Infrequently Asked Questions 2

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.
 

Question 1

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.
 

Question 2

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.

Interestingly, a small number of Austrians, such as Vijay Boyapati and Mike Shedlock, have also recently criticized the money-multiplier theory.

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.
 

Question 3

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.
 

Addendum

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.

16 thoughts on “Infrequently Asked Questions 2

  1. “If net saving is considered excessive, policy can be used to alter non-government behavior.”

    What is the criteria that is used to recognize an excessive saving?
    In other words what would transform normal saving into excessive one?
    I haven’t thought about it before.

  2. Peter –

    Definitely a fan of the blog as I follow billy blog daily as well. I am wondering if you have any insights into the hysteria in the media and neo-liberals about rising food prices vis-a-vis government fiscal and monetary efforts to support their respective depressed economies. Would you recommend concerted effort on the government’s part to support increased production of food through investment and incentives? Just interested in your take on how the government should respond to a rising imported price level. Not sure if my question is clear, let me know.

    Thanks!

  3. Very nicely done! You clearly understand MMT. It’s nice to be able to say that to someone when so often I have to say the opposite in response to comments/posts.

    One correction on question #1, though your response was quite good. The question reads “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.” In fact, in MMT, deficits are inflationary if it exceeds non-govt desired net saving at full capacity for the economy. That is, the amount the non-govt sector desires to net save at full capacity for the economy is what should be “supplied” by the govt sector. That amount will be a moving target over time.

  4. Scott: Nice catch and thanks for the very clear explanation. I’ve probably used that same inaccurate wording previously, too. I’d better watch myself!

    rvm: What I had in mind is that sometimes there might be a political view that net saving desires are excessive and a decision to alter that net saving behavior. For example, saving desires tend to be very high in Japan relative to the West. That is partly a function of government policy (no Western-style safety net, etc.). Introducing a universal pension would probably alter the net saving desire. It’s a political choice.

    Rob: Hi! Thanks for joining the conversation. I recognize your handle from billy blog. Your question is a good one. It deserves a full post to address it, and I need some time to think about it. Hopefully I can do that not too far down the track. Cheers.

  5. Dear Peter,

    Infrequently Asked Question: Can an economy with constant NFA (Net Financial Assets) grow — supported only by growth in endogenous money?

    Imagine an economy in which Net Financial Assets (for currency users) do not increase.

    (This would be the case if a currency issuing government always runs a balanced budget. It is also the case for the Eurozone as far as I can tell, as their currency issuer has no fiscal branch. There is only the ECB, which is not allowed to perform fiscal policy. It’s effectively like a gold standard system, but with a gold stock that does not increase. A peculiar design indeed.)

    Can the economy grow in the long run, in spite of this?

    One “solution” would be constantly decreasing prices and wages. (But no. Deflation is too messy for various reasons. Keynes, blah blah. You can’t rely on that growth will happen under deflationary pressure. Right?)

    Another “solution” would be if endogenous money could constantly increase (to compensate for the non-increasing NFA). Loans create deposits. Can this work? Can endogenous money grow sustainably forever and thereby support a growing economy? Probably not. But why not?

    Can you construct a reasonably simple toy economy example that illustrates that it won’t work? My attempt follows.

    Imagine a growing economy. Ever more stuff is produced. For simplicity assume zero inflation; nominal prices, wages and incomes don’t change. Assume NFA are constant. Instead, some agents in the economy take on ever increasing debt. That can support growth for a while, as it compensates for the non-growing NFA. But what happens? Tthe agents taking on ever more debt can not go on forever. After a while, debt-to-income-ratios reaches critically high levels. Agents will have trouble servicing the debt out of their income (which would be nominally non-increasing in this example).

    I’d like to write something on the MMTWiki on this point. Any thoughts appreciated!

  6. Hi Hugo. A few thoughts.

    Yes, endogenous credit creation in such a scenario could enable growth. This would be dependent on the level of non-government autonomous demand (private investment, autonomous consumption, export demand). For the growth to be sustained, the autonomous demand would need to grow more or less continuously, which could only be sustained if the incidence of non-government debt stress remained manageable.

    In a small open economy with a large external surplus, domestic private sector net saving would be positive alongside the ongoing budget deficits. This would improve the prospects for sustainable growth.

    Except in this latter case, I don’t think sustainable growth is likely. More probable is either that: (i) non-government attempts to net save are thwarted by the government’s determination to balance the budget, causing stagnation; or (ii) autonomous demand is sustained via private credit but ultimately proves unsustainable with a rising incidence of debt stress.

    I have taken your assumption that the budget is balanced for the sake of the exercise. In reality, the budget can’t be balanced continuously because of the automatic stabilizers. Starting from a balanced budget, if credit expansion facilitated growth in income, tax revenues would rise, pushing the budget into surplus. The corresponding non-government deficit would put further strain on the growth process. Conversely, reductions in autonomous demand would push the budget into deficit and the non-government into surplus, somewhat attenuating the effects of the downturn.

  7. Neil and Peter,

    Thank you both!

    Peter, you wrote: I have taken your assumption that the budget is balanced for the sake of the exercise. In reality, the budget can’t be balanced continuously because of the automatic stabilizers.

    Well, I don’t know about that. Surely, a government could — theoretically at least — manage to balance its budget?

    Also, I would argue that in the Eurozone, the “overall budget is always balaned”. New Net Financial Assets (for “currency users”) can not be created (unless a new Eurozone member is added, I assume). NFA is fixed! It’s like they have a gold standard system, but where the gold stock is fixed. There is not “vertical” money creation.

    Of course, that all depends on perspective. Whose NFA are we talking about? Who is the “currency issuer” and who are “currency users”? So, let me elaborate. As MMTers go on and on about, the Eurozone governments are not sovereign monopoly issuers of its own currency. As opposed to U.K, Australia or Sweden, they are currency users rather than issuers. They are revenue constrained. They can not sustainably take on ever more liabilities.

    Hence, the Eurozone governments do not create vertical money. So, is there a currency issuer? Well, that would be the ECB. But ECB is also considered to be revenue constrained ultimately. If it takes on too much liabilities, it will eventually become “insolvent” and have to be recapitalized using capital from the governments. (Or so I’ve read — maybe it’s a matter of opinion). In any case, the ECB is not “allowed” to perform fiscal policy. Anything that smells “money printing” is fiscal policy and thereby “forbidden” or at least highly controversial.

    In sum: There is nobody in the Eurozone that issues “vertical” money. NFA is constant. The EZ governments are like Australian states — but under an Australian government always running a balanced budget.

  8. My intuition is that the Eurosystem was doomed to fail for this reason. But it’s only intuition, and I’d like to get a more thorough understanding.

    The question is: Can an economy grow forever without increasing NFA?

    There would be a few candidate “solutions”:

    (1) Horizontal money growth
    (2) Constantly decreasing wages and prices
    (3) Growing exports (with inflowing foreign currency then)
    (4) — something I haven’t thought about? —

    I think (2) can be dismissed. Deflation is too messy. Sticky prices, deflationary traps, capital debates etc. You can’t design a monetary system relying on deflation for real growth to occur.

    Similarly, I don’t see the point with (3) export based growth. What would be the point in sending real goods to abroad an accumulating foreign currency? Living standards for the population will not increase. True, increasing exports would formally constitute GDP growth, but I’ll dismiss this “solution” as pointless. You just can’t design a monetary system relying on increasing exports for GDP growth to occur.

    But (1) “horizontal” money remains. Maybe that will work for the Eurozone.

  9. Peter, you wrote

    … I don’t think sustainable growth is likely. More probable is either that: (i) non-government attempts to net save are thwarted by the government’s determination to balance the budget, causing stagnation; or (ii) autonomous demand is sustained via private credit but ultimately proves unsustainable with a rising incidence of debt stress.

    (My emphasis). I tried to outline a case in which rising incidence of debt stress would occur (near the end of comment above, 13 November 2011 at 8:11 PM) but I’m not sure it holds water..? Probably not.

    Neil points to Keen who argues differently. Will have to look at it soon!

    Maybe I need some additional assumptions of the dynamics of the economy (such as net saving desires?) in order to show why horizontal money growth alone won’t work. (You will notice I’m taking the neoclassical approach to economic science here, having decided a priori what the final results should be 🙂 )

  10. Hugo, It’s not clear to me that Neil and myself are in disagreement. We both indicated growth could occur with zero net financial assets. I then went on to indicate I didn’t consider the process likely to involve strong, stable growth. I should probably have been clearer that, even then, I am not questioning whether growth on average would occur, but simply suggesting it would be highly unstable, with depressions and booms, etc.

    I think it is important not to equate horizontal money with endogenous money and vertical money with exogenous money. Both horizontal and vertical money are endogenous. So I took your question to be whether sustainable growth is achievable without budget deficits on average. Anything is possible. For example, the non-government might decide to consume mainly out of current income, invest mainly out of retained earnings, and resort to private debt only modestly as a proportion of income. I don’t consider it likely, though, but it is a possibility perhaps if regulatory policies or tax policies encouraged such behavior.

    The track record of capitalism suggests stable growth is unlikely alongside ongoing zero net saving of the non-government. Even alongside positive net saving, capitalism’s track record is not good apart from a relatively short postwar period in which accumulated non-government net savings were considerable.

  11. Peter,

    >“I think it is important not to equate horizontal money with endogenous money and vertical money with exogenous money. Both horizontal and vertical money are endogenous. So I took your question to be whether sustainable growth is achievable without budget deficits on average.”

    Ok, thanks, I saw your recent post on that. I think I understand. In this particular case I guess I’m pretty much thinking “there is no sovereign monopoly currency issuing government” here. There are no fiscal deficits — because there is no fiscal branch of the currency issuer. No vertical injections — NFA is constant. Everything is horizontal — and endogenous. This seems to be the case in the Eurozone, which is why I find it very relevant.

    > “Hugo, It’s not clear to me that Neil and myself are in disagreement. We both indicated growth could occur with zero net financial assets.

    Ok, yes. I guess I’d need some kind of model (visual or verbal) helping me understand/grasp this. Will look into Keen, as Neil suggests!

    > “… I then went on to indicate I didn’t consider the process likely to involve strong, stable growth. I should probably have been clearer that, even then, I am not questioning whether growth on average would occur, but simply suggesting it would be highly unstable, with depressions and booms, etc.” …. “The track record of capitalism suggests stable growth is unlikely alongside ongoing zero net saving of the non-government. Even alongside positive net saving, capitalism’s track record is not good apart from a relatively short postwar period in which accumulated non-government net savings were considerable.”

    Right, agree about the track record. For instance, there are numerous example of agents taking on unsustainable debt (to compensate for non-increasing NFA!?). One can look at Greece and Italy today, and perhaps American households during recent years.

    But I need a way to better grasp, understand and explain how perpetual zero-NFA growth happens. A model economy with some stocks and some flows etc. A model that also makes plausible that zero-NFA growth is likely to be fragile and weak..

    For example — will debt-to-income ratios for borrowers increase? (That sounds fragile and unsustainable! Maybe they will not necessarily increase? Under what circumstances will they remain constant? Maybe they are likely to increase? But for what reasons then?)

    I realize this is vague (my feeling is that I’m being vague). I feel I have a much clearer understanding of (for example) why wage cuts will not clear the labor market (Keynesian view). In this case here however, I don’t really understand what I’m talking about.

  12. You have to remember that Steve Keen’s model of the private circuit is highly constrained. Its value is that it shows that *in ideal circumstances* the private circuit can generate profits, pay the bank and the workers and generate production – which is something that had previously being thought completely impossible.

    The real world it is not.

  13. Ah, yes. The debt virus debate.

    Nevertheless, will read a few of Keen’s papers and watch the YouTube lectures. (And read the book eventually.)

    > “The real world it is not.”

    Right. And I’d like to be able to give an explanation of why MMTers suggest that private debt expansion is not a reliable strategy for growth (under zero-NFA-conditions).

    A model perhaps akin to the Keynesian explanation of why cutting wages is not a reliable strategy for eliminating unemployment. (“Not only are wages ‘sticky’ (for reasons blah blah), but decreasing wages for workers means decreasing spending out of wages which reduces aggregate demand … spending propensities … deflationary traps … blah blah blah”)

Leave a Reply

Your email address will not be published. Required fields are marked *