While casting a wary eye over the list of “Categories” here at heteconomist – a wary eye because a blogger, especially an undisciplined one, never knows what nonsense might be uncovered from the past – I couldn’t help noticing that some categories only contained a single entry. While this might be acceptable for category “Welcome” – one welcome is arguably enough – it seems less satisfactory in other cases. Most glaring seemed to be category “Q&A”. Its lone entry had a heading with a “1” appended to it, as if there would sooner or later follow an entry with a “2” heading, then perhaps even a “3” heading, though let’s not get carried away, making promises that might be difficult to keep. Surely it is time for post “2” in this “Q&A” series.
That seemed simple enough, but a further difficulty arose in that the heading of post “1” in “Q&A” strongly suggested that the words “Infrequently Asked Questions” should precede the “2” in the heading of this post. The problem is, apart from casinos online, ubiquitous bot and penis enlargement, whose questions I dealt with at far greater length than necessary in a previous post, readers have asked very few questions. Even ubiquitous penis left a comment without including a question. One commentator, brinn, did ask whether I was known as Anarcho in another forum, which I found intriguing, but unfortunately the answer (“No”) was less fascinating than the question, and seemed too brief to stretch out for an entire post, so I answered it straight away in the comments section.
The bottom line is that although I am willing to answer any and all infrequently asked questions here at heteconomist, there were only three at time of writing.
You wrote that the Austrians think deficit expenditure is always inflationary, yet in MMT it is only inflationary if it exceeds desired non-government net saving. Make up your mind. What gives?
Actually, in MMT, deficit expenditure is only inflationary if it exceeds desired non-government net saving at full-capacity output (please see Scott Fullwiler’s comment below). If the imaginary person who asked this question had known more about the topic than I did, this made-up question would not be worded so poorly.
In any case, the Austrians disagree with MMT, even when the MMT position is accurately stated. There are at least two sources of disagreement on this point. First, the Austrians have a different definition of inflation than other economists. For Austrians, inflation is defined as expansion of the broader money supply (currency plus private demand deposits). For other economists, inflation refers to a continuous increase in the general price level (average price of all final goods and services).
This accounts for some of the difference in perspective. For example, if the economy were operating below full employment, an expansion in the money supply could enable an increase in output with no overall effect on prices. To the Austrians, this would represent inflation because the money supply has expanded. For other economists, this would not represent inflation because the general price level has not increased.
Second, the Austrians tend to view private markets as the only valid arbiter of value. Although deficit expenditure can add to output, as measured by GDP, and not just the money supply whenever there is unemployment and excess capacity, the Austrians argue that the extra real output is not of the same value (per dollar) as output produced under private market conditions. In their view, deficit expenditure involves putting resources to less efficient uses than would occur under private market conditions. Since the market deems these resources unemployable in the absence of deficit expenditure, the Austrians take this as evidence that there is currently no efficient use for the resources.
The Austrians are alone in their assessment that private markets are always a valid arbiter of value. It is not just Keynes influenced economists (including MMT proponents) who disagree with the Austrians on this point. The neoclassical orthodoxy also considers markets to be inefficient when it comes to what they theorize as externalities, public goods and market failures. I have discussed this point previously, here and here.
Currently the government matches deficit expenditure with public debt dollar for dollar. What would happen if the government stopped doing that and just net spent without issuing debt? Do other economists agree with MMT on this point?
When the government net spends and matches the deficit with borrowing, there is an increase in net financial assets equal to the deficit but no overall change in high-powered money. The net expenditure, considered in isolation, results in a net injection of high-powered money (reserves) as well as a corresponding net increase in private bank deposits. The subsequent debt issuance, considered in turn, swaps reserves (and bank deposits) for bonds. Overall, there is an increase in net financial assets held in the form of bonds.
If, in instead, the government net spent and simply let the excess reserves build up, there would be an increase in net financial assets equal to the deficit and a change in high-powered money. The net expenditure would result in a net injection of high-powered money (reserves) and a corresponding increase in private bank deposits, and that would be the end of it. There would be an increase in net financial assets held in the form of reserves (and bank deposits).
Clearly, the only difference between the two procedures is that the additional net financial assets created through deficit expenditure are held as bonds under the current practice whereas they would be held as reserves under the alternative procedure.
Now, the traditional orthodox view and the position of most Austrians is that an expansion of reserves is more inflationary than an increase in bonds due to the so-called money multiplier. The initial increase in reserves, in this traditional view, increases the capacity of private banks to lend, which they are assumed to do by lending out a fraction of the extra reserves. These loans return as further deposits, and a fraction gets lent out again, and so on. The end result is meant to be a multiplied increase in the broader money supply.
In contrast, government borrowing, by neutralizing the effects of deficit expenditure on reserves, is supposedly less inflationary, because the multiplier effects on the broader money supply are then regarded as absent.
MMT rejects the money multiplier theory. Increased reserves do not encourage private bank lending any more than increased bonds. They don’t increase the capacity of banks to lend, and the reserves themselves can only be lent out to other banks to facilitate settlement.
Bank lending is demand, risk and capital constrained, not reserve constrained. To the extent private banks are encouraged to lend, it will be due to the impact of the deficit expenditure on demand and economic activity. Increased activity strengthens demand for loans from credit-worthy borrowers.
This is why, for instance, QE has virtually no impact on private bank lending. There is no money multiplier causing reserves to multiply into broader money. Increasingly, orthodox policymakers are recognizing this, too. Bernanke has stated explicitly that QE does not increase money in circulation (it just increases reserves). The only way QE can affect private bank lending is through interest-rate or wealth effects. This is what the Fed has in mind in implementing QE.
Once the absence of a money-multiplier mechanism is understood, it becomes obvious that excess reserves do not have an impact on the economy that is any different to an increase in bonds. Reserves and bonds both represent a financial asset of the non-government and a liability of the government. Further, as net financial assets, they both represent the same latent spending power. If a budget deficit poses no inflationary risk when matched with public debt, it would pose no inflationary risk under the alternative practice of simply net spending and allowing reserves to mount.
According to MMT, is there a correct size for the budget deficit?
There is no correct size of the deficit independent of the economic situation and the behavior of the non-government sector. Fiscal policy should be assessed by its effects on the economy, not by the size of the deficit or surplus in itself. It is a matter of functional finance.
More specifically, the budget deficit should be sized to match non-government net saving desires (at full-capacity output – again, see Scott’s comment). A deficit smaller than this creates unemployment. A deficit larger than this causes inflation. It is clear when the budget deficit is too small. The evidence is unemployment and excess capacity.
Since unemployment is the result of a budget deficit that is too small to enable non-government net saving intentions alongside full-employment output, there would appear to be two possible policy responses, depending on whether non-government net saving is considered excessive or appropriate.
If net saving is considered excessive, policy can be used to alter non-government behavior. One example would be to redistribute income from rich to poor through taxes and transfers to increase the propensity to spend of the non-government sector. Another example might be to discourage saving through tax policy. The effect of a reduction in net saving desires is a dollar-for-dollar decrease in the budget deficit necessary to sustain full-capacity output.
If, instead, non-government saving behavior is considered appropriate, then a larger budget deficit is required to enable full employment alongside current saving behavior. Increasing the deficit in line with desired net saving is not inflationary because the injection of net financial assets matches the amount demanded as a form of saving rather than spending power.
Regardless of the policy approach used to deliver full employment, the MMT position follows from an understanding that there is no automatic tendency to full employment. It is a fallacy of composition to think that wages, prices, and interest rates (the price mechanism, for short) can be relied upon to adjust in such a way as to induce full-employment output.
The MMT way of expressing this is that unemployment is due to a demand deficiency which, in the absence of government intervention, will only be eliminated if the non-government, for whatever reason, decides to reduce its net saving. Since the price mechanism cannot be relied upon to induce this reduction in net saving, it is necessary either for the government to alter non-government net saving behavior through deliberate policy or enable the desired non-government net saving alongside full employment through an increase in deficit expenditure.
The lack of an automatic tendency to full employment holds implications for the Austrian position on value; specifically, the Austrian notion that government deficit expenditure induces output of little or no value.
From an MMT perspective, it is incorrect for the Austrians to maintain that the market has deemed any additional economic activity to be unproductive, because the level of output currently produced is not determined by the market but by the amount of net financial assets the government has net spent into existence in conjunction with the non-government net saving desire.
It is incorrect to claim that the market would ensure net saving was lower if it were possible to produce more value because: (i) the price mechanism cannot be relied upon to ensure this expansion of demand and output; and (ii) there is nothing sacrosanct about the status quo distribution of income which results in this level of non-government net saving.