Modern Monetary Theory is the latest fashion that circulates among the academic community. This is a post-Keynesian theory that has gained influence in the environments that oppose austerity budgeting. Modern Monetary Theory states that fiscal deficits do not matter as long as countries are funded in their own currency and inflation is under control. It defends bigger government spending.

It is not surprising that the Modern Monetary Theory was established in Japan, where debt is denominated in yen, inflation is virtually zero, and the share of government debt in GDP jumped to the sky. The theory defenders argue that Japan is proof of it, but in fact, this is not true.

Different powerful forces have prompted two strange trends in the Japanese economy – dramatic changes in the balance between savings and investment in the public and private sector and the failure of monetary policy. Modern Monetary Theory does not explain either. At the outbreak of the global financial crisis in 2008, the Japanese budget deficit was only 2% of GDP, while the combined surplus in the corporate sector and households amounted to 5.1%. Within a year in Japan, there has been a massive contraction in private investment and consumption. In the last quarter of 2009, the surplus in the private sector reached 12% of GDP. At the same time, the budget deficit jumped to 9.9%. The surplus resulting from net savings caused a capital outflow, which now stands at 2.1% of GDP and finances a flow of Japanese foreign investment.

This pattern of large surpluses in private savings, partly offset by large public deficits, continues. The result is a huge increase in the size and role of the Japanese public sector. Government debt grew from 60% of GDP in 1990 to 235% today. But contrary to Modern Monetary Theory, fiscal expansion has failed to push the economy at all.

Unlike savings surpluses, the broad monetary aggregates in Japan have grown steeply. Since the 1990-1991 bubble burst, the monetary aggregates M2 has grown at an insignificant 2.6% per year. In addition, since the 1950s, the rate of money circulation has been negative, decreasing by an average of nearly 2% per year. This is one of the most astonishing and persistent macroeconomic links in history – the weak growth of broad money along with the decreasing circulation of money kept low the nominal GDP growth.

Faced with a shrinking circulation, Japan needs to increase broad money M2 by at least 5% per year (twice the current trend), achieve its 2% inflation target per year and reach potential economic growth of 1%. In practice, the inadequate growth of the M2 monetary aggregates for nearly three decades coupled with the declining pace of money circulation is projected at an average economic growth of only 0.9% per year. This put Japan in the straitjacket of deflation, with prices falling by 0.6% per year, as measured by the GDP deflator.

While the growth of M2 remains minimal, low inflation (or deflation) will prevail regardless of whether there are surpluses or savings deficits in the public and private sectors. The inflation is always and everywhere a monetary phenomenon. The same applies to deflation. Money dominates.

The understanding of Japan and other economies requires a classical monetary theory rather than a modern panacea. In the period 1974-1984, Japan enjoyed a golden period with broadly stable broad money growth, steady GDP growth, and low inflation. Monetary policy was then raced with signing the Plaza in 1985 and the Louvre in 1987. The Japanese Central Bank (BoJ) lowered monetary targets and began focusing on target rates. The result was the debilitating balloon of 1987-1990, followed by the so-called a lost decade, turned into a lost generation.

According to the BoJ, the idea of ​​targeting interest rates is that if interest rates are low enough, sooner or later companies and households will start to spend. But as economists showed a century ago, interest rates follow inflation, not the opposite. For this reason, high inflation economies such as Argentina and Turkey have high interest rates, while Japan and the Eurozone have very low or even negative.

In Japan and the Eurozone, the vicious circle can only be destroyed by an increase in the growth rate of broad money. The best way for this is for central banks to buy securities from non-bank institutions, such as insurance companies and pension funds, creating new deposits. Currently, however, the bulk of the securities that BoJ buys are from banks. For this reason, broad money growth remains anemic.

The recent US experience also demonstrates the superior explanatory power of classical monetary theory. In the period 1971-1982, the average growth of the broad monetary aggregate M3 averaged 11.6% per annum, while the average level of government debt was only 40.1% of GDP. This combination of strong monetary growth and low government debt has led to relatively high inflation.

Today, the United States faces the opposite picture – low growth of broad money and high government debt. Since 2009, M3 growth has averaged 4.5% per annum, while public debt exceeds 100% of GDP. This has led to relatively low inflation. There is no mystery – money always dominates.

The advocates of the Modern Monetary Theory have led us to believe that governments can sustain endless deficits as long as they are funded by local currency securities and while inflation is under control. What they have failed to understand is that budget deficits have nothing to do with inflation unless they are funded through the rapid growth of broad money. Money dominates economic trends, and classical monetary theory tells us why.