actual fiscal spending has been smaller
than the headline figures for the packages. He argues that fiscal spending has not been
sufficiently large to stimulate the economy. A suitably sized fiscal expansion would, in
his view, have been effective in ending economic stagnation and deflation. When theactual spending reached substantial size – in 1995, according to him – a recovery
followed (in 1996).11 However, actual GDP-based expenditure data or statistics for thegovernment borrowing requirement yield reasonably accurate measures of the fiscal
stance. Yet, Posen provides no such empirical test of fiscal policy effectiveness. Usingsuch figures, as cited above, we find that sizeable fiscal stimulation did take place andthat it failed to stimulate the economy. Furthermore, there is no evidence that even the
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This was the most common calculation, used by Japanese private sector research institutions, as well as key
government agencies. See, for instance, the Economic Planning Agency’s Nagatani (1996), who argued in favour offiscal stimulation, because “Even when the ripple-on effect is zero, fiscal stimulation policy will still at least have the‘direct effect’, which is that Y1 trn of increase in public investment will result in a Y 1 trn in GDP increase”.
11
Posen follows a calculation common in financial markets in Tokyo, namely to distinguish between investment that
“adds to demand” – so-called mamizu – and that which does not. The mamizu is defined as including increased public
spending and tax cuts. Loan programmes offered by government-affiliated institutions to the private sector and fundedby postal savings deposits investment is deemed not to add to demand, but merely reallocating funding among various
projects. The important insight from this distinction is the necessity to distinguish between government spending that
increases net purchasing power in the economy, and government spending that merely reallocates existing purchasing
power. However, the way this is attempted by the mamizu calculation is flawed. A meaningful distinction must focus on
the credit creation process and include the central bank and the banking system, rendering true mamizu the monetizedpart of fiscal policy (see below).
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first-round effect resulted from the spending.
Ito (2000) also remains convinced of the effectiveness of fiscal policy. While heconcedes that the unprecedented six fiscal stimulation packages that were implemented
between 1992 and 1994 have had “little impact” (p. 102), he argues that this does notprove fiscal policy ineffectiveness, as defined by him. In principle, two definitions ofeffectiveness are possible. One is a mutatis mutandis requirement for effectiveness,
defining it as the ability to create significant positive economic growth. This is thestrictest definition, and the one that matters to policy-makers, investors and the
population at large. In the first half of the 1990s, most private sector economists, forced
to make mutatis mutandis forecasts, predicted significant economic recoveries, mainly
based on the sizeable fiscal stimulation. However, this did not happen. Thus, by their
original definition, fiscal policy was ineffective.
There is another definition of policy effectiveness, which is employed by Ito (2000). It
is based on the ceteris paribus assumption:“Without any fiscal stimulus, the economy undoubtedly would have contracted. The
underlying economy was so weak that fiscal stimulus did not bring the economy all theway to its potential growth rate but it arguably kept things from becoming worse” (p. 102).

Supporters of the efficacy of fiscal spending, including Posen (1998), feel that evenmore fiscal stimulation is the solution for Japan. 12 The difficulty of establishingclear-cut proof is apparent: the ceteris paribus condition is invoked, only to claim its
violation. The argument relies on counter-factual analysis: things would have been
worse without the fiscal spending. Ito indeed relies on unspecified shocks, rendering
economic growth exogenous to fiscal and monetary policy. 13 These undefinedexogenous shocks cannot be isolated or quantified. What is worse, by invoking a
violated ceteris paribus assumption, the fiscal policy effectiveness claim cannot befalsified – it leaves the realm testable hypotheses.14 In science counter-factual analysis
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Ito follows Posen’s (1998) recommendations and suggests further stimulation in the form of lasting income tax cutsand tax incentives to stimulate private housing investment. Ito (2000), pp. 103ff.
13
Ito recognizes this, but leaves the questions raised unanswered. “The question remains as to what prevented theeconomy from getting back on a self-sustained growth path. Was it the series of bad shocks? Or has the dynamic
spill-over effect of fiscal packages become smaller in the 1990s? Or was the amount of actual stimulus smaller than
generally recognized?” (Ito, 2000, p. 102). No attempts at answers follow.
14This line of reasoning falls far short of Popper’s methodological principles. It may well be in the tradition of
deductivist economics, which takes little interest in empirical evidence and concludes from any gap between theory andreality that the latter needs changing, not the former. However, it defies common sense. Nevertheless, even in the
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is frowned upon. Ito’s claim appears to be an attempt at reconciling inconvenient facts
with a theory through the use of ad hoc assumptions about exogenous shocks. Evenleaving aside whether or not these assumptions are permissible, such an exercise cannot
be construed as constituting supportive empirical evidence. Hence the claim that fiscal
policy has been effective remains unsubstantiated and without empirical support.
(b) ‘Fiscal Policy was Ineffective’
Several arguments have been proposed over the years why fiscal policy may beineffective. In the case of the Japanese economy, three types of arguments were made.
All three point out that the simple first-round positive effects of fiscal policy may bepartially or completely negated by negative effects that result from the need of thegovernment to procure the money in order to fund the fiscal expenditure. The first isbased on a Keynesian relationship between interest rates and investment and argues that
crowding out of fiscal expenditure may occur via higher interest rates. The second isbased on a reduction in consumption and an increase in savings that is induced byincreased fiscal spending. It is commonly referred to as ‘Ricardian equivalence’. The
third is based on a modified credit view and emphasizes the link – or lack thereof – offiscal and monetary policy. The first two views will be reviewed briefly below, before
the third is analysed, applied and tested in greater detail.
Interest Rate-Based Crowding Out
A number of studies have argued that the effect of increased government expendituredepends on how it is financed. Lerner (1943) emphasized the distinction between
money-financed and bond- or tax-financed government deficits. As discussed above, theJapanese government relied almost entirely on bond finance during the 1990s. Lernerrejects tax-financed government deficits (as they would not fulfill the purpose ofgovernment deficits, namely to increase overall spending), as well as bond-financed
government deficits. The latter would reduce the amount of money available to theprivate sector, thus increase interest rates and hence reduce private sector investment.
This proposition of fiscal policy ineffectiveness is in line with classical theory, whichargued that government expenditure would result in an equal reduction in private
demand, via an increase in real interest rates. The crowding out effect of increased
government expenditure via higher interest rates is reflected in standard Keynesianmodels and the IS-LM synthesis, but also the mainstream monetarist models (such as
absence of omniscience concerning exogenous shocks, it is possible to test hypotheses concerning the cause of potential
fiscal policy ineffectiveness (see below).

Friedman, 1956, Brunner and Meltzer, 1976).15 While they differ in the size of the net
effect of fiscal policy, they agree that the transmission mechanism (and potential
crowding out) occurs via interest rates. Indeed, the substantial literature on thepossibility and size of crowding out of debt-financed fiscal expenditure has in common
that it centers on interest rates as the adjustment mechanism. 16 What all theseformulations (classical, Keynesian and post-Keynesian) have in common is that the
ineffectiveness of fiscal policy is the result of increased interest rates.
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In the case of Japan it was indeed argued by some economists during the first half of the
1990s that increased bond issuance to fund fiscal spending would lower bond prices andpush up long-term interest rates. This rise of interest rates would negatively affectinvestment and economic activity, it was said. A proponent of this interest rate-based
crowding out argument is, for instance, Yoshida (1996), who additionally warned thatthe long-term interest rate rises would tend to strengthen the yen and hurt net exports.
The main problem with these interest-rate based arguments for fiscal policy
ineffectiveness is that there is no empirical evidence in their support.17 Despite brief
periods of rising long-term nominal rates, nominal short-term (as measured by callrates) and long-term interest rates (as measured by ten-year government bond yields)
have trended down during the 1990s. There are only two instances where they rose:from 4.3% on average in 1993, to 4.4% in 1994, and from 1.3% in 1998 to 1.8% in
1999. However, in both cases rates subsequently resumed their decline to new lows (seeFigure 1).18
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Calculating real interest rates as the difference between these nominal interest rates and15

While proto-monetarist formulations did not rely on interest rates, but the equation of exchange, as outlined below, andearly monetarists (wisely?) said little about the precise transmission mechanism between money and the economy, latermonetarist models (such as Friedman, 1956, Brunner and Meltzer, 1976) accepted the Keynesian interest-elasticity of thedemand for money and thus argued that the ineffectiveness of fiscal policy relies on perverse wealth effects associatedwith bond-financed government spending, operating via interest rates (see Blinder and Solow, 1973). Since interest rates
failed to rise during the 1990s, such later monetarist models are not suitable to explain the Japanese experience and will
not be discussed further.
16
See Christ (1968), B. Friedman (1978), Blinder and Solow (1973), Ludvigson (1996),Those who argued that ‘portfolio
crowding in’ may offset ‘transactions crowding out’ and thus produce either a positive or ambiguous effect ofdebt-funded fiscal stimulation (such as B. Friedman, 1978) do not contribute towards finding an answer to thephenomenon observed in Japan during the 1990s, namely no significant rises in interest rates, but also no significant
effect of fiscal stimulation.
17
Examples of empirical studies of the link between fiscal policy and interest rates in the US are Hutchison and Pyle
(1984) and Hoelscher (1986). For examples and reviews of empirical work on the influence of fiscal policy on aggregate
demand, see, for instance, Aschauer (1985) and Tatom (1985).
18
The annual average of the prime lending rate has declined every single year during the 1990s.
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consumer price inflation (as measured by the CPI), we find that short-term real interest
rates fell from 4.2% on average in 1991 to 0.11% on average in 2000, while long-term
real interest rates fell from 3.0% on average in 1991 to 0.7% in 1998, though risingagain to 2.5% on average in 2000. These real rates were lower than during the 1980s.
These facts contradict interest rate crowding out arguments.
Invoking a violated ceteris paribus definition of crowding out, the theoretical argument
might be conceivable that the fall interest rates happened despite the crowding out, andas a result of exogenous shocks, without which interest rates would have risen. Just as
with the argument that fiscal policy was effective in Japan during the 1990s, as without
it things would probably have been worse, proponents of this view are faced with thedifficulty of having to isolate the exogenous shocks needed to justify the absence ofinterest rate rises. 19 Furthermore, this exercise in attempting to reconcile thecontradictory empirical record with the theory through the use of auxiliary assumptions
cannot be construed as constituting supportive empirical evidence. Thus the fact
remains that the argument of interest rate based crowding out is not supported by theempirical record. Given the historical and dramatic declines in short, long, nominal andreal interest rates, it can be safely said that few, if any observers seriously entertain theinterest rate crowding out argument.20
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Ricardian Equivalence
Another case for a different kind of crowding out has been made by Krugman (1998).
Applying his model of inter-temporally optimizing rational representative agents toJapan, he obtains Ricardian equivalence of the type Barro (1974) proposed: Japanese
consumers believe that any fiscal spending funded by the issuance of government debt
(as most of it has been) will require the debt to be fully paid off in the relevant future byraising taxes on individuals. Then for every yen in government spending, rational
consumers would increase savings by one yen - preparing the money to repay thegovernment in the future.
19

McKibbin (1996) engages in this difficult exercise, making use of a multi-country structural model to endogenise
shocks to the Japanese economy. Pointing out the anticipated nature of the fiscal spending packages (and their partial
overstatement), he concludes: “Rather than stimulating the economy, these fiscal measures acted to further slow
economic activity as well as appreciate the real exchange rate” (p. 37). In McKibbin’s model, the announcement effect offiscal stimulation occurs immediately, appreciating the exchange rate and real long-term interest rates, while the positiveeffect occurs later, or to a lesser extent than announced (due to overstatement of the package). However, only data
through 1995 is used, thus missing much of the 400 basis point drop in long-term interest rates over three-and-a-halfyears, from about 4.7% in February 1995 to 0.7% in October 1998, not to mention the further drop to 0.43 by June 2003.
20
Walker (2002:286), for instance, says: “The possibility of a crowding-out effect of government spending on
investment is dismissed ex ante, given Japan’s low real interest rates in recent years”.
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One analytical problem with this model is that it does not allow for the possibility thatthe debt will be paid off by other means - such as money creation, higher corporate
taxes, economic growth that boosts tax revenues without raising individual taxes, orasset sales to foreign investors. It is not clear why rational consumers would notconsider these possibilities.21
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Another problem is that the assumptions on which it is based are restrictive. Thus if there
is a simpler explanation (as will be presented below), the fundamental principles of logic
suggest that it would be preferable. Meanwhile, the empirical record of the Ricardianequivalence argument remains important to assess its relevance. The most basic test ofRicardian equivalence would be a comparison of the change of household savings andgovernment expenditure or borrowing within a fully specified savings function.
Proponents of this explanation of fiscal policy ineffectiveness have not provided such
evidence, as far as the author is aware.22 Indeed, Walker (2002: 286) holds that “It seems
unlikely that anything as austere as full Ricardian equivalence would obtain in the realworld.”23 We therefore proceed to the third possible explanation of why fiscal policy
appears to have been ineffective in Japan during the 1990s.
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The argument that debt could be paid for by non-inflationary money creation cannot be handled by the type of models
Krugman refers to, because due to further assumptions, including perfect information, they do not allow for the
possibility of less than full employment output. With record-high unemployment and a ten-year recession in Japan, therelevance of such models is not obvious.
22
If the fiscal stimulus takes the form of tax reductions for individuals and not increased government spending, thensavings increase, while consumption remains unchanged - as the higher disposable income is not used for spending. If
the fiscal stimulus takes the form of increased government spending on investment projects, incomes will not necessarilyrise, thus consumption may not necessarily rise. But savings would rise. Since fiscal stimulation took the form of a
combination of government spending and income tax changes (with the emphasis being clearly on government spending,though), the expected movement of consumption would be ambiguous with Barro-Ricardian equivalence. But the
behaviour of savings would unambiguously have to be counter-directional to the movement of government borrowing.
23
Walker (2002) also fails to test Ricardian equivalence directly. Instead, noting the low fiscal multipliers for Japan in
the 1990s, he proposes a theory according to which the fiscal multiplier declines the larger the level of the budget deficit.
He argues that government spending does exert a wealth effect on consumption, but one that is “proportionate to theamount of waste in the budget”. Without providing empirical evidence, Walker assumes that “the average quality of
public spending decreases with the level of spending”. Walker finds a positive fiscal multiplier, contradicting Ricardianequivalence. Making a number of auxiliary assumptions, Walker defines as a large fiscal deficit one that amounts tomore than 6 or 7% of output and finds that “there is a threshold beyond which the effectiveness of fiscal spending falls
off sharply” (p. 298). There is no test for robustness of these findings over different time periods or in other countries.
Further, Walker says nothing about the mechanism by which the effectiveness of fiscal spending is reduced. Walker
really argues that since fiscal policy was ineffective in Japan in the 1990s, and since it was large, it must have been toolarge to be effective. Thus, the main question of concern, namely why steady and significant fiscal stimulation during the
1990s failed to trigger a significant and sustained economic recovery, remains unanswered: by arguing that fiscal policy
was too large to be effective, Walker neglects to explain why fiscal policy, when it was not too large (and not too small),also failed to produce the desired results. Finally, Walker fails to address previous literature that discussed the issue of theabsolute size of fiscal deficits and government debts. Most previous theories failed to attach much significance to thesize of the fiscal deficit or national debt. One early example is Lerner’ s (1943: 47) case that “the absolute size of thenational debt does not matter at all”.
TP

PT

TP

PT

TP

PT

3. An Alternative Explanation of Fiscal Policy Ineffectiveness(a) Theory
Since the 1960s, with the rise of the Keynesian paradigm, fiscal policy had been given
prominence in policy-making in the US and many European countries. This wasjustified with the Keynesian government expenditure multiplier analysis. However, inthe late 1960s and until the end of the 1970s, a growing body of literature pointed outthat such analysis was misguided, as it focused only on the initial-stage multiplier effect.
An analysis of the complete multiplier would have to include the question of how thebudget deficit is financed, and incorporate the effects of such finance. Christ (1968),
Blinder and Solow (1973), Hansen (1973) and others showed that for bond-financed
deficit spending, the stimulative effect of fiscal policy is smaller than that derived in
traditional Keynesian models that do not take funding into consideration.
This body of literature has largely been neglected in more recent studies of the effect offiscal policy. Ludvigson (1996) appears representative in his neglect of the possibility ofmoney-financed government expenditure, which appears to have largely disappeared
from the policy debate. While this may reflect the changed institutional environment of
the past decade or so, where central banks have become independent, this does not
eliminate the possibility of central bank cooperation with government policy or the needto analyse it. The neglect of the possibility of money-financed fiscal expenditure is all
the more surprising as the literature had always agreed unanimously that fiscal policy, if
funded this way, will be effective:“There is no controversy over government spending financed by printing money. Bothsides agree that it will be expansionary; but one group likes to call it fiscal policy, while
the other prefers to call it monetary policy. Nothing much hinges on this distinction.”
Blinder and Solow (1973: 323).

Blinder and Solow (1973) also point out that the degree of effectiveness of debt-fundedfiscal policy is an empirical matter. The empirical record in Japan’s case appears to bethat such fiscal policy is not effective. We have seen that standard theories of fiscal
policy ineffectiveness have not been able to explain the facts observed in Japan during
the 1990s. There is no support for the Ricardian equivalence hypothesis, which does notrequire a rise in interest rates and argues that consumers spontaneously reduce theirspending and increase savings to match any increase in government expenditure. Thereis also no support for the classical, neo-classical, IS-LM synthesis and monetarist
models which argue for crowding out of private demand due to debt-funded fiscal
expenditure via a rise in interest rates: interest rates did not rise.
In order to adequately explain the Japanese experience since the early 1990s, a theory istherefore required which allows for crowding out of fiscal expenditure, without the needfor interest rates to rise, but also without relying on the empirically implausible
Ricardian equivalence argument (of perfectly foresighted savers replacing government
expenditure with savings yen by yen). This suggests that an older strand of literature,
which in accordance with Blinder and Solow (1973) could be called “pre-Keynesian”,
or alternatively “proto-monetarist”, should be reconsidered, namely Irving Fisher’s(1911) model, which does not rely on the monetary transmission through interest rates.
Instead, it relies on direct quantity-based crowding out of private demand, due toincreased claims on limited stocks of money by the government. Later monetarist
models adopted the Keynesian argument of an interest-based investment function andthus came to rely on interest-based crowding out of private demand. However, some ofFriedman’s writings indicate that he continued to sympathize with Fisher’squantity-based crowding out: “I regard the description of our position as “money is allthat matters for changes in nominal income and for short-run changes in real income”
as an exaggeration but one that gives the right flavor of our conclusions”, he said as late
as 1970 (Friedman, 1970: 217).
“On the transmission mechanism from money supply changes to income changes,
Friedman supported Fisher’s direct transmission mechanism – from money supply changes
directly to expenditures changes – over the indirect one – from money supply to interest
rates to investment – in Keynesian and IS-LM models”, says Handa (2000: 365).24
TP

PT

This direct transmission of money to the economy, and consequent quantity-based
crowding out of fiscal expenditure was also supported by the so-called ‘St. Louismonetarists’ (Handa, 2000: 370). They argue that government spending financed bybonds must be ineffective, because the money supply is left unaltered. Empirical24

As a result, “Friedman stands out in arguing that fiscal policy does not have strong effects on the economy…”(Dornbusch and Fischer, 1987: 671). “Fisher comes close to asserting that only changes in the quantity of money affectthe price level; Friedman is more clear in arguing that other factors can affect the price level, but that these other factors
are of secondary importance” (Dornbusch and Fischer, 1987:241).
TPPT

evidence in support of this contention have been provided by Andersen and Jordan(1968), Andersen and Carlson (1970) and Keran (1969, 1970). This view was indeed“commonplace” before Keynes (see the introductory quote).
But even Keynes was aware of the importance of the way government expenditure isfunded. Before Keynes developed the liquidity preference theory, he was moreconcerned with Fisher-type quantity equations (see Keynes, 1930). In 1929, he argued
that stimulatory fiscal expenditure should be funded by monetary expansion (Klein,1968). Crucially, Keynes emphasized (in 1929) that the central bank could negate theeffect of stimulatory fiscal policy and therefore “ensure that the expenditure financed by
the Treasury was at the expense of other business enterprise” (Keynes, 1932:126). A
simple model emulating the ‘pre-Keynesian’ or ‘proto-monetarist’ conception of the roleof fiscal policy is presented below.
Following the income version of Fisher’s quantity equation, this ‘common view’ heldthat nominal GDP (PY) is endogenous to the money supply (with velocity V being
constant) and can be written as in equation (1), where we have followed the convention
to place the endogenous variable on the left-hand side:(1)

PY = MV

Considering changes (so that the constant velocity drops out), we can rewrite this tostate that nominal GDP growth is equal to money supply growth (or proportional in
weaker versions):(2)∆(PY) = ∆M

It follows that any exogenous increase in a component of nominal GDP (such as in G)
cannot affect total nominal GDP, if the money supply remains unaltered: with ∆M = 0,
and breaking down nominal GDP (PY) into nominal consumption c, nominal
government expenditure g, nominal investment i and nominal net exports nx, we obtain:(3)∆M = 0(4)∆(PY) = ∆c + ∆i + ∆g + ∆nx(5)∆g = – (∆c + ∆i + ∆nx)

Equation (5) indicates that, following Say’s Law, each dollar of additional government
spending must crowd out exactly one dollar of private spending. The change ingovernment expenditure ∆g is countered by a change in private sector expenditure ofequal size and opposite sign. Thus the level of aggregate income will be unchanged andthe multiplier for bond-financed government spending is zero. Notice that thisconclusion is not dependent on the classical assumption of full employment. Instead ofthe employment constraint, the economy can be held back by a lack of money. Fiscal
policy can thus crowd out private demand even in the context of less than full
employment. Furthermore, the original formulation of Fisher, favoured also by
Friedman, does not include interest rates and thus does not require crowding out via
higher interest rates. Instead, the direct quantity effect of the government using up
money that will not be available for spending by the private sector is sufficient.
Equation (5) shows that without an increase in the money supply, a rise in government
expenditure must result in an equal reduction in private demand, leaving nominal GDP
unaltered and fiscal policy completely ineffective. As Milton Friedman put it:“The quantity theory implies that the effect of government deficits or surpluses depends
critically on how they are financed. If a deficit is financed by borrowing from the public
without an increase in the quantity of money, the direct expansionary effect of the excess ofgovernment spending over receipts will be offset to some extent, and possibly to a very great
extent, by the indirect contractionary effect of the transfer of funds to the government throughborrowing. … If a deficit is financed by printing money, there will be no offset, and theenlarged stock of money will continue to exert an effect after the deficit is terminated. Whatmatters most is the behavior of the stock of money, and government deficits are expansionary
primarily if they serve as the means of increasing the stock of money; other means ofincreasing the stock of money will have closely similar effects.”25
TP

PT

However, this explanation suffers from a significant empirical obstacle: it iswell-documented that macroeconomic models based on the quantity equation andpredicated on the assumption of constant velocity have suffered from “recurring bouts
of instability” (Goldfeld and Sichel, 1990: 349): Significant declines in velocity (andhence a “breakdown” in the money demand function) have been observed in a large
number of countries since the 1980s, including the UK, the US, Scandinavian countries,
TP

25
PT

Milton Friedman, in his entry under Money: Quantity Theory in the Encyclopaedia Britannica, p. 476.

and Japan. The previously stable relationship between M and PY “increasingly cameapart at the seams during the course of the 1980s” (Goodhart, 1989). As a result, theusefulness of the quantity equation has declined significantly. “Once viewed as a pillarof macro-economic models, it is now widely regarded as one of the weakest stones in
the foundation” (Boughton, 1991). The instability of velocity and hence the lack of astable relationship between monetary aggregates (such as M0, M1, M2 or M3) andnominal GDP has also been recognized in the case of Japan (see, for instance, Ishida(1984), Bank of Japan, 1988, Miyao, 1996, Yamada, 2000, and Kimura, 2001).
A suggestion has been made to solve the puzzle of the apparent velocity decline. It has
been pointed out that originally Fisher (1911) referred to a transactions equation, whichstates that the amount of money changing hands to pay for transactions during a given
time period must equal the nominal value of these transactions. Considering growth,
this can be written as follows:(6)∆(PQ) = ∆M

where M stands for money actually used for transactions and PQ stands for the value ofthese transactions. Now considering only those transactions constituting GDP (denoted
as PRY), we can write:
B

B

(7)

∆(PRY) = ∆MR
B

B

B

B

where MR stands for the money used for transactions that are part of GDP.26 Thus thevalue of GDP transactions can only increase, if there is an equal increase in the money
used for them. When attempting to employ actual statistics to represent this equation of
exchange, we have no difficulty in using nominal GDP, as calculated by the national
income accounts, for PRY. However, we find that traditional measures of the ‘money
supply’ (such as M1, M2, etc.) do not measure money actually used for transactions, butinstead subsets of the stock of savings. Furthermore, in financial systems as they
evolved subsequent to the paper money system of the Sung Dynasty in tenth century
China, the majority of new money has come about through credit creation of thebanking system (and, when relevant, the central bank). The emphasis on credit
counterparts, as opposed to deposit aggregates, is in line with the expanding literatureon the ‘credit view’ or ‘bank lending school’, which argues that credit should not be
B

B

B

TP

TP

26
PT

B

Following Werner (1997, 2002a).

PTneglected in macroeconomic analysis, as it may be at least a supplementarytransmission mechanism for monetary policy, if not more.27 Since bank credit extension
creates the deposits that are usually considered in so-called money supply measures, it
is also valid to utilize the credit counterparts in the quantity equation. This addresses
weaknesses of the previous formulation: Using credit to represent money M in theequation of exchange (6) and (7) allows us to measure the purchasing power actuallyused for transactions at any moment in time, as well as to disaggregate it into credit
used for GDP transactions (MR) and that used for non-GDP transactions (such as
real-estate and other speculative transactions).
TP

B

PT

B

Using credit creation to measure M, equation (6) indicates that economic growth is only
possible, if credit is created either via the banking system or the central bank, and used
for transactions that are part of GDP. Interest rates are not part of the model. Thisfeature of Fisher’s (1911) model can today be explained with further reference to the‘credit view’ literature: Relaxing the assumption of perfect information, it has beenshown that the credit market cannot be expected to clear. Markets that do not clear are
rationed and hence determined by quantities (following the ‘short-side principle’:
whichever of supply or demand is smaller will determine the market outcome). Since
there is always demand for money, the credit market is likely to be determined by its
supply (see, for instance, Stiglitz and Weiss, 1981).
This allows a monetarist-creditist synthesis, which describes economic growth as afunction of the supply of bank and central bank credit. According to equation (6), thehigh growth of the 1980s in Japan would be explained as resulting from high credit
growth. Since credit was also used for non-GDP transactions (especially speculativeloans to the real estate sector), and much of these loans turned into bad debts in the early
1990s, banks increasingly became risk-averse. This restricted the supply of credit, also
to borrowers that use the purchasing power for GDP-based transactions (consumption,
investment). As a result, economic growth declined. The credit shrinkage also resulted
in shrinkage of nominal GDP. While credit creation remains weak, equation (6) tells usthat GDP growth cannot recover significantly.

TP

27

See, for instance, Bernanke and Blinder (1988), Bernanke (1993), Gertler and Gilchrist (1993), Bernanke and Gertler(1995), Kashyap and Stein (1997). It is noteworthy that most of this literature does however not explicitly address theability of banks to create credit, and thus considers banks largely as financial intermediaries with the function to transfer
funds from A to B, comparable to the capital markets. This is not how banks are considered in this paper, as their ability
to create credit, through the well-known credit creation process, should be taken into consideration.
PTIn this situation neither lowering interest rates is useful (as it does not increase thesupply of credit from risk-averse banks), nor increasing fiscal stimulation (as pure fiscal
policy does not create credit): The findings of the proto-monetarist model apply in thistestable modification. Thus, without an increase in MR, there cannot be an increase innominal GDP:B

(8)

∆MR = 0(9)∆(PRY) = ∆c + ∆i + ∆g + ∆nx(10)∆g = – (∆c + ∆i + ∆nx)

B

B

B

B

B

In this framework, just as proposed by the early quantity theory literature, fiscal policy
cannot affect nominal GDP growth, if it is not linked to the monetary side of theeconomy: an increase in credit creation is necessary (and sufficient) for nominal growth.
To test the above framework empirically in the case of Japan in the 1990s, we first notethat in practice credit creation used for GDP transactions cannot be expected to havebeen precisely zero during the 1990s. There were periods of significant credit growth(such as in 1996), but also of credit contraction. Thus the more general formulation of
the model, with
(11)

∆MR > 0B

B

is required. Substituting (9) and (10) into equation (7), we obtain the testableproposition:(12)∆(c + i + nx)

=

∆MR –
B

B

∆g

whereby the coefficient for ∆g is expected to be approximately –1. In other words,
given the amount of credit creation produced by the banking system and the central
bank, an autonomous increase in government expenditure g must result in an equal
reduction in private demand. As the government issues bonds to fund increased fiscal
stimulation, private sector investors (such as life insurance companies) that purchase thebonds must withdraw purchasing power elsewhere from the economy. The same applies(more visibly) to tax-financed government spending. With unchanged credit creation,

every yen in additional government spending reduces private sector activity by one yen.
We observe a different kind of crowding out than postulated by Keynesian or Ricardianmodels: Unlike the Keynesian interest rate-based crowding out, and like Ricardianequivalence, it is quantity-based and does not require any particular movement ininterest rates. It therefore fits the observation of the 1990s that interest rates did not rise.
Unlike Ricardian equivalence, it does not depend on restrictive assumptions about
unobservable expectations and their formation. Moreover, it does not operate via achange in household savings. Instead, crowding out occurs due to the lack of newpurchasing power supplied by the financial system (credit creation).
The policy advice of this model is clear – and uncontroversial. As Blinder and Solow(1973:323) pointed out, there “is no controversy over government spending financed byprinting money. Both sides agree that it will be expansionary”. In the terms of ourmodified pre-Keynesian model: The Japanese authorities need to increase credit
creation, in order to stimulate growth. This can be done via fiscal policy that is fundedby credit creation or other measures, as will be discussed below.

(b) Empirical Evaluation
A model of nominal GDP growth
We proceed to test the above explanation of fiscal policy ineffectiveness. Our empiricalevaluation must begin with a general model of nominal GDP growth that also includes
the variables suggested by alternative approaches, including the money supply andinterest rates. This general model is then sequentially reduced to the parsimonious form,
which parsimoniously encompasses the alternative models (see Hendry and Mizon,
1978; Hendry, 2000). We formulate a general ADL model of nominal GDP, based onquarterly statistics:(13)∆GDPt=
BB+

αj + Σβj∆GDPt-j-1 +
B

B

B

B

B

B

B

Σωj∆HPM t-j +
B

B

B

B

Σγj∆MRt-j +Σδj∆WPI t-j +Σφj∆MS t-jΣρj∆Short t-j +Στj∆Long t-j +Σϕj∆ODR t-j +

B

B

B

B

B

B

B

B

B

B

B

B

B

All variables are in year-on-year percentage differences, with
GDP = nominal GDP
MR = Credit used for GDP transactions
B

B

B

B

B

B

B

B

B

B

B

B

B

B

εt
B

B

WPI = Wholesale Price Index
MS = Money Supply, M2+CD
HPM = High Powered Money
Short = Call RateLong = 10 year JGB yield
ODR = Official Discount Rate
Using the PC-Give software, we sequentially drop the insignificant variables, while
testing for the validity of these restrictions. The final parsimonious model resulting fromthis process is (t statistics in parentheses):
(14)

∆GDPt
B

=
B

0.004j + 0.327∆GDPt-1 + 0.222∆GDPt-3 +
B

B

B

B

B

(1.71)

B

B

B

B(2.53)

B

0.407∆M Rt +(2.10)

B

B

εt
B

B

(4.08)The results are reported in Table 4.

Table 4.

Estimation Results of GDP Model

The estimation sample is: 1990 (1) to 2000 (4); Dependent variable: ∆nGDP
Coefficient

Std. error

t-valuet-prob.

Part.R^2

Constant

0.00381350

0.002228

1.71

0.095

0.0683∆nGDP_1

0.326688

0.1293

2.53

0.016

0.1376∆nGDP_3

0.222120

0.1059

2.10

0.042

0.0991∆MR

0.406689

0.09980

4.08

0.000

0.2934

B

B

Sigma

0.00995221

RSS

0.00396186124

R^2

0.88463F(3,40)log-likelihood

142.502

DW

1.87

no. of obsv.

44

no. of parameters4mean(∆nGDP)

0.0211887

var(nGDPYoY)

0.000780463

AR 1-3 test:

F(3,37)=0.45124 [0.7179]

hetero test:

F(6,33)=0.20716 [0.9721]

ARCH 1-3 test:

F(3,34)=0.93630 [0.4338]

hetero-X test:

F(9,30)=0.55406 [0.8229]

Normality test:Chi^2(2)=0.13829 [0.9332]

RESET test:

F(1,39)=0.000462 [0.9830]=

102.2 [0.000]**

The usual statistical diagnostics show that there are no significant problems with theformulation. Furthermore, cointegration tests confirmed that a spurious correlation
could be ruled out. The credit model encompasses alternative theories. In Figure 1 weshow the raw data for nominal GDP growth and the key explanatory variable, credit
creation used for GDP transactions (∆CR). The close correlation of the raw (not fitted)
data is visible by eye inspection. Granger causality tests found that credit
Granger-causes nominal GDP growth, but not the other way.
B

B

MR& nGDP

YoY %

YoY %

12

12

10

10

8

8

6

6

4

4

nGDP (R)

2

2

0
-2

0

83

85

87

89

91

93

95

97

99

-2

MR (L)-4-4

Latest: Q4 2000

Figure 1. Credit creation used for GDP transactions (MR) and nominal GDP growth inJapan. Source: Cabinet Office, Government of Japan, and Bank of JapanB

B

Testing the fiscal policy ineffectiveness proposition
We now proceed to test the fiscal policy ineffectiveness proposition of our model.
Substituting the empirical formulation of nominal GDP, as shown in equation (14) into
equation (9) and solving for non-government demand, we obtain:(15)∆(ct+it+nxt) = β1 + β2∆GDPt-1 + β3∆GDPt-1 + β4∆MRt + β5∆gt + εt
B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

B

If we have found suitable empirical proxies for our model, a regression would yield thefollowing coefficient for government expenditure:
(16)

β5 =
B

B

–1

We use year-on-year changes of all variables. Figure 2 shows changes in government
spending and private demand. Eye inspection indicates that there is some form ofnegative correlation. The results of our regression are shown in Table 5.

Private and Government Demand

Bn yenBn yen
3000

10000

2500

G (R)

8000

2000
6000

1500

4000

1000

2000

500
0

0

90

92

-2000

94

96

98

-500

00

C+I+NX (L)

-1000

-4000

-1500
Latest: Q4 2000

Figure 2. Nominal private demand and government expenditure, absolute growth
rates. Source: Cabinet Office, Government of Japan

Table 5.

Estimation Results of Private Demand Model

The estimation sample is: 1990 (1) to 2000 (4); Dependent variable: ∆private
Coefficient

Std. error

t-valuet-prob.

Part.R^2

Constant

430.797

323.8

1.33

0.191

0.0434∆nGDP_1

0.369348

0.1275

2.90

0.006

0.1770∆nGDP_3

0.203399

0.1110

1.83

0.075

0.0792∆MR

0.0151281

0.004390

3.45

0.001

0.2334∆G-0.956970

0.2057

-4.65

0.000

0.3570

B

B

Sigma

1233.28

RSS

59317732.9

R^2

0.823256F(3,40)log-likelihood-372.946

DW

1.77

no. of obsv.

44

no. of parameters

5=45.41 [0.000]**

mean (∆private)1406.38var (∆private)1406.38

Solved static long-run equation for ∆private:
Coefficient

Std. error

t-valuet-prob.

Constant

430.797

323.8

1.33

0.191

∆nGDP

0.572747

0.1048

5.46

0.000

∆MR

0.0151281

0.004390

3.45

0.001

∆G

-0.956970

0.2057

-4.65

0.000

B

B

Long-run sigma = 1233.28
ECM = ∆private - 430.797 + 0.95697*∆G - 0.572747*∆nGDP - 0.0151281*∆MR;
B

B

WALD test: Chi^2(3) = 179.476 [0.0000] **AIC

14.3415SC

14.5443

HQ

14.4167FPE

1.69380e+006

When the log-likelihood constant is included:
AIC

17.1794SC

HQ

17.2546

FPE

17.38212.89293e+007

AR 1-3 test:

F-form F(3,36)=

0.58896 [0.6262]

ARCH 1-3 test:

F(3,33)=

1.4770 [0.2387]

Normality test:Chi^2(2)=0.68778 [0.7090]

hetero test:(8,30)=

1.5833 [0.1717]

hetero-X test:

F(14,24)=

1.7418 [0.1123]

RESET test:

F(1,38)=0.056661 [0.8131]

Skewness-0.17285

Excess Kurtosis-0.025167

Asymptotic test:Chi^2(2)=0.22026 [0.8957]

The coefficient for government expenditure (β5) is –0.95697. Rounding to one digit, we
obtain:B

β5 = –1.0.
B

B

Evaluation

B

The test suggests that for every yen in government spending that is not monetised (i.e.
not supported by credit creation), private demand must shrink by one yen. The empiricalevidence supports the contention of the pre-Keynesian economists that an economic
recovery requires monetary expansion, here defined as credit creation. The
pre-Keynesian model, in modified form, appears to fit the Japanese experience of the
1990s, in preference to alternative explanations.
Possible objection
There is a possible objection to this empirical finding: causality may run from private
demand to government spending, not the other way round. In other words, while it issuggested here that increased government expenditure has crowded out private
expenditure through laying claim on the limited amount of credit available, thegovernment expenditure may have responded perfectly to declines or rises in private
demand, in order to maintain stable growth. However, there are a number of serious
problems with this argument: In this case, the government would have to have perfectknowledge of current gross domestic expenditure, and be able to react simultaneously,
during the same quarter, by adjusting government expenditure. However, GDP statistics
are only available long after the end of the current quarter. Furthermore, government
expenditure is the result of a somewhat complex bureaucratic procedure, which involves
budgets drawn up by the Ministry of Finance and the government, which are approvedby the Diet. There is no empirical evidence that this process has been fast enough toaccommodate potential current-quarter changes in spending needs. More often than not,politicians appear happy if they can respond within the same fiscal year to perceived
changes in public spending needs. Thirdly, and perhaps most damaging to thisalternative explanation, if the government expenditure did not in fact crowd out private
demand, as suggested by our credit model, but instead the government counteractedchanges in private demand perfectly, then this argument would imply that government
expenditure was, after all, effective in changing total output and employment. If thatwas the case, then why did the government, apparently well-informed and infinitely
quick in its short-term spending policies, not use its allegedly highly stimulatory fiscal
policy to achieve the declared government policy goal of stimulating an economic
recovery? Surely, if fiscal policy had the desired effects, as this argument suggest, andcould counteract any change in private demand, then why did the government use it tocreate negative nominal GDP in 1998, 1999, 2001 and 2002? Why did the government
implement a contraction of nominal GDP by over 1% in those years? Alternatively, if
the argument accepts the credit constraint case presented by this model, then why did

the government, if so well informed and fast-acting, not simply increase credit creation?
It is clear that a large number of auxiliary assumptions – most of them highly
implausible – are required to rescue this counter-argument. The fundamental logicalprinciple of parsimony suggests that our proposed explanation should be considered
preferable.
(c) Policy Implications
The finding suggests that fiscal policy has been ineffective during the 1990s, because it
was not supported by monetary policy. The central bank could act to increase credit
creation, and hence stimulate the economy, by raising its net open market purchase
operations. For instance, the Bank of Japan could have sufficiently increased its bondpurchases.28 Policies to stimulate bank credit creation could also have been adopted.
Here, the central bank could have been more helpful, for instance by utilizing its uniquestatus to solve the bad debt problem at zero cost to the tax payer or society (bypurchasing the bad debts at face value from all banks). Given these findings, it appears
central bank policy has not been as helpful as it could have been. The lack of incentives
to coordinate monetary policy with the government’s fiscal policy may be one of thedisadvantages of central bank independence.29
TP

PT

TP

PT

Werner (1998, 1999, 2000) has suggested a policy for governments to monetise fiscal
policy even without cooperation from the central bank. The method renders fiscal policy
effective. So far, the majority of the borrowing requirement was covered through bondissuance. Without the cooperation of the central bank, money-financed fiscal policy is
not an option. However, credit-financed fiscal policy is possible: the Ministry of
Finance could cover the public sector borrowing requirement by borrowing from theprivate sector commercial banks. This would increase credit creation and stimulate theeconomy.
There are objections to this proposal. Hawtrey, before the Macmillan Committee of
1930, “considered the ‘radical’ idea of government spending out of new bank credit, but
28

Werner (1995, 1996). Hayashi (1998) argues that the central bank is essentially an agency that certain functions havebeen delegated to by the government. In this case it does not make sense for the government to issue bonds and pay
interest for its borrowing, if it could instead ask the central bank to print money and pay for fiscal policy through costless,interest free money creation. Hence the government could “exchange interest-bearing government bonds with interest
free reserves through the central bank’s purchase of government bonds”, as paraphrased by Okina (1999, p. 172).
29
Independence is not necessarily an obstacle, since a central bank can voluntarily cooperate to support the
government’s policy. As Bernanke (2000) pointed out, “Cooperation with the fiscal authorities in pursuit of a common
goal is not the same as subservience” (p. 163). Unfortunately, there are few examples of such cooperation by
independent central banks.
TP

PT

TP

PT

predicted that the result of such a policy would be inflationary, and a threat to the gold
standard, thus forcing up the bank rate of interest and causing credit contraction. [It]…
would mean the end of cheap money for free enterprise.” 30 However, Hawtrey’s
objection is predicated on the assumptions that (a) the market for credit is in equilibrium,
so that interest rates respond proportionately to an increase in the demand for credit;
and/or (b) that banks are merely financial intermediaries that cannot create new credit,
so that any extension of bank loans to the government must be at the expense of banklending to alternative uses. However, both assumptions are unlikely to hold: thetheoretical literature has provided ample arguments for the case of a rationed credit
market, whereby interest rates do not respond proportionately to changes in the demand
for money. Furthermore, the institutional reality of banking systems allows banks tocreate new purchasing power without withdrawing existing purchasing power fromother parts of the economy. Empirically, the Japanese example has also disproved
Hawtrey’s assumptions: Using Japanese data, no evidence can be found that interest
rates are in an inverse relationship with the quantity of bank loans extended.
Furthermore, Japanese banks currently have excess reserves of over Y30 trn with thecentral bank, and they continue to reduce bank lending. They have ample opportunity toincrease lending without withdrawing loans from current borrowers.
TP

PT

Thus the argument stands that funding of fiscal expenditure by borrowing from banks
would increase credit creation and hence the total amount of purchasing power in theeconomy. As a result, MR in equation (7) above would rise, which would, in turn, boost
nominal GDP. By shifting government funding away from bond finance and replacing itwith borrowing from the commercial banks via simple loan contracts, credit creation
will be stimulated.31 Unlike bond markets, banks create new purchasing power when
they lend. This means that overall economic activity can be boosted (via fiscal policy),
without any quantity crowding out that rendered fiscal policy ineffective during the
1990s.32
B

TP

TP

30

B

PT

PT

Klein (1968), as quoted by Spencer and Yohe (1970:15). It is not made explicit who had launched this ‘radical idea’.
However, there is some evidence that it may have emerged from the German credit school of economists. It isnoteworthy that this ‘radical’ idea was successfully implemented in Germany in the 1930s. On this, see Werner (2004).
31This is effectively the policy combination adopted by the Reichsbank from 1933 to 1937. Its President, Hjalmar
Schacht, appeared to have been well aware of the quantity crowding out problem of unmonetised fiscal policy. In
addition to stepping up the credit creation of the Reichsbank (by purchasing various forms of assets, including
government bonds and bonds of other government institutions), Schacht instructed the establishment of government
institutions that implemented fiscal spending programmes and were funded by the issuance of bills of exchange thatwere purchased by the banks and the central bank. Funding fiscal expenditure with money creation, as opposed to publicbond auctions is called ‘silent funding’ (geraeuschlose Finanzierung) in the German tradition. See Werner (2002b).
32
This proposal has found several supporters since, such as Congdon (2001), Smithers (2001) and the Financial Times’
Martin Wolf (2002).
TP

PT

TP

PT

TP

PT

Figures 3 and 4 are used to illustrate the difference between stimulatory fiscal policy –here the example of a fiscal spending package – funded via bond issuance taken up by
investors, such as life insurers, and stimulatory fiscal policy that is backed by credit
creation.

Fiscal stimulation funded by bond issuance(e.g. : ¥20trn government spending package)Non-bank private sector(no credit creation）-¥20trn

Fundingviabondissuance+¥20trn

Fiscalstimulus
Ministry of Finance(no credit creation)

Net Effect = Zero

Figure 3.

Fiscal stimulation funded by bankborrowing(e.g. : ¥20trn government spending package)

Bank sector
deposit Non-bank private(credit creation power)
sectorAssetsLiabilities(no credit creation)¥20 trn¥20 trn+¥ 20 trn
Funding
via bank
Loans

MoF(No credit
creation)
Net Effect = ¥ 20 trn

Fiscalstimulus

Figure 4.

Although the central government funded parts of the 1998 budget from banks, this hasremained negligible. With the majority of bond issuance taken up by the non-bankprivate sector (which does not have the power to create credit), fiscal spending had to
crowd out private activity.

4. Conclusion
The proposed alternative model has provided an answer to the question why fiscal
policy has appeared ineffective during the 1990s. It indicated that the cause of Japan’srecession has been the reduction in credit creation that began in 1992. We have also
found that this problem could have been addressed through monetary policy. Even
without bank lending, the central bank could have created a recovery, by significantly
increasing its own credit creation. Bad debts could have been taken off the banks’balance sheets without costs by the central bank. In other words, Japan’s recession of
the 1990s has been the result of the Bank of Japan’s policies. 33 However, thegovernment has also not adopted suitable policies to counter the lack of cooperationfrom the central bank. It could have (and still can) increase credit creation, and hence
render fiscal policy effective, by switching its funding from bond issuance to loan
contracts from commercial banks.
TPPT

Our research also raises new questions. If the solution to Japan’s problems has been
relatively straight-forward and virtually costless, why has the responsible authority not
implemented such or similar policies? The Bank of Japan’s Sawamoto and Ichikawa(1994) do not deny that the central bank could have acted, but they argue that “the basic
principle is that overall monetary policy should not be turned into a bank rescue
operation, except in very dire circumstances. At present, Japan is certainly not in such asituation” (p. 99). The assessment of whether circumstances are “dire” enough towarrant more aggressive monetary stimulation depends on the goal of monetary policy.
This, then, becomes another important area of future research: what precisely is or has
been the goal of monetary policy in Japan?

TP33This finding is also consistent with other empirical work. Bernanke (2000) attributes “much of Japan’s current
dilemma to exceptionally poor monetary policymaking” (p. 150).
PT

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