Modern Monetary Theory – what is new about it? – Part 3 (long)

I noted in Monday’s blog – Modern Monetary Theory – what is new about it? – that I am working on a paper (with my colleague Martin Watts) that will form the basis of a a keynote talk I will give at the – International Post Keynesian Conference – which will be held at the University of Missouri – Kansas City between September 15-18, 2016. That talk will now be held at 15:30 on Saturday, September. 17, 2016. I also listed four areas where we would discuss the novel contribution that Modern Monetary Theory (MMT) has made to macroeconomics, despite the claims of both mainstream economists and some Post Keynesians that there is nothing new in MMT. The first two blogs on this topic covered the juxtaposition of employment versus unemployment buffer stocks and the implications of that for how we view the Phillips curve, a central framework in macroeconomics linking inflation to developments in the real sector (unemployment etc). Today’s blog considers another section of the paper – the dynamics of fiscal deficits and public debt. We consider the difference between deficit doves, who consider fiscal deficits are appropriate under some conditions but should be balanced over some definable economic cycle, which we argue has been the standard Post Keynesian position, and the MMT approach to deficits, which considers the desirable deficit outcome at any point in time to be a function of the state of non-government spending and the utilisation of the productive capacity of the economy. We argue that fiscal rules expressed in terms of some rigid balance to GDP target are not only meaningless but dangerous. Fiscal rules in MMT are only meaningful if related to the state of non-government spending and the utilisation of the productive capacity of the economy. This body of MMT work is clearly novel and improves on the extant Post Keynesian literature in the subject which was either silent or lame on these topics.

MMT says that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

A sovereign government in MMT is one that issues its own currency, floats it on international markets, sets its own interest rate and never accumulates liabilities in foreign currencies.

Never revenue constrained means that such a government is not financially constrained and can spend whatever it likes without recourse to ‘funding’, unlike a household (a user of the currency), which has to finance all its spending from income earned, prior savings, asset sales and/or borrowing.

Palley (2014: 4) claims that MMT proponents cite this recognition of a lack of a financial constraint on a sovereign government as being one of its “main contributions”, where he quotes a phrase from a 2013 paper by Eric Tymoigne and Randy Wray (Tymoigne and Wray 2013).

A careful reading of the Tymoigne and Wray paper suggests that the main contribution is not to introduce the notion that a sovereign government is never revenue constrained but, rather, “to explain why monetarily sovereign governments … have a very flexible policy space that is unencumbered by hard financial constraints” (Tymoigne and Wray, 2013, 2).

That is quite a different statement. It focuses on the policy space options rather than the more banal recognition that governments that issue their own currency can clearly never run out of it!

MMT authors have never claimed that they were the first to understand that point. The language that these authors use is clearly different to the way that mainstream or other Post Keynesian macroeconomists discuss this point.

And their understanding of the options that follow from that are very different.

But it is obvious, as Palley (2014: 4) points out that “it has been known for decades by all macroeconomists worth their salt” that such a government can spend what it likes given it issues the capacity to spend (currency).

Palley (2014: 4) prefers to express this fact within what he calls “consolidated government budget restraint relations” and there is a world of difference in that construction and the way MMT thinks about these relations.

Palley’s depiction (in four accounting statements) is squarely in the mainstream tradition. It suggests, by language, alone that government spending decisions are ‘restrained’ by its ability to raise tax revenue, issue debt to the non-government sector and/or issue new ‘money’ via the central bank.

Independent of the capacity to issue new ‘money’ via the central bank, Palley’s construction implies that the tax revenue and bond sales to the non-government sector ‘fund’ public deficit spending.

There is an implied causality operating here – a mainstream macroeconomic causality – that the tax revenue and bond sales have to come prior to the spending, although his accounting model has limited temporal dynamics expressed.

Given his simple four-equation, accounting model abstracts from the detailed institutional arrangements that are in place to facilitate government transactions of all types in the real world, he cannot appeal to the voluntary constraints that governments impose on themselves, which we analysed in the previous section on central bank-treasury consolidation, to justify the inference that government spending is restrained in some way by the tax and bond sales revenue it can contemporaneously achieve.

[Note here – the paper we are writing has three main sections – my blogs cover 2 of the 3 – so the reference in the last paragraph to a ‘previous section on central bank-treasury consolidation’ refers to part of the paper that my colleague Martin Watts is drafting initially – I will make that available in due course].

Palley denies he is imputing temporal causality – ” It is a pointless exercise to try and determine which comes first” (2014: 6) but using terms such as “restraint relations” inescapably pushes us to think in those terms and makes the analysis indistinguishable from the mainstream literature on the ‘government budget constraint’.

Restraint, constraint – from the same genus of thought!

MMT understands the accounting structure that Palley offers although it does not use the term “government budget restraint” to describe it because it rejects the notion that funds flows (from taxes or bond sales) are restraints.

In the spirit of the accounting rules, Palley’s “equations” are, in fact, ex post numerical entities that have to be true by definition but have little significance in explaining the real constraints on government spending, which belong in the real not the monetary sector.

MMT thus makes no claims to have invented the idea “that government can money finance any amount of money spending it wants” (Palley, 2014: 6).

But that does not then allow one to claim that this accounting structure (in Palley’s words “the budget restraint – high- powered money supply relation” p.7), which just links deficits, tax revenue, bond sales, central bank high powered money together – $ for $ “fully captures the core monetary arguments of MMT”.

Once again, MMT does not consider that the government deficit is restrained in any way by tax revenue or bond sales. The ability to earn income or have access to credit is important to a household or business firm, which uses the currency.

But to a sovereign government the role of taxes or bond sales is not akin to any experience that a household or business firm would know.

The accounting structure Palley thinks is important (and is used by many Post Keynesians), and, which, he thinks “is shocking” (p.6) that it is not a central part of the MMT literature, is, in fact, a trivial exercise in adding and subtracting.

Does it provide any clue to the real constraints facing a sovereign government intent on creating full employment? Answer: Absolutely not.

And it is here that MMT has provided significant new insights.

For example, if taxes are not necessary to fund government spending then what role do they play at the macroeconomic level (and here I ignore taxes designed to alter resource allocations – such as carbon or tobacco imposts)?

Palley’s accounting framework provides zero clues to that question and steers the reader towards accepting that governments raise taxes in order to spend – a neo-liberal proposition inherited from the days before fiat currency systems emerged with the downfall of the Bretton Woods fixed exchange rate system in the early 1970s.

By linking taxation to real resource usage in the non-government sector, MMT brings to the fore the insight that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities.

This insight allows us to see another dimension of taxation which is lost in mainstream and extant Post Keynesian analysis, including Palley’s so-called “old Keynesian representation of the government – central bank sector” (Palley, 2014: 5).

Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of public spending) by design creates unemployment (people seeking paid work) in the non-government sector.

The unemployed or idle non-government resources can then be utilised through demand injections via government spending, which amounts to a transfer of real goods and services from the non-government to the government sector.

In turn, this transfer facilitates the government’s socioeconomic program.

While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

That perspective is not found in the non-MMT literature. It is true that way back Abba Lerner’s Functional Finance approach recognised that (Lerner, 1943: 39):

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …

Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …

Taxation thus drains non-government purchasing power.

Palley (2014: 5) thinks it is a body blow against MMT to point out that “it is easy to show that budget surpluses destroy high-powered money balances and lower the privately held high-powered money supply”.

But that trivial accounting fact was at the heart of Lerner’s observation and no MMT author claims any originality for building it into the monetary framework they use.

The more important point, which is not at the forefront of Lerner’s representation, and certainly not apparent in the trivial accounting relationship that links the monetary flows, is that the MMT literature directly links taxation to the real constraints that governments have to deal with to achieve socio-economic goals.

This brings out into relief – in a clear way – why mass unemployment arises.

It is the introduction of State Money (which we define as government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment.

As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period).

Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.

As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

So the purpose of State Money is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain.

Government achieves this transfer by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency.

This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending.

It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets).

From the previous points, it is also clear that if the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions in force at any particular time.

That type of construction is clearly an innovation introduced by MMT authors.

Fiscal policy and the economic cycle

There is also misunderstandings in the Post Keynesian literature about the role that fiscal deficits should play over the economic cycle.

Palley (2014: 11) enters this fray by claiming that in “a static economy, the MMT model should deliver full employment with a balanced budget”.

He notes that Tymoigne and Wray (2013: 18) explicitly note that:

… there is no need to assume that the government budget should be balanced at full employment to prevent inflation:

So what is the correct position? The balanced budget assertion is derived from Palley’s 2013 paper (p.8) where he claims that “once the economy reaches full employment output, taxes … must be raised to ensure a balanced budget … in order to maintain the value of fiat money”.

This is an argument that so-called ‘deficit doves’ make and it is a position that is representative of the mainstream Post Keynesian position.

There is no question that if nominal spending continues to grow at a rate that outstrips the capacity of the productive sector to meet that spending with real output then firms will move to price-adjustment and inflation will result.

MMT puts that generally accepted observation at front and centre of its analysis – but has never claimed to have introduced it into the literature.

In part, it helps us to understand the previous discussion over the role of taxes. For there to be real space in the economy for the government to spend, the non-government sector has to be deprived of its capacity to utilise the real resources the government seeks to command.

But Palley (2013: 809) qualifies the assertion by noting that this “balanced budget condition” applies only to “a no growth economy”.

He also noted in his 2014 retort that (p.10):

It is true an economy can reach full employment with either a budget deficit or surplus, depending on the state of the private sector’s investment – saving balance. However, in a static economy such as I explicitly modeled, persistent money financed budget deficits or surpluses would lead to inflation or deflation, absent very special and implausible conditions about money demand.

So it is hard to see the disagreement here when discussing the real world that cannot be assumed away for the sake of some simplistic algebra to be a ‘static’ environment.

But even then, the ‘static’ or ‘no growth’ economy qualification is also in error and demonstrates how MMT authors have moved away from the ‘deficit dove’ position to properly articulate the role of deficit spending in the monetary economy.

In this blog – The full employment fiscal deficit condition – I outlined what I called the full employment fiscal deficit condition, which is the only fiscal rule that is important, despite the plethora of rules proposed by the mainstream (deficit to GDP ratios etc) and Post Keynesians (balanced budgets over the cycle).

Tymoigne and Wray (2013) are correct to say that at full employment there is no necessity for the fiscal balance to be zero. Under some conditions, a fiscal surplus might be appropriate. In other situations, which will be more often encountered by nations, continuous fiscal deficits will be required.

That is a central insight provided by MMT authors and you will struggle to find it in the mainstream or Post Keynesian literature.

But is it correct?

In an open economy, if there was no government spending or taxation (so a fiscal balance of zero) the level of economic activity (output) will be determined by private domestic spending (consumption plus investment) and net external spending (exports minus imports). If one or more of those spending sources declines, then activity will decline.

A spending gap is defined as the spending required to create demand sufficient to elicit output levels which at current productivity levels will provide enough jobs (measured in working hours) for all the workers who desire to work.

A zero spending gap occurs when there is full employment. From a functional finance perspective the role of government fiscal policy is obvious – to ensure there is no spending gap.

It becomes obvious (and incontestable) that if the non-government spending sources decline from a given position of full employment, the only way that the spending gap can be filled is via a fiscal intervention – direct government spending and/or a tax cut (to increase private disposable income and stimulate subsequent private spending).

That is standard Keynesian thinking and certainly not newly introduced by MMT.

What about the maintenance of full employment?

The fiscal position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports (with net income transfers included).

But that relationship can be easily satisfied at levels of economic activity that are associated with persistently high levels of unemployment. Keynes’ General Theory was important in history because it showed how market economies could get stuck in these sort of high unemployment steady-states.

To maintain a full employment level of national income, which is generated when all resources are fully utilised according to the preferences of workers and owners of land and capital etc, the fiscal deficit has to be sufficient to offset the saving and imports that occurs at that level of income, less the sum of private capital formation and export revenue that is forthcoming at that level of income.

I could have written that in algebra (along Palley’s lines) to get a ‘model’ if I chose::

Full-employment fiscal deficit condition: (G – T) = S(Yf) + M(Yf) – I(Yf) – X

Where Yf is the full employment level of income and the sum of the terms S(Yf) and M(Yf) represent drains on aggregate demand when the economy is at full employment and the sum of the terms I(Yf) and X represents spending injections at full employment.

Either way, the point is clear:

If the drains outweigh the injections then for national income to remain stable, there has to be a fiscal deficit (G – T) sufficient to offset that gap in aggregate demand.

If the fiscal deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the fiscal deficit beyond the full employment limit (G – T)(Yf) then nominal spending will outstrip the capacity of the economy to respond by increasing real output and while income will rise it will be all due to price effects (that is, inflation would occur).

In this sense, MMT specifies a strict discipline on fiscal policy. It is not a free-for-all. If the goal is full employment and price stability then the Full-employment fiscal deficit condition has to be met.

But also note that the full-employment fiscal deficit condition does not necesarily (or usually given history) solve to zero on the right-hand side (more algebra talk!).

If it did, then at full employment, the appropriate fiscal position would be a balance.

But there is nothing necessary for that to happen and as history tells us, it usually will not happen.

Making this deficit condition explicit is novel in MMT and has not been articulated in the extant Post Keynesian literature, which has become trapped into thinking that deficits in downturns must be offset by surpluses in upturns to stabilise public debt.

MMT breaks with that Post Keynesian tradition because it places no particular importance on any specific public debt ratio. It also recommends breaking the nexus between deficit spending and debt-issuance per se, by advocating Overt Monetary Finance, which Post Keynesians have typically rejected because they have bought the mainstream line that it would be inflationary.

For example, Palley’s own attempt at implicating deficits with inflation when no private debt is issued to match the injection is to invoke the “static economy” assumption (2013: 11):

In a static economy that means the money supply would keep growing relative to output, causing inflation that would tend to undermine the value of money.

So a reference to fairy land, which is standard way that mainstream economists operate as well. Define a situation that renders a proposition true by definition.

In the real world, capital formation is rarely constrained to equal depreciation. In other words, the capital stock typically grows and, with it, the productive capacity of the supply side. In that situation, the Palley claims become irrelevant.

Fiscal policy and banking

Finally, it is without doubt that the MMT authors have introduced new insights in the relationship between fiscal policy and the banking system which overturn much of the conventional wisdom found in the macroeconomics literature.

One of the enduring myths that are to be found in the mainstream macroeconomics literature relates to the so-called ‘financial crowding out’ assertion.

The financial crowding out assertion is a central plank in the mainstream economics attack on government fiscal intervention. At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.

The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times.

If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded.

The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising fiscal deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to ‘finance’ its fiscal deficit, it crowds out private borrowers who are trying to finance investment.

The mainstream economists conceive of this as the government reducing national saving (by running a fiscal deficit) and pushing up interest rates which damage private investment.

The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash! It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.

Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek ‘funding’ in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.

Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.

But we jump ahead.

The Post Keynesian literature rejects the crowding out claims. Davidson’s (1994) discussion (pp.131-135) is representative of the arguments that are offered in this regard. He places the debate within the so-called IS-LM framework, where the debate as to whether fiscal deficits cause rising interest rates comes down to whether the LM curve is vertical or not (which comes down to a debate about the income and interest-rate sensitivity of the demand for money when the money supply is fixed).

Clearly, even the starting points of this framework are at odds with reality. Most Post Keynesians eschew the crowding out hypothesis by recourse to statements about the capacity of the government to ‘print money’ or the access global capital markets, which are outside of the direct influence of domestic interest rates, offers local borrowers.

In other words, they do not directly challenge the notion that fiscal deficits drive up interest rates per se, an effect which can be mitigated by these other channels (money printing, global borrowing).

Where MMT departs from this literature is to explicitly integrate bank reserves into the analysis in a way that no previous Post Keynesian author has attempted.

The MMT framework shows that far from placing upward pressure on interest rates, fiscal deficits in fact, set in place dynamics that place pressure on interest rates in the opposite direction.

You will not find that result in the extant Post Keynesian or mainstream literature.

How does that occur?

The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance.

In achieving this aim the central bank may: (a) Intervene into the interbank money market (for example, the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; (c) offer a return on excess bank reserves, and (d) impose penal lending rates on banks who require urgent funds.

In practice, most of the liquidity management is achieved through (a), although in recent times (as QE has become the norm) central banks are using option (c) more than in the past.

That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.

Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. All these transactions net to zero.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly.

In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. This support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

MMT has highlighted those relationships but does not claim any originality for doing so.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.

Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing.

Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.

When the system is in surplus overall this competition would drive the rate down to the support rate.

The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt.

In the absence of adjustments to the support rates offered on reserves, when the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt.

This open market intervention therefore will result in a higher value for the overnight rate.

The significant point for this discussion is to expose the myth of crowding out.

Net government spending (deficits) which is not taken into account by the central bank in its liquidity decision, will manifest as excess reserves (cash supplies) in the clearing balances (bank reserves) of the commercial banks at the central bank.

MMT refers to this a system-wide surplus.

In these circumstances, the commercial banks will be faced with earning the lower support rate return on surplus reserve funds if they do not seek profitable trades with other banks, who may be deficient of reserve funds.

The ensuing competition to offload the excess reserves puts downward pressure on the overnight rate. However, because these transactions necessarily net to zero, the interbank trading cannot clear the system-wide surplus.

Accordingly, if the central bank desires to maintain the current target overnight rate, then it must drain this surplus liquidity by selling government debt or offering a competitive return on the excess reserves to choke off the competitive forces.

That is, the bond sales (debt issuance) allows the central bank to drain any excess reserves in the cash-system and therefore curtail the downward pressure on the interest rate. In doing so it maintains control of monetary policy.


  • Fiscal deficits place downward pressure on interest rates;
  • Bond sales maintain interest rates at the central bank target rate.

Accordingly, the concept of debt monetisation, which is a central part of mainstream thinking, is a non sequitur. So Friedman, for example, claimed that “the entire deficit must be financed by a concomitant increase in the supply of money (to avoid ‘crowding out’) (Davidson, 1994: 133).

That assertion remains standard doctrine. Even the Post Keynesian economists consider crowding out to be overcome by the government’s capacity to print money (Lavoie, 2014).

But once we understand how bank reserves are affected by fiscal deficits (an MMT insight), we quickly realise that once the overnight rate target is set by the central bank, the latter should only trade government securities if liquidity changes are required to support this target.

Given the central bank cannot control the reserves then debt monetisation is strictly impossible unless the central bank permits the excess reserves to rise indefinitely and pays a return to the banks for excess reserve holdings.

Imagine that the central bank traded government securities with the treasury, which then increased government spending. The excess reserves from the fiscal deficits would force the central bank to sell the same amount of government securities to the private market or allow the overnight rate to fall to the support level (which might be zero).

This is not monetisation but rather the central bank simply acting as broker in the context of the logic of the interest rate setting monetary policy.

Ultimately, private agents may refuse to hold any further stocks of cash or bonds.

With no debt issuance, the interest rates will fall to the central bank support limit (which may be zero).

It is then also clear that the private sector at the micro level can only dispense with unwanted cash balances in the absence of government paper by increasing their consumption levels.

Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the deficit, eventually restoring the portfolio balance at higher private employment levels and lower the required budget deficit as long as savings desires remain low.

Clearly, there would be no desire for the government to expand the economy beyond its real limit.

Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. That is not compromised by the size of the budget deficit.


Next week I will provide the fourth part of this series which will consider the consolidation of the central bank and the treasury.


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Lucas, R.E. Jnr (2003) ‘Macroeconomic Priorities’, American Economic Review, 93(1), March, 1-14.

Mehrling, P. (2000) ‘Modern Money: Fiat or Credit’, Journal of Post Keynesian Economics, 22(3), 397-406.

Mitchell, W.F. (1987) ‘The NAIRU, Structural Imbalance and the Macroequilibrium Unemployment Rate’, Australian Economic Papers, 26(48), 101-118.

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Mitchell, W.F. (1998a) ‘The Buffer Stock Employment Model and the Path to Full Employment’, Journal of Economic Issues, 32(2), June, 547-555.

Mitchell, W.F. (1998b) Essays on Inflation and Unemployment, PhD Thesis, University of Newcastle, NSW, Australia, February.

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That is enough for today!

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    12 Responses to Modern Monetary Theory – what is new about it? – Part 3 (long)

    1. Neil Wilson says:

      “By linking taxation to real resource usage in the non-government sector, MMT brings to the fore the insight that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.”

      And once you understand that function, you quickly discover that there are many ways that you can gain offers from private entities, that are far more surgical in nature than carpet bombing the entire economy with taxation and hoping for the best.

      For example planning restrictions that prevent private entities building anything until they have accepted the contract and built the required hospital. Or bank lending restrictions that stop financial companies and private entities from undertaking projects that do not advance the capital development of the economy – freeing off the resources that would be used in the process.

      So actually what MMT says is stop talking about government spending and start talking about government *buying* instead. What matters is in the arena of procurement and supply, not finance.

    2. Neil Wilson says:

      “In a static economy that means the money supply would keep growing relative to output, causing inflation that would tend to undermine the value of money.”

      That is money stored in the proverbial bottle – out of circulation. How can money in a bottle cause inflation?

      Why is it that mainstream economists and Post-Keynesians can’t get their head around the idea that at any point in time some of the ‘money supply’ is static and not doing anything other than sitting there. Do they personally keep non-increasing balances on their cheque accounts at all time and refuse to hold notes in a wallet?

      This obvious error is so universally accepted that I’m worried the €50 I’ve kept in the drawer here for the last ten years has been the butterfly wings that collapsed the Eurozone economy.

    3. larry says:

      “In terms of the diagram all these transactions are horizontal and net to zero.” There is no diagram, either in this post or in the two previous ones. I think I know which one you mean but it isn’t here.

      When you use scare quotes around “model”, which I like and think is the better usage than the standard one, and which occurs (deplorably) in disciplines other than economics, this enables an interpretation of the term, “model”, in terms of model theory, which can enable all sorts of useful practices. Your use of the scare quotes clearly indicates to me that “model” in the standard usage means nothing more than a mathematically formulated theory or hypothesis. Hence, subject to all the conventions surrounding theory construction, including falsification, and avoiding what otherwise might be a tendency to interpret such mathematically formulated statements instrumentally, thereby enabling a side-stepping of considerations of truth conditions. It also suggests to me that you are adopting a realist conception of theory construction, which in my view is the right way about things if a discipline is to be accorded the status of a science, a status that must be denied generally to mainstream economic theories, especially the mathematically formulated ones.

      Hahn and Arrow, who knew exactly what they were about, published General Competitive Analysis around 1971, where in the Preface they point out that their study had no direct application to reality, if I remember rightly. They were right. It didn’t. Their colleagues, unfortunately, have not been generally so honest or insightful. Arrow views his mathematical work as interesting rather than practical, which is fine, as long as he is honest about it and doesn’t try to pass it off as something else.

      The formula you do use exemplifies your position that equations are to be preferred, where available, when a natural language formulation of a given relationship would become rather prolix. However, it might help to explicitly specify what each of the variables stands for. It perhaps also may help to mention that the equation exemplifies the sectoral balances approach developed by Godley, best illustrated by simple algebra (plus a nice graph).

    4. Hacky The Hufrex says:

      I find it distracting for NKs to be lumped with Keynesians. They believe in DSGE. Krugman was very honest in stating that this is “sorta kinda neoclassical”.

      Keynes rejected the gross substitution axiom. Without gross substitution axiom:

      * There is no mechanism for general equilibrium.
      * There is no mechanism for monetary policy transmission (either by quantity or price).
      * There is no natural rate of anything.
      * Inflation is meaningless other than as a crude average that could mask an infinite variety of spreads.

      There are also people calling themselves PK yet expressing ideas that seem identical to NK. I think this whole group needs to be grouped with the neoclassical school.

    5. larry says:

      Hackey, Krugman is hardly honest about anything.

      Keynes also rejected what is known as the ergodic axiom, that the future will resemble the past, which holds for some distributions (not uncommon in a number of physics contexts). He advocated what I call ontological uncertainty, to be distinguished from epistemological uncertainty. In a scenario of ontological uncertainty, one can’t know in principle what is going to happen, while, in a situation of epistemological uncertainty, the level of uncertainty depends on how much data you have at your disposal. In the latter situation, it is possible to construct a risk metric, while this is impossible under conditions of ontological uncertainty. Knight made a similar, though I think less clear-cut, distinction.

      Another way of putting this is: under a condition of ontological uncertainty, no probabilistic assessments are possible, while, under a condition of epistemological uncertainty, a probabilistic assessment is in principle possible although the associated confidence interval may be quite large (i.e., confidence in the assessment is low).

    6. larry says:

      Mandelbrot, in the early 1960s, showed that market distributions did not follow a Normal curve with its associated mean and standard deviation. Rather, they followed a Cauchy-Lorentz distribution, which has no calculable mean or variance. Prior to the GFC, it was common to use what was known as the Black-Scholes-Merton option pricing formula for assessing certain risks associated with complex derivatives, credit default swaps, and the like.

      This formula assumes that the market distribution of such special purpose vehicles is Normal or Gaussian and, based on this assumption, could be used to calculate the risks associated with these products. Calculation of the risk values of these products relies directly on being able to calculate the standard deviation derived from the variance of the distribution; since market distributions are invariably non-Normal, no such calculations can be carried out and, therefore, no reliable or valid risk assessment can be carried out either. In particular, it would have amounted to fraud to sell such an investment vehicle in terms of its Value at Risk, or VaR, although such a practice was not uncommon. Since VaR assumes market distributions are generally normal or Gaussian in character while they are anything but, there was no way to actually calculate the VaR. Taleb views any trader engaged in this practice as a charlatan.

      Under the umbrella of neoliberal assumptions, which characterizes the market as efficient and optimal in its operations, no attention was paid to Mandelbrot’s empirically based work, or that of others. Consequently, we are still having to deal with a paradigm that has been empirically falsified and whose fundamental assumptions do not make any sense.

    7. Jerry Brown says:

      This has been an excellent series of posts. Thanks! And while I appreciate the warning -“long”- in the titles of some, I hate to break this to you Bill, but you aint got no short posts.

    8. Brendanm says:

      larry, I would like a citation for the Mandelbrot paper. Discussions of uncertainty are always interesting and should always be viewed from the point of view of the predictions you can make about a system. The problem with systems involving motivated agents is that you can’t stochastic predictions, of any distributional form. Risk management is quite the charlatan’s tool whenever people are involved in a system.

      Check out

      for some useful mathematical tools.

    9. Nicholas says:

      What is the difference between reserves and cash in the context of this sentence?

      “central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.”

    10. Matt B says:

      Nicholas, in that context it’s physical cash, I believe (someone correct me if I’m wrong!).

    11. Neil Wilson says:

      “What is the difference between reserves and cash in the context of this sentence?”

      Bank Reserves are central bank promissory notes that can only be held by authorised institutions and generally attract an interest rate (or charge)

      Cash is a central bank promissory note that can generally be held freely and attracts no interest rate or charge.

    12. larry says:

      Brendanm, the problem doesn’t lie with distributions where probabilities can be computed due to the nature of the distributions, but where the distributions have no calculable variance and hence no risk assessments and hence no calculable probabilities of risk for any given event, to overstate the situation. Mandelbrot’s most accessible discussion of this issue is The (Mis)Behavior of Markets. I don’t have my resources to hand so am unable to give you the reference at this time to the original sources. But my recollection is that they can be found in the bibliography.

      The link is useful for showing the kinds of work that is being carried out, but how much of it applies to applied heterodox macroeconomics.

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