Classical vs Modern Monetary Theory

Classical vs Modern Monetary Theory

I am intrigued that both Classical Monetary Theory (CMT) and Modern Monetary Theory (MMT) have a way of explaining how macroeconomics works, yet both think the other theory is wrong, while their own theory is right.  

I think it is generally agreed that it is bad to let a sovereign currency inflate, i.e. devalue. It is tantamount to stealing from anyone who holds cash in that currency. It is embarrassing and to be avoided. But deflation is also to be avoided. It seems there is an international consensus that a currency should inflate, but only by a steady 2% per annum. 

CMT believes that a thrifty, well run country should not run a deficit but should raise in taxation as much money as its government spends.  If there is a deficit, CMT believes that printing money, or simply writing it into existence, causes inflation –– at least, in the absence of growth in the economy.  For it believes that the value of a currency is a simple but inexorable function of the total quantity of 'Goods' divided by the total quantity of 'Money'.  The preferred CMT response to a deficit is to borrow on the international bond market. But the CMT economists warn that too much borrowing will 'spook' the markets and interest rates will go up. The country will find itself stretched over a barrel as more and more of our tax goes straight off to pay interest on our National Debt. Were inflation to occur, the Bank of England would raise interest rates, which inhibits the economy. That would curb spending by the poorer (indebted) citizens while cushioning (or even rewarding) the better-off lenders.

MMT believes that deficits are vital if the economy is to grow, as it is the only way that money (currency) can enter the private sector. MMT holds that taxes are not required to "pay for government", for there is no reason why the money cannot be created (by a sovereign government; provided that it does not cause inflation). If there is idle capacity in the economy, printing money should stimulate the economy. If the economy is at full employment and surplus money is still chasing goods and services there will be inflation. The MMT answer to inflation is to raise taxes (rather than interest rates). This takes money off those that have it (rather than those that do not have it). Taxes can have other beneficial effects besides reducing demand for goods; it can reduce inequality, and it can reduce e.g. smoking or carbon dioxide emission.

Where CMT thinks that the value of a currency is set by the ratio of the total quantity of 'Money' (defined narrowly, or broadly?) to the total quantity of 'Goods', it could be argued that prices are set much more locally, by people who know neither the total quantity of 'Money', nor of 'Goods'; prices even respond to 'expectations'. Look at the way BP's profits soared when the Iranians closed the Strait of Hormuz. Perhaps the biggest difference between the two theories is in the different ways in which they propose to handle inflation. Though both schools aim to reduce the local availability of money, the CMT school would raise interest rates, inhibiting business and penalising the indebted, while the MMT school would raise taxes. 

Japan's Debt:GDP ratio

Japan and its Debt-to-GDP ratio 

Introduction
How can we expect the 'propensity to save' to be the same in Japan as in Europe or the USA? History matters.  I am a Scottish 'war baby', and 80 years later I am still hoarding writing paper.  While Europe was evolving the goose-down duvet, Japan was evolving the wooden takamakura pillow. The Japanese temperament, history and  laws are all very different from ours in Britain. Japan struggles to raise its inflation rate to 2%; we in the UK struggle to lower our rate to 2%. 

Japanese regulations and saving propensity
From 1945 - 1990 the average Japanese household saved nearly a quarter of its disposable income. (C.f. 18% in France and 20% in Germany. ) For some reason we in Britain favour investing in stocks and shares. The Japanese psyche (and/or government regulatory preference) seems to prefer the simple, low-interest savings account in a simple bank. I quote Takeo Hoshi (2023): 

"As early as the mid-1990s, the Japanese government realized that various regulations in financial markets made households hold most of their financial assets in the form of cash and deposits." [8].

There is currently "too much money" in such accounts, and banks offer negative interest to try to drive that money away [8]. Managed funds are not favoured in Japan, neither by the public nor the government. Stock brokers would like the Japanese to gamble on the stock market like people do in UK and USA because that is how they make their money, but they cannot get the public enthusiastic [8].  In the period 1950 - 1990 the social security provision in Japan was weak; workers had to save to provide both pensions and 'security against hard times'. (I learn that there is some regulation in Japan that makes low-interest bank-deposits a favourite place for workers to store the money they have saved for their pension. But I do not know what; perhaps rules about interest rates and tax breaks. From [11], I learn that tax breaks for private savings (maruyū) were introduced in 1963, encouraged household savings.)

The 'Bubble' and the 'Burst'.
From the sixties to the eighties, times were good for Japan.  Real Japanese GDP increased fivefold between 1960 and 1990, and with it net household savings increased by the same factor to 45 trillion yen at 1990 [11]. Japan ran a large trade surplus with most developed countries, and in particular with the USA. However, the surging value of the yen eventually depressed sales. In addition, the growth of competition from other Asiatic economies also lowered profitability.  The USA wanted Japan to curb the bubble by raising interest rates, but the Bank of Japan (BOJ) lowered interest rates, trying to "stabilize exchange rates". In 1987 Japanese money supply (M2) was still expanding at 10% p.a. even while inflation dipped to negative values [10]. The BOJ failed to note (in time) the 'overheating' of the economy; and the 'bubble' burst. 

The  'bubble-burst' came in December 1989, with the Nikkei 225 dropping 41%  in 8 months, from 39,000 to 23,000 by August 1990 [12]. But that sudden decline was followed by a persistent slow decline for 18 further years till it bottomed at 7,000 in October 2008, having lost 82% of its maximum value.  The revival of the Nikkei 255 did not really begin till mid 2013, when the BOJ started large scale purchase of Japanese stocks and shares. Since then it has climbed steadily to a new high at the beginning of 2026. 

CPI Inflation

As far as the Japanese themselves are concerned, the Yen has proved to be a very stable currency, since 1991. Between 1956 and 1991 the Yen lost more that 80% of its value, but has remained very steady since then [13]. Conventional wisdom is that it is better to have annual inflation of +2%. Not too much higher, and not too much lower. By 1987 the growth of other Asian economies had created over-production and the need to shed workers. However, in the face of competition Japanese firms tended to hold on to their workforce offering security in place of wages. So wages sank. And prices sank. 

The BOJ saw persistent negative annual inflation (-0.3%) for 15 years from 1998 - 2013, (and again from 2019 - 2026 according to Ian Webster, [13]). That worried them, as every other country had inflation.  So, in 2013 the BOJ instituted a programme of 'Quantitive and Qualitative Monetary Easing', QQE) [14], with the aim of intentionally de-valuing (inflating) the Yen till it achieved the desired 2% inflation rate. They also aimed to lower the risk-aspect of interest rates by underwriting. (Basically, by systematic buying of Japanese government bonds (JGBs) and exchange-traded funds (ETFs) at the rate of some 60 Trillion Yen per annum.).

By the end of 2013 the BOJ had achieved an annual inflation rate of 1.6 %, so in 2014 the board decided to scale up the QQE by some 20% to 80 Trillion Yen per annum. They ended 2014 with an annual inflation of 2.4% [15].  However, the CPI inflation rate again slumped to near zero in 2015 [15]. On the other hand, the economy did start to improve; job vacancies appeared, and wages rose. However, after 15 years of deflation  the expectation that prices would remain static had became deeply embedded in the national psyche. Bank deposits placed at the BOJ were charged with a negative interest rate of (-0.1%) from Jan 2016 till March 2024; only reaching +0.75% in Dec 2025. (Presumably in an attempt to drive the saved money into investments.)

Debt:GDP (as %)

In the 1970 Japan had the lowest ratio of Debt:GDP of all the G7 economies; since 2000 it has had the highest ratio. In 2020 (with COVID) debt reached 250% of GDP. It does seem odd that a relatively wealthy country like Japan should run a fiscal deficit (spending more each year than it raises in tax). But it is relevant to note: [a]  it has (till recently) enjoyed very low interest rates, and [b] 90% of Japan's government debt is owned by Japanese. The benefit of low interest rates needs no explanation. The fact that most of the Japanese debt is held domestically has two benefits.  Institutional Japanese holders are unlikely to attack the Yen in the way that predatory foreign owners can (See Greece in 2011). And the interest paid on the debt is not lost to the country; it could even be viewed as part of GDP.

Diverting Savings to Investment.
From Jan 2016 (till March 2024) deposits placed at the BOJ were charged with a negative interest rate of -0.1%. Presumably this was an attempt to drive the money saved in bank accounts into productive investments. The economy did recover; GDP has maintained a small annual growth from 2013 till 2020 (COVID!). The Silicon Review of 22 Dec 2025 wrote [18]: "The Japanese government is looking to mobilize a portion of the nation's US$ 7 trillion pile of household savings to create fresh demand for its bonds."

The buildup of the 1,324 Trillion Debt.
According to Wikipedia, Japanese debt rose steadily from the bubble-burst of 1990 until COVID: "At the end of March 2025, the general gross debt of the Japanese Government was 1,324 trillion yen, or 234.9% of the country's gross domestic product" [17]. It is now declining. The longer-dated bonds in particular are not selling well; and, as their market price sinks, their apparent 'yield' (or return per annum) rises.

Conclusion.

Japan has struggled to raise its inflation rate to 2% while most other countries have struggled to lower their inflation rate towards 2%. If it ever succeeds, will it have lost something distinctively Japanese?

References:   

[1]  https://notayesmanseconomics.wordpress.com/2025/12/24/2025-and-all-that-the-economics-version/
[2]  https://conversableeconomist.com/2025/12/23/how-does-japan-sustain-such-high-government-debt/
[3] https://worldpopulationreview.com/country-rankings/debt-to-gdp-ratio-by-country 
[4] https://fred.stlouisfed.org/series/IRLTLT01JPM156N 
[5]  https://occidentis.blogspot.com/2014/06/interest-rates_4.html
[6]  https://www.statista.com/statistics/661908/japan-consumer-price-index/
[7]  https://www.bis.org/review/r240527d.pdf    
[8]  https://internationalbanker.com/finance/japans-elusive-goal-of-savings-to-investments/
[9]  https://www.ifo.de/DocDL/cesifo1_wp8927.pdf
[10]  https://en.wikipedia.org/wiki/Japanese_asset_price_bubble
[11] https://www.econstor.eu/bitstream/10419/195770/1/1663195218.pdf
[12]  https://en.wikipedia.org/wiki/Nikkei_225
[13]  https://www.in2013dollars.com/japan/inflation/1956?amount=100
[14]   https://www.boj.or.jp/en/mopo/outline/ref_qqe.htm
[15]  https://www.inflationtool.com/rates/japan/historical
[16]  https://www.reuters.com/business/finance/why-is-boj-tweaking-its-buying-japanese-government-bonds-2025-06-17/
[17]  https://en.wikipedia.org/wiki/National_debt_of_Japan
[18]  https://thesiliconreview.com/2025/12/the-silicon-reviewdec-2025japan-eyes-7t-household-savings-bond-demand

Growth, Inflation and Interest

       The terms Growth, Inflation and Interest are familiar enough from the news media, but this surface familiarity hides complexities. Without being synonyms, they overlap, have elements in common, mingle and contaminate each other. In this piece I share my struggles to understand.

Interest

       Though usury was banned by the church for many centuries, yet the practice of paying interest on borrowed money has become accepted in the West, and for centuries we have understood that money lent will yield an increase. However, today the yield is very small.

       We understand the principles of compound interest, and with it that of logarithmic growth. Suppose £100 were deposited at 4% p.a. compounded annually. At the end of the first year we would have £104.00. But at the end of the second year the account balance, though enlarged by the same factor (f=1.04), would have enlarged by a bigger amount than in the first year, and become £108.16. That is to say, our deposit grows exponentially; the increment each year is bigger, because the balance is bigger, but the factor (f ) stays constant.

We can see that the formula is:

                      Final deposit = initial deposit x  fⁿ

 (where n=number of years, and fⁿ means f raised to the power n

So:                         £108.16 = £100.000 x (1.04)²

In 18 years we would have £202.58, and we would have more than doubled our money [1]. 

       Of course, there are many different interest rates, depending on whether you are lending or borrowing, big or small, safe or risky. 

       One interest rate that is of special significance in the UK is the so-called Base Rate of the Bank of England (BoE); i.e. the rate the BoE charges when it lends for short periods to commercial banks.[2]   On 19th March 2020  Base Rate was lowered to 0.1% APR where it has since remained. Its record high point was 17.00% for the period 15th Nov 1979 – 3rd July 1980.

Inflation 

       Inflation can be thought of as the cost of a basket of purchases constructed to represent the average purchases of a household, relative to the cost of the same basket in an index (or base) year. The basket may change from year to year, as mobile phones come into fashion and horses go out. From 1750 till 1934 the value of the British pound remained rather constant overall, with periods of inflation balanced by periods of deflation. Britain finally abandoned the gold standard in 1931. From 1934 inflation has always been positive (save for 1 year during the 2009 banking crisis), but inflation has not been constant; in 1975 the annualised rate of inflation was running at 24%, but in 2020 at only 0.8%. Inflation operates as a tax on the hoarders of money.

       Just as there are many different interest rates, so there are many different inflation rates, depending what you put in the basket [3,5]. Current European practice is to use the Consumer Price Index (CPI) which ignores housing costs. Until April 2011 Britain used the Retail Price Index (RPI) which included housing costs, and tends to rise a little faster then the CPI.  

       Figure 1 shows data points for each quarter year from 2000 to 2020, plotting Log(base 10) for both 'CPI' and 'RPI' against year, and fitting 'least squares' trendlines. Both sets of data swerve off the trendline at times, but it is possible to determine a convincing average annual Inflation factor (f) for each (See Fig.1 legend). Over the last 20 years RPI has averaged a growth of 2.92%, while CPI has averaged 2.26%. The cost of housing clearly grows faster than most other things in the two baskets. 

 

Fig. 1 Plot showing Log₁₀ CPI and RPI (UK). 

Standardised to 100 for 2015, for each quarter year from 2000 to 2020. The pink squares show RPI; the blue lozenges show CPI. The slopes are obtained by least squares. In such plots, slope = Log₁₀ f;  so f = antilog (slope).  Log RPI grew at an average (over that period) of 0.0125 per annum, corresponding to a factor (f) of 1.0292 p.a. or 2.92%, while Log CPI grew at an average of 0.0097  p.a.. corresponding to a factor of 1.022586 (2.25%). (The intercept values can be ignored in the present context; they point to values for the year 0 A.D..)

       Gold is still a popular measure of value, and there seems to be a notion in some quarters that its value is constant, as the world supply will remain fixed (apart from the slow process of mining). But monetary policy and fashion cause arbitrary fluctuations.  The real rental value of agricultural land fluctuates even more [4], buffeted by politics, and the rising population.

       We probably use CPI because it is the simplest, best, agreed, means available for correcting the steady devaluation of the currency that is inflation. But it is important to keep an eye on special cases such as house and land prices. (Gold, bit-coin and the Stock-Markets are surely the concerns only of gamblers.)

'Causes' of Inflation

       It seems that, in the present atmosphere of pandemic emergency, the central banks can give large quantities of  'money' to government where it is handed out to needy people at a rate not seen since WWII; and still the inflation rate is near zero.  People wonder why there is no inflation.

        The Austrian monetarist school believes that inflation is inevitable if the Quantity of Circulating Money (QCM) relative to the Quantity of Purchased Goods and Services (QPGS) is raised. But it is too simplistic to look only at the quantity of money in either the narrow (M0,M1) or the wide sense (M2,M3,M4), for it has to circulate, through purchases. 

        Causes of inflation include:-

·      External price rises, e.g. oil prices. 
·      Insufficient production to meet demand. 
·      Full employment and shortages of skilled labour. 

·      Expectation that prices will rise. 
·      Expectations  from 'Index-linked' wages, or pensions.

Growth 

            Growth of the economy is usually measured in terms of Gross Domestic Product (GDP) measured in a standard way, e.g. by totalling all the income (or all the spending) in the country, quarter by quarter (more or less in line with international practice; e.g. the European System of Accounts 2010, [6]).  Clearly the total actual incomes are not computed; surely estimates are made of how many dentists, how many cleaners; and of the average dentist's salary, etc. Otherwise, what an immense task!  To make these data useful they have to be corrected for the size of the population, and the current value of the £ Sterling. Thus, from Nominal GDP, we get GDP per head, and Real GDP . The latter correction is complicated [7,8], and I deal with it in the next section on Overlaps.

 

Overlaps:  Growth and Inflation

            Growth of the economy indicates a general increase of wealth (and is presumed to be 'good'); inflation on the other hand indicates erosion of value. It is essential to strip the inflation out of the Nominal growth figures. This could be done using the somewhat flawed CPI data, but is not. The CPI 'basket' of goods is seen as artificial. The GDP data purport to be the whole data set of which the CPI is a sample. 

            The Office of National Statistics (ONS) publish several tables of historic GDP data stretching back to 1955. One table is titled "GDP at market prices: Current Prices: Seasonally adjusted £m". A second table is titled "GDP: chained volume measures: Seasonally adjusted £m". The former (Current Prices) is clearly Nominal GDP; the second (Chained Volumes) is more obscure, but is in effect Real GDP, corrected for inflation [8], and I think that could be mentioned on the page. 

            Taking data points for each quarter year from 2016 to 2019 and plotting Log(base 10) GDP against date for both 'Current' and 'Chained', it is possible to determine an average annual Growth factor (f) for each. (See Fig. 2) It is obvious that the GDP growth rate using Current Prices (f=1.0361) grows at a faster rate than the Chained Volume data (f=1.0146). 

 

Fig. 2 Semi- Log₁₀ plot of UK GDP growth, 2016 to 2020. 

The pink squares show data using Current Prices (so Nominal GDP); the blue lozenges show Chained Volumes data (so Real GDP). The slopes are obtained by least squares. In such plots, slope = Log₁₀ f;  so f = antilog (slope). Current data grew at an average (over that period) of 3.61% per annum, while the Chained data grew at an average of 1.46% p.a.. The latter data is clearly corrected for inflation, which will be given by the ratio of the two slopes ( f_nominal = f _realx f_inflation). So we see that inflation was running at an annualised rate of  2.117% over that period. (compare CPI and RPI  in Fig. 1 above) . (The intercept values can be ignored in the present context; they refer to the extrapolated value of £GB in the year 0 A.D.)

             In the Chained Volumes method of adjusting for inflation [8], there is no 'base' year. First the cost of the GDP basket for a given year is calculated as a product of price and quantity for each item. (These products are called volumes but the units are £GB as the quantities are dimensionless numbers.) The volumes are aggregated over the entire productive economy producing Aggregate at Current Year's Prices (ACYP). Then the exercise is repeated using the same year's quantities but the previous year's prices, producing APYP. Dividing ACYP by APYP produces a quotient (Q_(n), where n is the given year) which is the factor by which all prices increased over the previous twelve months, weighted according to their importance in the economy.  By chaining successive quotients (Q_(n) x Q_(n+1) x Q_(n+2) etc.,) one can determine the course of inflation over a period of years and also determine the real Growth Rate of the economy. 

Overlaps:  Interest Rate and Inflation

            Over the centuries the UK Treasury has sold undated bonds to raise money to pay for e.g. The South Sea Bubble, and various wars, offering interests rates of up to 4%. Various debts of this sort were consolidated in 1927 as undated 4% consols, but were retired or bought back by the government in 2015. Of course, the sums involved have shrunk in importance due to inflation; £100 in 1927 would have had the purchasing power of £6,323.57. in today's money (as inflation has averaged 4.56% per year in the intervening period). The owner of such a consol thought he was gaining at 4% p.a., but was in fact losing at 0.56%.

            Inflation seems not to arise from the rapid and arbitrary extension of credit to the Government for the paying of bills (often seen as the "printing paper money"). That has been done on a massive scale since the banking crisis of 2008, and currently during the COVID pandemic. Yet interest rates and inflation are both extremely low. 

            But inflation did occur in 1975 under the influence of (a) OPEC oil price rises, (b) leap frogging wage claims by undisciplined trade unions, and (c) the expectation of rising prices. 

            With inflation at 24% APR, it seems reasonable to charge roughly the same in interest, otherwise the lender eventually pays back only a fraction of what he borrowed.  Tough luck if you took out a loan at 5%, then found the rate rise to 15%. Similarly, inflation peaked in 1990 at 9.46%, with Bank of England base rate peaking a few months earlier in October 1989 at 14.88%, while 5, 15, and 25 yr Gilts all peaked in April 1990 [9] 

Overlaps:  Interest Rate and Growth

            For centuries the central bankers have manipulated the Base Interest Rate in an attempt to control Inflation and Growth. When they want the business cycle to slow down they raised base-rate in the expectation (largely realised) that all other rates would go up, and borrowers and buyers would hesitate. It was similarly believed that that "lowering of interest rates would encourage growth of GDP"

            Lee and Werner (2018) [10] challenged that theory – that lowering "interest rates" encourages growth of GDP.  For 4 major economies (Japan, USA, UK, and Germany), they plotted the fluctuations of Nominal GDP on top of the fluctuating interest rate of contemporary government bonds. They concluded that interest rates follow GDP growth (rather than precede) and are positively correlated with growth (rather than negatively correlated).  Well yes! Is that not the same thing? If a rise in GDP is routinely followed by a fall? What is clear is that the BoE raised base rate before the peak of inflation, and bond rates rose soon after base rate. But I do not think the utility of central bank operation can be tested in that way; it is very difficult to strip inflation out of GDP data –– and Lee and Werner did not even try to do so.  

Conclusions

            My conclusions, from this discussion, can be summarised:

(1)  Inflation is subject to external influences, such as oil prices, which the BoE cannot influence.

(2)  The financial world is largely composed of greedy gamblers who hope to make their money from the rising and falling of stock prices where the smart can take money off the less smart.

(3)  In large part the business cycle is driven by expectation. Announcing a forecast can be as effective as raising or lowering base rate. Your decision to build a factory is based, not on today's interest rates and markets, but on those you expect in 2 - 5 years time. 

(4)  The absurd inflation rates of 1979 and 1989 suggest mis-management of the economy.

(5)  Close attention will be required to control credit, when money begins to circulate again. 

 (Please comment directly to cawstein@gmail.com )

References

[1] The doubling time (n_d) is a useful alternative measure of the interest rate factor,  (i.e. f); and each can be calculated from the other. If n_d is the doubling time in years.

                                                2 = f ^nd ; f= ^nd√2

[2] https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp

[3]  See my previous post on "CONSUMER versus RETAIL PRICE INDICES"   

[4]  Lloyd, T. (1992) "Present value models of agricultural land prices in England and Wales". PhD thesis, University of Nottingham.

[5]  Shaun Richards quoted Andrew Sentance (24th March 2021) 

[6]https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/methodologies/nationalaccounts.

[7]https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/methodologies/chainlinkingmethodsusedwithintheuknationalaccounts

[8] https://www.oecd-ilibrary.org/docserver/9789264027657-2-en.pdf?expires=1617443621&id=id&accname=guest&checksum=5F6F66D21A4173A9AB86F5D591A569FC

[9]https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1991/the-gilt-edged-market-developments-in-1990.pdf?la=en&hash=8A97A143E4A2ECCE8353116627AF1A4103EF4488

[10] https://www.sciencedirect.com/science/article/pii/S0921800916307510#bb0020

(Please comment directly to cawstein@gmail.com )