There is much criticism leveled at MMT that it is a 'Free Lunch' theory or that it's main purpose is to preserve the status quo by not allowing deflation and the liquidation of malinvestment to occur. I agree those are legitimate concerns. Because frankly how recent administrations (both Republican and Democratic) have implemented fiscal policy (and have allowed those in control of monetary policy to run amok) would lead one to believe that governments will implement policies in the worst possible fashion.
I will discuss monetary systems and political decisions within the framework of those systems a little later in the post.
But I wanted to tackle some MMT framework up front (because there continue to be basic misunderstandings on how our monetary system actually works) to set the stage for the real constraints in our current system and how policies move against those constraints. And then to explain some opinions on how policies could be implemented to promote stability (smooth out fluctuations in the business cycle), curb malinvestment, and promote long term economic growth.
1. MMT Framework, and What are Federal Government Deficits?
What follows here is not a comprehensive description of the MMT framework (it couldn't possibly be). For a very good (if not the best) place to start: See this post
We must start with a model of the macroeconomy of a sovereign currency issuer of a fiat currency floating exchange rate monetary system. Examples of which are: the United States, Australia, Japan, Canada, Great Britain, etc. The EMU countries [Germany, Greece, Spain, Italy, etc.] do *NOT* fall into this category. The EMU is a fundamentally different system. This model is derived by looking at GDP from both the sources and uses perspective into order to come up with a 'sectoral balances' model.
-- Macroeconomic Sectoral Balance Model
The key concept in this section will be the derivation of the Macroeconomic Sectoral Balance Equation
First, we define GDP from the perspective of 'sources'
GDP = C + I + G + (X-M)
C = Private consumption
I = Private investment
G = Government Spending
(X-M) = Net exports - Net Imports
Next we define GDP from the perspective of 'uses'
GDP = C + S + T
C = Private consumption
S = Private savings
T = Government Taxes
Equate the two
C + I + G + (X-M) = GDP = C + S + T
=> C + I + G + (X-M) = C + S + T (Cancel C, on both sides)
=> I + G + (X-M) = S + T
Now rearrange into a more useful form:
(G-T) = (S-I) - (X-M)
This is the macroeconomic sectoral balance equation. What this says is Net government spending (G-T, which is spending minus taxation) equals Net private savings (S-I, which is savings minus money spent on investment) minus net exports (X-M, exports minus imports, or the current account).
When the government spends money, it has to go somewhere. It either goes into the private sector and is either saved, invested, or spent, or it goes to the foreign sector. Some portion of that money comes back to the government in the form of taxes.
If we run a few scenarios just to see how the sectors interrelate:
If X-M is positive (more exports than imports) and S-I is negative (the private sector is investing more than it is saving) then the government is in surplus (G-T is less than zero, which means it taxes more than it spends).
If X-M is negative (more imports than exports) and S-I is positive (the private sector is saving more than it is spending) then the government is in deficit (G-T is greater than zero, which means it spends more than it taxes).
-- Macroeconomic stocks and flows
A 'flow' is an economic quantity (in this post it is assumed that the quantity is in terms of US Dollars) measured over a unit of time. For example GDP is a flow (the net economic activity generated in a quarter or a year). The US Budget deficit is a flow (how much the Federal Government spends more than it taxes over a year).
A 'stock' is an economic quantity (again in terms of Dollars). The US National Debt is a stock.
'Flows' accumulate to 'Stocks'. At the end of a measurement period, the US Budget Deficit accumulates to the National Debt.
You cannot compare stocks and flows in any meaningful way. You compare stocks against stocks, you compare flows against flows. These both give ratios. But comparing stocks and flows gives you a number in units of time. For example: The US National Debt (say $50 Trillion) / The US GDP (say $10 Trillion/yr) gives you a result of 5 years. This is not a meaningful metric, because it has no context.
-- How does money get into our financial system?
The key concepts in this section will be 'horizontal' vs. 'vertical' money creation and currency 'issuer' vs. currency 'users'. See here for more detail
Let's start with a simple case. The Government runs a balanced budget (G-T) = 0 and the Current Account is balanced (X-M) = 0.
Since (G-T) = (S-I) - (X-M), and substituting in the above values:
0 = (S-I) - 0 => (S-I) = 0
Which means that the private domestic sector is in balance (S-I) = 0, or S = I. The definition of *net* saving for any person or company is to consume and invest less than your income. And when you aggregate all of these individual savings states over the entire private domestic sector you get the *net* savings state of the sector. And in this case there is no net savings. With a Government balanced budget and a Balanced current account it cannot be any other way. There are individuals that are saving *more* than they invest and consume and there are individuals that are saving *less* than they invest and consume, but on net these states balance each other such that there is no *net* saving. Remember from the above equations, consumption is both a use and a source (spending = income) so the actual state of consumption does not affect the *net* savings position (which is dependent on both savings and investment). So how does money move into and through this system?
-- Enter Horizontal money creation.
In this example the Federal Government balance is zero (G-T) = 0. This could mean that the Government spends $1 Trillion and taxes $1 Trillion, or spends $0 and taxes $0. Let's just say it spends $0 and taxes $0 for now to illustrate the horizontal money creation process (we will fix this contrived setup in the next example).
Individuals could trade their 'stock' (see above) of previously accumulated money between each other. But that doesn't answer any questions like: how did they get that money to begin with? I will be tackling this next. But there are entities that can generate new money: banks.
A bank makes a loan (creates money out of thin air) to any credit worthy customer. However, the bank cannot simply give the money away, it must record that transaction as a liability on its own balance sheet. Which means that the bank did not increase the *net* amount of money in the financial system. It created an asset (money out of thin air) but also created a liability of equal magnitude (that loan/money must be paid back). The fact that this transaction did not generate any *net* financial assets is why it is called a 'horizontal' transaction.
What is true for an individual bank is also true for the entire banking system. The banking system cannot by itself create *net* financial assets. All money loaned into existence must be paid back (or defaulted on).
As a real world example of this situation, consider the lending boom from 2002-2007. Absolutely mammoth amounts of money was loaned into existence by the banking system. But any credit boom necessarily has a credit bust, because the dynamics are unstable. If a person's income does not grow sufficiently to service their interest payments they become insolvent. A bank system has no incentive to lend to an insolvent party. So that individual must cut consumption to service the debt. This is true for individuals and is also true for the aggregated banking system and private domestic sector. As individuals cut consumption (and spending = income) to service debt payments, by definition any transactions subsequent to that decision have less income. Less income means a greater debt servicing ratio => less income for the next part => greater debt servicing ratio for the next party, etc. The next party might be a company and seeing a loss in income will start to run down their inventories and lay people off. Forced unemployment further compounds this dynamic. These are the mechanics of how a credit contraction manifests at both the micro and macro levels. This is what we see in 2008-present.
Horizontal transactions can lead to credit booms and credit contractions/busts. But Horizontal transactions can *never* lead to the accumulation of *net* financial assets. So what can lead to the accumulation of net financial assets?
-- Enter Vertical money creation.
So let's add some more complexity to our simple scenario. The Government runs a deficit (G-T) > 0 and the Current Account is balanced (X-M) = 0.
Since (G-T) = (S-I) - (X-M), and substituting in the above values:
(G-T) = (S-I) - 0 => (S-I) = (G-T)
Which means that the private domestic sector net savings position (saving more than it invests) is *exactly equal to* the government net deficit spending position (spending more than it taxes).
If you haven't seen that before, let that sink in for a minute.
From the first example, we showed that the banking system by itself cannot generate net financial assets. Which means that the answer to the question "how did they get that money to begin with?" has two answers: 1) *NOT* from the banking system, 2) From previous Government deficit spending.
The reason why we have net savings (accumulated net financial assets) is because the Federal government spent those net financial assets into existence.
This is precisely what the national 'debt' is. It is the accumulated net financial assets of the non-Government sector (the private domestic sector and the foreign sector) based on the accumulated deficit spending position of the US Federal Government. To the penny.
But how does Government spending manifest? If the private domestic sector and banking system *cannot* generate net financial assets by themselves, and the Government spends by issuing debt (so we are told), but government spending is also responsible for providing the non-government sector with net financial assets to begin with, how could they have the money to buy the 'debt'? How can government spending be 'debt'?
The Government spends by crediting private sector bank accounts that exist at the Federal Reserve. This credit has no corresponding liability. This is why this spending is called 'vertical'. A 'horizontal' transaction (bank lending) is termed that way because it generates and asset *and* a liability. A 'vertical' transaction generates only an asset.
This is precisely how 'net' financial assets can manifest in the financial system and can be accumulated. By the Government creating net financial assets via deficit spending. Federal Government taxation does the opposite, it destroys net financial assets. For a more detailed description, refer here (Read the whole thing, but especially the section 'Mechanics of Federal Spending')
But if the Government credits private sector bank accounts, where does it 'get' the money to begin with? It creates it out of thin air. Just as a bank creates money out of thin air when it loans money into existence (with a corresponding liability), the Government creates money out of thin air when it spends money into existence (with *no* corresponding liability).
It is now self-evident that the Government does not need to be 'funded' in order to spend. The government does not need 'income'. It can credit private sector bank accounts (move numbers in a spreadsheet) at any time and does so each and every day when it spends on DoD projects, Social Security payments, Government payroll, etc. It doesn't wait for taxes to be paid to provide it with 'funds'.
-- Enter the currency issuer.
When we pay our taxes every April 15th, the spreadsheets that say how many 'dollars' you have are debited from your bank and added back to the Treasury's Tax and Loan accounts at the Fed. So what happens then, does the Treasury say 'Now we have more money and we can now spend it'. No. They can always spend at any time regardless of tax inflows. Paying your taxes does not mean the government saves them and can spend them later. It is the currency issuer, it can *always* spend any time it wants by crediting private sector bank accounts.
Let's make this clearer. Now lets say instead of paying your electronically you actually go to your bank make a withdrawal in the amount of taxes you owe, go down to your IRS office and pay your taxes in cash. Does the Treasury 'save' those dollars? Nope. Most likely it records the transaction and shreds the paper money. If they are in good condition, they might put them back into circulation.
The point being that concept of a sovereign currency issuer 'saving' in the fiat currency that they have monopoly control of and create on demand at any time is a meaningless concept. It is like saying an alchemist can 'save' gold, even though they can create as much gold as they need at any time. An alchemist saving gold does neither inhibit nor help the alchemist from creating gold at any time. It is an inapplicable concept.
This means that US Government Bond issuance does not 'fund' US Government spending. US Government Tax collection does not 'fund' US Government spending.
-- Enter the currency user.
The Federal Government spends money into existence by crediting private sector bank accounts. It can never 'not' have money. It is an inapplicable concept. It follows that the Government can never become 'insolvent'. It never has to 'finance' its spending. It can always 'afford' to create money (out of thin air) to honor any US Dollar denomination obligation. Always.
The non-Government sector (private domestic and foreign sectors) cannot. They are currency users of the US Dollar. Citizens, Corporations, US States, and Foreign Countries are all currency users of the US Dollar. They do have to finance their spending. In order for any of those entities to be able to accumulate net financial assets the Federal Government must first spend them into existence.
This is the paradigm between currency issuers and currency users. Currency users are dependent on the currency issuer to spend financial assets into existence. By imposition of a tax that is payable *only* in the financial assets that the Government provides (in this case US Dollars), a demand for the currency is created. Fiat currency is not a real resource. It is one thing only: a tax credit. (A 'tax credit' and 'debt' are *not* synonymous). It is not valuable in and of itself. It is a unit of account that is utilized to facilitate trade and commerce. That is what makes it 'useful'.
-- Is calling government spending 'debt' accurate?
No. Debt allows a party to spend more that their income temporarily by assuming a liability to be repaid. The Federal Government can spend (crediting private sector bank accounts) at any time independent of tax 'revenues' and bond 'proceeds' (both of which are erroneous descriptions). There is no operational constraint that prevents it from doing so. (There is a self-imposed constraint, i.e. the debt ceiling, but that does nothing to alter the underlying mechanics of Government spending). As such the concept of 'income' for a sovereign currency issuer is meaningless. There is no operational constraint preventing the Federal Government from honoring any US Dollar denominated obligation, such as interest payments on US Treasury bonds.
US Government spending and Treasury issuance is clearly not 'debt'. It is nothing more than the accumulated net financial assets of the non-Government sector. The interest payments on which the US Government never has any operational constraint from honoring. It is not a 'burden'. It is not a 'problem that will be handed to our grandchildren'. It is nothing of the sort. They are accumulated net savings. Nothing more fancy than that.
-- Why does the US Government Issue Bonds? History of Bond Issuance, Self-Imposed Debt Ceiling Constraints, Reserves, OMO, and QE
As was detailed above, US Government bonds 'fund' absolutely nothing. They are not a 'burden' to anybody, and are nothing more than the accumulated net savings of the Non-Government sector. So then, what to bonds 'do'?
They allow the Federal Reserve to maintain its target short term rate. Deposits within the banking system create reserves. A bank manager has a few options with what to do with those reserves, after using a portion of those reserves to ensure balances are cleared and other maintenance activities, and to maintain reserve requirements (and it is worth noting that many banking systems in other countries have no reserve requirements at all). They could let it sit in the vault as cash (earning no interest). They could keep it on account at the Federal Reserve (which relatively recently now earn a mere 25 bp, they earned 0 for a very long time before that). They could lend the reserves overnight (at an interest premium) on the interbank lending network to banks that require reserves to meet requirements. Or one of the few options beyond that is the purchase of US Government bonds. Reserves are not lent out. With the purchase of the bonds the banks are able to earn more interest in a very liquid asset (the US Treasury market is by far the biggest on the planet).
This is how this manifests in the current system: The Federal Reserve has a mandate to maintain short term interest rates consistent with its policy goals. If the banking system has a system-wide deficit of reserves relative to requirements, then competition overnight on the interbank network will drive up the short term interest rate. The Fed reacts to this by buying US Treasury bonds on the open market and prints reserves (out of thin air) in exchange for those bonds. The result is a system wide increase in reserves and a system wide decrease in the amount of US Government bonds (an asset swap). This allows the Fed to put a cap on the short term interest rate relative to its policy goals. On the flip side, If the banking system has an excess amount of reserves relative to requirements, then competition overnight on the interbank network will drive down the short term interest rate. The Fed reacts to this by selling US Treasury bonds from its portfolio on the open market. The banks trade their reserves in exchange for the bonds. The result is a system wide decrease in reserves and a system wide increase in the amount of US Government bonds (again, nothing but an asset swap). Since the Fed is the entity that 'printed' those reserves to begin with, they disappear 'into the ether' when they are returned to the Fed's balance sheet.
For more on OMO and QE (which is functionally identical to OMO) and the role reserves play in our financial system (and dispelling the myths of the Money Multiplier), see here, here, and here
Here is are the key points about US Government bonds:
1 ) The US Federal Government spends (via the US Treasury) by crediting private sector bank accounts at the Federal Reserve
2) There is a Congressional constraint that all US Federal Government spending be matched by Government Bond sales
3) There is a 'debt ceiling' associated with the size of outstanding Government bonds
4) Both 2 and 3 are self-imposed constraints with historical origins and neither are an operational constraint to Federal Spending
5) The US Federal Government is monopoly issuer of the US Dollar, is the source of all Dollars, and can never 'not' have Dollars
6) From 5, the US Federal Government can never become 'insolvent' in terms of honoring US Dollar denominated obligations. The only way it cannot honor its Dollar denominated obligations is if it *willingly decides* not to pay them. This is another self-imposed constraint, not an operational one
7) Net Federal Government spending (spending in excess of taxation) creates net deposits which creates net reserves in the banking system. An increase in reserves pushes down the overnight lending rate. The Federal Reserve maintains control of its target overnight rate by selling US government bonds from its portfolio (via OMO) to ensure demand for reserves (the overnight interest rate) matches its target policy rate.
When all these points are considered, it becomes obvious that the US Government bond market:
a) Does not *fund* anything (It did under a convertible currency standard but does not under a fiat currency floating exchange rate standard)
b) Provides the non government sector with interest income which the US Government will always be able to provide since it is monopoly issuer of the US Dollar
c) Has relevance in the US Monetary System to facilitate liquidity management operations.
That's it.
Bonds serve no funding purpose now. They serve a place in the very convoluted process of OMO to drain reserves in order to allow the Central Bank to hit its target rate. But this could be much more easily accomplished by simply paying a remuneration rate at the target rate on all reserves. They are absolutely unnecessary to the functioning of a fiat currency system.
Here is where things get interesting when you consider how the current monetary system actually works and how unnecessary some (many) of the current components are. As shown above, Government bonds don't fund anything and their primary purpose for existence is to drain reserves in the banking system. This leads you to some very interesting conclusions:
1. The natural rate of interest is zero. As the government deficit spends to match the savings desires of the private sector, reserves accumulate in the banking system. Without government bonds to act as a reserve drain, then the supply of reserves will push the overnight lending rate to zero.
2. The 'loanable funds' theory is garbage. The current thought behind austerity is that government spending is 'crowding out' private investment, that as the government spends it pushes *up* interest rates, which raises the costs to access 'capital'. And we can plainly see that based on point 1 this is completely false. Deficit spending is the one and only mechanism that allows for net financial assets to accumulate in the private sector.
-- So why did Government bonds exist in the first place?
Since 1971 the gold window was closed. And as I show here this was accompanied by some very ad hoc activities. Namely the issue of the continued issuance of US Government bonds. Since the US Dollar is no longer convertible into gold, it is no longer debt in the literal sense that it had under the gold standard.
Under the Gold Standard the US Government was required to have all currency issued backed by gold. When the government need to finance spending (say to pay for a stimulus or a war) in excess of held gold reserves, the US government would issue bonds. In this case, the term financing is accurate, US Government bonds under the gold standard were most definitely debt. The US Dollar, being convertible into gold, had that constraint on it. Which meant that the US government was most definitely revenue constrained. That taxes were a repayment of Dollars such that the outstanding liability of conversion back into gold was reduced. Under Congressional mandate, all spending in excess of taxation must be accompanied by US Government bond sales. Sometimes the non-government sector would buy the Government bonds. But sometimes they would be bought by the Federal Reserve. And this is where the term 'debt monetization' comes from. Under the gold standard, US Dollars were convertible into gold which made US Government bonds, which were convertible into Dollars, indirectly convertible into gold. So when the Federal Reserve would issue currency in exchange for those bonds, the debt would become 'monetized'.
That is very different that what happens today in a fiat currency system, and why 'debt monetization' is (at best) an inapplicable and (more often at worst) highly misleading concept.
-- Do they need to exist now? What would happen if the US Government stopped issuing bonds tomorrow?
From the perspective of the US Federal Government being able to spend .... NOTHING. It would still credit private sector bank accounts at the Federal Reserve (move numbers in a spreadsheet) just like it does today. But it would stop doing the additional step of issuing bonds as it did the crediting.
This would mean that reserves would build up in the banking system and competition for reserves would become very small, pushing the overnight rate to zero (just like it is right now with the current level of excess reserves). So basically nothing would happen that isn't already happening in the banking system.
In fact, the US Government doesn't have to void all the current bonds. Just stop issuing new ones. The old ones will then expire at maturity and the whole US Government bond system will just gradually go away over the next 3 decades (however the average bond duration held by the non-government sector is something like 6 years so it would lose relevance much sooner in actuality).
At sometime in the future, if the Federal Reserve wanted a non-zero Fed Funds Rate, it could just start paying a remuneration rate on all reserves held at the Fed. That would become the new interest rate floor, and the unnecessary song and dance of OMO could be avoided altogether.
The Private sector would come up with some new benchmark (instead of the 10 year and 30 year US Treasury bonds) to price longer term loans (corporate loans, mortgages, etc.).
When you follow this logic all the way through, you come to this very simple and inescapable conclusion:
The US Federal Government does not need the US Federal Government Bond Market (Primary Dealers, Secondary Dealers, PIMCO, etc.) to provide it with funds, IT IS THE OTHER WAY AROUND!!
-- The Debt Ceiling and Self-Imposed Constraints
The fact of the matter is, as unnecessary as it is for the US government to issue bonds, it still does. And as meaningless as it is for the US government to have a debt ceiling, it still has one.
Other than simply stopping bond issuance (which is my preferred approach) like I discuss above, there are other ways to get around this debt ceiling charade. This is a very viable approach.
However, a self-imposed constraint is still a constraint. It is exactly like a runner tying their shoelaces together before running a marathon. It makes no sense, but it will still prevent the runner from accomplishing their objective (which is to run a race).
Until we stop issuing bonds or remove the debt ceiling or implement a coin seigniorage policy to avoid the debt ceiling, the US Government will continue to trip on their shoelaces from this bogus and contrived self-imposed constraint.
2. MMT and 'Free Lunches'
Okay, if MMT tells us that the US Government can spend at any time independent of inflows by crediting private sector bank accounts, then why aren't we all rich? Why doesn't the Government just credit all of our bank accounts by $10,000. Or $100,00. Or $10,000,000?
Because there is no Free Lunch. MMT certainly does not say there are 'free lunches', and MMT certainly does not suggest that course of action is a 'good' thing. There is nothing operationally preventing the US government from crediting any private sector bank account by any amount of money, but there are implications to any fiscal policy decision the government makes.
The constraint is inflation.
Every American could be a billionaire tomorrow if the Government credited a sufficient number of bank accounts, but the result would be the massively increased net financial assets chasing the same amount of goods. So this is obviously not a viable fiscal policy strategy.
However there are very different manifestations of inflation and they are not all the same. These will be discussed in the next section.
But first let us discuss some implementations of fiscal policy and to show how those decisions affect the economy. Because there are no 'free lunches' there as well.
The Government deficit spends when G - T > 0, or rearranged, when G > T. That is government spending in excess of taxation. The difference is one of the important values. A $10 Trillion deficit would exist if a) G = $11 Trillion and T = $1 Trillion, or if b) G = $100 Trillion and T = $90 Trillion. It is a net spending position.
Both conditions would satisfy the macroeconomic sectoral balance equation if the two non-Government sectors were saving $10 trillion. But do both conditions affect the economy in the same way?
Money does circulate through the economy (spending = income) such that the non-government sector *as a whole* has access to that money. But as we know the economy is not uniform and money does not distribute through the economy uniformly.
Spending is the mechanism by which the government encourages / stimulates economic activity. It could spend in the Defense sector, or Healthcare, or Financials, etc. And each spending decision affects the economy differently. In particular the sector/company/individual that receives the money first from the Government has the ability to mark up the highest profit margin (unless it is specifically prohibited from doing so as some Defense contractors are) before they make their spending decisions (which becomes the receiving party's income). As such, parties that are first in line for Government spending get the biggest benefit from it. This aspect will be discussed further in a bit.
Taxation on the other hand can be seen as discouragement / drain of economic activity. If for example the government wanted to discourage real estate speculation (other than through lending regulations, which were extremely lax at the time of the housing boom) it could levy special purpose real estate taxes. If it wanted to encourage employment, it could remove payroll taxes. Remember, Federal taxes fund *nothing*. So the Government does not need to tax for 'revenue' purposes (even though that misnomer still exists). Since tax policy can be targeted, just like spending policies, the government can quash malinvestment by levying temporary taxes in overheating sectors of the economy. Or if the economy is in a balance sheet recession it could reduce the tax burden on working class citizens.
Remember these points as we will be revisiting them.
3. The Fiat Currency System and Inflation
As was elaborately detailed in this post it is unambiguously stated that the long term trend in inflation is in direct response to the long term deficit spending position of the United States.
Since the US Government is the only party that can create net financial assets, cumulative budget deficits that accumulate to the national debt is money that is 'persistent' within the financial system. At any given time in the economy there are real resources for sale. All things being equal, more fiat currency for the same resources => higher general prices.
*However* things are not equal all the time. There are times when competition for resources is fierce and there are times when competition for resources is mild. So at any given time a deficit spending position does not necessarily mean that general price levels will rise dramatically. Again, it all depends on the state of the underlying economy.
Besides Federal deficit spending, horizontal credit booms can also affect inflation. Let's say one takes out a loan (or margin) to speculate on oil futures because they think the price of oil is going up due to inflation concerns. Lets further control this example by saying there is no fundamental reason at that time for inflation concerns, and oil demand and production stays the same. If more buyers than sellers felt this way then the price of oil would rise. The oil price rise is a very real event. We could attribute this to 'inflation'. But lets say that the buying pressure abates and the oil price starts to fall. Then there are net sellers and maybe even margin calls as people try to cover their positions. At the end of that cycle all of the the horizontally loaned money had to be repaid (because the lenders held those loans as liabilities). This is another example of a self-extinguishing credit boom/bust cycle.
This is the manifestation of credit booms (which put upward pressure on prices) and credit busts (which put downward pressure on prices) on inflation. Since all horizontal money creation is matched by an equal sized liability (activity within the banking system does not create *net* assets), horizontal transactions cannot generate long term inflation. It can create cyclical booms and busts as credit cycles begin and then implode. This could be modeled as something like a sine wave. (Oscillation about a mean value of zero as prices overshoot, mean-revert, and then undershoot).
Whereas vertical money creation has no corresponding liability. This does create net assets in the financial system. So while there are now still credit booms and busts, they can be modeled more like a sine wave superimposed on the deficit growth line (Oscillation about a non-zero and positively increasing mean value).
-- Myths regarding the 'Money Supply' causing Inflation
The problem with using any version of the money supply is that it lumps together vertically and horizontally created money. I have talked about the difference extensively above. The Federal Reserve cannot generate net financial assets, since it can only swap reserves for assets that already exist. It does 'money printing' in only a literal and trivial sense. This would be different if the Fed started paying a remuneration rate, but they don't so I won't detail that complication right now. It can only swap reserves for existing net financial assets, and the only party that can generate those net financial assets to begin with is the Treasury.
This is important because 'money supply' analysis mixes both horizontal and vertical money and as such has no predictive ability regarding inflation or deflation.
Consider the current failure of this type of analysis. "The Fed added 1 Trillion in reserves to the monetary base! This is going to be massively inflationary (if not hyperfinflationary)!!". .... Where exactly is this hyperinflation? Nowhere. Okay, then where is the 'massive' inflation? Nowhere? hmm.....Why is that?
Because the Money Multiplier model is a myth (see here and here). And even if it did work (which it doesn't) then all it would do is describe some mechanism of horizontal money creation (not vertical money creation). This means that the Quantity Theory of Money is also incorrect in describing how inflation manifests. Because as was shown above, horizontal money creation can only lead to credit booms and busts, not long term inflation.
Instead of swapping 1 Trillion of reserves for Treasuries, the Fed could swap 10 Trillion and the effect would be equally meaningless. Because monetary policy cannot be enforced strictly from the supply (lending) side. In fact, the demand (borrowing) side of the equation is far more important. *BUT* even if the Fed could induce another lending boom right now, it would be completely horizontal. Which means it would lead to a private sector credit boom followed by a credit sector credit bust (just like 2002-2007 lending boom, 2007-20xx bust / balance sheet recession).
Monetary policy is largely worthless. It can cause all kinds of dislocations and malinvestment when inflation expectations are high. It is spectacularly ineffective when inflation expectations / borrowing demand is low.
So the Monetary Base leverering up to some 'money supply' theory through the money multiplier model is wrong. Looking at MZM, M0, M1 and M2 to draw inflation conclusions is wrong. Looking at M3 is a little bit closer to correct, but that is simply because it captures a large portion of net financial assets, so using it from a 'money supply' perspective is wrong.
-- Cost-Push vs. Demand-Pull Inflation
The previous section discussed the differences between vertically created money and horizontally created money on both short term and long term inflation trends. This section discusses the two main types of inflation and how they manifest.
Demand-pull inflation is caused by too much government spending when the economy is operating near full capacity. If we have an economy running near full capacity, high utilization of resources (including and most especially employment) => low unemployment and a positive current account, then a Government Budget Deficit (G-T > 0) is exactly the *wrong* position for the government to take. Because all resources are already bid for at the prices where they produce useful economic output. Further increase of net financial assets into that environment does not cause any further economic output to take place it just raises the general price level across all components of the CPI index.
Cost-push inflation can happen independent of the government spending position. It is not driven by primarily by either vertical money creation or the credit boom of horizontal money creation, but by production control. The obvious example is oil imports for the US. The US is the worlds biggest energy importer and is especially sensitive / at the mercy of OPEC. They are price setters in this scheme (OPEC has general price targets and varies production quantity to meet those targets) and the US just has to take it. Food production being energy intensive is also subject to this effect which is why food and energy prices have been moving (mostly) in a similar fashion. These rises can be affected by the deficit spending position, but they are primarily driven by production controls or constraints. As another constraint consider that oil is in demand across the globe, so low 'money creation' and low oil demand in one country might still see oil import prices rise based on this dynamic.
-- What is the inflation environment like right now?
Currently we are back up to 3% inflation. However this is not 'uniform' inflation across all components that make up an inflation index. Inflation is high for energy and food (which is cost-push inflation), moderate inflation for healthcare (which is another victim of price setting based on policy decisions), low/no inflation for most of the other components, and *deflation* in housing. This very uneven inflation environment is telling us directly that current deficit spending is not resulting in demand-pull inflation.
We have relatively low utilization of resources, including and most especially unemployment (>9% official employment and closer to 30% underemployment), we have wealth concentrated in a few sectors (especially Financials), a sluggish economy, low core CPI. This means that the current deficit spending position of the US will not result in demand-pull inflation, which substantiates the above view.
4. Current Macroeconomic Environment
The reason why this discussion is important is because policy decisions must be based on this type of analysis. The health of the underlying private domestic sector must be gauged when the government decides to alter its spending position.
Consumers are in a balance sheet recession. They are trying to pay down debt. Debt/income for the private domestic sector is >110%. So from a sectoral balance of the macroeconomy, (S-I) savings - investment, or net savings, by the private domestic sector will need to be a large positive quantity (something on the order of several percent of GDP, maybe 5-10%) for a very long time as that debt is being paid off. At the same time we continue to have a current account deficit. Exports minus imports (X-M) is a negative number (something on the order of 3% of GDP). This means that since S-I is positive (and will stay that way since the private domestic sector has a continued savings desire because they want to [NEED to] pay down debt accumulated during the last cycle of 2002-2007), and we have a current account deficit, then (S-I) - (X-M) is a positive quantity. This is precisely why the private sector has been able to net save up to this point, because the government has been running a deficit (G-T) > 0 (and on the order of 10%).
This type of analysis gives key insight into the interrelationship of the 3 macro sectors, but it far from tells the whole story.
Because as I discussed above, money does not move through the private domestic sector evenly. Those sectors directly receiving the Government spending have a tremendous financial advantage to those who get the spending second-hand. What this means is that even though the private domestic sector desires to net save something like 5-10% of GDP, the section of the private domestic sector that needs those assets the most (to pay down debt) are likely only getting a small fraction of those net savings.
This leads to another critique of MMT, which is a 'feed the beast' mentality. We have anemic economic activity yet the government has had large deficit spending positions for the last few years. MMT advocates continued deficit spending because the sectoral balance is clear: for the private sector to net save with a current account deficit, we must deficit spend. But all of this deficit spending doesn't seem to be 'fixing' anything. From a non-MMTer point of view, it seems like we are just 'feeding the best'. The sectoral balance equation must hold ... but we need to think about the situation more deeply in order to advocate for specific policy decisions.
5. Bad Fiscal Policy Decisions / The Financialization of the US Economy
This section will bring together the economic dislocation observations stated above and major sources of unproductive activity in the economy
The Clinton Administration in 1999 made one of the worst policy decisions ever enacted: the repeal of Glass-Steagall. This was the legislation enacted during the Great Depression that prevented banks (with a charter able to accept deposits from the public) from also being investment banks. The repeal of this act consolidated the shadow banking system with the real banking system and was the single biggest step in creating a "Too Big To Fail" industry.
Since that time many horrible policies were enacted under the G.W. Bush Administration that allowed the financial sector to gain more power, more influence, to deregulate itself, to engage in financial innovation.
The financial sector is non-productive, but it is not useless. There are a list of several vital functions that a financial sector must provide:
• Central bank oversight of the payments system.
• Capital adequacy standards for financial institutions.
• Bank depositor protection.
• An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis.
• An institution to ameliorate coordination failure among private investors/creditors.
• The provision of exit strategies to insolvent institutions.
But this list of functions can be accommodated by a financial system that is a small fraction of the size of today's system. The size of the financial system today is a direct result of several years of bad policy decisions.
6. Creative Destruction within a Deficit Spending Policy Stance and Promoting Healthy Economic Activity
The size of today's financial system allows it to gain access to politicians (the financial sector has by far the biggest, most well-paid and influential lobbyists). It has positioned itself to be of the the biggest beneficiaries of government spending.
What should have happened during the last crisis was for the FDIC to resolve the insolvent institutions and break them up. Creative destruction should have been allowed to happen for an industry that was clearly too large to be stable. This is one of the hallmarks of efficient capitalism. Instead what happened was that the financial sector received the biggest portion of the stimulus and bail-outs.
So for all those who criticize MMT under the 'feeding the beast' theme, MMT absolutely did not advocate for this propping up of failed institutions. Professor L. Randall Wray was a critic of the bailouts (see his thoughts on financial reform in the first part of this video).
The bailouts of the financial system was a massive failure of public policy. It was not a failure of either capitalism or MMT.
Despite massive stimulus / deficit spending the last few years, much of it was spent on propping up insolvent institutions. Deficit spending is not to blame for this scenario, it is the direct decision of policy makers at the time and even now to continue to support these institutions.
One of the single best decisions that could be made is to reinstate Glass-Steagall. Today. To say that banks with a charter cannot do proprietary trading, investment banking, etc. If the shadow banking system want to take risks, it should not do so with either implicit or explicit public backing.
Which brings us to now.
The US economy still has all of the problems listed above in section 4. The US economy also has the problem of a financial system whose size and instability still pose a systemic risk. What do we do?
Recall above that there is no danger of running a budget deficit. It does not raise the specter of 'insolvency' for the Government, it does not 'crowd out' private investment. Other than a completely manufactured 'debt ceiling crisis' there is no issues to continue to run deficits. But the government must make decisions about what spending it wants to support.
We could spend it on financialization of the economy (non-productive), we could spend it on one-time stimulus with no lasting effect like the Homebuyer Tax Credit or Cash for Clunkers (non-productive), and we could then just continue with that path and run deficits to service the interest payments on Treasuries (non-productive). Deficits just by themselves can 'prop' economic activity but will not necessarily lead to productive economic activity.
On the other hand, the Government could cut the deficit to 'clean house'. To allow insolvent institutions to fail and to 'take our medicine'..... I call this mentality 'cutting off your nose to spite your face'.
When Government forces a balanced budget, then (G-T) = 0. This means that since we will still be running a current account deficit (we won't magically become a net exporter instead of a net importer overnight), then by definition (S-I) will go negative. This means the private domestic sector will no longer be able to net save (despite needing to desperately). The private sector is in no position to undergo a new credit boom (NOR SHOULD IT!).
This means that economic activity will massively slow down as the private sector attempts to meet their savings desires. It simply bears pointing out that in the midst of a balance sheet recession where the private domestic sector desires to net save and we have a current account deficit that no Government Deficits will lead directly to a loss of economic activity. That is a factual conclusion based on a sectoral balance of the macroeconomy.
This also means that along with the industries that the Government is trying to 'clean' there will be a lot of 'collateral damage'. Like hardworking lower and middle class American's who are trying to save money and pay down debt in the middle of this sluggish economy. Who are trying to do the right thing despite a Government that has bailed out everybody except them. A balanced budget, with the private domestic sector desiring to net save and with economic activity slowing, would result in firms likely to lower inventories and staff. This means likely unemployment will rise. With a balanced budget the automatic stabilizers (unemployment benefits, food stamps, etc.) will be severely cut back and thus unemployment will be a much larger drag on economic activity that it would be under a deficit spending position. This further reinforces the above conditions, etc.
A 'Cut, Cap and Balance' approach is spitting in the face of these Americans, whether they realize it or not.
I propose a different approach
The sectoral balance for our current economic environment is clear: The private domestic sector desires to net save and we have a current account deficit => The Government *must* run a deficit to allow the private domestic sector's savings desires to be realized.
This means a Federal Government budget deficit is required in this environment. It does not pose any 'solvency' risk (as elaborated above), and because the economic environment is weak does not pose a significant inflation risk (as elaborated above). But while the sectoral balance tells us a deficit is needed, it doesn't say how it needs to be implemented. This is where we draw on previous observations regarding how money from Government spending moves through the economy and how unproductive (and dangerous) the financial sector is.
The biggest obstacle in the current environment is the no current direct spending paths to help Main Street. In particular all stimulus plans have been 'jobs poor' (propping up financial institutions spends a lot of money but does not create jobs).
A) Remove all subsides and stimulus from the financial sector immediately.
Reinstate Glass-Steagall. Make banks choose whether they want to be a regular bank or an investment bank. Without stimulus likely some of those institutions will fail. Resolve them. Do not prop them up via bail outs. We need to start breaking down the 'Too Big Too Fail' structure now, immediately, while insolvent banks can fail in a non-crisis environment. This will facilitate orderly resolution of these institutions to other more efficient institutions that are prepared to handle those assets. Allow 'Creative Destruction' to work the way it was intended to.
B) Implement an Energy Independence Initiative
The cost-push inflation that the US has endured with energy prices is a direct result of the trade imbalance and short-sightedness for decades in assuming uninterrupted access to cheap and plentiful oil. The biggest thing the US could do to smooth out this source of inflation is not to have better monetary policy (which is mostly worthless anyways), but to really become serious about energy independence. That is the only real solution.
We have massive under-utilization of resources and can 'afford' (literally and figuratively) to implement a massive spending project that has a number of long term and short term benefits:
1) Long Term Energy Independence - This will significantly reduce future cost-push inflation spikes from volatile energy prices.
2) This will be a very large long term industry providing long term employment.
3) This will help with the current large unemployment situation as we can soak up a lot of those underutilized resources.
The projects included in an energy independence plan would be: Implementation of a Natural Gas Policy Agenda (the US has abundant Natural Gas resources), which would include increased storage and pipelining and require resources to build those (materials and labor), Subsidies/Grants to start transitioning the auto fleet from Oil to NG, more efficient people and freight moving systems (such as Rofgile's high speed rail idea), Investment in alternative energy power generation projects (Wind, Solar [PVs, CSPs], etc.), etc.
All of these projects would cost a lot of money (which we could afford to deficit spend right now), a lot of materials (China already appears to be slowing and they already have large materials stockpiles, so this plan would have upward pressure metals/materials prices but probably not as much as it would say 5 years ago), and a lot of labor (and with >9% unemployment, that would be a good solution). But the long term benefits would be enormous. I think they would be akin to the benefits from the Interstate Highway system.
C) Implement a Job Guarantee Program
For the unemployed that wouldn't be soaked up by project B above, a Job Guarantee would fill in the gap. Thoughts on plans of that nature here and here (skip down to the section What is the Job Guarantee?).
More on why a Balanced Budget is the worst possible economic idea
I suppose the only economic idea that is worse than a "Balanced Budget" proposal would be a "Balanced Budget Amendment" proposal (making this absolutely horrible idea into a law).
The reason why this idea is so bad is that it *forces* fiscal policy to be pro-cyclical. From here
Balanced budget amendments are another one of these artificial constraints that look better on paper than they do in reality because they are procyclical.
In the eurozone, the stability and growth pact provides a 3% deficit hurdle which almost all of the euro zone breached during the recession. Austerity attempts to meet the hurdle we see have created larger deficits in the periphery (Spain, Greece, Portugal and Ireland).
The same problems were apparent in the US states where balanced budget amendments are the order of the day. Before Barack Obama entered the White House, I asked in January 2009 “Will federal largesse be countered by state and local cutbacks?” By June 2010, it was obvious the answer was yes. That’s what procyclicality means.
Procyclicality is fine for states as a constraint despite how they exacerbate the swings in the business cycle, creating deadweight losses. The federal government can always counter this pro-cyclicality and smooth out the cycle. This is one of the structural flaws of the euro zone; there is no federal agent to do this, and, thus, the business cycle will invariably be volatile.
Now, America is looking to impose the same sort of procyclicality on the US federal government. When downturns hit, revenues drop because tax receipts drop due to income shortfalls and spending increases because of automatic stabilisers. So, a balanced budget amendment would require even more cuts. But since those cuts reduce income and tax receipts, you need enough cuts to overcome the negative revenue effects on the budget. That means a balanced budget amendment would require deep, deep cuts in federal spending at precisely the worst moment in the business cycle. That’s procyclicality.
This is a recipe for disaster. And it will lead to huge volatility in the business cycle, deadweight economic losses and growth underperformance. If you hear anyone telling you this is a good mechanism for reining in deficit spending, you will know they haven’t thought through the effects of procyclicality.
What we have learned from the MMT Framework discussion in Section 1 above is that not only does deficit spending not impose any solvency risk for the US Government, the Government sector is the *only* sector of the macroeconomy that can expand its balance sheet on demand. This means that the Government spending position should *NOT* be discretionary and instead be driven by the current account balance and the saving desires of the private domestic sector
The signal for excess or deficient government spending as outlined in detail above in Section 3. is demand-pull inflation. When the economy is running near full capacity, and resources are fully utilized (including and most especially employment => low unemployment) then the Government should run a Balanced Budget. Not before that. The clarification of course being a clearing out of major unproductive economic behavior should be part of any spending plan.
7. The Ineffectiveness of using/changing the Monetary System as a Guard against Bad Policy Decisions / Politicians
Bad policies under a convertible currency standard will produce bad results. Just like bad policies under a fiat currency floating exchange rate standard will produce bad results. There is nothing intrinsic about either system that precludes the possibility of wasted output, unemployment, economic malaise, etc.
The problem right now is that so many are using convertible currency economic models to draw conclusions / make policy recommendations for what to do in our fiat currency system. It is comparing apples and oranges, and is bad macroeconomics. We need to first understand how our system actually operates and to dispel inapplicable causes/effects that would occur under a different monetary system.
MMT is not a panacea (simply understanding it won’t prevent one from making bad decisions based on good information), but understanding it will prevent policy makers from making basic *mistakes* (making bad decisions based on bad information).
A corrupt state will attempt to prop itself up regardless of the monetary system. MMT is useful in that if understood and used correctly could smooth out pro-cyclical tendencies of the business cycle, by understanding how money enters into our system. But it requires understanding and *discipline* to not turn that spending into the propping up of non-productive sectors.
Unfortunately the 'lack of discipline' aspect is the problem with government. It was a problem under the Gold Standard (which caused the issuance of bonds in the first place as well as implementation of the Federal Reserve). It is a problem under our current monetary system with the propping up of Financials.
There is no guard against bad policy. And if we think we can change the monetary system to prevent bad policy decisions from happening (which we can't) then we need new politicians. It's as simple as that.
From E-T: Weekend Post – March 10, 2018
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There is a new post on my blog at this LINK. Cheers and enjoy the chart! E-T
6 years ago
