Saturday, March 24, 2012

Modern Monetary Theory outsmarts DeLong and Summers.

Thanks to Winterspeak (23rd March 2012) for drawing attention to this paper by Summers and DeLong.

The argument in this paper is thus. Normally central banks negate the stimulatory effect of a fiscal boost. Or as the authors put it in their abstract, “In normal times central banks offset the effects of fiscal policy.”

But at the zero bound they don’t do this. Thus at the zero bound, fiscal policy can allegedly be used to provide stimulus.

Now there is flaw in that argument as follows.

If a central bank is keeping its base rate at zero (or any other figure, come to that), then it must be printing money and buying back government debt in sufficient quantities to negate any interest rate raising effect of fiscal policy. Put another way, the central bank will be doing some QE.

In fact in the latter scenario, my guess is that for every dollar government borrows, the central bank will print a dollar and buy back a dollar of debt, though admittedly there might not be an exact “dollar for dollar” relationship here.

Anyway, in this scenario, what is taking place is not pure “fiscal policy”. What is taking place is a combination of fiscal and monetary policy. Put another way, what is taking place is exactly what Abba Lerner advocated, namely that in a recession, the government / central bank machine should simply print or create new money and spend it into the economy (and/or cut taxes).

Governments / central banks don’t need to be “self-financing”.

The second flaw in this paper is the extreme concern the authors have with whether a fiscal boost will ultimately be what they call “self-financing”. Here are some typical passages.

1. Section II presents a highly stylized example making our basic point regarding self-financing fiscal policy…

2. They say their argument “analyzes necessary conditions for expansionary fiscal policy to be self-financing…”

3. “A very simple calculation conveys the major message of this paper: A combination of low real U.S. Treasury borrowing rates, positive fiscal multiplier effects, and modest hysteresis effects is sufficient to render fiscal expansion self-financing.”

Now where is the merit in a fiscal boost being “self-financing” in the long run? Darned if I know.

The government / central bank machine can print and spend any amount of money it wants so as to effect stimulus. Conversely it can confiscate any amount of money it wants anytime from the private sector simply by raising taxes.

MICROECONOMIC entities have to be self-financing in the long run. If they fail to “self-finance”, they go bust.

But the government / central bank machine is a totally different kettle of fish: it is not under the same constraints as a microeconomic entity.
If a fiscal boost fails in to the long run to be self-financing, that means the government / central bank machine must have supplied the private sector with a permanent increased stock of net paper assets (monetary base and/or government debt).

What of it? Why does that matter? If the effect if that increased stock is to induce the private sector to spend at a rate that causes excessive inflation, then the stock needs to be reduced via extra tax. But if the private sector wants to hold this increased stock for the next twenty years, where’s the problem? Moreover, if this stock IS REDUCED the result will be paradox of thrift unemployment. So the stock should very definitely NOT BE reduced.

P.S. (4th April). Sumner also attacks the above Summers and De Long paper (on 26th March)

P.S. (2nd May, 2012). The above nonsensical DeLong / Summers “self-financing” argument is also criticised by L.Randall Wray in an EconoMonitor article published on 1st May 2012.


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