Modern Monetary Theory (MMT) offers a dangerous half-truth that has become particularly seductive now that governments are desperate for tools with which to keep their economies afloat. A recent statement by MMT proponent Stephanie Kelton to the Financial Times is a case in point. Referring to the United Kingdom’s current Conservative government, she argues that, “They’re going to have massive deficits. And it’s fine.”
The problem is that while this assessment is correct for now, it won’t necessarily be correct in the future. Indeed, we should anticipate that the year following the end of the COVID-19 lockdown could be when MMT falls flat on its face – starting, perhaps, with a burst of inflation in the UK. But, even barring that specific outcome, policymakers are flirting with disaster if they accept MMT’s main message, which can be paraphrased as: “Deficit, schmeficit. Just boost public spending or cut taxes, then monetise the resulting imbalance.”
To be sure, some parts of MMT make sense. The theory views the treasury (or finance ministry) and the central bank as components of a single unit called the state. The treasury is the beneficial owner of the central bank (or, put another way, the central bank is the treasury’s liquidity window), which implies that central-bank independence is an illusion, especially when it comes to its fiscal and quasi-fiscal operations.
MMT holds, correctly, that because the state can print currency or create commercial bank deposits with the central bank, it can issue base money at will. And because the monetary base is irredeemable, it is not in any meaningful sense a liability (even though it is certainly viewed as an asset by the holder). As long as the non-monetary debt issued by the state is denominated in domestic currency, sovereign default is a choice, not a matter of necessity, because debt servicing can always be funded (by creating money).
But if sovereign default is a choice, there are circumstances in which it might be chosen. If the deficit that needs to be monetised is large enough, and if the interest on the public debt accounts for a significant part of that deficit, the monetary financing required to maintain sovereign solvency might result in a politically unacceptable rate of inflation. In that case, the sovereign might opt for the “lesser evil”: defaulting on its domestic-currency-denominated debt.
To get to the heart of the matter, forget about issues such as bond financing, and focus directly on how the state funds the deficit by creating money. Assume that public spending and tax revenues are fixed in real (inflation-adjusted) terms. The resulting real deficit will be equal to the increment in the real stock of base money that the private sector must be willing to absorb each period.
There are two “regimes” for base-money demand. The first is where many of the advanced economies now find themselves: in a liquidity trap at the effective lower bound (ELB) for the nominal policy rate. At the prevailing near-zero risk-free short-term nominal interest rate, the effective demand for real-money balances is infinitely elastic. In this case, it is proper for fiscal authorities to follow a simple dictum: when in doubt, shovel it out. “Helicopter money” – monetised increases in public spending or tax cuts – is an appropriate policy response under such extraordinary conditions. So long as interest rates are stuck at the ELB, cash disbursements will not be inflationary.
Yet one must remember that domestic or foreign developments affecting financial markets or the real economy can quickly eject a country from its ELB perch, landing it in what economists would call a normal monetary regime, where the policy rate is above the ELB. With Japan stuck at or near the ELB for the past 20 years, the concept of “normal” may require some rethinking. Nonetheless, it would be reckless to design policies on the assumption that the neutral interest rate (the interest rate that would prevail with the economy at full employment and inflation on target) will hover near zero for the foreseeable future.
In this second, normal scenario, there still would be no inflationary threat so long as the economy has excess capacity (idle resources). But when demand for the monetary base is constrained by interest rates and the level of economic activity (measured, say, by income or consumption), the unbridled monetisation of state deficits eventually would eventually exhaust what slack there is, putting upward pressure on the rate of inflation.
At this point, no one can know whether the COVID-19 pandemic will have lasting effects on supply relative to demand. Although weak investment and strong precautionary saving are likely to depress neutral and market interest rates while the pandemic persists, we should be prepared for when social distancing becomes a thing of the past and supply chains are at least partly restored. Governments will have to adjust their fiscal position and its financing accordingly. MMT thus ignores the level of demand for base money at its peril.
Willem H. Buiter, a former chief economist at Citigroup, is a visiting professor at Columbia University. This content is © Project Syndicate, 2020, and is here with permission.
28 Comments
I admit that there is much I do not understand about this, and look forward to reading others comments. But a question arises from this article; it reads like the base assumption in MMT is that the sole source of money creation in a country is the central bank, if this is so what then of the trading banks? Another question; is there a difference between credit and money? The trading banks have been creating credit hand over fist for years, funding a property bubble that has become so large it is essentially a threat to everything, but no one seems to want to regulate against this. Is this credit creation seen as a risk at all to the central bank/treasury function?
I am also not an expert but this has also puzzled me. It is not clear to me that MMT proponents acknowledge the role of commercial banks in money creation. Or maybe they just don't mention it because it would confuse their message? I would welcome any insights on this from others.
I think most of the time it is glossed over or discounted as banks create credit, not money. The thing is, there is practically no functional difference and credit is what forms around 97% of our money in circulation (M3 money supply).
Back about a year ago, an interest.co.nz interviewer (can't remember who it was) interviewed Adrian Orr and asked him "do bank create money" to which he replied "no they create credit" and the matter was left at that.
Credit creation has proven far more important than money creation but no one aside from us mere commentators dares question it.
Edit - I found the old interview - https://www.interest.co.nz/banking/98181/rbnz-governor-adrian-orr-says-…
Gareth asks about money creation at the 10 min mark.
So credit is not money. But that raises a point that is most concerning. If the trading banks are creating credit, in the most common case to fund a property bubble that threatens the entire economy, that credit must still be paid off and this must be done with money, because in effect credit = debt. So the central bank is busy creating money for the economy, but the trading (private) banks are busy vacuuming it up from the economy as profits to go overseas to their parents. Why is this being allowed? Are those who refuse to regulate it corrupt, complicit or wilfully ignorant?
MMT does indeed acknowledge money creation by the banks. An article here about it on Prof Bill Mitchell's blog.
http://bilbo.economicoutlook.net/blog/?p=14620
MMT recognises the broad money supply is endogenous. Demand for credit will increase the broad money supply as loans create deposits. Banks lend and worry about reserves after. The central bank accommodates the banks' demand for reserves at a price. However, the existence of more base money in an of itself does not cause an increase in the broad money supply. MMT says the multiplier idea is a fallacy. Loans are made when there is demand from worthy borrowers independent of how many reserves there are in the system. So fiscal deficits increasing base money supply will not in and of itself increase credit creation. Credit creation may take off due to an improvement in general demand caused by the fiscal deficit increasing spending and income in the real economy however.
http://bilbo.economicoutlook.net/blog/?p=44871
Bill Mitchell's full reply to this article. Spending beyond the capacity of the real economy to absorb it will create inflation - CORE MMT.
Mmt is at pains to say that when capacity is reached and inflation takes off you pull back on the deficits. Why is that always ignored by critics? It really shows they fail to read the mmt literature. Now if you have inflation in only some sectors and are not yet at full employment then you need to target taxes and spending accordingly. It's not rocket science people. Deficits do matter (used functionally to sustain full employment offsetting leakages to tax imports and saving), just not in the way you think (bond vigilantes default etc).
And therein lies the underlying problem - it doesn't matter what MMT purists believe, it only matters what Governments believe; and asking them to 'pull back' when inflation appears is not part of their playbook. MMT, like all asset appreciation theories, is great on the way up but is NEVER applied when it is needed on the way down.
Governments' are comprised of representatives who have 99% less understanding of monetary policy than you do. Expecting them to 'pull back' when needed is not what they can understand, let alone do.
What structure do you propose?
Ya know, given that it is impossible to constrain the power of governments. And that they are, by nature, elected.
MMT essentially relies on fiscal policy as the tool for regulating inflation - enlighten us all about how any govt. will be successful in instigating any contractionary policy.
Automatic stabilisers are the best mechanism. A job guarantee at the minimum living wage that spends a lot in recessions and automatically pulls back in booms. GST could also rise and fall. Right now we have automatic stabilisers like the dole. The government's deficit is ultimately determined by private sector spending and saving decisions. Even now.
Voters will tolerate years of unemployment and depressed economies, but woe betide a government that creates inflation. Democracy will be harsh on governments who allow things to get out of control.
CS, you assume the transition from no inflation to low inflation to moderate inflation to extreme inflation takes place in a predictable and orderly fashion. That is exactly what does not happen in a crisis. As Vladimir Ulyanov put it "There are decades when nothing happens and there are weeks when decades happen". In a crisis it is as if time speeds up.
Well, not using the insights of MMT right now will result in a crisis of epic proportions that will be costly in human lives and misery. Inflation may take off eventually, but we can be prepared for that with good auto stabilisers and supply side shocks are best dealt with in a targeted way without cutting spending across the board. Don't let the alarmist propaganda about "Zimbabwe" prevent you from weighing up the risks of not doing enough.
MMT fails the growth test.
As do all growth-of-consumption-requiring formats.
At this point in the Limits to Growth trajectory (how silly the bleaters of the last few decades must be feeling right about now) even the pre-virus debt was unrepayable. So the flood of debt since the virus is doubly so. We were already asking the future to fund today (that is what debt is) and now we are doing even more so, while there is ever-less to do the repaying with.
I suspect this fellow is arguing for the status quo, the neolib 'less Government the better' kind of thing. The joke is that when thew chips were down, Govts were the only thing in town and the Trump blundering shows us what happens when they aren't in town. This trend away from 'freemarketry' has been evident for 25 years, if you look dispassionately at trends.
But MMT doesn't solve the dilemma. No more than Nissan Leafs solve the dilemma - though the two are often championed by the same echelon.
Does it PDK? If the central bank is the sole source of money/credit available in the economy then wouldn't it be easy for the Government or it's functionaries to place limits on growth? The current situation certainly fails here as it is based on an assumption of eternal growth. There is also the factor that you hint at and is mentioned in another stream that the current model of economic policy and thought is based on an ideology that needs to change, but few seem to be advocating that, or how it could/would change, and any who do are subject to considerable criticism.
We are at a point where one of the 4 FACTORS OF PRODUCTION , namely money , is basically worthless .
Debased through printing the stuff
This is dangerous , just look at history , and look at Communism destroying 2 factors of production , namely entrepreneurship and the value of land through nationalization.
It does not end well
Money and credit creation is what lead us to this precarious economic point. The power is currently in the hands of banks, MMT would see it in the hands of the government. Both are terrible ideas (just look at the pork-barrel politics last election). Monetary power needs to be in the hands of individual citizens, that was achieved through sound money previously and that is why both banks and governments worked and continue to work so hard to wrestle control away.
Basically, it works until it doesn't. While we are happy to accept payment in NZD and to keep our savings in NZD, then all is well. However, this assumes that nothing much changes, that we have mild volatility.
If the NZD suddenly starts dropping against the USD, there comes a point where everyone starts taking their savings out and putting them in a USD account. Effectively a giant bank run takes place. These things start slowly at first and then accelerate as the idea catches on.
The catalyst for the sudden change in NZD value could be anything, not necessarily something you can see coming. It is a type of phase transition, like ice melting into water.
A currency crisis could hypothetically occur if the government went mental but it is unlikely (who wants to realise such massive losses?) if the fiscal deficits are sensible and sustain spending at an appropriate level for the capacity the economy can handle- right now merely replacing some of the lost spending/income. NZD are the only thing you can pay your taxes in. So there will always be demand. The NZD is a long way off its previous lows and some economists moan about it being too high right now and want negative rates to bring it down. A growing NZ economy not mired in depression will be a place that will continue to attract capital flows. Many many years of CADs and we haven't seen a balance of payments crisis yet.
In practice the US Treasury finances all of its spending by first collecting fiscal receipts. It does so by taxation or via the sale of government bonds. In doing so, the government is always a redistributor of existing inside money. The fact that the Treasury is a user of bank money does not mean that it need be revenue-constrained though one would not get this actuality from the words of our politicians or the mainstream media or even most economists. There is a broad myth that the government has a true solvency constraint similar to that of a household, business or state government, all of whom are currency users.
It is important to understand that the Federal Reserve and private banks can always be relied on to provide financing for the Treasury with the mechanics working via borrowing operations. Yes, the existing US monetary system is one where banks can be harnessed as agents for the federal government. Although the US government chooses to be a user of private bank money this does not mean it can “run out of money”. Like any bank, the Federal Reserve is an issuer of money
and could always be counted upon to fund the spending of the US government, even in a worst case scenario.It’s also crucial to understand how the US government harnesses its banking system to help provide certain funding sources given the legal constraints imposed on the government. There are a number of legal obligations on the “primary dealers” (i.e. a select group of the largest private banks who provide various services for the US government) not least of which is to offer bids at Treasury bond auctions.12 So the US Treasury will always find a buyer for its bonds; and,
if there is weak demand from private banks, non-bank private agents and/or foreign agents for Tbonds,the central bank can always buy them in the open market. The US Fed is a bank and has a potentially unlimited capacity to buy T-bonds with ex nihilo (from nothing) money creation. So it is misguided to worry too much if at all about the US Treasury ever going bankrupt on its fiat dollar-denominated debts: it never need do so and if it were that would be due to political wrangling. Usually the US Congress postures on whether or not to raise the “debt ceiling” of the federal government and then acts sensibly.With this understanding it’s important to note that the government does not operate without constraint. The true constraint for a currency issuer is always inflation, foreign exchange risk and not solvency. This is a crucial distinction that makes a currency issuer quite different from a currency user (like a household or business). Of course, this does not mean the government can spend infinitely, but we will cover this topic more fully later. first link - pdf
After carefully considering the complexities of reserve accounting, it is argued that the proceeds from taxation and bond sales are technically incapable of financing government spending and that modern governments actually finance all of their spending through the direct creation of high-powered money.
MMT is not something to be adopted or introduced, as Prof Bill Mitchell tells us, it is just a lens to look through to show us how our monetary system operates. MMT advocates really have only one policy and that is for a job guarantee to smooth out demand within the economy.
The main problem with excessive QE is affect it has on those with skin-in-the-game and those who do not! It also knows no borders and is exported to other nations that welcome the money!
It creates disjointed markets (Financial & Realty) from the reality of life for those working under the market.
Everything is tickity-boo until a shock like the one we have starts to make people question if the King has any clothes on?!
Questions I have are... does more QE return the 'reality' we had or does it make it worse. What happens if we do nothing. Both likely to have side-effects...what's the best option for our society!
Business goes in cycles; they grow - stabilise - then die (liquidate or subsumed)…. may be Economies should do the same!
"because the monetary base is irredeemable, it is not in any meaningful sense a liability" - that's the point. By posting a liability in the books, the central bank is able to hide the assets it gets with money creation TO THE TREASURY. Now, imagine that the Treasury really create the money directly: by avoiding posting a fake liability, there will be an asset position expendable that can completely cover the need of any further taxation. The same is true for the commercial banks books where bank created money is again hidden through a fake liability to customer. In short, money creation IS a (hidden) fiscal measure and should be exclusive of the state. Any private party doing a "taxation" is usually seen as a racket - as "mafia" - here in Italy. And it should be everywhere.
Bill Mitchell's full reply to this article.
http://bilbo.economicoutlook.net/blog/?p=44871
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