Strong Money Demand in Financing War and Peace

This chapter briefly provides empirical and theoretical motivations for research papers that are collected in this book. In the modern Japanese economy, strong money demand has appeared twice. It first appeared during World War II and then, more recently, after the mid-1990s. Such strong money demand enabled the Japanese government to finance large-scale military spending in the first occasion, while it has supported massive fiscal operations developed by the government in the second. For the former part, the economy was forced to implement strict fiscal reforms to prevent hyperinflations from happening once the strong money demand disappeared immediately after the war ended. For the latter, on the other hand, near-zero rates of interest and stable prices continue to coexist with affluent money and poor fiscal surpluses, while strong money demand survives.

The observations associated with the emergence and disappearance of strong money demand are hard to explain by either the quantity theory of money or the fiscal theory of the price level. Here, a monetary and fiscal theory of the price level is proposed as their alternative. In particular, it can successfully identify additional sources of money demand. More concretely, the strong money demand appearing during the war was attributed to immense demand for BOJ notes from black markets, while the current one has been driven by extremely low interest rates, starting from 1995. Employing rich implications from this alternative theory, I fully elucidate the extent to which the current monetary and fiscal situation of the Japanese economy is sustainable, and how it will break down in the near or far future.

Employing the Japanese case of large-scale black markets under extensive price controls during and immediately after World War II, we first explore how much income leaked out of the formal economy into the black markets. Then, we investigate the extent to which the circulation of Bank of Japan (BOJ) notes helped the leaked income to flow back into the formal economy when the notes were held as an instrument to conceal illicit income by the black marketeers. According to our estimates, 6–30% of national income leaked into the black markets in the above period, while more than 40% of the leaked income returned to the treasury as massive seigniorage revenues in the last years of the war. Inflation was not too high during the war because of the black marketeers’ strong money demand. After the war, however, the black marketeers shifted their portfolios from BOJ notes to physical assets and land, thereby reducing their money demand and accelerating inflation. We also demonstrate that the black markets helped to reserve scarce physical resources for the post-control economy starting in the late 1940s.

This chapter demonstrates how wartime seigniorage benefits for the occupation forces and postwar withdrawal costs for the defeated government were balanced in large-scale monetary operations in the Japanese occupied territories during the Pacific War (from December 1941 to August 1945). The Japanese government financed war expenses locally by two methods. First, the government forced extemporaneously installed reserve banks in north/central China and the southern regions (Southeast Asia) to issue enormous quantities of banknotes. Second, it requested existing central banks in Manchuria, Indochina, and Thailand to underwrite Japanese government debts by issuing legal tender. In the former territories with high inflation rates, poor circulation of reserve banknotes limited the purchasing power of the occupation forces, but the cost to the postwar government of withdrawing banknotes was minimal. In the latter territories with relatively mild inflation rates, however, good circulation of legal tender generated substantial seigniorage for the occupation forces, but there were substantial costs to the defeated government of repaying its liabilities to the central banks of the previous territories.

In the past quarter century, Japan’s economy has seen rates of interest, including those on long-term public bonds, remain quite low despite colossal accumulation of public debt, while the price level has been mildly deflationary or almost constant despite rapid monetary expansion. In this chapter, these puzzling phenomena are interpreted using a simple disequilibrium analysis framework. The major reasons for adopting disequilibrium analysis are that (1) Japan’s economy often fell into excess supply in both goods and labor markets after short-term rates of interest were controlled below 0.5% in mid-1995, and (2) public bond markets were clearly in serious excess supply given the expectation that the primary fiscal balance was not going to turn into surpluses in the future relevant to those bonds being issued. In the proposed disequilibrium model, excess supply in goods, labor, and public bond markets is absorbed by excess demand in money markets, induced by strong money demand at near-zero interest rates. In particular, strong money demand absorbs public bonds not as investment instruments, but as money substitutes. This chapter also demonstrates that excess demand in money markets in disequilibrium analysis can be interpreted as public bond price bubbles in equilibrium analysis. Given the analogy between the two approaches, as far as the bubble is sustained, mild deflation and near-zero interest rates continue in spite of massive issues of public bonds and rapid expansion of money stocks. On the other hand, once the bubble bursts, money demand shrinks drastically, a wide range of interest rates rise suddenly, and the price level jumps abruptly. With the government’s credible commitment to future fiscal reforms, a one-off price surge would stop immediately at a level two or three times higher than before, but without the reforms, the price process would be hyperinflationary.

Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates:​ Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy” presented a simple framework of disequilibrium analysis, in which strong money demand, induced by near-zero rates, helps to absorb excess supply in goods, labor, and public bond markets. However, the analysis is at most diagnostic without any theoretical rigor or quantitatively precise simulation. In this chapter presents a formal equilibrium model, in which public bond price bubbles are present temporarily or even persistently, but burst with a tiny probability per year. As discussed in Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates:​ Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy”, those bubbles and their bursting in equilibrium analysis are interpretable as excess money demand and its disappearance in disequilibrium analysis. One of the most important implications in this chapter is that the model can yield reasonable predictions concerning the price level and a wide range of public bond yields, not only for the period when the short-term rate was already near zero (from the mid-1990s), but also for the period when it was far above zero (from the mid-1980s to the mid-1990s). For the latter period, the model predicts that the price level switches from mildly inflationary to mildly deflationary, and that the short-term rate declines quickly, but that yield curves remain upward sloping. For the former period, on the other hand, yield curves were gradually flattening at near-zero rates. In terms of future implications, if the bubbles burst, then the price level and rate of interest would jump immediately. As discussed in Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates:​ Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy”, strong commitment to future fiscal reforms by a government would help a one-off price surge to stop at a level several times higher than before. Here, it is assumed that a rare but catastrophic event, such as a large-scale inland earthquake in Tokyo, causes the bubbles to burst, leading to sharp declines in real output in the following years. Given a strong aversion to catastrophic endowment shocks, the model is able to yield even more realistic predictions for the price paths and the shape of yield curves, both of which would prevail before the bubbles burst.

This chapter discusses the possible macroeconomic consequences of the introduction of cryptocurrencies by central banks (so-called central bank cryptocurrencies or CBCCs) in a competitive equilibrium environment. In this setup, central banks set not only the money supply, but also the interest rate on CBCCs, whereas bond interest rates, the price level, and the exchange rates between CBCCs are determined in competitive markets. We first resolve a severe confrontation between the quantity theory of money (QTM) and the fiscal theory of the price level (FTPL) in that, as long as the currency interest rate lies below the bond interest rate, the QTM is applicable in principle. However, once the bond interest rate (asymptotically) matches that of the currency, the QTM is replaced by the FTPL, or the monetary and fiscal theory of the price level (MFTPL), in which the government’s budget constraint as well as money market conditions jointly work to determine the price level as discussed in Chapters “Public Bonds as Money Substitutes at Near-Zero Interest Rates:​ Disequilibrium Analysis of the Current and Future Japanese Economy and Long-Run Mild Deflation Under Fiscal Unsustaina-Bility in Contemporary Japan”. We then investigate whether the introduction of CBCCs plays a role in the disappearance of strong money demand (currently present at near-zero interest rates in Japan) and its alternatives. We find that if a central bank sets the currency interest rate below a near-zero bond interest rate, then strong money demand disappears, and the massive issuance of long-term public bonds is no longer absorbed in currency markets. However, once the consolidated government succeeds in lowering the currency interest rate to be deeply negative, it can obtain immense seigniorage, allowing it to repay these public bonds. In addition, if the bond interest rate also falls, even below zero for long periods, then the government can exploit seigniorage from CBCC holders without limit.