This is a draft I am working on for a leading US publication. For many regular readers it will be nothing new. But while there are several things I am probing at the moment which I would normally use my blog space to tease out, time is short this week (really) and so I have to combine things. In other words, the blog space and time today is being used to fulfill commitments with very tight deadlines. But, putting the arguments together in this way might just provide some different angles for people who haven’t thought about things in this way before.
People in the financial markets are increasingly becoming aware of an approach to macroeconomics, which is known as Modern Monetary Theory (MMT).
As in any new development, especially one that challenges the basis of belief systems and ‘understandings’ that have dominated for decades, there has been a lot of what we might consider to be ‘noise’ in the growing depictions of MMT. Many articles being written about MMT bear no relation to the body of knowledge that we have developed over a 25 year period.
This is because the noise is driven, in part, by an almost visceral resistance to any paradigmic shift in the macroeconomics and monetary economics disciplines.
There is a strong incentive to stylise, misrepresent and outrightly lie about our work to discourage people from embracing it.
Social psychologists have long identified the patterned behaviour they call Groupthink that can form within an academic discipline. It facilitates the resistance to change even when the empirical content of the “sequence of theories” that comprise discipline constitute, what philosopher Imre Lakatos referred to as a degenerative research program, a ‘pseudoscience’ with little empirical content.
Think about the way neurogenesis evolved. In the 1960s and before, the clinical treatment for patients with brain injury was predicated on the view that adult brains, once damaged, cannot create new neurons.
In the early 1960s, American biologist Joseph Altman showed this presumption was false but his research was fiercely denied by contemporary thought at the time.
The senior professors would not accept the new knowledge and clinical practice continued as before.
It wasn’t until the phenomenon was ‘rediscovered’ by another scientist (Elizabeth Gould in 1999) that the proposition became fashionable. Neurogenesis is now one of the most significant areas in neuroscience.
Why were Altman’s discoveries ignored for almost 30 years?
Charles Gross wrote in 2008 “the dogma of ‘no new neurons’ was universally held and vigorously defended by the most powerful and leading primate developmental anatomist of his time” (Gross, 2008: 331).
So for decades, patients were subjected to clinical practice that was based on false premises, which undermined their chances of recovery.
The Groupthink formed a ‘mob rule’ that prevented the new knowledge from taking root and it was only when the weight of evidence that was dissonant to the orthodoxy was so compelling that the paradigm shifted. Altman’s work represented the potential for a paradigm shift but it was resisted by the mob until change became ineluctable.
By then, Max Planck’s rule of thumb, that paradigms shift ‘one funeral at a time’, also had done its work.
The point is that at some point, a research programme (the business of academic disciplines) may become degenerative, in that its content diminishes in the face of increasing empirical anomaly.
That is, the theories no longer provide an adequate explanation of what people know and see.
But a degenerating research program can maintain its hold on a professional group for an extended period such is the resistance to change among those within it.
We are at that point in macroeconomics now.
MMT is challenging the orthodoxy and providing a body of work that resonates with our lived experiences and observations of what is happening in the economy around us.
Each of us have different experiences and observations, according to our backgrounds, cultural artifacts we hold, education and working environments.
But in each of these ‘worlds’, the dissonance between the statements and predictions of mainstream economists and our lived reality is widening, which is why there is increasing attention on MMT.
MMT is about the world we live in not some other world
To make progress, we have to be clear away notions that MMT is some sort of regime or a set of economic policies that we can shift to or not. A government does not suddenly ‘apply’ or ‘switch to’ or ‘introduce’ MMT.
Rather, MMT is a lens which allows us to see the true (intrinsic) workings of the fiat monetary system to better understand the capacities of the currency-issuing government and the consequences of using that capacity in a policy context.
It allows us to understand that most choices that are couched in terms of ‘budgets’ and ‘financial constraints’ are, in fact, just political choices.
It helps us understand that there are no intrinsic financial constraints on a currency-issuing government, only real resource and political constraints.
In other words, an MMT understanding lifts the veil imposed by the ‘sound finance’ ideology espoused by mainstream macroeconomics that draws a false analogy between an income-constrained household and the currency-issuing government.
Households use the currency that the government issues under what we might think of as monopoly conditions. Households always have to finance their spending choices, whether through earned income, drawing down savings, selling assets, or through borrowing. A currency-issuing government never has to do any of those things when they spend.
All the elaborate accounting structures and institutional processes that governments have put in place to make it look as though tax revenue and/or debt sales are funding the spending are voluntary smokescreens, which serve an ideological purpose of constraining or disciplining government spending in a political sense
Renowned British journalist Martin Wolf, commenting on MMT, recently wrote: “In my view, it is right and wrong. It is right, because there is no simple budget constraint. It is wrong, because it will prove impossible to manage an economy sensibly once politicians believe there is no budget constraint.”
This is a profound statement of how a ‘fictional’ world is promoted by mainstream economists to serve as a brake on political volition.
MMT exposes these fictions but some still think it is better for the public to be kept in a state of ignorance.
In the real world, currency issuing governments have no intrinsic financial spending constraint. They can purchase whatever is for sale in their own currency including all unemployed labour desiring work.
Mass unemployment is thus a political choice. Imagine if citizens understood that, rather than labouring under the current deceptions.
We should also be clear that an MMT understanding is neither right-wing nor left-wing – liberal or non-liberal – or whatever other value-system (ideological) descriptors you care to deploy.
To operationalise an MMT understanding as policy choices, we have to overlay that understanding with a set of values. Two people from the extremes of the ideological spectrum can share the MMT understanding but articulate radically different policy mixes.
To talk about MMT’s prescriptions or MMT policies is to reveal a lack of understanding about this distinction.
The point is that MMT is what is and for years mainstream economists have created a fictional world to hide that reality from us.
Importantly, MMT reveals the ‘fictional’ world that mainstream macroeconomics has created and provides new ways of thinking about normal business in a range of sectors.
The disservice of mainstream macroeconomics
Relevant to this readership, the financial community has been badly served by mainstream macroeconomics. There are two ways in which this disservice has manifested.
First, mainstream macroeconomics proposes a theoretical framework that links policy choices by government to a range of aggregates, which form the basis of private sector investment decisions. The problem is the framework is deeply flawed and has no robust evidence base to support the predictions that flow from it.
There are many notable examples of this disservice. Take the famous ‘widow maker’ investments, which have resulted in sustained losses over several decades.
The most notable example is the short-selling of long-term Japanese government bonds. Why would financial speculators think they could profit from such a trade?
In the late 1980s, Japan experienced a property market boom driven by a credit frenzy. This was particularly concentrated in the commercial property market.
The bubble burst in early 1992, the largest commercial property market crash in history, and to insulate the real economy, the Japanese government allowed fiscal deficits and the public debt ratio to rise significantly.
Further, the Bank of Japan embarked on its first episode of quantitative easing (buying government bonds in the secondary market and adding reserves to the banking system) in the early 2000s, which saw its balance sheet expand dramatically on the asset side.
In early 2001 (March-quarter), the Bank of Japan held 11.9 per cent of total outstanding Japanese government bonds. Four years later (March-quarter 2005), it held 20.2 per cent.
Mainstream economists predicted that government bond yields would rise because investors would demand an increasing risk premium and that inflation would accelerate because, in their language, the Bank of Japan was increasingly ‘printing’ money. These predictions flowed directly from the core New Keynesian model that dominated their thinking and is taught around the world in our universities.
Following these predictions, investors started to take short positions, mainly on longer-term Japanese government bonds, thinking that the prediction of rising yields would drive spot bond prices down at the time the contracts matured and generate profits.
They didn’t realise that the Bank of Japan could control all yields and interest rates and was able to maintain both close to zero. As a result, the trades failed.
The culprit – erroneous economic theory and unquestioning financial market actors.
During the Global Financial Crisis (GFC) a similar dynamic played out. Financial investors, fearing capital losses on government bonds, as fiscal deficits in around the world reached new heights, were encouraged by economists to eschew long positions in government debt.
Further, as more central banks followed the Bank of Japan’s lead and engaged in quantitative easing programs, mainstream economists peddled their standard predictions of accelerating inflation and encouraged investors to move into assets such as real estate as an inflation hedge.
Neither prediction was realised and as a result significant profits were foregone because of the faulty advice emanating from mainstream macroeconomics.
Knowledge of Modern Monetary Theory (MMT) makes it easy to understand these dynamics and would have allowed the money managers to avoid these losses or foregone profits.
The second way in which mainstream macroeconomics has provided a disservice to the financial markets is in its insistence that monetary policy should dominate the counter-stabilisation function and concentrate on maintaining low inflation with discretionary fiscal policy eschewed and biased towards running surpluses.
Taken together, this bias in the aggregate policy mix has, over time, increasingly undermined the business model of investment banks, and pension and insurance funds.
The fiscal austerity bias has created growth stagnation, elevated levels of labour underutilisation and subdued inflation rates.
Further, it is easier to cut public spending on capital goods because the loss of services of a bridge, for example, is less apparent in the short-run relative to a cut in a pension payment, which means that the political consequences are easier to minimise.
The lack of public infrastructure development then restricts the range of low risk investment opportunities that have historically formed the ‘bread-and-butter’ sources of profit for large investment funds.
To make matters worse, the central bankers have responded to the low inflation and growth stagnation, by progressively cutting interest rates, to the point that in many jurisdictions, rates are negative.
After all, their policy toolbox is limited and they have pushed the available tools to their limits.
This, in turn, has meant public bond yields have fallen dramatically, with the result we are now seeing negative yields on long-term bonds in many jurisdictions.
Take the pension funds as an example. There is now increasing maturity mismatch in the sector as returns on assets have become compromised by low or negative interest rates and yields and a lack of investment opportunities elsewhere (for example, public infrastructure).
As a consequence, fund managers are taking riskier investment positions to increase earnings on their assets given their contractual liabilities. This is an unsustainable situation and insolvency risk is heightened.
An understanding of MMT allows the financial community to make better investment decisions and demonstrates that reliance on monetary policy at the expense of discretionary fiscal policy is an ineffective approach to stabilising the economic cycle and providing the conditions for material prosperity.
So, what is MMT?
MMT combines descriptive narratives, accounting practice, and, importantly, behavioural conjectures to provide a series of interlinked ‘stories’ about how the macroeconomic system works.
We have written a textbook (Macroeconomics published by Macmillan, 2019) that provides the essential treatment of these interlinked stories. Clearly there is too much detail to discuss properly here.
But MMT places the currency-issuing government at the centre of the analysis because of its unique capacities as the sole issuer of the currency. While commercial banks can certainly create money through loans creating deposits, they do not create any net financial assets in this way.
When the government spends its currency into existence, net financial assets are created in the non-government sector.
Let’s consider some of the salient issues confronting the investment community.
That community focuses a lot on inflation dynamics and factors that may change those dynamics.
MMTs point of departure from the mainstream is that there is no inevitable inflationary consequences arising from continuous fiscal deficits.
MMT says that the inflation risk is in the spending rather than the monetary operations that might accompany it. And that risk relates to private and public spending alike.
If nominal spending growth outstrips the productive capacity of the economy then inflationary pressures will emerge.
If the government competes for productive resources (such as labour or capital) with other bidders in the non-government sector, then there will be nominal price pressures.
The MMT statement that a currency-issuing government can purchase whatever is for sale in that currency, including all unemployed labour is a fact but not a prescription.
How much the government should spend and tax is not a financial consideration but must be assessed relative to the available productive resources and the mandate the government is elected to pursue.
Consider the case of a monetarily sovereign nation, such as Australia or the US that issues its own currency, floats it on foreign exchange markets, does not issue debt in a foreign currency and sets its own interest rate.
It faces two scenarios: (a) a fully employed economy; (b) an economy where existing productive resources are being underutilised.
In the first case, if the government wants to increase its share of use for whatever reason, then it has to deprive the existing users of that use so as to transfer the resources into the public sector.
If it tries to do that by competing at market prices with the existing users then inflation will result.
Deprivation can be achieved in a number of ways but an important vehicle is tax policy.
The imposition of taxes reduces the purchasing power of the non-government sector and renders the resources they would have been deploying with that purchasing power unemployed.
The government spending then brings those ‘unemployed’ resources back into productive use.
The taxes, however, do not provide any extra financial capacity to the government. As the issuer of the currency, it has all the financial capacity it needs.
So the mainstream idea that the government is financially constrained in this situation is false. It is real-resource constrained and so has to accompany any extra spending policies, say to help a green transition, with policies that reduce the inflation risk.
In the second case, where there are idle productive resources that can be brought back into productive use with extra spending (higher deficits usually) the currency-issuing government, there are no inflationary threats and MMT says the spending is unconstrained.
In this situation does it matter if bonds are issued to the non-government sector or not to ‘match’ any spending over taxes?
In mainstream economics the answer is a firm yes. In MMT, the answer is no. A major point of difference.
Over the last decade (and for Japan several decades), central banks have increased their balance sheets via large-scale quantitative easing programs in an effort to drive up inflation rates in their nations and bring them into line with their conception of ‘price stability’.
The strategy has not worked. Why, then, would they have thought this would have been a successful strategy? The answer lies in their acceptance of flawed mainstream reasoning that ‘printing’ money (which is how QE is falsely characterised) will increase the money supply, and which via the Classical Quantity Theory of Money, drives up the price level.
MMT exposes the flaws in this approach by bringing into focus real resource availability.
While Keynes exposed the fiction of quantity theory in the 1930s and subsequently economists demonstrated if the economy was not at full employment and/or the velocity of circulation (the number of times the money stock turns over each period) is not constant, then even in terms of its own logic there is no direct relationship between shifts in the stock of money and the aggregate price level, MMT goes further.
For financial market players it is important to break with the mainstream thinking here. Students of a standard undergraduate macroeconomics are confronted with the concept of the ‘government budget constraint’ (GBC) whereby it is alleged that, a priori, governments have to ‘finance’ all spending either through taxation, debt-issuance to the non-government sector, or via what they term ‘money printing’, which really means the central bank ensures the currency injections on behalf of government are facilitated.
The first departure that MMT makes to this schema is to note that that government spending is performed in the same way irrespective of the accompanying monetary operations.
In March 2009, the US program 60 Minutes interviewed the then Federal Reserve Chairman Ben Bernanke. He was asked “Is that tax money that the Fed is spending?” To which he replied: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.”
Earlier, in September 2004, then chairman Alan Greenspan said during a Federal Open Market Committee (FOMC) meeting during a deliberation over difficulties the bank was having sustaining its policy rate target at 1.5 per cent said the officer in charge of reserves “has no limit on the number of reserves he can create at will. You cannot tell me he is trying and failing; he’s just not pushing the button hard enough.”
So by way of an amusing interjection, the chairman was admitting that the central bank creates credits in the non-government sector through computer key strokes, which have no limit.
The same can be said for all government spending.
Do bond sales reduce the inflation risk?
When government spends currency into existence, bank reserves increase. If the new level of reserves is considered excessive then the government can drain them via taxation or the central bank can drain them via open market operations (selling debt).
If the central bank is targetting a positive interest rate and doesn’t want to offer a return on the excess reserves, then it has no choice but to drain the excess reserves via open market operations or risk losing control of its policy target through the competition between banks in the interbank market to shed themselves of the excess reserves they might hold.
Of course, a system-wide excess cannot be eliminate through this competition, which will, other things equal, drive the short-term rate down to zero.
The only other option the central bank has is to offer a return on the reserves, which is functionally equivalent to selling public debt to the banks.
The MMT solution is to allow the overnight rate to fall to zero and leave it there thus conditioning lower rates out along the yield curve. MMT considers fiscal policy to be a more effective counter-stabilisation suite of tools to replace the reliance on relatively ineffective and ambiguous monetary policy changes.
This makes the mainstream concept of ‘debt monetisation’ somewhat difficult to understand in isolation of other institutional arrangements that students are rarely confronted with such as central banks paying interest on excess reserves.
But, mainstream economists claim that money creation (central banks crediting bank accounts as the government’s banker) is inflationary while private bond sales is less so. These conclusions are based on their erroneous claim that ‘money creation’ adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.
The crowding out story relies on classical loanable funds ideas, categorically rejected in the 1930s but still in vogue post Monetarism. We are told that banks loan out deposits and as there is a finite pool of ‘savings’, any competition for those savings from government deficits will drive up interest rates and damage interest-sensitive non-government spending.
The problem with the mainstream approach is that is not ground in the foundations of a fiat monetary system and the banking reality.
First, loans create deposits. Banks will extend credit to any credit worthy customers knowing they can always get the reserves to cover the payments system implications from the central bank if necessary. Banks do not loan out reserves. There is no finite pool of savings that is squeezed by government auctions in debt markets.
Second, what would happen if a sovereign, currency-issuing government ran a fiscal deficit without issuing debt?
Like all government spending, the Treasury would credit the reserve accounts held by the relevant commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management as noted above. There is no reason for interest rates to rise or fall. That is at the discretion of the central bank.
But the inflation risk is already in the system courtesy of the government spending. The accounting operations that accompany it do not reduce nor increase it.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
It is clear that the funds used to purchase the bonds were not currently being ‘spent’ on goods and services. Thus, the bond sales do not ordinarily reduce non-government spending. The funds were being ‘saved’ anyway. And if you think about it, the funds to purchase the debt came from past deficits that had not yet been taxed away by government and were ‘left’ in the non-government sector as accumulated net financial assets.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector nor the inflation risk embodied in the government spending.
The financial community is well advised to understand these points of departure from the mainstream. With elevated fiscal deficits and increasing use of central banks of non-standard monetary policy (buying the public debt), it is highly unlikely that inflation will be stimulated, which means that interest rates are likely to remain low for extended periods.
I have more to write here and will finish it in due course. But you get the drift.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.