Throughout the history of economic thought, opposing perspectives on interest and money have created fundamental divides between the various schools. In the one camp, interest is regarded as having a real determination, with monetary policy ultimately at the mercy of the markets. In the other camp, the determination of interest is considered to be monetary, and a politically determined variable.
This post is a little broader than normal. It was prompted by a couple of questions that are not really connected, but acted as a catalyst for what follows. I will probably explore individual aspects of the subject matter here in future separate posts.
The first question was one I read recently on a discussion forum. It is a very common question, and the topic of lots of orthodox fiscal analysis:
I don’t say that all public debt is bad. Only public debt that is disproportionately large.
Let me ask you a question. Suppose the public debt is so high that the interest on it is 100% of GDP. Do you recognize that that would be a problem?
MMT suggests that the rate of interest has a monetary determination, and is in fact a policy choice. In view of this, it would make little sense for the central bank to maintain interest-rate targets that caused the government’s interest obligation to be 100% of GDP. Scott Fullwiler provides a comprehensive analysis of the MMT position in this paper.
In fact, MMT economists typically argue for a zero interest-rate policy (e.g. see this post at billy blog).
Ideally, there would be no debt issuance (reserves would just be allowed to mount in the case of deficit spending) and a zero (or near zero – e.g. 0.25%) interest rate paid on reserves. There is little reason to provide a risk-free positive rate of interest. It is basically just corporate welfare.
Even so, let’s briefly reflect on the consequences of a 100% of GDP interest-rate obligation before exploring the MMT position. A key question, in this scenario, would be: what are the recipients of these interest payments going to do with them? If they are going to spend out of them beyond the capacity of the economy to absorb the extra expenditure at current prices, there will be inflation. If, instead, they are simply going to allow the interest payments to add to their existing financial wealth, it will not be inflationary until and unless they do decide to spend them at a rate too rapid to be absorbed by the economy at current prices.
But even if the situation was non-inflationary, this does not mean the policy would be a desirable one. There is still the question of why this risk-free interest income should be handed over to the recipients. Paying out an amount of interest equal to GDP represents a large handout to a section of society for riskless and unproductive activity.
It is clear that even though there is no need to match debt with deficit spending, some financial interests would object to the discontinuance of the practice, and would also oppose a zero interest-rate policy. For one thing, simply allowing deficit expenditure to result in a build up of reserves makes patently clear that the corporate sector is playing absolutely no funding role. And if they are not playing a funding role, it is hard to see why they should be entitled to an interest payment.
In a revealing post, Bill Mitchell recounts how the class-interested politics of this issue played out in Australia in the early 2000s. The government of that country ran budget surpluses ten years out of eleven from 1996-2006. Initially, the government stopped issuing debt. After all, they were in surplus. By conventional wisdom, there was no need to borrow when taxes exceeded spending.
But the reduced supply of government bonds caused consternation in the financial community, which felt it “needed” the risk-free interest rate as a basis for “pricing” riskier financial assets (although zero would surely serve just as well as any other rate as a basis for such “pricing”). The response of the government – ridiculously – was to start issuing debt even though it was running surpluses. It could hardly be made any clearer that public debt issuance is corporate welfare, not financing of deficits.
As for the 100% of GDP interest obligation, strong economic growth causes the budget deficit to shrink endogenously through the automatic stabilizers. Public debt, or the build-up of reserves if debt-issuance is discontinued, will automatically decline as a proportion of GDP. Fullwiler, in the paper linked to above, points out that, under most scenarios, provided the nominal rate of interest is kept below the nominal rate of GDP growth, this will be sufficient to ensure “fiscal sustainability” in the sense the term is used by the orthodoxy (that is, deficit expenditure under these circumstances will not eventually cause runaway inflation).
Consider what happened during and after WWII. The US budget deficit during the war reached twice its current level as a percentage of GDP. This deficit expenditure and debt issuance directly preceded the only sustained period under capitalism of generally strong growth, low unemployment, and fairly stable inflation. In numerous countries, unemployment remained very low in the twenty-five year period after the war alongside modest, stable inflation.
The opponents of deficits and debt in the 1930s and 1940s were just as vehement as now, and the arguments proved to be baseless. But whereas public debt actually had some meaning in the postwar period – unproblematic as it proved to be – it has no real meaning under the current monetary system.
Returning to the MMT perspective on monetary policy, there is little reason to think a zero interest-rate policy would be inflationary if pursued in conjunction with appropriate fiscal policy and financial regulation. Fiscal policy has the advantage of being more readily targeted at the specific sources of inflationary pressures, in contrast to the bluntness of monetary policy. (See Bill Mitchell’s Asset bubbles and the conduct of banks). Those who think low interest rates are inevitably inflationary need to explain the monetary transmissions mechanism they have in mind.
The argument used to be based on the so-called money-multiplier mechanism. It is getting harder to find prominent orthodox monetary policymakers who would defend that position now. I have linked to a BIS paper that discusses these issues from the orthodox perspective numerous times. It has now got to the point where even a couple of Austrians can be found who reject the money-multiplier mechanism. I linked to a couple of examples in a recent post. The reason I linked to them is that the idea an Austrian would ever take such a position seemed remote not so long ago.
Bernanke knows that monetary policy does not work directly from reserves to money (see this post). That is not what he is trying to achieve through QE, for instance. He is hoping for either interest-rate or wealth effects on aggregate demand and an increase in expected inflation (because this would lower the real rate of interest, which the orthodoxy hopes might encourage demand for credit and private investment).
From the perspective of MMT, Bernanke’s hopes are forlorn. Interest rates don’t have strong effects on aggregate demand. More importantly (since it is not even clear that Bernanke is confident on the likelihood of significant interest-rate effects), the attempt to induce wealth effects is ill advised. If this policy succeeded, all it would do is encourage another unsustainable build up in private debt. In the meantime, to the extent the Fed’s policy succeeds in screwing around with market expectations, it is probably exacerbating financial instability, for instance in commodities. Although these effects should be self-corrective once market participants realize an expectational shift has no sound basis, the false perceptions may be temporarily, and needlessly, disruptive.
The appropriate policy approach under current circumstances is to enable the private sector to get its debt under control, not encourage it to go further into debt. This can be done through either orderly debt write downs or deficit expenditure that sustains demand, income, and private saving, enabling the private sector to repair balance sheets.
The Rate of Interest
There is a fundamental difference between the orthodox perspective on interest rates, and the perspective of Marx and Keynes influenced economists. The orthodoxy thinks real interest rates are determined by real factors (summed up as productivity and thrift) and that they are indices of scarcity. The heterodoxy thinks interest rates have a monetary determination and are distributive variables.
MMT obviously belongs in the latter broad-based camp. I like the way Fullwiler sums it up in the paper linked to above:
In short, the orthodox concept of fiscal sustainability is flawed due to its assumption that a key variable—the interest rate paid on the national debt—is set in private financial markets as in the orthodox loanable funds framework. On the contrary, as a modern or sovereign money (Wray, 1998, 2003) system operating under flexible exchange rates, interest rates on the US national debt are a matter of political economy (Fullwiler, 2005, 2006).
The sharp difference in perspective over interest-rate determination is partly what the Cambridge Capital Controversy was about. Once it is acknowledged that capital goods are heterogeneous, interest rates cannot be assumed to play the role traditionally attributed to them by the orthodoxy at the aggregate level, nor have the real determination traditionally conceived in that approach. This is well established, but largely ignored by the orthodoxy (or avoided, by avoiding macro questions).
The capital debates showed that the notion of an aggregate production function was invalid outside a single-commodity world. That meant, in turn, that the supposed downward-sloping aggregate ‘demand for capital’ schedule, based on the ill-defined concept of an aggregate marginal productivity of capital, was also shown to be invalid. This aggregate ‘demand for capital’ function was supposed to form one half of the ‘loanable funds’ market and, in combination with the preferences of savers, determine the real rate of interest.
But on top of the aggregation problems uncovered in the capital debates, there is no such thing as a ‘loanable funds’ or ‘investment-saving’ market in any case. This concept, along with its associated notions (e.g. “crowding out”), is not applicable to the current monetary system. Investment (and government expenditure) are not dependent on the prior existence of some pool of saving (or tax revenue), and in fact this would be operationally impossible in a modern monetary system.
Vertical transactions (those between the consolidated government sector and non-government) determine the level of net financial assets. Horizontal transactions (those within the non-government, such as private bank lending) essentially leverage off the level of net financial assets provided through vertical transactions. (These concepts are explained very clearly in this paper by Warren Mosler and Mathew Forstater.)
Vertically, government spending creates tax revenue. That is, ex nihilo creation of net financial assets through spending makes possible the destruction of net financial assets through taxing.
Horizontally, private loans create deposits. That is, non-government assets create corresponding non-government liabilities.
In the real economy, investment creates saving through income adjustments. More generally, there can be no leakages until there have been injections. Government spending, private investment and export demand create private saving, import spending and tax revenue. There can be no private saving until there is some income to save out of, and there can be no income until production is initiated through investment or government expenditure.
The other question that motivated this post is the following:
MMT is just a fringe theory, and also relatively new. Why should I take it seriously?
The extent to which MMT is fringe and new depends on which aspect is considered.
Understanding of the chartalist nature of money has a long history. Mosler and Forstater (in the paper just linked to) note:
Interestingly, the Chartalist view of a tax driven currency can be found in the writings of Keynes (not to mention Adam Smith!), the Post Keynesians, and the Circulation theorists, yet it is almost always presented as an aside, with the implications remaining unexplored (see Wray, 1998, on Smith, Keynes, and Post Keynesians such as Minsky; for the Circulationists, see Graziani, 1988).
In general equilibrium theory, economists increasingly make use of the notion of a tax basis for the currency (a fundamental chartalist position) because otherwise it is hard for them to work money into their theoretical system in a way that makes any sense; i.e. that can explain a motive for holding money rather than simply engaging in barter. None of the commonly heard post-rationalizations of money can explain this point, but instead fall into an infinite regress, such as if A is willing to hold money because B is, why was B willing to hold money? Why was the first person who held money willing to do so? Once there is a satisfying answer to this question, a lot is learned about what drives a particular monetary system.
Endogenous-money theory has been strongly established in Post Keynesian theory for some time now. Although Post Keynesianism is heterodox, it is a broad grouping that includes the vast majority of heterodox economists. They are significant in number, though obviously not rivaling the orthodoxy. Endogenous-money theory is entirely consistent with MMT. Basically, MMT provides insights into the interactions between the vertical and horizontal components, whereas earlier endogenous-money work in Post Keynesianism focused on the horizontal aspects.
Further, aspects of endogenous-money theory are increasingly finding their way into orthodox monetary economics. It does not seem out of the question that this will increasingly occur in the case of MMT as well, because close analysis of monetary operations and the endogeneity of money leads to these insights.
It may not be apparent to many non-economists how completely confounding the events of the last few years have been for the orthodoxy. On a personal level, the main reason I became aware of MMT was that I was searching for different explanations of the crisis. The orthodoxy, as it existed prior to the crisis, had no answer for how and why the crisis arose, and certainly didn’t see it coming. They had no idea how to respond to the crisis other than revert to what they had rejected as “Keynesian” (i.e. fiscal measures) in the past. They could not conceive, within their theory, that a massive expansion of reserves by the Fed could possibly have no impact on the broader money supply and prices.
In contrast, if it is asked who anticipated the crisis, the answer is either economists who always expect crisis (e.g. Austrians) or economists who had a relevant reason for expecting crisis (debt deflationists understood much of the story, MMT almost the whole story). Wynne Godley and others working within the sectoral-balances approach, including Randall Wray (a leading MMT economist, and Minsky’s most well known student), have a trail of papers dating from the late 1990s pointing out that the fiscal austerity of the period corresponded, as a matter of accounting, to an unsustainable build up of private debt. This point was emphasized, for example, in a paper by Godley and McCarthy in 1998 entitled, ‘Fiscal Policy Will Matter‘, and in another by Godley and Wray in 1999, ‘Can Goldilocks Survive?‘. This argument, though undeniably prescient in retrospect, had no place at all in orthodox theory of the time.
Now, in contrast, things have shifted quite a lot in the orthodoxy. Although there are extremists (e.g. the Chicago School) who simply ignore reality and persist with their fantasies no matter what, this is not how the moderate majority of the theoretical orthodoxy operates. Their modus operandi, when they see valid ideas from outside the mainstream that help reconcile empirical contradictions of their own theory, is to find ways to work them in to the mainstream theory without doing so to such an extent that it dismantles their entire theoretical superstructure. They did this with Keynes, and bastardized his theory in the process. What many people know as Keynesian economics is not Keynesian economics at all, but the neoclassical synthesis.
Currently, some in the orthodoxy are doing the same with endogenous money (e.g. rejecting the money multiplier) and Minsky. There has been a significant increase in orthodox interest in Minsky, which would have been unthinkable until recently. Even a Nobel Prize recipient has turned his hand to a model that in some sense tries to incorporate insights of Minsky.
So, yes, MMT can be regarded as fringe and relatively new in some respects, but it has emerged out of long theoretical traditions (e.g. chartalism, the principle of effective demand, functional finance) or well established monetary theory (e.g. money endogeneity) in response to the changed institutional realities of the post-Bretton Woods era, and I think there are already signs that the newer aspects are becoming less fringe, and it seems likely the trend will continue.