April 16, 2019 Warren Coats - Monetary Policy Expert, Advisor for Central Banks
So called Modern Monetary Theory (MMT) has become popular with Green New Dealers because it claims to remove or at least loosen traditional constraints on government spending. MMT offers unconventional ideas about the origins of money, how money is created today, and the role of fiscal policy in the creation of money. It argues that government can spend more freely by borrowing or printing money than is claimed by conventional monetary theory. “The most provocative claim of the theory is that government deficits don’t matter in themselves for countries—such as the U.S.—that borrow in their own currencies…. The core tenets of MMT, and the closest it gets to a theory, are that the economy and inflation should be managed through fiscal policy, not monetary policy, and that government should put the unemployed to work.” James Mackintosh, “What Modern Monetary Theory Gets Right and Wrong’WSJ April 2, 2019.
In fact, despite its efforts to change how we conceive and view monetary and fiscal policies, MMT abandons market based countercyclical monetary and fiscal policies for targeted central control over the allocation of resources. It would rely on specific interventions to address “road blocks” upon the foundation of a government guaranteed employment program.
MMT is an unsuccessful attempt to convince us that we can finance the Green New Deal and a federal job guarantee painlessly by printing money. But it remains true that shifting our limited resources from the private to the public sector should be judged by whether society is made better off by such shifts. Printing money does not produce free lunches.
Where does money come from?
It has been almost 50 years since the U.S. dollar (or any other currency for that matter) has been redeemable for gold or any other commodity whose market value thus determined the value of money. It remains true, however, that money’s value depends on its supply given its demand. The supply of money these days reflects the decisions of the Federal Reserve and other central banks.
The traditional story for the fractional reserve banking world we live in is that a central bank issues base or high-powered money (its currency and reserve deposits of banks with the central bank) that is generally given the status of “legal tender.” You must pay your taxes with this money. We deposit some of that currency in a bank, which provides the bank with money it can lend. When the bank lends it, it deposits the loan in the borrower’s deposit account with her bank, thus creating more money for the bank to lend. This famous money multiplier has resulted in a money supply much larger than the base money issued by the central bank. In July 2008, base money (M0) in the United States was $847 billion dollars while the currency component of that plus the public’s demand deposits in banks (M1) was almost twice that — $1,442 billion dollars. Including the public’s time and savings deposits and checkable money market mutual funds (M2) the amount was $7,730 billion. [I am reporting data from just before the financial crisis in 2008 because after that the Federal Reserve began to pay interest on bank reserve deposits at the Fed in order to encourage them to keep the funds at the Fed rather than lending them and thus multiplying deposits. This greatly increased and distorted the ratio of base money to total money, i.e. reduced the multiplier. In October 2015 at the peak of base money M0 = $4,060 billion, of which only $1,322 billion was currency in circulation.]
The neo Chartalists, now known as MMTists, want us to look at this process differently. In their view banks create deposits by lending rather than having to receive deposits before they can lend. While a bank loan (an asset of the bank) is extended by crediting the borrower’s deposit account with the bank (a liability of the bank), the newly created deposit will almost immediately be withdrawn to pay for whatever it was borrowed for. Thus, the willingness of banks to lend must depend on their expectations of being able to finance their loans from existing or new deposits, by borrowing in the interbank or money markets, or by the repayment of previous loans at an interest rate less than the rate on its loans.
The money multiplier version of this story assumes a reserve constraint, i.e., it assumes that the central bank fixes the supply of base money and bank lending and deposit creation adjust to that. The MMT version reflects the fact that monetary policy these days targets interest rates leaving base money to be determined by the market. Traditionally the Fed set a target for the over-night interbank lending rate—the so-called Fed Funds rate. In order to maintain its target interest rate, the central bank lends or otherwise supplies to the market whatever amount of base money is needed to cover private bank funding needs at that rate. The market determination of the money supply at a given central bank interest rate is, in fact, similar to the way in which the market determines the money supply under currency board rules under which the central bank passively supplies whatever amount of money the market wants at the fixed official price (exchange rate) of the currency. With the Federal Reserve’s introduction of interest on bank reserve deposits at Federal Reserve Banks, including excess reserves (the so-called Interest On Excess Reserves – IOER), banks’ management of their funding needs for a given policy rate now involve drawing down or increasing their excess reserves.
According to MMT proponents, loans create deposits and repayment of loans destroys deposits. This is a different description of the same process described by the money multiplier story, which focuses on the central bank’s control of reserves and base money rather than interest rates. It is wrong to insist that deposits are only created by bank lending and equally wrong to insist that banks can only lend after they receive deposits.
How is Base Money Produced?
MMT applies the same approach to the creation of base or high-powered money (HPM) by the government as it does to the creation of bank deposits by the private sector:
“It also has to be true that the State must spend or lend its HPM into existence before banks, firms, or households can get hold of coins, paper notes, or bank reserves…. The issuer of the currency must supply it first before the users of the currency (banks for clearing, households and firms for purchases and tax payments) have it. That makes it clear that government cannot sit and wait for tax receipts before it can spend—no more than the issuers of bank deposits (banks) can sit and wait for deposits before they lend.”
This unnecessarily provocative way of presenting the fact that government spending injects its money into the economy and tax payments and t-bond sales withdraws it does not offer the free lunch for government spending that MMT wants us to believe is there. Central banks can finance government spending by purchasing government debt, but this does not give the Treasury carte blanche to spend without concern about taxes and deficit finance. This is the core of MMT that we must examine carefully.
MMT claims that:
“(i) the government is not constrained in its spending by its ability to acquire HPM since the spending creates HPM…. Spending does not require previous tax revenues and indeed it is previous spending or loans to the private sector that provide the funds to pay taxes or purchase bonds….
“(iii) the government deficit did not crowd out the private sector’s financial resources but instead raised its net financial wealth.
“Regarding (iii), the private sector’s net financial wealth has been increased by the amount of the deficit. That is, the different sequencing of the Treasury’s debt operations does not change the fact that deficits add net financial assets rather than “crowding out” private sector financial resources.”
MMT is correct that federal government spending does creates money. But what if the resulting increase in money exceeds the public’s demand (thus reducing interest rates), or the destruction of money resulting from tax payments or public purchases of government debt reduces money below the public’s demand (thus increasing interest rates)? MMT claims to be aware of the risk of inflation and committed to stable prices (an inflation target) but ignore it most of the time.
If the central bank sets its policy interest rate below the market equilibrium rate, it will supply base money at a rate that stimulates aggregate demand. If it persists in holding short term interest rates below the equilibrium rate it will eventually fuel inflation, which will put upward pressure on nominal interest rates requiring ever increasing injections of base money until the value of money collapses (hyperinflation). If instead the central bank money’s price is fixed to a quantity of something (as it was under the gold standard, or better still a basket of commodities) and is issued according to currency board rules (the central bank will issue or redeem any amount demanded by the market at the fix price), arbitrage will adjust the supply so as to keep the market price and the official price approximately the same (for a detailed explanation see my: “Real SDR Currency Board”). Unlike an interest rate target, a quantity price target is stable.
Does the Story Matter?
But does the MMT story of how money is created open the door for government to spend more freely and without taxation, either by borrowing in the market or directly from the central bank? According to MMT, “One of the main contributions of Modern Money Theory (MMT) has been to explain why monetarily sovereign governments have a very flexible policy space that is unencumbered by hard financial constraints. Not only can they issue their own currency to meet commitments denominated in their own unit of account, but also any self-imposed constraint on their budgetary operations can be by-passed by changing rules.”
MMT maintains that: “Politicians need to reject the urge to ask ‘How are we going to pay for it?’… We must give up our obsession with trying to ‘pay for’ everything with new revenue or spending cuts…. Once we understand that money is a legal and social tool, no longer beholden to the false scarcity of the gold standard, we can focus on what matters most: the best use of natural and human resources to meet current social needs and to sustainably increase our productive capacity to improve living standards for future generations.”
MMT proclaims that a government that can borrow in its own currency “has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors. Thus, insolvency and bankruptcy of this government is not possible. It can always pay…. All these institutional and theoretical elements are summarized by saying that monetarily sovereign governments are always solvent, and can afford to buy anything for sale in their domestic unit of account even though they may face inflationary and political constraints.” But inflating away the real value of obligations (government debt) is economically a default. Moreover, debt cannot grow without limit without debt service costs absorbing the government’s entire budget and even the inflation tax has its hyperinflation limit (abandonment of a worthless currency).
MMT advocates do acknowledge that at some point idle resources will be used up and that this process would then become inflationary, but this caveat is generally ignored. But if MMT is serious about an inflation constraint, we must wonder about their criticism of asking how government spending will be paid for. In this regard MMT is a throwback to the old Keynesianism, which implicitly assumed a world of perpetual unemployment.
Is There a Free Lunch?
MMT states that when the government spends more than its income (and thus must borrow or print money) private sector wealth is increased “because spending to the private sector is greater than taxes drawn from the private sector, the private sector’s net financial wealth has increased.” As explained below this deficit spending increases the private sector’s holdings of government securities, but not necessarily its net financial wealth.
Whether we take account of the future tax liabilities created by this debt in the public’s assessment of its net wealth (Ricardian equivalence) or not, we must ask where the public found the resources with which it bought the debt. Did it substitute T-bonds for corporate bonds, i.e. did the government’s debt (or monetary) financing of government spending crowd out private investment thus leaving private sector wealth unchanged, or did it come from reduced private consumption, i.e. increased private saving. Any impact on private consumption will depend on what government spent its money on. MMT claims that “the government deficit did not crowd out the private sector’s financial resources but instead raised its net financial wealth,” is simply asserted and is unsupported. Whether the shift in resources from the private sector to the public sector is beneficial depends on whether the value of the government’s resulting output is greater than is the reduced private sector output that financed it.
One way or another, government spending means that the government is commanding resources that were previously commanded by or could be commanded by the private sector. If the government takes resources by spending newly created money that the central bank does not take back, prices will rise to lower its real value back to what the public wants to hold. This is the economic equivalent of the government defaulting on its debt, contrary to MMT’s claim that default is impossible. This inflation tax is generally considered the worst of all taxes because it falls disproportionately on the poor. In fact, MMT proponents rarely mention or acknowledge the distinction between real and nominal values that are, or should be, central to discussions of monetary policy. The exception to the inflationary impact of monetary finance is if the resources taken by the government were idle, i.e. unemployed, which, obviously, is the world MMT thinks it is in.
MMT claims to have exposed greater fiscal space than is suggested by conventional analysis. They claim that government can more freely spend to fight global warming or to fund guaranteed jobs or other such projects by printing (electronic) money. However, the market mechanism they offer for preventing such money from being inflationary (market response to an interest rate target that replaces unwanted money with government debt), implies that such spending must be paid for with tax revenue or borrowing from the public. Both, in fact all three financing options (taxation, borrowing, and printing money), shift real resources from the private sector to the public sector and only make society better off if the value of the resulting output is greater than that of the reduced private sector output. There is nothing new here.
Fiscal Policy as Monetary Policy
Government spending increases M and the payment of taxes reduces it. MMT wants to use taxation to manage the money supply rather than for government financing purposes. MMT wants to shift the management of monetary policy from the central bank to the finance ministry (Treasury). The relevant question is whether this way of thinking about and characterizing monetary and fiscal policy produces a more insightful and useful approach to formulating fiscal policy. Does it justify shifting the responsibly for monetary policy from the central bank to the Finance Ministry? Should taxes be levied so as to regulate the money supply rather than finance the government (though it would do that as well)?
In advocating this change, MMT ignores the traditional arguments that have favored the use of central bank monetary policy over fiscal policy (beyond automatic stabilizers) for stabilization purposes. None of the challenges of the use of fiscal policy as a countercyclical tool (timing, what the money is spent for, etc.) established with traditional analysis have been neutralized by the MMT vision and claim of extra fiscal space. In fact, as we will see below, despite their advocacy of fiscal over monetary policy for maintaining price stability, MMT supporters have little interest in and no clear approach to doing so as they prefer to centrally manage wages and prices in conjunction with a guaranteed employment program.
But the arguments against MMT are stronger than that. The existing arrangements around the globe (central banks that independently execute price stability mandates and governments that determine the nature and level of government spending and its financing) are designed to protect monetary stability from the inflation bias of politicians with shorter policy horizons (the time inconsistence problem). The universal separation of responsibilities for monetary policy and for fiscal policy to a central bank and a finance ministry are meant to align decision making with the authority responsible for the results of its decisions (price stability for monetary policy and welfare enhancing levels and distribution of government spending and its financing). It is the sad historical experience of excessive reliance on monetary finance and the costly undermining of the value of currencies that resulted that have led to the world-wide movement to central bank independence. MMT is silent on this history and its lessons. As pointed out by Larry Summers in an oped highly critical of MMT, the world’s experience with monetary finance has not been good. Modern Monetary Theory-a-foolish-pursuit-for-democrats
The establishment of central bank operational independence in recent decades is rightly considered a major accomplishment. MMT advocates bring great enthusiasm for more government spending—especially on their guaranteed employment and green projects, which will need to be justified on their own merits. MMT’s way of viewing money and monetary policy adds nothing to the arguments for or against these policies.
The Bottom Line
To a large extent, most of the above arguments by MMT are a waste of our time as MMT advocates actually reject the macro fine tuning of traditional Keynesian analysis. “This approach of government intervention aims at avoiding direct intervention to achieve the goal (e.g. hiring to achieve full employment, or price controls to achieve low inflation), but rather using indirect “tools” while letting market participants push the economy toward desired goals by tweaking their incentives. MMT does not agree with this approach. The government should be directly involved continuously over the cycle, by putting in place structural macroeconomic programs that directly manage the labor force, pricing mechanisms, and investment projects, and constantly monitoring financial developments…. But MMT goes beyond full employment policy as it also promotes capital controls for open economies, credit controls, and socialization of investment. Wage rates and interest rate management are also important.” No wonder Congresswomen Alexandria Ocasio-Cortez is excited by MMT.
MMT attempts, unsuccessfully in my opinion, to repackage and resurrect the empirically and theoretically discredited Keynesian policies of the 1960s and 70s. A 2019 survey of leading economists showed a unanimous rejection of modern monetary theory’s assertions that “Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt” and “Countries that borrow in their own currency can finance as much real government spending as they want by creating money.” http://www.igmchicago.org/surveys/modern-monetary-theory Both the excitement and motivation for MMT seem to reflect the desire to promote a political agenda, without the hard analysis of its pros and cons—its costs and benefits.