MMT
Modern Money Theory: How I Came to MMT and What I Include in MMT
My remarks for the 2018 MMT Conference, September 28-30, NYC.
I was asked to give a short presentation at the MMT conference. What follows is the text version of my remarks, some of which I had to skip over in the interests of time. Many readers might want to skip to the bullet points near the end, which summarize what I include in MMT.
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As an undergraduate I studied psychology and social sciences—but no economics, which probably gave me an advantage when I finally did come to economics. I began my economics career in my late twenties, studying mostly Institutionalist and Marxist approaches while working for the local government in Sacramento. However, I did carefully read Keynes’s General Theory at Sacramento State and one of my professors—John Henry—pushed me to go to St. Louis to study with Hyman Minsky, the greatest Post Keynesian economist.
I wrote my dissertation in Bologna under Minsky’s direction, focusing on private banking and the rise of what we called “nonbank banks” and “off-balance-sheet operations” (now called shadow banking). While in Bologna, I met Otto Steiger—who had an alternative to the barter story of money that was based on his theory of property. I found it intriguing because it was consistent with some of Keynes’s Treatise on Money that I was reading at the time. Also, I had found Knapp’s State Theory of Money—cited in both Steiger and Keynes—so I speculated on money’s origins (in spite of Minsky’s warning that he didn’t want me to write Genesis) and the role of the state in my dissertation that became a book in 1990—Money and Credit in Capitalist Economies—that helped to develop the Post Keynesian endogenous money approach.
What was lacking in that literature was an adequate treatment of the role of the state—which played a passive role—supplying reserves as demanded by private bankers—that is the Post Keynesian accommodationist or Horizontalist approach. There was no discussion of the relation of money to fiscal policy at that time. As I continued to read about the history of money, I became more convinced that we need to put the state at the center. Fortunately, I ran into two people that helped me to see how to do it.
First, there was Warren Mosler, who I met online in the PKT discussion group; he insisted on viewing money as a tax-driven government monopoly. Second, I met Michael Hudson at a seminar at the Levy Institute, who provided the key to help unlock what Keynes had called his “Babylonian Madness” period—when he was driven crazy trying to understand early money. Hudson argued that money was an invention of the authorities used for accounting purposes. So over the next decade I worked with a handful of people to put the state into monetary theory.
As we all know, the mainstream wants a small government, with a central bank that follows a rule (initially, a money growth rate but now some version of inflation targeting). The fiscal branch of government is treated like a household that faces a budget constraint. But this conflicts with Institutionalist theory as well as Keynes’s own theory. As the great Institutionalist Fagg Foster—who preceded me at the University of Denver–put it: whatever is technically feasible is financially feasible. How can we square that with the belief that sovereign government is financially constrained? And if private banks can create money endogenously—without limit—why is government constrained?
My second book, in 1998, provided a different view of sovereign spending. I also revisited the origins of money. By this time I had discovered the two best articles ever written on the nature of money—by Mitchell Innes. Like Warren, Innes insisted that the dollar’s value is derived from the tax that drives it. And he argued this has always been the case. This was also consistent with what Keynes claimed in the Treatise, where he said that money has been a state money for the past 4,000 years, at least. I called this “modern money” with intentional irony—and titled my 1998 book Understanding Modern Money as an inside joke. It only applies to the past 4,000 years.
Surprisingly, this work was more controversial than the earlier endogenous money research. In my view, it was a natural extension—or more correctly, it was the prerequisite to a study of privately created money. You need the state’s money before you can have private money. Eventually our work found acceptance outside economics—especially in law schools, among historians, and with anthropologists.
For the most part, our fellow economists, including the heterodox ones, attacked us as crazy.
I benefited greatly by participating in law school seminars (in Tel Aviv, Cambridge, and Harvard) on the legal history of money—that is where I met Chris Desan and later Farley Grubb, and eventually Rohan Grey. Those who knew the legal history of money had no problem in adopting the MMT view—unlike economists.
I remember one of the Harvard seminars when a prominent Post Keynesian monetary theorist tried to argue against the taxes drive money view. He said he never thinks about taxes when he accepts money—he accepts currency because he believes he can fob it off on Buffy Sue. The audience full of legal historians broke out in an explosion of laughter—yelling “it’s the taxes, stupid.” All he could do in response was to mumble that he might have to think more about it.
Another prominent Post Keynesian claimed we had two things wrong. First, government debt isn’t special—debt is debt. Second, he argued we don’t need double entry book-keeping—his model has only single entry book-keeping. Years later he agreed that private debt is more dangerous than sovereign debt, and he’s finally learned double-entry accounting. But of course whenever you are accounting for money you have to use quadruple entry book-keeping. Maybe in another dozen years he’ll figure that out.
As a student I had read a lot of anthropology—as most Institutionalists do. So I knew that money could not have come out of tribal economies based on barter exchange. As you all know, David Graeber’s book insisted that anthropologists have never found any evidence of barter-based markets. Money preceded market exchange.
Studying history also confirmed our story, but you have to carefully read between the lines. Most historians adopt monetarism because the only economics they know is Friedman–who claims that money causes inflation. Almost all of them also adopt a commodity money view—gold was good money and fiat paper money causes inflation. If you ignore those biases, you can learn a lot about the nature of money from historians.
Farley Grubb—the foremost authority on Colonial currency—proved that the American colonists understood perfectly well that taxes drive money. Every act that authorized the issue of paper money imposed a Redemption Tax. The colonies burned all their tax revenue. Again, history shows that this has always been true. All money must be redeemed—that is, accepted by its issuer in payment. As Innes said, that is the fundamental nature of credit. It is written right there in the early acts by the American colonies. Even a gold coin is the issuer’s IOU, redeemed in payment of taxes. Once you understand that, you understand the nature of money.
So we were winning the academic debates, across a variety of disciplines. But we had a hard time making progress in economics or in policy circles. Bill, Warren, Mat Forstater and I used to meet up every year or so to count the number of economists who understood what we were talking about. It took over decade before we got up to a dozen. I can remember telling Pavlina Tcherneva back around 2005 that I was about ready to give it up.
But in 2007, Warren, Bill and I met to discuss writing an MMT textbook. Bill and I knew the odds were against us—it would be for a small market, consisting mostly of our former students. Still, we decided to go for it. Here we are—another dozen years later—and the textbook is going to be published. MMT is everywhere. It was even featured in a New Yorker crossword puzzle in August. You cannot get more mainstream than that.
We originally titled our textbook Modern Money Theory, but recently decided to just call it Macroeconomics. There’s no need to modify that with a subtitle. What we do is Macroeconomics. There is no coherent alternative to MMT.
A couple of years ago Charles Goodhart told me: “You won. Declare victory but be magnanimous about it.” After so many years of fighting, both of those are hard to do. We won. Be nice.
Let me finish with 10 bullet points of what I include in MMT:
- What is money: An IOU denominated in a socially sanctioned money of account. In almost all known cases, it is the authority—the state—that chooses the money of account. This comes from Knapp, Innes, Keynes, Geoff Ingham, and Minsky.
- Taxes or other obligations (fees, fines, tribute, tithes) drive the currency. The ability to impose such obligations is an important aspect of sovereignty; today, states alone monopolize this power. This comes from Knapp, Innes, Minsky, and Mosler.
- Anyone can issue money; the problem is to get it accepted. Anyone can write an IOU denominated in the recognized money of account; but acceptance can be hard to get unless you have the state backing you up. This is Minsky.
- The word “redemption” is used in two ways—accepting your own IOUs in payment and promising to convert your IOUs to something else (such as gold, foreign currency, or the state’s IOUs).
The first is fundamental and true of all IOUs. All our gold bugs mistakenly focus on the second meaning—which does not apply to the currencies issued by most modern nations, and indeed does not apply to most of the currencies issued throughout history. This comes from Innes and Knapp, and is reinforced by Hudson’s and Grubb’s work, as well as by Margaret Atwood’s great book: Payback: Debt and the Shadow Side of Wealth.
- Sovereign debt is different. There is no chance of involuntary default so long as the state only promises to accept its currency in payment. It could voluntarily repudiate its debt, but this is rare and has not been done by any modern sovereign nation.
- Functional Finance: finance should be “functional” (to achieve the public purpose), not “sound” (to achieve some arbitrary “balance” between spending and revenues). Most importantly, monetary and fiscal policy should be formulated to achieve full employment with price stability. This is credited to Abba Lerner, who was introduced into MMT by Mat Forstater.
In its original formulation, it is too simplistic, summarized as two principles: increase government spending (or reduce taxes) and increase the money supply if there is unemployment (do the reverse if there is inflation). The first of these is fiscal policy and the second is monetary policy. A steering wheel metaphor is often invoked, using policy to keep the economy on course. A modern economy is far too complex to steer as if you were driving a car. If unemployment exists, it is not enough to say that you can just reduce the interest rate, raise government spending, or reduce taxes. The first might even increase unemployment. The second two could cause unacceptable inflation, increase inequality, or induce financial instability long before they solved the unemployment problem. I agree that government can always afford to spend more. But the spending has to be carefully targeted to achieve the desired result. I’d credit all my Institutionalist influences for that, including Minsky.
- For that reason, the JG is a critical component of MMT. It anchors the currency and ensures that achieving full employment will enhance both price and financial stability. This comes from Minsky’s earliest work on the ELR, from Bill Mitchell’s work on buffer stocks and Warren Mosler’s work on monopoly price setting.
- And also, for that reason, we need Minsky’s analysis of financial instability. Here I don’t really mean the financial instability hypothesis. I mean his whole body of work and especially the research line that began with his dissertation written under Schumpeter up through his work on Money Manager Capitalism at the Levy Institute before he died.
- The government’s debt is our financial asset. This follows from the sectoral balances approach of Wynne Godley. We have to get our macro accounting correct. Minsky always used to tell students: go home and do the balance sheets because what you are saying is nonsense. Fortunately, I had learned T-accounts from John Ranlett in Sacramento (who also taught Stephanie Kelton from his own, great, money and banking textbook—it is all there, including the impact of budget deficits on bank reserves). Godley taught us about stock-flow consistency and he insisted that all mainstream macroeconomics is incoherent.
- Rejection of the typical view of the central bank as independent and potent. Monetary policy is weak and its impact is at best uncertain—it might even be mistaking the brake pedal for the gas pedal. The central bank is the government’s bank so can never be independent. Its main independence is limited to setting the overnight rate target, and it is probably a mistake to let it do even that. Permanent ZIRP (zero interest rate policy) is probably a better policy since it reduces the compounding of debt and the tendency for the rentier class to take over more of the economy. I credit Keynes, Minsky, Hudson, Mosler, Eric Tymoigne, and Scott Fullwiler for much of the work on this.
That is my short list of what MMT ought to include. Some of these traditions have a very long history in economics. Some were long lost until we brought them back into discussion. We’ve integrated them into a coherent approach to Macro. In my view, none of these can be dropped if you want a macroeconomics that is applicable to the modern economy. There are many other issues that can be (often are) included, most importantly environmental concerns and inequality, gender and race/ethnicity. I have no problem with that.
Paying for Hurricanes
By J.D. ALT What you believe America can build—or rebuild—as a collective society hinges on how you answer one fundamental question: When the U.S. government issues a treasury bond, is it “borrowing” money that must be repaid with future tax-dollars—or … Continue reading →
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Jayadev/Mason Article On MMT
Arjun Dayadev and J.W. Mason recently published "Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them?", which suggests that the gulf between Modern Monetary Theory (MMT) and mainstream macroeconomics is smaller than suggested, that MMT is much closer to orthodoxy than is normally portrayed.
I have been battling with installing a locking floating floor, which is an engineering task that I discovered that my doctorate in engineering provided little training. As a result, I have been somewhat distracted, and only quickly read the article.
I am unsure how the academic MMT community will view the paper; being portrayed as orthodox is perhaps not the way that they think of themselves. Furthermore, some of the theoretical points run into the thorny questions of academic originality. As an ex-academic, I understand concerns about originality and distinctiveness. Since I only browse the economic academic literature looking for useful tidbits, I cannot comment on the academic originality of MMT.
From my decidedly ex-academic perch, I am open to the idea that the gulf between the mainstream and MMT in policy terms is more a question of political economy and terminology. If mainstream economists actually paid attention to the mathematics that they say is so important, a lot of the distinctions with MMT would disappear. Essentially, they have built qualitative folklore around not particularly useful mathematics. Modern Monetary Theory is battling with the folklore, not the mathematics.
I just want to comment briefly on a few points that I saw some disagreements. (These are the points that stuck out to me when I was sprawled on top of a pile of building materials, and are not necessarily the most important parts of the paper.)
InflationThey state the following:
Output below this level implies unacceptably high unemployment and perhaps deflation; output above this level implies unacceptably high and/or rising inflation. This assumption can be represented as a Phillips curve, the same general form of which is used by MMT as in conventional textbook presentations. A corollary is that policy affects inflation only via the level of output.
From what I have seen, the MMT story on inflation is more complex than that text suggests. The "nominal price level anchor" provided by the Job Guarantee wage is constantly emphasised. My interpretation of the Functional Finance part of MMT as suggesting that "large enough" fiscal loosening leads to inflation -- but until we hit that "large enough" level, inflation may do whatever it does. The psychological anchoring of wages relative to a Job Guarantee wage may be far more effective tool for inflation stability than changing the overnight rate on risk-free collateral.
If the MMT inflation story was as simple as just a Phillips curve, why don't they say that themselves?
Aggregate Demand ManagementThe article was premised entirely on aggregate demand management. And MMT economists have discussed such aggregate management with respect to current events. However, the emphasis in MMT is on using a decentralised automatic stabiliser -- the Job Guarantee. The key advantage of the Job Guarantee is that it is spatially targeted at the areas of greater need.
The Debt Ratio (My Perspective...)
We noted above that while MMT advocates would probably agree that the debt ratio should not rise without limit, in general, they do not see the debt ratio as an important target for policy.
I cannot speak for MMT academics, but I am far more worried about a Martian invasion than a country's debt ratio rising without limit.
If we start from a stock-flow consistent modelling perspective, we assume that the stock of private sector wealth enters into consumption decisions. As the government debt ratio rises, by definition, private sector wealth is rising. Eventually, the drawdown from saving will dwarf spending out of income if it is not otherwise budging. The increased spending creates a circular flow of income, driving nominal GDP above expectations. Since the duration of government debt is not zero, the debt-to-GDP ratio will fall -- as exactly happened in the post-war uplift in inflation.
As always, inflation is the limit for fiscal policy.
This allegedly does not happen in mainstream DSGE models, mainly because the mainstream economists make no real effort to solve the models. If they actually did the math, they would probably see the same effect.
(c) Brian Romanchuk 2018
Japan And The Costs Of Bond Yield Control
The dangers of distorting free market interest rates is one of the bits of market folklore that keeps getting passed around. There is actually not a whole lot of data to defend this view; it is best viewed as faith-based reasoning. This topic is particularly interesting in the case of Japan. I am somewhat agnostic on this issue; I do not see particular risks from manipulating the yield curve in the current environment, yet I can see some plausible dangers.
This article was triggered by the article "Bank of Japan once again shows who calls the shots," by Bill Mitchell, one of the leading Modern Monetary Theory (MMT) economists. In addition, I had a discussion about this topic with someone doing some research awhile ago. Rather than re-hash Professor Mitchell's points from the MMT perspective, I will put on my "generic market analyst" hat and give a description of the issue from a more theory-agnostic perspective. This article probably covers topics I have already covered, but I am still recovering from the Banjo Bowl disaster on the weekend (plus I am now doing more home renovations).
Mainstream Macro TheoryI do not want to get involved in the great mainstream-heterodox mud-slinging match right now. However, it would be crazy to ignore the distinction in views when discussing this topic. The standard view is that interest rates are critical for determining economic outcomes, and so any manipulation of the yield curve is extremely important.
Standard mainstream macro -- and even offshoots, like Austrian theory -- assume that interest rates are critical for all economic decisions. The reason being is that everyone buys all products in spot and forward markets extending over all time horizons. Interest rates are assumed to be important for the relative prices between spot and forward.
For fixed income markets, interest rates and forward purchases obviously matter. Furthermore, there are some flexprice commodities (oil, grains) that are bought/sold forward. However, these markets are a small subset of all market transactions in the economy. So it is very much unclear how applicable the assumption that interest rates are paramount really is.
From what I have seen of the mainstream empirical literature (which is admittedly a small portion), the analysis bakes the assumption that interest rates matter into the cake; there is literally no way of falsifying the thesis that interest rates matter or not. From my perspective, the interesting observation is that I cannot think of any empirical observations that confirms the conventional view of the effectiveness of interest rates, beyond the Volcker episode. Being able to point to one data point -- at a period of history when there was a lot of economic policy shifts -- is not the most impressive defence of a theory.
I am not going to resolve that debate herein. All I can say is that if one is not willing to assume that small changes to interest rates are of critical economic importance, we need to dig further into what the costs to yield curve manipulation are (which is what will be discussed in the remainder of this article).
Costs to Yield Curve ManipulationThe Mitchell post explains why the government can set the entire yield curve. I will instead focus on the potential risks to such a posture.
- Losing the ability to influence the economy via setting interest rates.
- The political cost of changing bond prices.
- The loss of market information.
- Political cost of interest expense.
I will cover these in turn.
Influencing the EconomyFrom a real world political perspective, the dominance of conventional thinking about the effects of interest rates on the economy makes this the primary practical concern. However, since I am skeptical about the ability of the central bank to control the economy with interest rates, I will dig further into the topic from this vantage point.
Even if "control" of the economy with interest rates might be far less feasible than mainstream thinking suggests, it seems reasonable to argue that interest rates can be useful to influence it under certain circumstances. For example, higher interest rates will eventually curtail real estate speculation. Admittedly, this is not a big worry in Japan right now.
An alternative use of high interest rates is of more interest: attempting to defend the value of a currency in foreign exchange markets. I am unconvinced that a high policy rate will necessarily help defend the value of the currency, but I am almost certainly in the minority with that view. If enough market participants believe that high interest rates boost a currency's value, that is what we should expect to happen. (This is perhaps a better topic for anthropology than economics.)
For Japan, defending the yen in a reasonable concern (if we put aside Japan's rather sizeable foreign exchange reserves). Japan is an island nation in a rather awkward geopolitical neighbourhood, and is dependent upon various imported raw materials. The Japanese government can certainly always buy domestically produced goods and services with yen (as per MMT arguments), but import requirements need to take into account the external value of the currency.*
Another practical problem is the design of pension systems. Pension systems were designed on the assumption that it would be possible to eventually meet actuarial cash flows with assets with a positive real rate of return. Locking bond yields at a negative real rate represents a serious incoherence in policy design. This is a problem for Japan, as well as elsewhere.
If everyone switched over to a MMT-ish world view, concerns about the loss of interest rate control might disappear. However, this has not happened yet.
The remaining sections of this article are based on the assumption that interest rates can change in the future; if they are locked at 0% permanently, they are moot.
Political Cost of Changing Bond PricesIf the central bank changes the policy rate, it is changing the pricing of an overnight instrument -- with a duration remarkably close to zero. If it changes its target for bond yields, it is handing capital gains/losses on long duration instruments.
This will cause annoyance among bond holders, and creates a huge potential for shenanigans. We live in a world where there is a revolving door between governmental posts and the private sector, and I am unsure whether there is a widespread belief that this revolving door should be closed. (I am a prairie populist, and not a fan of these revolving door arrangements. However, I recognise that my view is in the minority.) Even if there are no shenanigans, the suspicion that they exist will always be there. If I were a central banker, I certainly would not want a system that induces people to assume that central bankers are corrupt.
Loss of Market InformationAnyone from the Chicago School, or of an Austrian bent, will be quite adamant about the importance of market information. By pegging bond yields, policymakers have destroyed the information content of the yield curve, which is one of the most reliable recession indicators (in the United States; ZIRP destroyed the information content of the JGB curve).
I am highly skeptical with regards to the importance of the loss of market information for the private sector. In the real world, people do not plan all consumption decisions in hypothetical forward markets that use the risk-free rate as a discounting instrument. Meanwhile, changing the risk-free rate will not greatly influence lending decisions: the private sector lends on a spread basis. Government interference in private lending only matters if they are distorting credit decisions -- exactly like the CMHC in Canada. Otherwise, we are just back to the debate around the importance of the level of the risk-free curve for the economy, as discussed earlier.
Where the loss of information might matter is for policymakers. If we believe that policymakers can fine tune the economy with interest rates, the signal provided by the yield curve presumably gives them some information from private sector market participants. The exact value of the information can be debated. If one believes that the term premium tears around in a random, unpredictable fashion, the curve is not going to contain a lot of information. Furthermore, the market consensus can be quite wrong, particularly in the early parts of expansions.
Policymakers could turn to other markets for information, such as the inflation-linked market. (My book on which is supposed to be nearly done...) All they need to do is avoid destroying the information available in the market by passing it through an affine term structure model, or by pinning those prices as well. (In the same fashion that Market Monetarists insist that central bank can set the level of nominal GDP by buying or selling hypothetical GDP futures, one could imagine the New Keynesian brain trust arguing that inflation rates can be set by pegging inflation breakeven rates.)
Political Costs of Interest ExpenseOne of the side effects of central bank yield curve control is that it cannot force people to buy long maturity bonds at the price it sets. Eventually, it will run into a situation where it owns most of the long end of the yield curve.
If we consolidate the central bank with the Treasury (which we should), this creates a situation that is economically equivalent to replacing long maturity debt with short maturity paper. As a result, changes to interest rates will immediately change fiscal interest expense, whereas a long-duration debt structure will insulate overall interest expense for years.
Financial commentators, mainstream economists, and politicians have a well-recorded tendency to scream about rising interest costs. Since there is no chance of a competent currency sovereign going bankrupt, these concerns are meaningless. However, in the real world, we have to deal with people who indulge in magical thinking (as I believe most anthropologists would attest).
Although it would be great if everyone were willing to think sensibly about government finance. I am not going to hold my breath waiting for that to happen. From my perspective (which I believe would not be shared by Bill Mitchell and other MMTers), I would not want to waste political capital walking into an obvious trap.
Returning to Japan, I see very little risk of rising inflation on any reasonable horizon, outside the possibility of some form of energy price shock. However, I see the risk of the Bank of Japan robotically raising rates in response to some inflationary shock. This will create a feedback loop to fiscal policy, with rising interest spending creating the spending power to sustain higher prices. (This was a common view in the inflationary 1970s, which disappeared after the consensus decided that high interest rates suppressed inflation.) A short maturity debt structure allows for such a feedback loop; if interest costs are largely fixed, this effect cannot kick into gear. In other words, a long maturity debt structure helps prevent the economy from being blown up by pro-cyclical policies by mainstream central bankers (again).
The relatively high debt-to-GDP ratio of Japan makes this more than a theoretical corner case. It would not be hard to craft a "Japan is doomed!" narrative based on post-Keynesian theory, and assuming that Japanese policymakers follow the mainstream script to the letter.
Concluding RemarksAustrian economics is far more influential in market commentary than it is academia. As a result, we should expect complaints about the dangers posed by distorting the yield curve to continue. That said, there is not a great deal of evidence that it actually matters.
Footnote:
* Some Post-Keynesians go on about the "external constraint" when discussing MMT. For floating currency sovereigns, the "external constraint" is really just the external value of the currency. A falling currency value should probably be lumped in with "inflation," which is already discussed in Functional Finance. In other words, people who are concerned about "the external constraint" are more worried about semantics than the operational effects of policies.
(c) Brian Romanchuk 2018
Which Keynesianism?
I posted this enormous torrent of blather on Blackboard the other day. It's mostly a restatement of stuff I've said before, but I'll repost it here for the purposes of copying and pasting in the likely case I have to restate it yet again elsewhere.
Because I've been studying economics for the last few years, rather than sticking to the curriculum and dutifully cultivating my employability, I feel obliged to chip in with a cautionary note: Almost all of the academic economists, and their policy prescriptions, which are characterised as Keynesian have nothing to do with the work of Keynes.
The post-war economic order established at Bretton Woods is conventionally understood as being Keynesian, but in fact Keynes was railroaded by the US representative Harry Dexter White, who insisted upon the system of fixed exchange rates pegged to the US dollar, with global dependency on holding US dollar reserves being greatly to America's benefit; the US gained the benefit of cheap foreign imports sold to acquire those reserves. Neither was Keynes responsible for the "Bretton Woods institutions", the World Bank and the IMF. His plan for regulating and settling international financial flows was considerably more humane than the usurious loans and standover tactics these institutions became notorious for.
Even "progressive" and "liberal" economists like Paul Krugman and Joe Stiglitz are members of the school of "New Keynesianism", a product of what Paul Samuelson called the "Neoclassical Synthesis"; taking some of the superficial trappings of Keynes' work and melding it with the earlier "neoclassical" school of economics, which Keynes actually intended to entirely overturn. Neoclassical models of the economy ignore the role of money and banking, believing that all economic transactions are ultimately barter transactions, and that money is therefore said to be "neutral", and banking is just redistribution of loanable funds, ultimately of no macroeconomic effect. Keynes wrote of this "Real-Exchange economics" (in an article unfortunately unavailable via SCU):
Now the conditions required for the "neutrality" of money, in the sense in which it is assumed in […] Marshall's Principles of Economics, are, I suspect, precisely the same as those which will insure that crises do not occur. If this is true, the Real-Exchange Economics, on which most of us have been brought up and with the conclusions of which our minds are deeply impregnated, […] is a singularly blunt weapon for dealing with the problem of Booms and Depressions. For it has assumed away the very matter under investigation.
This is the answer to Queen Elizabeth's question on how economists failed to see the Global Financial Crisis (GFC) coming; if the financial sector is macroeconomically neutral, as the neoclassicals claim, there cannot be any financial crises. However, outside the neoclassical tradition, the normal functioning of the economy, and the pathologies leading to crises, are well understood:
- The Chartalists determined that all money is credit, ultimately issued by the state. Michael Hudson recently did some exhaustive historical work on this, which David Graeber popularised in his book Debt: the First 500 Years.
- Wynne Godley showed how currency-issuing states must spend more than they tax if the private sector is to have the money necessary to spend and save.
- Irving Fisher identified the role of debt deflation in turning a rush to liquidate debt into an ongoing crisis where outstanding debts become impossible to repay.
- Hyman Minsky's financial instability hypothesis extended Fisher's work to describe how financial crises arise from the normal workings of a capitalist economy.
- Keynes implicitly regarded the money economy as a tool for allocating real resources in pursuit of public policy objectives, a principle explicitly formulated by Abba Lerner as "functional finance". This is in opposition to the neoclassical intuition that a household is like an individual, a firm is like a household, and a government is like a firm; therefore a government must follow the principles of "sound finance" and "live within its means".
- All of the above are incorporated in the teachings of "Post-Keynesian" economics, which Keynes' biographer Robert Skidelsky considers closest to Keynes' own thinking. The sub-field of Modern Monetary Theory (MMT) synthesises all of these into a single coherent framework for analysing the economies of countries which issue their own currency.
By the end of World War II, functional finance was so well established as to be almost universally understood to be common sense. The 1945 White Paper on Full Employment in Australia, prepared for John Curtin by H. C. "Nugget" Coombs, and based on the principles in Keynes' General Theory of Employment, Interest, and Money, declared:
It is true that war-time full employment has been accompanied by efforts and sacrifices and a curtailment of individual liberties which only the supreme emergency of war could justify; but it has shown up the wastes of unemployment in pre-war years, and it has taught us valuable lessons which we can apply to the problems of peace-time, when full employment must be achieved in ways consistent with a free society.
In peace-time the responsibility of Commonwealth and State Governments is to provide the general framework of a full employment economy, within which the operations of individuals and businesses can be carried on.
Improved nutrition, rural amenities and social services, more houses, factories and other capital equipment and higher standards of living generally are objectives on which we can all agree. Governments can promote the achievement of these objectives to the limit set by available resources.
(Emphasis mine.) As expressed by MMT, currency-issuing governments are not fiscally constrained. The only limits on public policy are real resource limits. During the last UK election campaign, Theresa May was vehemently insisting "there is no magic money tree". But in fact there is: it's called the Bank of England (we have the Reserve Bank of Australia), and Her Majesty's Treasury has an unlimited line of credit there. Whenever the government wants to spend, the Bank of England just credits the accounts of commercial banks. I was delighted when while campaigning May was confronted by a furious protester wanting to know "Where's the magic doctor tree? Where's the magic teacher tree?" The policy limits we should be worried about are real resources (including people), not money.
Nevertheless, mainstream economists and politicians believe, in some vague way, that (as Stephanie Kelton puts it) "money grows on rich people". So it's not surprising to read already on the discussion boards here that Keynesianism is all very desirable, but how will the federal government pay for it? This is a meaningless question. The government will pay for it like it pays for anything: by spending the money into existence. That's where all money comes from, net of private sector credit creation. Logically, it can't come from anywhere else. If the government were to try to achieve fiscal (or, conflating governments and firms again, "budget") surpluses over the long term by taxing more than they spend, as neoclassicals, including New Keynesians, recommend, they would merely be draining savings from the private sector for no good reason. State-issued money is an IOU, a tax credit. When the credit is redeemed it ceases to exist. The government doesn't have to tax in order to spend. It has to spend in order to tax. Think about it: where else would the first dollar ever taxed come from?
Now you might be thinking, hang on: what about the most fiscally responsible government we've ever had (Howard/Costello) and their record run of "budget" surpluses? The economy was going gangbusters! Okay, here's the fiscal balance for that period:
As with every currency-issuing sovereign state in history, deficits are the rule, not the exception. Here's what happened to private sector debt over the same period:
(Data from the Bank of International Settlements and OECD.) As soon as the government started taxing more than it spent, private sector debt took off, and subsequent fiscal deficits were insufficient to reverse the damage. Notably, at the same time household debt overtook corporate debt, as credit was used to sustain consumer demand, not to mention standards of living, rather than for investment in productive capacity. Australia "Nimbled it, and moved on", and to hell with the consequences.
Australia recently passed two milestones of note: total private sector debt (the blue line above) exceeded 200% of GDP — at roughly the level that Japan's private debt was at in the early 90s when its real estate bubble burst — and bank equity in residential real estate passed 50%. That's 50% of the total residential real estate stock, not just houses built in the last x years. Minsky describes the path to financial collapse as progressing through the stages of "hedge finance", then "speculative finance", and finally "Ponzi finance". When you see phenomena like interest-only mortgages — where the principal is never repaid, on the assumption that housing prices only ever go up, and the debt will be settled whenever you sell the property, presumably pocketing a tidy and lightly-taxed capital gain at the same time — you know which stage you're in.
So why does nobody in mainstream politics or economics know anything about this? To put it succinctly, because neoliberalism. On the left, the "balancing the books" rhetoric serves a useful purpose: it gives you a disingenuous pretext to do what you want to do anyway that is compatible with the dominant paradigm. As Randy Wray said at a recent MMT conference:
"[Progressives] link the good policies they want to 'we'll tax the rich to pay for it'. So when you point out we don't need to tax the rich to pay for it, they're just crestfallen because they want to tax the rich. So I say 'Of course we should tax the rich. Why? They're too rich.' You don't need any other argument than that."
Taxes drive demand for the currency. If you know you have to pay taxes, you will work to get the money to pay for it. It's a coercive way for the government to mobilise labour to achieve its policy objectives, but assuming policy is arrived at democratically, it's relatively fair and vastly preferable to the autocratic alternative of having a gun put to your head. Taxes are also a fiscal instrument that can be used to discourage certain kinds of behaviour, and harmful social phenomena (like income inequality).
In the neoliberal era, that's why Australia has a retrospective tax on education called HECS-HELP, which in turn is why SCU has no school of history, or philosophy, or in fact any of the traditional academic disciplines. Students know that their education will be retrospectively taxed, so they can't afford to choose disciplines unlikely to offset that tax with increased earnings. There are twice as many universities as there were in 1988, but the new ones are glorified vocational colleges with next to no permanent academic staff. Australian post-Keynesian economist Steve Keen, who correctly predicted — and more importantly, explained — the GFC, subsequently lost his job at the University of Western Sydney when they closed down their economics department. Who needs academic economics when you have business studies courses, after all? He ended up at Kingston University in London, another young neoliberal institution, where last year he was given an ultimatum to spend more hours teaching or take a significant pay cut. He's ended up having to put his hat out for donations from the public in order to continue his work as a public intellectual.
Why would public policy function like this? Why would policy makers want a population uneducated about how the world actually works, and instead merely trained in how to work in it? Why is the conventional wisdom so full of assertions that are demonstrably untrue, and profoundly damaging to society? Paul Samuelson, author of the macroeconomics textbook that gave generations of undergraduates a completely misleading interpretation of Keynes' work explained this in an interview:
I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he would say "uh, oh what you have done" and James Buchanan argues in those terms. I have to say that I see merit in that view.
So basically, belief in myths must be maintained among the general population wherever doing so provides support for the elite political preference for small government, i.e. for control over the economy to be exercised by private finance rather than public fiscal policy. This is what neoliberalism fundamentally is, an Orwellian fiction imposed on a deliberately dumbed-down populous, with access to the truth as much the reserve of a select educated elite as ever. "Long-run civilised life" has been restored, thanks to neoliberalism's making of the 21st century by its un-making of the 20th.
I could go on forever (evidently) but others explain all this better than I:
- Here's a short interview with Steve Keen explaining how neoliberal austerity economics leads inevitably to financial crises.
- Stephanie Kelton is probably the best person to explain MMT to a general audience. Watch her describe the Angry Birds Approach to Understanding Deficits in the Modern Economy.
- Here's Bill Mitchell explaining in 15 minutes how fiscal policy works in the real world.
- Warren Mosler explains here why fiscal deficits are generally desirable. If you find reading easier than listening, I recommend Warren's slim volume (and even slimmer PDF file) Seven Deadly Innocent Frauds of Economic Policy.
If you have read this far, I admire your tenacity.
'Straya: Basically, she's rooted mate
Charts! Nobody asked for them, but I have them anyway! Over the last few years the Bank for International Settlements have been publishing a fab set of statistics that are not usually brought to bear in the tea leaf reading of mainstream economists. This is a shame, as they are exactly the sort of statistics which would indicate the risk of imminent financial crisis. Last month the BIS updated the data to the end of (calendar year) 2016. Here's an illustration (courtesy of LibreOffice) of where Australia is, relative to some comparable and/or interesting countries (click to embiggen):
As the BIS explains, the Debt Service Ratio (DSR):
"reflects the share of income used to service debt and has been found to provide important information about financial-real interactions. For one, the DSR is a reliable early warning indicator for systemic banking crises. Furthermore, a high DSR has a strong negative impact on consumption and investment."
So as a measure of Australia's ability to pay at least the interest on our private sector debts, if not pay down the principal, you might think this is not a bad result. We clearly substantially delevered after the GFC, thanks in large part to the Rudd stimulus pouring public money into the private sector, then levered up a bit since, but we've ended up between Canada and Sweden, which is a pretty congenial neighbourhood. But this is total private sector debt; what happens when we take business out of the equation and just look at households (and non-profit institutions serving households - NPISHs)?
Woah! Suddenly we're in a league of our own. Canada's flatlined here since the GFC, meaning the subsequent increase in their total private debt burden has largely come from investment in business capital. In such a case, provided this investment is directed at increasing productive capacity, and is accompanied by public sector spending to proportionally increase demand, this is sustainable debt. Australia has been doing the opposite.
Here's another way of looking at the coming Australian debt crisis, private sector credit to GDP:
This ratio will rise whether the level of debt rises, GDP falls, or both, so it's another good indicator of unsustainable debt levels. The current total level (in blue) of over 200% is at about the ratio Japan was at when its real estate bubble burst in the early 1990s. Breaking this down again into household and corporate sectors, we see that over the mid-1990s Australia switched the majority of its private sector borrowing from business investment to sustaining households. What happened in the mid-90s? Data here from the OECD:
From the mid-1990s to 2007 Australia experienced the celebrated run of Howard/Costello government fiscal (or "budget") surpluses. We all know, or should know, thanks to Godley's sectoral balances framework, what happens when the public sector runs a surplus: the private sector must run a corresponding deficit, equal to the last penny. There is nowhere else, net of private sector bank credit creation (which zeroes out because every financial asset created in the private sector has a corresponding private sector liability), for money to come from. When the government taxes more than it spends, it is withdrawing money from the private sector. Mainstream economics calls this "sustainable", and "sound finance", meaning of course it is nothing of the sort.
How did the private sector, and the household sector in particular, continue to spend from that point onward, behaving as though losing money (not to mention public infrastructure and services) down the fiscal plughole was not merely benign but quite wonderful? It chose to Nimble it and move on, going on a massive credit binge. The banks were happy to provide all the credit demanded, because the bulk of the lending was ulitimately secured by residential real estate prices, and these were clearly going to keep rising without limit (thank heavens, because if they were to fall like they did in the US in 2007…).
The Global Financial Crisis put a dent in the demand for credit, but as subsequent government fiscal policy has tightened, under the rubric of "budget repair", it is rising again. We are already in a state of debt deflation: Australia's household debt service ratio (as above), at between 15 and 20 percent of household income for over a decade, has dampened domestic demand, leading to rising unemployment and underemployment, leading to more easy credit as a quick fix for income shortfalls ("debtfare"). More of what income remains is redirected to debt servicing rather than consumption, and so we spiral downwards, our incomes purchasing less and less with each turn. [I will post more about some of the social and microeconomic consequences in (over-)due course.]
The Australian government needs to spend much, much more - and quickly. Modern Monetary Theory, drawing on an understanding of the nature of money that goes back a century, shows us that government spending (contrary to conventional wisdom) is not revenue-constrained; a currency-issuing government can always buy anything available for sale in the currency it issues. There is nothing about our collective "budget" that needs repairing before we can do so. The same data from the OECD shows that most currency-issuing governments with advanced industrial economies run fiscal deficits almost all the time:
In fact, under all but exceptional conditions, government fiscal surpluses (i.e. private sector fiscal deficits) are a recipe for recession or depression. The greater the surplus, the greater the subsequent government spending required to lift the private sector out of crisis, as can be seen above in the wild swings in neoliberal governments' fiscal position from the mid-90s on. The fiscal balance over any given period is nothing more than a measurement of the flow of public investment into the private sector. What guarantees meaningful sustainability is a government's effective use of functional finance to manage the real (as opposed to financial) economy in pursuit of public policy objectives. Refusing to mobilise idle resources (including, crucially, labour) for needed public goods and services is not "sound finance"; it is the very definition of economic mismanagement, as was once widely recognised:
"It is true that war-time full employment has been accompanied by efforts and sacrifices and a curtailment of individual liberties which only the supreme emergency of war could justify; but it has shown up the wastes of unemployment in pre-war years, and it has taught us valuable lessons which we can apply to the problems of peace-time, when full employment must be achieved in ways consistent with a free society.
"In peace-time the responsibility of Commonwealth and State Governments is to provide the general framework of a full employment economy, within which the operations of individuals and businesses can be carried on.
"Improved nutrition, rural amenities and social services, more houses, factories and other capital equipment and higher standards of living generally are objectives on which we can all agree. Governments can promote the achievement of these objectives to the limit set by available resources.
"The policy outlined in this paper is that governments should accept the responsibility for stimulating spending on goods and services to the extent necessary to sustain full employment. To prevent the waste of resources which results from [un]employment is the first and greatest step to higher living standards."
We chose to forget all this from the 1980s onward. We can choose to remember it at any time.
Wednesday, 15 February 2017 - 5:22pm
I'm ranting altogether too much over local "journalism", and this comment introduces nothing new to what I've posted many times before, but since the Advocate won't publish it:
Again I have to wonder why drivel produced by the seething hive mind of News Corp is being syndicated by my local newspaper. This opinion comes from somebody who appears to be innumerate (eight taxpayers out of ten doesn't necessarily - or even very likely - equal eight dollars out of every ten) economically illiterate, and empirically wrong.
Tax dollars do not fund welfare, or any other function of the federal government. Currency issuing governments create money when they spend and destroy money when they tax. "Will there be enough money?" is a nonsensical question when applied to the federal government. As Warren Mosler puts it, the government neither has nor does not have money. If you work for a living, it is in your interest that the government provides money for those who otherwise wouldn't have any, because they spend it - and quickly. Income support for the unemployed becomes income for the employed pretty much instantly. Cutting back on welfare payments means cutting back on business revenues.
And the claim that the "problem" of welfare is increasing in scale is just wrong. Last year's Household, Income, and Labour Dynamics in Australia (HILDA) report shows dependence on welfare payments by people of working age declining pretty consistently since the turn of the century. This opinion piece is pure class war propaganda. None of us can conceivably benefit in any way from pushing people into destitution in the moralistic belief that they must somehow deserve it.
The Joy of Economic Irresponsibility: or how I learned to stop worrying and love the public debt
If there's one thing I've learned in the last year that I think is so important it's worth shouting from the rooftops, it's that simultaneously studying economics and the psychology of stress while also being personally stressed about money is a very, very bad idea.
If there are two important things I've learned in the last year, I'd say that the more generally applicable one to the citizen in the street is that a government which issues it's own money can never run out of it.
Such a government can of course pretend, or at least behave like, it can run out of money. In fact, many have done so for the last thirty years or so, and the results have been disastrous. You don't have to take my word for it. Here are some graphs, mostly from the RBA Chart Pack, except where otherwise indicated. Here's the Australian government fiscal balance, misleadingly labelled "budget balance" as per the conventional misunderstanding of reality.
Things took a dip from 2007/8, but deficits are improving, and we were in surplus for most of the preceeding decade. And that's good, isn't it? Surpluses mean we have more money, don't they?
Generally, yes. A "budget surplus" for a business or household means more money at hand to spend later. However, for an economy with a sovereign-currency-issuing government, public fiscal surpluses mean we have less money.
How is this possible? To understand this, you have to understand that accountancy—specifically double-entry bookkeeping and balance sheets—is the foundation of economics; at least economics of a realistic kind. All money is credit money. You make money—literally—by being in debt to somebody, and by denominating this debt in the country's transferrable unit of account. Spending is the simultaneous creation of a debt on the buyer's side of the ledger, and a corresponding credit on the seller's side. However, if you happen to hold enough credits that have already been generated as the flipside of a debt in your favour, you can use these credits to immediately cancel the debt of the current transaction. One way most of us do this on a daily basis is by using cash. Cash is a transferrable token of public sector debt and private sector credit.
Three percent of the immediately-spendable money in the private sector is in the form of cash. The other 97% is just numbers stored on computers in the commercial banking sector. Most of this is money that originated as commercial bank loans, and will disappear from the bank's balance sheets as those loans are repaid (though of course in the meantime more loans will have been made). However, a significant amount of money originates as loans the government makes to itself (technically the central bank lends to the treasury), eventually ending up in the private sector as cash, or (through a mindbending process I will mercifully omit from this account) as commercial bank deposits. A currency-issuing government can always lend more money to itself in order to spend, and never has to pay it back. It follows that such a government does not need to tax in order to spend, and only ever taxes for other reasons. Economics textbooks, and economic commentators, routinely get this utterly and comprehensively wrong. Consider this textbook description of economic "automatic stabilisers":
"During recessions, tax revenues fall and welfare payments increase thereby creating a budget deficit. In times of economic boom, tax revenues rise and welfare payments fall creating a budget surplus."
Budget deficits are not an eventual consequence of government spending; the spending and the creation of a debt are the same operation. Tax revenues merely redeem a part of the already-accrued debt; the money issued by public spending is a public IOU that effectively disappears when private parties use it settle their tax debt owed to the public. Tax revenues therefore cannot be used to fund public spending; in order to spend, new public debt must be issued. The automatic stabilisers are real (assuming a somewhat sensible tax system), but the important part of their function is on the private side: injecting new money to stimulate demand when needed, or putting the brakes on dangerous speculative activity in a boom. The government's fiscal position from one year to the next is an inconsequential side-effect.
Taxation is the elimination of money, and hence of the demand for goods, services, and assets that drives the private sector economy. Don't believe me? Lets take a wider focus on the fiscal balance numbers above:
[Source]
Generally, and especially prior to the neoliberal period, public fiscal surpluses are the exception, not the rule. And for a good reason; it's generally not a good idea to drain demand out of the economy. So what happens when you toss good sense aside, and insist on surpluses for their own sake? Here's what happened to public sector debt:
I'm presuming (the ABS Chart Pack doesn't specify) that this is debt owed to private sector banks in the form of loans and government securities. I should stress that, as with taxation, these operations are not required to finance spending, and are only ever done for other reasons (such as hitting interest rate targets). Also, because they don't issue currency themselves (though this is possible, and has worked elsewhere), lower levels of government do have to rely in part on revenue-raising to fund spending, though grants from the federal government also play a big part in determining their fiscal position.
Still—phew!—we got that scary public sector debt under control until the GFC, and we can do it again! But hang on, if that's taking money out of the private sector, where does the private sector get the money to sustain demand? Here's the private sector debt over the same period:
Note that this is one and a half times GDP, compared to the one third of GDP outstanding to the public sector, at the height of its alleged fiscal irresponsibility. When government self-imposes limits on its ability to spend, private sector credit creation takes up the slack. Who do you want controlling how much money is created, who gets it, and what it gets spent on? A mix of the commercial finance sector and a (somewhat) democratically-accountable government? Or just the bankers?
Most of private-sector money creation is commercial bank loans, and as economist Michael Hudson notes, in the US, UK, and Australia, 70 percent of bank loans are mortgages. That's a hell of a lot of money (what's 70 percent of one and a half times GDP?) dependant for its existence on the soundness of pricing for a single class of asset. If real estate prices suddenly crash, and mortgagees start to default on their loans, poof! The corresponding credits on the other side of the ledger are gone too, and the real estate sector takes the whole economy down with it. You can't argue with balance sheets.
Still, I expect we'll be fine as long as we stay the fiscal responsibility course, and don't let the government "spend more than it earns". Real estate prices only ever go up, don't they? And it's not like bankers would ever be led by their own short-term interests to make a huge amount of risky loans and inflate an enormous real estate price bubble…
Thursday, 11 February 2016 - 1:39pm
I'm reluctant to contribute to the Piketty backlash, as it seems to me to be mostly motivated by the unrealistic expectation that his book should have provided a comprehensive theory of everything. However this blog post from Alexander Douglas provides such a pithy account of the workings of public fiscal balances that it's worth recirculating. In response to the claim that "there are two main ways for a government to finance its expenses: taxes and debt," he writes:
Government spending isn’t financed by anything. The government pays for everything by crediting the non-government sector (employees, companies, foreign governments, etc.) with financial claims. Some of these claims are returned to the government in order to settle liabilities to the government (for instance in tax payments); others remain as financial holdings for the non-government sector. At any given moment the claims remaining as financial holdings constitute the whole of the ‘public debt’.
Tax revenue largely depends on the volume of spending. Decisions to spend rather than save are largely at the discretion of non-government agents. It is therefore very misleading to speak, as Piketty does, as if the government chooses to ‘finance its spending’ through taxation or debt. The amount of government spending that remains as ‘debt’ is largely up to the discretion of non-government agents choosing whether to hold onto financial claims or pass them on so that they can eventually find their way back to the government.
It therefore makes no sense to panic about government "budget" deficits, if you're not also going to bemoan private savings. Ironically, as it happens, private savings currently is a big problem, as corporations hand out mattress stuffing — in the form of dividends and share buybacks — rather than investing. Yet more ironically, the appropriate response is for the government to make up the investment shortfall through large fiscal deficits. Otherwise the economic stagnation rolls on until (sorry, I can't resist it) r>g.