Sixteen reasons why MMT is right on the fiscal versus monetary policy question.

Note: this post is an updated version of a post I did in February this year called “Twelve reasons why MMT is right on the fiscal versus monetary policy question.” That post is now deleted. The text explaining the first twelve reasons below are is almost identical to that post. The four additional reasons 13-16 are new.

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Abba Lerner is often said to be the founding father of Modern Monetary Theory (MMT). He argued that in a recession, government should simply create new money and spend it into the economy (and/or cut taxes) – effectively combining fiscal and monetary policy.

I’ll ASSUME that this “combined” policy is part of MMT (though perhaps some MMTers will disagree). Anyway, the arguments AGAINST implementing fiscal or monetary policy SEPARATELY are thus.

1. Adjusting interest rates is a form of monetary policy, BUT interest rate adjustments are DISTORTIONARY. An interest rate change works only via households or firms which are significantly reliant on variable rate loans: i.e. those reliant on FIXED rate loans or not reliant on loans at all are not affected by an interest rate change. Thus this policy makes no more sense than boosting an economy only via people with black hair, with blondes, red-heads, etc waiting for a trickle-down effect.

Bizarrely, James Bullard, president of the St Louis Fed claimed (p.9) that TAXES ARE DISTORTIONARY! Well it depends which taxes. Sales taxes like VAT or payroll taxes are pretty distortion free. (Incidentally, Krugman demolishes another of James Bullard’s papers here.)

2. QE, another form of monetary policy, has the same defect: it works only via a limited proportion of the population, that is, the rich.

3. The idea that there is a close relationship between interest rates and the ACTUAL availability of credit has been shown to be TOTAL NONSENSE over the last two years. That is, rates are currently at record low levels, but banks are reluctant to lend.

4. Low interest rates can have a DEFLATIONARY effect (pointed out by Warren Mosler). If rates are cut, the central bank will then pay out less by way of interest. That is, less new money will be injected into the private sector.

Minor technical point: this effect depends to some extent on the rules governing the relevant central bank, Treasury, etc. To illustrate, in some countries a rate reduction may NOT automatically reduce the above injection. That is, the reduction may be treated as a reduced budgetary expense for the Treasury, which in turn is expected to collect less tax to compensate. In this case the above deflationary effect would not operate.

5. An interest rate reduction is an inducement to borrow and invest in assets, which tends to cause asset price bubbles. In contrast, a straightforward change in government net spending has less of a “bubble blowing” effect. That is, if the additional net spending is directed at a cross section of the population (not just the wealthy), there will not be a significant asset bubble effect.

6. The optimum price for borrowed money (i.e. the optimum rate of interest) is determined by the same sort of factors that determine the optimum price for concrete, steel or any other commodity: supply and demand. To put that in economics jargon, the rate of interest is optimised when the marginal disutility of forgone consumption by savers equals the marginal utility or marginal benefit from the investments that those savers fund.

If government interferes with this free market rate of interest, then the total amount invested will not be optimum. GDP will not be maximised.

7. Low interest rates allegedly encourage investment. Unfortunately those making investments look at LONG TERM rates, not the fact that the central bank has recently cut rates and will probably raise them again in two years’ time. And that applies both to firms investing in productive capacity and people who borrow with a view to buying houses.

While most people will not buy houses just because interest rates have dropped for a couple of years, there ARE those NINJA mortgage suckers who bought houses on the basis of near zero interests for the first year or two. I.e. there ARE idiots out there. So in that the “low interest rates encourages investment” argument DOES WORK, it works by encouraging idiots to behave irresponsibly!!! Now that’s a ringing endorsement for “low interest rates encourage investment” argument - I don’t think.

Incidentally, the difficulty central banks have in influencing interest rates for corporate bonds or mortgages, this seems to have been born out in the current recession. According to this Jan 2009 Bloomberg article, rates for mortgages and corporate bonds were NOT following the Fed’s low interest rates downwards. In contrast, by May 2011, the Fed’s low interest rates WERE starting to have an effect.

8. The idea that reduced interest rates encourage investment is rendered irrelevant by the fact that in a recession, more investment is exactly what is NOT needed. In recessions (certainly in SHORT recessions) there is more than the usual amount of capital equipment lying idle! Of course it takes TIME to manufacture or create real investments like machinery or factories, and assuming an economy will return to trend growth shortly after a recession, employers need to make sure they are not SHORT of capital equipment after a recession. But employers do not need governments to tell them this. Nor will irrelevant little inducements like 2% changes in interest rates do much to optimise any given employer’s investment strategy.

9. Radcliffe Report on monetary policy in the U.K. published in 1960 concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’.

10. As to the possibility that credit card spending is influenced by changes in a central bank’s base rate, there seems to be no link between those rates and credit card rates. See here.

11. Now for the possibility of using fiscal policy alone: that is implementing the classic Keynsian “borrow and spend” policy. The problem with this policy is crowding out: that is, fact that when government borrows, that tends to raise interest rates, which has a deflationary effect, which negates the whole object of the exercise: imparting stimulus. THE EXACT EXTENT of this crowding out is disputed, but to the extent that it is a problem, the central bank can easily counteract the undesirable effect by cutting interest rates – which it does by creating money and buying up government debt.

BUT HANG ON……… What’s going on here is that the government / central bank machine is implementing the Abba Lerner “create money and spend it into the economy” policy!!!!!!!

Alternatively, to the extent that “borrow and spend” DOES WORK without a crowding out effect, there is another problem: what in God’s name is the point of government borrowing something (i.e. money) when it can create money in infinite amounts any time it likes and at no cost? You ever heard of anything so daft?

12. A novel argument in favour of using monetary policy alone was produced recently by Nick Rowe. This is that fiscal is already doing a huge amount, in the form of taking thousands of micro economic decisions a day - like deciding where to build bridges, to cite Rowe’s example. Thus, allegedly, we cannot impose more burdens on fiscal.

Well the answer to that argument is that the amount of work currently being done by any system has nothing to do with whether it should be given more work to do, or whether the latter work should be allocated to some other system. For example the fact that the military is already spending billions on warships, aircraft and so on has nothing to do with whether the military or the police should be responsible for dealing a riot or natural disaster. If the military are best at the job, they should do it, and be given the necessary funds. If the police are best at the job, they should do it, and get the relevant funds. Period. Full stop. End of argument.

Moreover, having fiscal influence demand is not difficult (contrary to James Bullard’s claims, (p.1). It is not a “burden” on fiscal. Britain has altered its VAT rate twice during the current recession. I’ve heard nothing about excessive bureaucratic costs involved in doing this.

By the way, Bullard makes just about every mistake it is possible to make in his paper. For example he claims government debt is a burden on future generations (p.17). For a demolition of this idea, see here. Bullard also got a drubbing on Warren Mosler’s site recently.

Incidentally, the Fed does have what might be called a “political excuse” for the low interest rate policy it has adopted over the last few years. This is the refusal by Congress to allow enough stimulus. In contrast, the Bank of England and some other central banks have fewer excuses for implementing interest rate reductions and QE.

13. Keynes said, “I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of interest...it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital...will be too great to be offset by any practicable changes in the rate of interest." Keynes’s General Theory – near the end of Ch 12. (h/t to skeptonomist).

14. It is sometimes argued that monetary policy (interest rate adjustments at any rate) can be made quickly, i.e. fiscal changes take longer to implement.

That point is irrelevant. The IMPORTANT question is TOTAL TIME LAG between the decision to implement a policy and the actual effect. I’ve seen eighteen months cited as the relevant figure for interest rate adjustments, whereas the evidence indicates that a significant proportion of the additional cash that wage earners find in their pay packets as a result of a reduction in employees’ contribution to a payroll tax reduction will be spent IMMEDIATELY. For the evidence, see here, here, here and here.

Also, in that fiscal policy consists of expanding the PUBLIC SECTOR, the effect ought to be pretty well IMMEDIATE. That is, if government decides to hire additional people, the effect comes just as quickly as people can be interviewed, and given the means to get on with whatever job they are doing.

15. Borrowing from abroad.

Borrowing is an alternative to raised taxes, and where government borrows, some of the money is inevitably lent by foreigners. But there is a problem there, which is that money flowing into a country from abroad temporarily boosts living standards in the country. And that standard of living boost will be reversed if and when the money is repaid.

Now those standard of living “gyrations”, have nothing to do with solving the basic problem, namely raising employment. The gyrations are an unnecessary and complicating factor. Plus, the temporary boost to living standards poses big temptations for politicians: it enables them to raise living standards while in office, while the mess is left for their successors to sort out.

16. There is disagreement amongst economists as to how effective monetary and fiscal policies are. That little problem can be solved by doing both policies at once. If one policy I much more effective than another, it doesn’t matter: the COMBINATION is guaranteed to have an effect. 

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P.S. (10th June 2012). Some research done by G. L. S. Shackle concluded that the connection between interest changes and investment was weak. The entrepreneurs questioned said that estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.

(Hat tip to Macroresiliance.)


P.S. (16th July 2012). Reason No.17. The effect of interest rate adjustments is hindered by foreign currency movements. E.g. a rise in interest rates designed to damp down an overheated economy draws foreign capital into the relevant county, which reduces the desired effect. In contrast, a straight cut in government spending (a la MMT) has the opposite effect, if anything, on internationally mobile capital. That is, given a cut in demand in a particular country, capital will tend to leave the country in search of better opportunities elsewhere.

P.S. (24th July, 2012). There is more evidence on the non-relationship between central bank rates and interest rates charged by credit card operators here:

http://www.guardian.co.uk/money/2011/may/05/credit-card-interest-rates-13-year-high


P.S. (15th Sept 2012). Reason No.18. Using interest rates to regulate an economy exacerbates asset price bubbles. Reason is that when the private sector shifts a significant portion of its spending to asset price purchase from other types of spending there is not necessarily any effect on inflation because the increased inflation stemming from the increased price of the relevant asset(s) will tend to be cancelled out by reduced inflation in other areas. Thus the central bank leaves interest rates unchanged, which in turn makes it easier to borrow and speculate in the relevant asset.

In contrast, if government and central bank ignore interest rates and regulate the economy by creating money and spending it into the economy when required (or raising taxes and “unprinting” money when required), then interest rates would rise in response to borrowing funded asset speculation.

Not that that would bring a total end to asset bubbles, but it would certainly help.


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States didn’t actually spend stimulus money.

This is a significant bit of research by John Taylor. He claims that states did not actually spend stimulus money. The incompetence is staggering.

That is an important lesson for the next recession. I.e. it is no use just taking the horse to water: you’ve got to make it drink as well. States need to be specifically told not to sack staff (which is what did in this recession), and if anything, to actually take on additional staff, as well as increasing their spending.

Also Taylor argues in a separate post that other forms of stimulus are ineffective because of consumption smoothing. Or as he puts it, “This is exactly what the permanent income or life cycle theories of Milton Friedman and Franco Modigliani tell us. People largely saved the injection of cash.”

Now there is a problem there. If everyone smooths their consumption to perfection, recessions would be almost unheard of! Households which found themselves underwater would carry on spending as before. And if they did reduce spending a bit, those who lost income as a result of less demand coming from underwater households would not cut their weekly spending either.

Well I don’t buy it. Recessions DO OCCUR.

Plus there are four studies here which DO FIND a relationship (surprise, surprise) between changes in household income and changes in household expenditure. See:

http://onlinelibrary.wiley.com/doi/10.1111/j.1745-6606.1984.tb00322.x/abstract

http://www.nber.org/digest/mar09/w14753.html

http://www.kellogg.northwestern.edu/faculty/parker/htm/research/johnsonparkersouleles2005.pdf

http://finance.wharton.upenn.edu/~rlwctr/papers/0801.pdf


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Look after demand, and funding for businesses looks after itself.

The British establishment continues to hyperventilate about the alleged shortage of bank lending to businesses. E.g. see here, here, here,or here.

Well here is some news for the establishment: the banking industry is heavily subsidised. Thus it needs to contract. So if we want to allocate resources optimally, we need to get used to a smaller bank industry. And that bit of news will have the establishment soiling their pants, given that they are so keen on banks funding small and medium sized businesses.

According to Andrew Haldane of the Bank of England, the too big to fail subsidy is significantly larger than bank profits. See 3rd paragraph under the heading “Implicit subsidies” here:

According to Mervyn King, the bank industry has expanded by a whapping factor of ten relative to GDP over the last fifty years. That is, total bank balance sheets have expanded from 50% of GDP fifty years ago to five times GDP nowadays.

But mysteriously, economic growth fifty years ago was perfectly respectable.

So contrary to the above claims by the establishment, optimum allocation of resources (i.e. maximising economic growth) will come from treating banks like any other business, and boosting demand by enough to bring us back to full employment.

Anyone with a grasp of economics knows what changes will ensue, but I’ll run through them for the benefit of those who are not sure. Also anyone with a grasp of the subject knows how to bring bank subsidies to an end, but I’ll explain how to do it below as well for those who don’t know. In short, those with a grasp of economics can stop reading now – except for a quick point about the title of this post: “Look after demand, and funding for businesses looks after itself”.

That phrase is of course a variation on Keynes’s dictum: “Look after unemployment, and the budget will look after itself”. And the latter two phrases also amount to much the same as Mosler’s law: “There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it.” (See near top of Warren Mosler’s site.)


The changes brought by a smaller bank industry.

Stopping bank subsidies will raise the cost of borrowing. That in turn means businesses will have to put more reliance on other forms of funding: equity, friends and family, retained profits. But the total capital available to businesses will nevertheless decline. That means business will have to go for less capital intensive forms of production. Plus some relatively capital intensive forms of economic activity will become uneconomic, while labour intensive activities will tend to expand.

The change WILL CAUSE a temporary rise in unemployment because a new set of skills will be required, and it takes time to learn new skills. But enduring a period during which unemployment is higher than it otherwise would have been is entirely justified if it leads to a better allocation of resources.


Ending or reducing bank subsidies.

Those who deposit money in banks can currently “have their cake and eat it”. That is, they reap the benefits of having their money used by their bank in a commercial manner, while being insulated (thanks to the taxpayer) from the risks normally associated with commercial activity. This is a farce, and it should be stopped. For more details, see here.

Leftie dimwits claim the U.K. government’s Work Programme involves “unpaid” work.

The Guardian is always a rich source of loony left nonsense in the U.K. And always keen to side with the downtrodden workers in their unequal struggle with wicked exploitative capitalistic employers, numerous Guardian articles have recently claimed that the UK government’s Work Programme involves “unpaid work”. E.g. see here, here and here.

Well, people on this scheme are not “unpaid”: they continue to get benfits.

Of course there is an argument to be had as to what the hourly rate of pay and/or weekly pay should be in schemes of this sort. But to say that the work is “unpaid” is just nonsense.

Moreover, benefits for many people in the UK are often at such a level that there is little difference between what they get living on benefits and doing a minimum wage job. So it can’t even be claimed that the pay on this scheme for some of those involved is much different to what they’d get on minimum wage work.


What about the “unpaid” work done by taxpayers?

A further piont which is a mile above the heads of the aforesaid leftie dimwits is thus. If one person sits around doing nothing while claiming benefits and consuming food, fuel, etc then someone else has to do some work to produce and market said food, fuel and so on.

That is – and this really is the revelation of the century – food, fuel and so on do not float down from heaven or appear from nowhere.

In short, where one person is allowed to live on benefits, someone else has to do “unpaid” work to produce said food, fuel, etc.

But lefties for some reason see fit to foam at the mouth in realtion to the “unpaid” work done by Work Experience people, but seem totally unconcerned about the “unpaid” work done by those funding people living on benefits.


Research . . . evidence?

As for any awareness of the vast amount of research done since WWII into the effect of schemes of this sort, Guardian journalists appear to be blissfully ignorant. But then the job of journalists has always been primarily to sit at their desks and make it up as they go along.

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The Eurozone’s balmy 0.5% deficit limit.

The EZ wants structural deficits to be no more than 0.5%, with a maximum total deficit for any country of 3%. (A “structural deficit” is the deficit that exists when an economy is at capacity.)

There is a simple flaw in the 0.5% deficit limit. You need the maths skills of a five year old to understand it. I’ve set it out several times before on this blog. But I’ll do it again.

The EZ, like most monetarily sovereign countries / areas, targets a rate of inflation of about 2%. (I’ll treat the EZ as a nation by the way.)

That means that the national debt and monetary base of the nation will shrink at 2% a year unless the debt and base are regularly topped up in nominal terms. And that means enough deficit to effect the topping up. So let’s do some back of the envelope calculations so as to see how big the deficit needs to be to effect this topping up.

Say the debt and base are 50% of GDP. Given the 2% rate of inflation, the deficit needs to be 1% of GDP, (50% of 2%). Which is DOUBLE the above 0.5%!!! But it gets worse.

Assuming economic growth of let’s say 2%, yet another 1% worth of deficit is need (50% times 2% again).

So the total structural deficit needs to be 2% of GDP, not 0.5%.

Or have I missed something?

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A little mistake by Brad DeLong which Abba Lerner would not have made.

Brad DeLong argues that excess unemployment leads to a semi-permanent loss of productive potential because employers fail to invest the amount that would be suitable at full employment. Thus, so he argues, having government borrow and spend now is highly beneficial because in addition to the normal and not too spectacular increased GDP that comes from “borrow and spend”, the above loss of productive potential is avoided. And the latter is where the real benefit of borrowing and spending in 2012 comes in.

That is his basic arument and there is nothing wrong with it. But at the end of his article, he makes a slight mistake. He argues that current low interest rates make “borrow and spend” even more worthwhile than normal, because borrowing costs are currently low.

The flaw in that argument is that interest payments are just TRANSFERS, which are not a REAL cost. That cannot be set against or compared to any increased REAL output that comes from borrow and spend.

That is, when government borrows, interest is paid to those who have lent to government. While the people who PAY for this interest are taxpayers. But that is simply a TRANSFER between two groups of people: the net cost to the nation is nothing, or thereabouts.

To illustrate, suppose one had the option of increasing GDP in such a way that the interest so called “cost” actually EXCEEDED the rise in GDP. According to DeLong (as I understand him) that option would not be worthwhile.

I say it WOULD BE worthwhile, because the increase in GDP is a REAL benefit, whereas the interest rate so called “cost” has no effect whatever on total incomes for the population as a whole: to repeat, it simply boosts the income of one lot of people at the expense of another lot.

But . . . going ahead with “borrow and spend” in those circumstances would lead to a rise in governemnt debt, and possibly an exponential rise. Shock horror.

So there must be something wrong with the DeLong model. And what is wrong is that the basic idea of borrowing so as to fund government spending is one big nonsense. As Abba Lerner, said, in a recession, government should simply create new money and spend it into the economy.

Or as I put it two years ago on this blog, “Borrowing is particularly nonsensical given that when a government borrows, it borrows “stuff” (i.e. money) which it can produce an infinite supply of at no cost. Government borrowing money is a bit like a dairy farmer buying milk at the supermarket when there is a thousand gallon tank of milk a few yards from his house.”

If government “prints” instead of borrowing, that disposes of interest payments. Thus the only question for government is: “Will printing and spending (and/or cutting taxes) boost GDP without exacerbating inflation too much?”

As to which DEPARTMENT of government ought to take this stimulus decision, it is technical decision, a mile above the heads of politicians. Thus the decision is best taken by the central bank or some fiscal committee made up of economists (fallible as they are).

In contrast, there is the decision as to whether the stimulus takes the form of extra public spending or tax cuts. That is a POLITICAL decision which ought to be left to politicians and the democratic process.


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The sectoral balance equation again.

That ‘s the equation (I – S) + (G – T) + (X – M) = 0

There has been much discussion about this since my last post on this topic. E.g. here.

I’m sticking to my original point, namely that “I” (investment) should be scrubbed from the equation. But my reasons are now better thought out. They are as follows.

The sectoral balance equation must work as long as it refers simply to movements of cash or the movement of goods and services. But the two cannot be mixed.

Reason is that if goods worth $X move from sector A to sector B, the relevant entities in sector B certainly OUGHT to pay for the goods, but they might not. Moreover, even if they do pay, they might not pay during the time period under consideration.

The equation must work where it refers, for example, just to movements of cash, because a movement of cash from one sector must be matched by a movement of cash into another. (And if you want to do the equation on a goods and services basis, rather than a cash basis, then the same point applies: a movement of goods from one sector must equal a movement into another sector).

So if we go for a cash basis, then the defintions of I,S,G etc must be such that they clearly refer to movements of cash and nothing else.

For example, the definiton of exports (X) in the equation CANNOT BE the conventional one which is something like “value of goods sold to foreigners”. It must be something like “payments by foreigners to domestic entities for ANY reason including payments by foreigners for goods supplied by domestic entities”.


Investment should be scrubbed from the equation.

As for the idea that “investment” ought to be in the equation, I’m sticking to my point that investment should be scrubbed from the equation. Reasons are as follows.

If one private sector entity purchases an investment item from another, cash does not leave the private sector, so that particular “investment” is irrelevant to the equation. In contrast, if a private sector entity purchases an investment item off governemnt (e.g. some land), then cash crosses a sectoral boundary. Thus it must be included in the equation somehow.

One way of doing this is to scrub “investment” from the equation and replace it with something like “ non-tax payments made by private sector entities to governemnt for goods or services supplied by government”.

Alternatively, investment can be scrubbed from the equation, and “tax” could be replaced with “all cash received by government including tax and payments to government not normally classified as tax”.

And the final nail in the “investment coffin” is that it is perfectly possible for a private sector entity to make an investment without purchasing anything from anyone – never mind purchasing stuff from another sector. For example if the value of shares I own rise, that increases my “investments”, but I haven’t purchased anything from anyone to bring that about. Or if I make an improvement to my house which will last say ten years, and using materials I’ve got lying around in my garage, that is an investment which needn’t involve a purchase from anyone during the relevant time period.

Here endeth the lesson. 

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P.S. (3rd March). (X-M) and (G-T) are by their very nature CHANGES to a stock, i.e. a flow. That means that if “I” is scrubbed from the equation (leaving just S), then S must also refer to a “change in a stock” (i.e. a change in the total of private sector cash savings). Thus the equation is arguably best written:
∆S + (G-T) + (X-M) = 0
(h/t to Paulie46)




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