Monetary policy under challenge … finally

The central bankers have been meeting in Wyoming over the weekend as part of the annual Economic Symposium organised by the Federal Reserve Bank of Kansas City. While not all of the papers and discussion are yet available for public scrutiny there were some notable presentations (that you can access in full) which suggest that key central bankers are starting to realise that the economic crisis in not over and the fiscal-led recovery is slowing and that monetary policy alone cannot provide the solution. Moreover, one leading central banker indicated that monetary policy is not a suitable tool for controlling longer term problems such as price bubbles in specific asset classes. This view challenges the basis of the mainstream macroeconomics consensus that has dominated the policy debate for 30 odd years and culminated in the worst financial and economic crisis in 80 years. It is certanly a welcome trend in a debate which is typically flooded with ideological input from the mainstream macroeconomics profession.

This afternoon (August 30, 2010), Bloomberg is reporting that – Bernanke Faces Skepticism on Policy Tools, May Need Fiscal Aid.

The news report is updating coverage of the Economic Symposium organised by the Federal Reserve Bank of Kansas City. You can access the papers for the Symposium – HERE – but at the time of writing they were not yet available for the 2010 event.

Over the weekend, the Economic Symposium at Jackson Hole, Wyoming heard two strong presentations from central bankers – Ben Bernanke and Bank of England deputy Charles Bean.

Modern Monetary Theory (MMT) posits that fiscal policy is the most effective counter-stabilisation tool available to national governments if they are sovereign (that is, run a currency-issuing monopoly and float the currency on international foreign exchange markets).

MMT downplays the effectiveness of monetary policy claiming it is a blunt instrument which cannot be targetted (by demographic cohorts, region etc) and has uncertain aggregate impacts on overall spending because it creates winners and losers each time the interest rate is changed.

At the Economic Symposium this theme has begun to emerge among the mainstream speeches of Bernanke and Bean. I guess they cannot go on ignoring the empirical evidence forever even if the mainstream academic economists seem unable to poke their heads out the window to see what actually happens in the real world and why.

Ben Bernanke’s speech on August 27, 2010 has received a lot of press coverage.

It essentially admitted that monetary policy alone cannot keep economic growth moving. It was reported by Bloomberg that “some attendees at the annual symposium said … that the effects of … quantitative-easing measures may be weak or that fiscal policy should play a bigger role”.

So the point is that the mainstream emphasis on monetary policy has been exposed as a flawed policy stance and the insistence by the profession on fiscal austerity is now likely to cause more damage.

Bernanke told the Symposium that:

Notwithstanding some important steps forward, however, as we return once again to Jackson Hole I think we would all agree that, for much of the world, the task of economic recovery and repair remains far from complete. In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high … [and] … Central bankers alone cannot solve the world’s economic problems.

This is clearly the case. Remember that economic growth (real GDP) has to at least outstrip the growth in the labour force and productivity growth for the unemployment rate to start falling. In most countries (including Australia) real GDP growth is still not strong enough to eat into the pool of unemployed that expanded during the early part of the downturn.

As a consequence long-term unemployment is rising and labour markets are stagnating.

Given the significant monetary policy shifts in the last three years, it is quite clear that the interest-rate sensitive components of spending (the targets of monetary policy) have not been responsible to the lower rates. Further, while the quantitative easing has reduced long-term interest rates the result has been a massive build up of bank reserves and very little investment spending.

So there is not much evidence to suggest that monetary policy has saved the day during this downturn.

As Bernanke notes – “(e)xpansionary fiscal policies and a powerful inventory cycle, helped by a recovery in international trade and improved financial conditions, fueled a significant pickup in growth”. That is, economic growth comes about as a consequence of aggregate spending driving production decisions by firms.

The demand for credit by the private sector is still low exactly because there is not enough spending in the US at present and so firms fear that sales will not be strong enough to justify the expansion of their working capital (via credit) and further production growth.

He then said:

At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily. For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.

This statement is clearly wrong. What he is saying is that politically the US government is not able to fill a greater proportion of aggregate demand with public spending.

Fiscal spending impulses can always underwrite whatever proportion of activity is desired into perpetuity. A permanent expansion public employment would immediately increase and maintain a rise in productive activity.

If net public spending “fueled a significant pickup in growth” then it can also sustain the same growth. A budget deficit, after all, is just a flow of spending. For the flow of spending to be maintained the deficit has to be maintained. Some people (including me) might not like where the spending is flowing too (that is, the composition of final demand) but that is a different issue which doesn’t negate the obvious fact that the spending is beneficial for economic activity.

Bernanke is correct though in his summation that:

… although private final demand, output, and employment have indeed been growing for more than a year, the pace of that growth recently appears somewhat less vigorous than we expected.

This is because the rise in private spending that was predicted to follow the low interest rates has not materialised. Why would it when the overal uncertainty relating to on-going fiscal support for spending and sales is rising as the deficit terrorists win the battle and push governments into austerity programs? The lack of responsiveness of aggregate demand to the rather substantial shifts in monetary policy is one of the stories of the recession.

For too long the mainstream has promoted monetary policy as the sole aggregate policy with fiscal policy being relegated to providing passive support. That is, governments have been pressured for a decade or more to run tight fiscal positions which has entrenched persistently high unemployment so that the inflation genie would not break out of the bottle. Monetary policy was aimed squarely at that genie.

The problem is that inflation really was culled from the system in the 1991 recession rather than by inflation targetting. The downside of this policy mix has been that the private sector has kept growth going as tight fiscal policy squeezed their purchasing power by increasing their levels of undebtedness – to unsustainable levels.

The economic crisis is, in part, an adjustment to these excessive private debt levels. Please read my blog – The origins of the economic crisis – for more discussion on this point.

In this context, Bernanke notes that:

The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions. Among the most notable results to emerge from the recent revision of the U.S. national income data is that, in recent quarters, household saving has been higher than we thought–averaging near 6 percent of disposable income rather than 4 percent, as the earlier data showed. On the one hand, this finding suggests that households, collectively, are even more cautious about the economic outlook and their own prospects than we previously believed. But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

MMT proponents have been saying for some years (more than 15) that this re-adjustment had to eventually come. This insight is not one of the predictions that eventually have to come true so you just keep saying it for long enough and you will be right some time. The claims by MMT proponents come from an understanding of the way the sectoral balances interact and, in particular, from an emphasis of the impacts of fiscal positions on the non-government sector. These are all insights that are ignored or denied by mainstream macroeconomists.

Please read – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for a basic introduction to MMT ideas in this regard.

Bernanke should have followed up his point by noting that these developments in the private sector (which are occurring in all advanced nations) reinforce the case for increased fiscal intervention. Expanding fiscal policy further will provide further support to private saving while continuing to expand aggregate demand and employment growth.

If the non-government sector desire a surplus then the government sector has to target a deficit for growth to be maintained.

Most of Bernanke’s speech that followed was not particularly insightful or objectionable and showed that he is seemingly coming to terms with the limitations of monetary policy.

For example, in relation to the FOMC’s decision to lower long-term interest rates by buying debt instruments in the markets he notes that:

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

Clearly he realises that the build-up of bank reserves that followed from this policy has not had any impact in their own right. The main impact has come via the “portfolio channel”.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion which reinforces Bernanke’s understanding.

This (new) understanding is further demonstrated when he says:

We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning.

So the build-up of reserves was not considered to be inflationary.

But he admitted that the changes to the Federal Reserve’s balance sheet was sailing into unchartered territory and they “do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions”.

MMT tells us that the increasing reserves will not impede anything of consequence or promote any damaging trends. The growth in credit will not be enhanced by the excess reserve holdings and there are thus no aggregate demand impacts to consider.

The uncertainty that I worry about relates to the lack of knowledge about the impacts of the portfolio channel on aggregate demand. It is clear that despite fairly large movements in portfolios in recent years between the government and the non-government sector aggregate demand has not proven to be very sensitive.

That means that monetary policy is not a suitable tool for stimulating and maintaining aggregate demand.

This message was also reflected in the other significant speech presented to the Economic Symposium at Jackson Hole on August 28, 2010 which was based on the paper by Bank of England deputy, Charles Bean (with co-authors) – Monetary Policy After the Fall/

You can also read the Bank of England News Release.

The UK Guardian (August 30, 2010) in the article – Interest rate rises not enough to stop a crash, says Bank of England chief – described the article as a:

… startling departure from the orthodox view … [and] … warned that central bankers will be unable to prevent the next financial crisis if they are forced to rely on raising interest rates alone … [the] … speech … overturned the orthodoxy that has determined policy for the last 20 years …

Bean summarised “the pre-crisis consensus over the appropriate macroeconomic policy framework” as such:

  • “Automatic stabilisers aside, fiscal policy was unsuitable as an instrument of macroeconomic demand management”. Bean claims that this was “justified theoretically” using “Ricardian Equivalence” notions. He doesn’t mention that there has was never any empirical support for these theories.
  • “Monetary policy was therefore assigned the primary role in short-term aggregate demand management, with policy conducted through the manipulation of a suitable short-run interest rate.”
  • “The monetary transmission mechanism operated mainly through longer-term interest rates, asset prices and expectations of future inflation”. So the central bank was pushed into a position where it vigorously pursued an anti-inflation agenda.
  • “The conduct of monetary policy was best delegated to an independent central bank, free of short-term political considerations”. This followed from the last point. It was claimed by the mainstream macroeconomists, without any empirical support, that it was “optimal” for the central bank to only focus on what Bean calls “long horizons” and ignore short-term considerations like rising unemployment. It was believed (erroneously) that unemployment in the long-run would not persist beyond some optimal rate (the natural rate) and that governments could not influence this rate using aggregate policy.
  • “Asset markets were thought to be efficient at distributing and pricing risk and financial innovations were normally welfare enhancing”. So there was a belief in the efficiency of self-regulated financial markets.
  • “Systemic financial crises were seen only in history books and emerging markets; they were unlikely to happen in advanced economies” because these markets were efficient in the sense just noted.

Clearly the financial and then real economic crisis has shown each of these mainstream consensus perspectives to be deeply flawed despite the vast bulk of the profession seemingly intent on hanging on to every last vestige of their belief system.

The purpose of Bean’s paper was to examine whether the mainstream macroeconomic consensus still held water.

He concludes that it does not!

He initially confirms the conclusions that I provided in this blog – Monetary policy was not to blame – which counters the mainstream claim that US interest rates were too low and cause the housing bubble. Bean categorically concludes (with associated empirical support) that monetary policy decisions can only explain “part of the excess growth of credit in the United Kingdom and United States prior to the crisis”.

He also investigates how effective the monetary policy responses to the crisis were and how effective the monetary policy tools (interest rate adjustments) would be in combatting asset and credit bubbles.

He notes that:

… the sharp increases in a range of credit spreads from the onset of the crisis in August 2007, and especially after the collapse of Lehman Brothers in the Autumn of 2008, meant that policy rates had to fall sharply merely to maintain the pre-existing levels of key borrowing rates4, let alone lowering them in order to stimulate aggregate demand to counteract the substantial contraction over 2008 Q4 and 2009 Q1. As a result, many monetary policymakers soon found themselves with policy rates at, or near, the zero interest rate lower bound (ZLB) and were forced to turn to other means to inject further monetary stimulus.

Monetary policy in this situation has only two options: (a) a commitment to “keep future policy rates low”; and (b) “reducing the spreads of longer-term interest rates over expected policy rates through asset purchases financed by money creation” (that is, quantitative easing).

He notes that mainstream economics eschews option (a) because it suggests inflation and doesn’t consider option (b) because Ricardian households and firms will “internalise the budgetary implications of the public sector’s asset acquisitions” and constrain their spending (for example, because they fear higher taxes).

In relation to the mainstream (religious) belief in Ricardian Equivalence, Bean notes that “it is relatively easy to think of reasons why it might not hold in practice” and then lists all the crazy assumptions that have to be satisfied for the theory to be predictive. In the real world none of the assumptions ever hold.

Please read my blog – Pushing the fantasy barrow – for more discussion on this point.

He concluded that quantitative easing and asset purchases works (a bit) but “are probably best kept in the locker
marked For Emergency Use Only” because: (a) the impacts of changes in long-term interest rates is uncertain and not well understood; (b) during a crisis there is insufficient financial market activity to “to correct any excessive compression of the spread between government bond yields and expected policy rates”; and (c) it will stir the conservatives up who will accuse the central bank of operating “at the behest of the government in order to lower the cost of budgetary finance, rather than for monetary policy purposes”. So an ideological complaint!

Overall Bean concludes:

But, generally speaking, monetary policy seems too weak an instrument reliably to moderate a credit/assetprice boom without inflicting unacceptable collateral damage on activity. Instead, with an additional objective of managing credit growth and asset prices in order to avoid financial instability, one really wants another instrument that acts more directly on the source of the problem. That is what “macro-prudential policy” is supposed to achieve.

I agree with that conclusion but not what followed.

Bean correctly notes that the “twin beliefs that financial markets are efficient and that financial innovation is necessarily welfare-enhancing have been
dealt a serious blow by the crisis” and that “financial markets are riddled with any number of incentive distortions and market failures.” He also correctly notes that the crisis ” has also raised serious question marks about a policy of benign neglect towards credit/asset-price booms”.

So he is really railing against the mainstream Greenspan-Washington consensus that was embodied in the smug conclusion by many mainstream macroeconomists that the business cycle was dead. Please read my blog – The Great Moderation myth – for more discussion on this point.

He then concludes that the “deployment of macro-prudential instruments, focussed more directly on the source of the excessive exuberance seems more appropriate” is not the complete story in my view. He admits that central bankers “still have much to learn about how such instruments work in practice and how they interface with monetary policy”. In other words, this pursuit is still not able to overcome the endemic bluntness and uncertainty that makes monetary policy an unsuitable tool for counter-stabilisation.

I am for increased regulation which would change the face of banking and the way financial markets work, but the main work to stabilise the economy and its sub-markets should be done by fiscal policy.

The following blogs outline from an MMT perspective how specific asset price inflations (bubbles) should be addressed – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks.

From the MMT perspective fiscal policy is capable of targetting specific segments of specific markets without endangering wider economic activity. Monetary policy is incapable of achieving that state of fine tuning.

But the essential point that Bean was making – that monetary policy as it stands is not an effective tool to place all your counter-stabilisation hopes on is sound and should reverberate within the mainstream profession. The problem is that as a religous community the mainstream macroeconomists will just hold up their crosses and expel any new ideas that might cause them discomfort.

And to reinforce that point, consider the continued attacks on fiscal policy – Saddled with legacy of fiscal extravagance – by former Australian Treasury official now professor of economics at Griffith University (one of the lower ranked research universities in Australia) Tony Makin published by the right-wing propaganda machine otherwise known as our national daily The Australian.

Makin said:

All spending must be funded one way or another, however, and the funds borrowed for that purpose exhaust funds that could finance other economic activity. This brings to mind an observation by Walter Bagehot, the influential late 19th-century editor of The Economist Magazine who opined, way back in 1873, that: “We have entirely lost the idea that any undertaking likely to pay, and seen to be likely, can perish for want of money; yet no idea was more familiar to our ancestors.”

Yet it is still not at all familiar to many Keynesians.

Poor Tony. What he fails to mention and perhaps even understand is that to the penny the funds borrowed by the federal government are made available to the private sector courtesy of the deficit spending anyway.

He clearly is still hanging onto the old Classical theory of loanable funds, where the interest rate was alleged to mediate saving and investment to ensure that there was never any gluts in real production (the old Say’s Law).

The erroneous mainstream logic claims that investment falls when the government borrows to match its budget deficit – the borrowing allegedly increases competition for scarce private savings pushes up interest rates. The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment. This leads to the conclusion that given investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.

It is clear that governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?

No and No! MMT never says that central banks will not increase interest rates. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

But the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending.

Central banks push up interest rates up because they believe they should be fighting inflation and they think the rising interest rate stifle aggregate demand.

Most significantly, from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. We call this “a wash” – the funds used to buy the government bonds come from the government!

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.

Finally, the consumer smoothing argument is based on the Ricardian Equivalence nonsense that I have blogged about regularly. Please read my recent blog – Defunct but still dominant and dangerous – for more discussion on this point.

Please read my blog – Fiscal austerity is undermining growth – the evidence is mounting – for more discussion on the fallacies that accompany the crowding out hypothesis.

In fact, the only time that national government borrowing does squeeze liquidity is when they continue to issue debt to satisfy the demands of the financial markets who desire continued access to the guaranteed annuities that are embedded in the government bonds but run budget surpluses.

Can someone send Tony a knitting book so that he might occupy his time more productively instead of insulting our intelligences with the stuff he writes? It would be a win-win strategy!

Conclusion

Meanwhile the US Republican Party seems to be pursuing increasingly irrelevant issues such as whether the US President is a muslim or not. When the same party continually quotes from the US Constitution in ways that suit themselves I have read their allegations about the Presidents supposed religious preferences with some amusement. Even if they were true who should care? They should just get out more often!

That is enough for today!

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This Post Has 109 Comments

  1. Hi Bill

    Nice post.

    Can’t believe you didn’t find the time to have a go at Trichet’s speech from Jackson Hole as well.

    Basically the same garbage as Makin- a few Barro quotes, a sprinkiling of Ricardian Equivalence here and there.

    No references to data, history, just general boogey monster type arguments.

    crazy stuff

  3. ‘MMT downplays the effectiveness of monetary policy claiming it is a blunt instrument which cannot be targetted (by demographic cohorts, region etc) and has uncertain aggregate impacts on overall spending because it creates winners and losers each time the interest rate is changed.’

    Please…I think I learnt this in Year 8 and Bernie Fraser would regularly state the same. I doubt you’d get much argument from any mainstream economists about the bluntness of MP. Unfortunately it is the laziness of governments or their inability to use fiscal policy to its fullest outside of crisis situations (nor even to pass many logical bills through parliament). As such central banks seem to have been given the role of economic manager by proxy which is wrong.

    I still don’t follow why you believe a sovereign state need not fear about running large deficits or having ridiculous debt/gdp ratios. Surely you can’t be serious that all it does is credit one side of the ledger to solve its obligations. I’m thinking here of Zimbabwean buying power after its currency has become toilet paper in the free market.
    Or are we just talking about a theoretical world here?

  4. @Ray
    Yawn! Can you come up with a new and interesting objection to MMT? This Weimer Hyperinflation and Zimbabwe Trilllion Dollar Stories are so old and boring. I know no MMT proponent, who thinks the government should produce trillion paper currency to procure a basket of eggs.

  5. Ray, you should search for Z-related post in the archive here.

    Bill, what about introducing some extra logic into comments system that whenever a Zim- or Wei- or hyper- word is mentioned then not just a simple math skills are tested but also some basic understanding of Z-, W- or h-. These W- questions come up every time somebody new bumps up here which unfortunately often means that these people post their comments here but never come back to read responses.

  6. I find all the MMT arguments very convincing in terms of explaining how a fiat currency system works. However I still wonder whether it all also dodges an elephant in the room. To me, whatever currency system is in use, the economy will work wonderfully given a situation where wealth is evenly distributed but people believe that by their effort they can gain an uneven share of that wealth for the future. Perhaps USA in 1960 was like that. The critical problem seems to me that it is a self defeating scenario. When wealth is evenly distributed there is plenty of custom for goods and services and money for investment has scarcity value and so is efficiently targeted to where it most efficiently provides those goods and services. The successful investors then accumulate wealth and so the wealth is no longer distributed evenly. Goods and services no longer have customers who can afford them and there is a glut of money for investment with no profitable opportunities for investment. Lending money back to the customers so that they can buy more may give a temporary fix even under a gold standard currency. My impression is that MMT proponents are claiming that Fiat currency could provide a permanent, stable solution. Under MMT, government spending acts to feed wealth in, in an evenly distributed way, at one end and wealth is allowed to accumulate indefinitely with successful capitalists at the other end. That does fit in with what seems to be occurring but it seems a road to implosion. It seems very hard for government spending to avoid certain pitfalls. In Japan and UK it falls into the trap of creating a snowballing quagmire of public administration. Administrators further their careers by dreaming up procedures that will entail them employing more staff who will themselves need to think of ways of employing more staff under them etc etc. The exponentially increasing wealth of successful capitalists is an even more severe danger. As they gain more relative wealth they are more able to control the government and more able to protect their wealth. As the glut of money for investment becomes ever more acute, more and more sophisticated financial engineering is employed. A greater and greater proportion of the talent and resources of the people gets sucked in to money management. I wonder whether what is really needed is some universal acceptance that wealth accumulation can not go on for more than one human generation.

  7. Good post. I’ve said this before on Billyblog: I don’t understand why Bill puts so much effort into defending government borrowing without mentioning that the whole idea of government borrowing is a farce (at least according to the founding father of MMT, Abba Lerner – and I agree with Lerner.)

    To enlarge on that, where a government borrows and spends so as to bring stimulus, the borrow part of “borrow and spend” is deflationary, while the “spend” part is reflationary or “stimulatory”. There is thus NO POINT to the borrow part. Forget it. Just don’t do it! In other words why not just create money and spend it, rather than borrow and spend?

    Conversely, if inflation looms, taxes can be raised and money can be “un-created”, i.e. extinguished.

  9. For stone:
    MMT describes the operations and consequences of monetary practices. It explains how to maintain full employment while controlling inflation. Ii explains that the household logic of borrowing to spend is an irrelevent diversion. It DOES NOT show how to resolve political issues of wealth, power and fairness. Those still require resolution through political means.

    For Ralph: I don’t understand your complaint regarding Bill defending government borrowing. It seems to me he is constantly criticising the practice and calling for government deficits to accumulate as excess reserves in the banking system without compensation to the banks. Some of those excess reserves would disappear if the government ran budget surpluses in the future.

  10. Sergei:

    While I agree in spirit with your comment – I think we don’t want to discourage newcomers to the blog – we can politely point out the introductory blogs and with good humor accept someone who shows some interest in at least visiting an MMT site.

    If they visit on a Saturday, they will surely be intimidated by the quiz!

  11. As purely political speculation – it seems that Bernanke and Bean obviously coordinated their papers/speeches. Clearly there is institutional concern that as the stimuli wears down that there will be a downturn – uncharted territory. Also, maybe a bit of a punt – “monetary has done all we can do, we are willing to throw old theories under the bus, the ball is now in your court”.

    I also believe a 2nd downturn will have very negative impacts – public wealth has been greatly reduced, unemployment is at a much higher baseline, the effects on financial markets will be severe, etc.

    Perhaps this is simply a message from the technocrats to certain powers saying “greedy pigs can be slaughtered, be forewarned”.

  12. @ray
    “I’m thinking here of Zimbabwean buying power after its currency has become toilet paper in the free market.”

    Um, actually right now Zimbabwe is suffering from runaway deflation at around -10% per month.

    I’m sure Bill could give good reasons for both, and equally sure you can’t.

  13. Dear Bill,

    I can tell you that this blog opened a very big window in my mind, and in my political work. I’m introducing the MMT concepts to my colleagues and incorporate them in the Political Program of a new party that we are launching in Portugal.
    I never liked economists because of their incapacity to predict anything, and explaining financial markets. I have even discouraged my soon to go economics graduation. Now I understand how the economics work and I am enthusiastic about this.
    I started to comment in Seeking Alpha, an US investment portal. I started to ask many commentators why US issues long term treasury’s at higher rates, instead of just short term paper (two years is just 0.5%) just to see the answers. From 2 years you can go to one year, half a year, 1 month, 1 week, one day, to zero days, and that is just money. Maybe this could be a path to more people understand the basics of money and credit.

    I really admire your hard work and clear propositions.

    paulo pereira

  14. ‘These W- questions come up every time somebody new bumps up here which unfortunately often means that these people post their comments here but never come back to read responses.’

    I think you will find this happens moreso due to the belligerence shown by some of the regulars here to anyone challenging their system and who hasn’t the time to read through inches of theory.
    I find it interesting and slightly ironic that most of you (along with your leader) deride the NL free marketers as devil worshippers yet are doubtless more than happy to enjoy all the benefits that such a system instills into an economy. You also never mention the ‘C’ word but is that not largely what you all advocate? Equality for all, job for life and huge government?
    I find it frightening that my tax dollars are paying for these views being taught to our kids.

  15. ‘pebird says:
    Tuesday, August 31, 2010 at 0:15
    Sergei:

    While I agree in spirit with your comment – I think we don’t want to discourage newcomers to the blog – we can politely point out the introductory blogs and with good humor accept someone who shows some interest in at least visiting an MMT site.’

    thank you pebird. I can’t say I particularly agree with many views here but am at least willing to be convinced as long as it is not in a condescending way. Having watched this site for a while it seems there are a couple masters-at-arms who aren’t particularly friendly to conscientious objectors.

  16. Keith: I don’t remember Bill saying that deficits should just accumulate as extra reserves until the last half hour so, when I trawled through some of his references above, and found the sentence “Our preferred position is a natural rate of zero and no bond sales.” So you are right, but the phrase “preferred position” does not put the point very forcefully.

    For reasons I gave above, I think government borrowing is a farce. Thus I’d like to see Bill make the “no bond” sales point more often and more forcefully.

  17. Ray:

    It takes a while to get the concepts and mechanics figured out. A very interesting post today on Naked Capitalism from Scott Fullwiler addresses a number of these concepts, as well as more complicated processes. Scott often comments here. Bill’s “101” blogs here are a great way to get acquainted with the fundamentals, and there are a lot of links scattered in many of the blog comments that are helpful.

    MMT basically turns your head upside down in terms of cause/effect and what drives financial flows. While you may or may not agree with the policies that some advocate, the basic description of how the monetary system operates is compelling. Again, you need to be able to resist conventional thinking (remember than conventional thinking helped create the financial crisis).

    Good luck!

  18. Actually Ray’s comments on Zimbabwe and inflation are quite valid. There is an very good reason why people continue to ask questions about it, and that is because MMT has not come up with a convincing answer to the question.

    And yes, before dozens of people start directing me to Bill’s post about Zimbabwe, I have read it several times, and it is unconvincing to me.

    My understanding is that MMT believes that the hyperinflation was caused by the reduction in output, and that the creation of huge amounts of money did not have anything to do with the increase in prices.

    My main objections are that:

    1) The increase in prices was many orders of magnitude greater than the decrease in production. Output declined in the order of 10% pa for a number of years, while prices were increasing thousand-fold and million-fold per year during that time. We would have to accept a hugely non-linear relationship between output and prices for this to be the case. Which brings me to my second point:
    2) If the increase in prices was caused by a supply-side forces and had nothing to do with the money supply, then surely the prices of goods should have increased in when measured in other currencies as well. For example, US dollars were circulating widely in Zimbabwe well before the final peak in inflation. Did the prices of goods go up massively in US dollars? Yes, the probably went up, but nothing like the increases in Zim dollars.

    The reality is that the Zimbabwe hyperinflation was caused or influenced by monetary as well as real factors.

  19. thanks pebird for taking the time…I will read through some of the material you mention and resist the urge to type till then!

  20. Zimbabwe was in a crisis for a number of years:

    1) unstable social situation – wars, political party battles (literally), government opposition suppression, etc.
    2) collapsing real economic output – related to 1), the government was literally putting its political enemies out on the street under the guise of urban renewal. Growing refugee camps, all land nationalized in 2005.
    3) food shortages, etc.

    The government as a stop gap (since they really were not interested in the real economy, focusing instead on political power and paramilitary actions), chose to print money to pay off their cronies and temporarily buy some time. Big surprise … hyperinflation.

    The fact that price changes were nonlinear with reductions in production are not surprising, but doesn’t really mean all that much. The increase in currency was generated for political reasons – I doubt anyone in the Presidential palace was checking out the GDP statistics before printing another gazillion Zimbabwean dollars. There was no excess capacity in the Zimbabwean economy when the increase in money supply started. In fact, MMT predicts inflation under such circumstances.

    There is post after post after post here that says that governments cannot just spend at will without regard for inflation. Inflation is a phenomena rooted in the real economy (real output, real social stability, real economic constraints) that is reflected in the monetary system.

  21. In defense of Ray and in agreement with Sergei:

    I’ve been reading the billyblog for a few weeks now & find it incredibly intellectually challenging for an English major. Bill’s reasoning is trenchantly stated, but nonetheless difficult to adopt at an age where I’ve been reading the Gospels of the mainstream media (orthodoxy) for decades. It takes a while to square all of that history – which we thought we understood – even with logically rigorous MMT thinking. (I must admit that I have been reading the main posts, but not the comments until today)

    I’m reminded of a quote from Seneca: In an insane world, the sane man is insane.

    Thanks for the references to Weimar/Zimbabwe posts on this blog – I hadn’t thought to look those up here, but I need to read them…they might be my true Damascene moment…

    Best,

    -G

  22. Dear Gamma and Ray

    If you cut the supply capacity of an economy by 50 or 60 per cent then nominal demand (private plus public) will immediately be very excessive and inflation will result leading to hyperinflation. Even if the public sector in Zimbabwe had have contracted severely – and caused people to die from lack of income support – there would have been hyperinflation as a result of the continued private demand. Yes, the money supply expanded but that chased the inflation caused by the supply contraction. Yes, if all spending had have contracted severely to match the output decline there would not have been inflation. Instead there would have mass starvation.

    Zimbabwe was the result of a poorly run economy and the government was culpable, although we can understand their motivation if we suspend our prejudices. But it does not demonstrate what happens when you run continuous budget deficits to fill a spending gap left by the private desire to save.

    Japan over the last two decades might give you a clue. But the US, Australia and most nearly every other country ran continual deficits for three decades without hyperinflation.

    And Ray, the unprecedented build-up of bank reserves in the US and elsewhere in the last three years without a dramatic escalation in the price level must cause you to question your held theories about how the monetary system works. It disproves empirically all the theory that you seemed to have learned in high school and perhaps beyond.

    If you find an empirical example to contradict what I theorise and write about let me know. You will not be successful in your search though. Mainstream macroeconomics is dead. It has clearly failed to foresee, explain or solve the current crisis. The body of theory is moribund. I suggest you leave it behind and embrace the operational realities of the monetary system and a body of theory that captures that reality (MMT).

    best wishes
    bill

  23. thank you, I will certainly read on. I must agree with GregL however…much of the heavy stuff takes a clear head and quiet room to understand.

    I do notice that Japan is referenced regularly here as the economy that defies traditional market-based analysis. Having lived there for a number of years and perhaps understanding a little of their social behaviour I might say that there are many unique aspects that may not occur elsewhere. A lack of mark-to-market accounting really turned the whole banking sector into zombieland which in turn kept credit from where it needed to be. The extent of their property bubble and subsequent implosion makes the US bubble look like a blip. Many property values outside of Tokyo are still less than 50% of their 1985 value and the banks took this on the chin. Furthermore, life companies have to guarantee fixed income returns so virtually full domestic takeup of jgb’s is assured which is a stark contrast to the rest of the world. The result is deflation, ridiculously low bond yields yet a seemingly endless bid for ever increasing supply. Perhaps shifting demographics may end this phenomenom.

  24. Once again about LT rates and monetary policy.

    LT rates and the portfolio balance channel substitutions depend on many factors including several sources of risk (inflation, credit, exchange rate, etc.), risk aversion and conditions in secondary markets which are not relevant for the very short end of interbank reserves and discount instruments, where liquidity and counterparty risk are essential. These LT factors and conditions cannot be controlled effectively by the CB operations, so the portfolio balance channel of transmission substitutions is unstable, truncated and can be neutralized by market forces. Furthermore, the portfolio bance channel is not relevant for MMT as I understand it. The continuous refernce to this relationship is problematic at best and provides ammunition to the Neoclassical Consencus!

  26. I still do not see how unemployment is going to be reduced by any of this stimulus to the top end of the system.
    Given that the cost of employing someone for 40 years and finding the money for another 30 of retirement means that the population has to keep expanding to pay for this, ponzi, and that is what we have had, nothing to do with money at all. The fact that so few people actually work now, many are only subsisting, does not create anything much. Also an increasing amount of employment is looking after the old and sick, nonproductive.
    In fact all this theory is irrelevant unless one looks at society and the politics of living.

  27. Thanks Keith Newman for giving me the MMT response:
    “For stone:
    MMT describes the operations and consequences of monetary practices. It explains how to maintain full employment while controlling inflation. Ii explains that the household logic of borrowing to spend is an irrelevent diversion. It DOES NOT show how to resolve political issues of wealth, power and fairness. Those still require resolution through political means.”
    I have to point out that my concern was not at all about “fairness”, it was about the purely economic consequences of having diverging wealth levels. Where wealth is evenly distributed even a gold currency gives full employment (doing useful work what is more) without inflation. Fiat currency, even fully embraced as under MMT, surely just papers over the cracks whilst the cracks continue widening. If MMT results in a low inflation full employment situation where everyone either works as a money manager or as a government administrator and no food, transport or housing is produced, then MMT would seem to me to be a rubbish system. In the UK we seem to be heading in that direction. We rely on the rest of the world to provide us with the real production we consume and we use financial manipulation to essentially defraud the rest of the world (for the time being until it comes unstuck). The “cheap money” required for highly leveraged financial manipulation is constantly pilled up by the fiat currency system surely.

  28. stone: If MMT results in a low inflation full employment situation where everyone either works as a money manager or as a government administrator and no food, transport or housing is produced, then MMT would seem to me to be a rubbish system.

    MMT is about economics not politics. The way money/real resources/power/influence/privilege are distributed in a society is the result of political decisions. If you want things to change in the UK toward greater distributive justice, you’ll have to elected a sympathetic government. What MMT can do in that case is inform the government of viable options, as well as remove illusions about what is possible financially and what is not.

    One of the primary justifications of unequal distribution is economic neoliberalism. MMT demonstrates where and how neoliberalism goes off the rails.

  29. For Ralph:
    I don’t really want to belabour the point about no bond issuance but Bill did a post on this on August 29, 2009 entitled The Natural Rate of Interest is Zero (https://billmitchell.org/blog/?p=4656). Here’s a quote: ”We also know that budget deficits add to bank reserves and create system-wide reserve surpluses. The excess reserves then stimulate competition in the interbank market between banks who are seeking better returns than the support rate offered by the central bank. Up until recently this support rate in countries such as Japan and the USA was zero. In Australia it has been 25 basis points below the cash rate although there is no theoretical reason for that setting.

    It makes much better sense not to offer a support rate at all. In that situation, net public spending will drive the overnight interest rate to zero because the interbank competition cannot eliminate the system-wide surplus (all their transactions net to zero – no net financial assets are destroyed).”

    Of course this is not essential for MMT prescriptions to work but a possible policy prescription. As I have noted in the past this practice imposes a small tax on the banks as they accumulate non paying assets. Presumably they will make it up elsewhere through lower interest on deposits, lower wages to bank workers, etc. As a matter of interest, Marc Lavoie did a presentation on this topic at the Levy conference last June where he indicated it was of course perfectly doable to issue no bonds as Bill and others suggest. His only negative take was that people did in fact want them so why not issue them. As a personal comment I have myself traded some Government of Canada bonds as a retail customer and acquired interest and capital gain. A gift from the Govenment of Canada I guess! So I would be one of those people.

    For stone: I may not have understood you initially. In any event I find one of the appealing elements of MMT is its focus on the real world – real people, and real production of goods and services, and real capacity to produce. It explains how the monetary system works but in such a way as to not allow us to forget what is important – the real world. The neo-classical (conservative) economics gets us to focus on erroneous household finance logic and concludes that the real world should be needlessy constrained for financial reasons, causing much distress for millions of people.

    With respect to ”the rubbish system” you describe, I suppose it would be possible but only on condition that a country was able to get foreigners to accept its financial assets in exchange for endless imports despite the collapsing state of its real economy at home. Possible but unlikely, although to some extent the United States is doing this as the owner of the world currency. But if you believe the UK should have a more balanced economy with more rewarding jobs for its citizens, that is a political battle you will have to wage.

    On a relatd topic you may want to look up a blog Paul Krugman wrote a couple of years ago. In it he fears that the US economy is becoming highly polarised into a small group of extreme ”haves” who spend all their income rather than save it, allowing the economy to function at close to full employment, and a very large group of have-nots who service them. He reiterated this fear several months ago at a conference. Of course this is an empirical issue based on today’s propensity to consume of the US wealthy and the decreasing wages of everyone else. How accurate this is I don’t know but at first glance it seems plausible at least to some extent.

  30. “Where wealth is evenly distributed even a gold currency gives full employment (doing useful work what is more) without inflation.”

    Wealth is never evenly distributed, and it is a pipe dream to pretend that it can be.

    “We rely on the rest of the world to provide us with the real production we consume and we use financial manipulation to essentially defraud the rest of the world (for the time being until it comes unstuck).”

    Free trade doesn’t defraud. Whoever is selling us stuff desires our fiat currency more than the stuff they are selling. Ultimately that cash must come back here at some point because a Pound is only any good to those of us with UK tax bills to settle.

    It’s probably patronising to question their motives or suggest that we are manipulating them.

    Eventually those abroad will sell more in their own currency and eliminate the currency risk as demand in that currency increases. Then as imports get more expensive and subside, the UK will have to rediscover its manufacturing base again – subject to comparative advantage.

    Trade is a tug of war that nobody can win. MMT informs us that we have better and more sophisticated dampeners available to us that ensure wild oscillations that make people suffer don’t happen.

  31. Tom Hickey: economics surely is pointless except as a means of trying to set up a money system where following what makes sense in money terms leads to what makes sense in human terms. My issue with MMT is whether it is going in the wrong direction in those terms. I’m really trying to get my head around how more fully embracing the capabilities of fiat currency (that is what MMT seems to do) can possibly avoid just further expanding the adverse effects of “cheap money” (ie increasing size, influence and instability of the financial sector). To me unequal distribution is the direction any form of capitalism has to be driving in -which is all well and good so long as the unequal distribution setting gets reset often enough to maintain aggregate demand and prevent a distorting plutocracy. MMT seems to just be a way to put off resetting the unequal distribution setting by prolonging adequate aggregate demand but at the same time inevitably allowing asset prices to get further out of hand. It seems to me irresponsible to advocate a currency system that inevitably leads to a glut of “cheap money” empowering and expanding a destructive plutocracy. To say that that is a political issue not an MMT issue is saying that if everyone just ignored money and somehow sensed what was the right thing to do and did it then MMT would work perfectly- ie what would be true under any money system however awful. Surely the people who starved when the wheat price spiked, because Goldman Sachs had a massive glut of money that was shifted into wheat to get it out of collapsing assets in 2008, are the victims of the idea that a constant inflow of fiat currency is harmless.

  32. Neil Wilson, I’m not after some pipe dream where everyone has exactly the same wealth, I just think MMT advocates need to open their eyes to the consequences of MMT. Under MMT a dynasty of financial speculators could compound their wealth by say %20 per year for ever. That could never happen under say a gold standard currency or even under a system with deficit spending matched by government debt issued with an above inflation interest rate. Under conventional currency systems the finite size of the world rapidly curtails the power of any financial entity. We already have a political system largely captured by the”financial services industry”. What do you think would happen if individuals or investment banks sequestered multiples of the global GDP? Surely even a 10x increase in the current financial power of the large investment banks would be incompatible with a functioning economy (because markets could be cornered) and also unobtainable without MMT or similar innovations.

  33. stone, this is where I think you are going wrong:

    Under MMT, government spending acts to feed wealth in, in an evenly distributed way, at one end and wealth is allowed to accumulate indefinitely with successful capitalists at the other end.

    The spending does not have to feed wealth in an evenly distributed way, nor does is have to allow the accumulation you describe. Spending can be targeted to provide the most public good and taxation can prevent excessive accumulations of wealth as necessary to maintain a functioning economy. In fact, my understaning is that MMT does not advocate net government spending under any and all circumstances.

    Were a given non-government domestic sector and external sector to create excess demand, net taxation could be employed to prevent inflation by reducing that demand. Net government spending is necessary to offset net private saving and/or trade deficits, which are not givens in all cases. But even within those cases, like the US today, where there is net private saving and a trade deficit, there are still distributional considerations when it comes to spending and taxation allowed, if not advocated, under MMT. Money doesn’t have to come into and out of the economy willy-nilly, allowing predatory speculators to do as they wish unimpeded. Nor does MMT prohibit financial regulation that would inhibit speculators. I think these things are all manageable under an MMT regime, probably moreso than what we have in the US right now. Even if MMT is silent regarding certain issues, there’s no need to infer that MMT doesn’t allow those issues to be addressed in ways beyond the purview of MMT.

    I hope that helps (and that I got it more or less right in terms of the basics of MMT).

  34. stone: Under MMT a dynasty of financial speculators could compound their wealth by say %20 per year for ever. That could never happen under say a gold standard

    The Great Depression occurred under the gold standard, which did not deter financial capitalism from running amok. The political restraints on the monetary system imposed by the US did not deter the running amok of financial capitalism this cycle either.

    Just what kind of a monetary system do you propose that would rectify the problem as you see it?

    BTW, what you are talking about is the result of rent-seeking – land rent, monopoly rent, and financial rent – taking precedence over productive investment and an actual market for labor instead of a rigged one. See (Minskian) Michael Hudson’s work, for instance. This has nothing to do with the monetary system in place, although MMT does address reforms on this order in its endeavor to ensure full employment and price stability. MInsky’s work also underlies MMT.

  35. “If MMT results in a low inflation full employment situation where everyone either works as a money manager or as a government administrator and no food, transport or housing is produced, then MMT would seem to me to be a rubbish system”

    Is this scenario even possible? Money managers and govt administrators with so much money, they dont need a place to live or anything to eat.
    Hmmmmmm thats an odd situation to blame on the monetary system.

    How ’bout this one
    “And if our current system were to run balanced budgets, debt to GDP ratios of less than .1% and have no taxes but we all had the Ebola virus, the monetary system would be rubbish”

  36. “Under MMT a dynasty of financial speculators could compound their wealth by say %20 per year for ever. ”

    They might be able to in financial terms, but could they in real terms? Ultimately there are more have nots than there are haves, and it is still one man one vote. So it is for the political process to sort this out.

    The ‘haves’ can only continue to ‘have’ until the have nots do something about it. If you have a country where people who would benefit from universal health care vote against it, then I’m afraid that is the political choice they have made. They prefer to suffer because of their beliefs.

    MMT doesn’t prescribe any political outcome. It tells you how a monetary system works and what power that provides to the currency owner. If the currency owner abuses that power then you get Zimbabwe. If it abuses that power with the consent of the people then you get the US or the UK.

    So if you want a political outcome that includes a land value tax and a general suppression of rentiers, it’s for you (and others) to make the political case to do that. But I would suggest that the flexibility of the currency has at least as much power to create a decent standard of living for everybody as it has to create an oligopoly. Crippling it with a lock to gold (or worse the Euro) would be a fantastically stupid move.

  37. Keith Newman: “As a matter of interest, Marc Lavoie did a presentation on this topic at the Levy conference last June where he indicated it was of course perfectly doable to issue no bonds as Bill and others suggest. His only negative take was that people did in fact want them so why not issue them.”

    Suppose that the gov’t did not in fact issue bonds. That would allow us to eventually eliminate the national debt without eliminating the money that it now represents. That would have huge political ramifications, since the fear mongers of the debt would have no ammunition. 🙂

  38. Thanks guys for trying to put me straight about the merits of MMT. However I still have the feeling that our current problems stem because the global economy has become too close to an MMT system rather than not close enough. I think the intractable root problem of all money systems is that for investments to be productive there needs to be a customer base able to afford the products. Henry Ford realized that and so doubled the pay of his workers so that they could buy cars. The problem is that in a finite world as wealth accumulates with successful investors it is lost from potential customers and so investments no longer pay off and so everything grinds to a halt. MMT tries to redress that by maintaining the purchasing ability of the customer base. However that means that under MMT the investments continue to accumulate wealth. As a result asset prices increase to the point where potential earnings from the assets are trivial compared to the value of the assets. Investors then become less and less concerned with value investing (which benefits the real economy by ensuring effective resource allocation) and focus instead on financial engineering exploiting asset price volatility. The financial engineering system takes over the economy and the state and catastrophe results. If you argue that state intervention could reallocate resources from investors and so prevent that scenario- then what is the point of MMT. If relative wealth was transferred from investors to customers then the problem addressed by MMT would not occur in the first place. Our system currently accepts that when a person dies, their debts die with them and also that owners of a limited company are not liable for the debts of that company. I think it would take no more of a leap of faith to accept that ownership of assets can no more be inherited than can liability for debts. Also that investment banking (ie a perpetual company whos business is investing) is not compatible with a functioning economy. If those conditions were met then the whole problem MMT is supposed to sort out would not occur.

  39. “The financial engineering system takes over the economy and the state and catastrophe results.”

    I’m afraid that is not an argument against MMT, any more than the possibility of all the oxygen molecules in a room disappearing to one corner and suffocating everyone is an argument against Quantum Physics.

    Co-incidence isn’t causality and possibility isn’t probability.

    MMT describes how the monetary system works as a matter of fact. It is not prescriptive. What we do with that knowledge is the same choice we face with our knowledge of enriched uranium. Do we destroy or create.

  40. Neil Wilson, ok I agree with you so long as MMT is taken as a theory that illuminates people of the dire dangers of running continuous deficits which inevitably leads to financialization of the economy and state since the money has to go somewhere and that somewhere is asset prices. Perhaps people will learn in history that in the early 21stC, Japan, USA and UK started erring towards running continuous deficits, vast wealth accumulated in the coffers of investment banks, almost all mathematically trained people became coopted into financial engineering, the capital markets were trivialized and gross malinvestment occured, commodity price volatility caused starvation and governments were made up essentially of appointees of the investment banks. If MMT is taken as such an explanation of how we currently have done this to ourselves then I agree it is important that MMT is widely recognized. If instead you are saying that sustained asset price inflation and its resultant ills are just a coincidental phenomenon unconnected to running continuous deficits, then I totally don’t understand your view point.

  41. stone, MMT is not “supposed to solve” any problems at all. It is a macro theory based on current operational reality, given the current monetary system. It is descriptive, explanatory, and predictive. That’s what any macro theory is about. The test is whether it corresponds with data and operations, and whether its explanations yield hypotheses whose predictions are testable based on data. That is what any scientific theory is supposed to do. Theories are then applied to solve problems. That is the engineering aspect of a science.

    Given its findings, MMT makes predictions about various policy options based on its explanatory power. It can be used in a variety of ways be those of different political persuasions. People that are on the left may use it to solve what they see as the problem of unemployment, and people on the right may use it for expanding the military. Art Laffer, who was an architect of supply side economics under President Reagan, understands the operational principles on which MMT is built very well. Vice-President Cheney’s remark that “Reagan proved deficits don’t matter” is a case in point. MMT’ers are aware that operational principles can be used in a variety of ways, based on political decision-making. That is true of just about anything. Nuclear energy can be used for bomb-making or electrical power generation. Where is the problem here?

    The value of MMT in contrast to mainstream economics, New Classicalism and New Keynesianism, is that it is reality-based and operationally consistent, not myth-based and operationally inconsistent.

    All of the objections you raise are actually addressed by MMT’ers. These are all problems that Minsky and Minskians like Michael Hudson have studied, and MMT is well aware of this. You are not telling us anything we don’t know and haven’t considered. MMT’ers have suggested solutions based on increasing global demand by increasing incomes and broadening equality of distribution, as well limiting rent-seeking (land-rent, monopoly rent, and financial rent), which is parasitical on the global economy.

  42. stone, what you seem to be proposing is that a developed, modern economy is not viable, regardless of MMT. I don’t see how MMT in particular is implicated in your criticism of a developed, modern economy. In fact, if it is effective resource allocation that concerns you, you should probably read more of bill’s writings, because I tend to think he addresses that as well as any economist I’ve read.

    If you argue that state intervention could reallocate resources from investors and so prevent that scenario- then what is the point of MMT.

    The problem MMT addresses isn’t necessarily the problem you describe. The problem is that mainstream economists and most politicians have causalities reversed, leading to stupid decisions like instituting austerity during recessions. It’s that responses to macroeconomic problems are hamstrung by dogma based on obsolete notions of how fiat currency-based economies work. Don’t you think it worthwhile to know that there is no need to tax or borrow to fund government, and that taxation and borrowing can serve very different functions that most people think they actually do when it comes time to make policy to address whatever situation may be at hand?

    If I were to inform you of the benefits of modern medicine to disuade you from relying on blood-letting to treat whatever ailed you, would that be worthless simply because you were still subject to potential illnesses? Or what your being subject to potential illnesses make that information all the more worthwhile?

  44. If instead you are saying that sustained asset price inflation and its resultant ills are just a coincidental phenomenon unconnected to running continuous deficits, then I totally don’t understand your view point.

    I can’t say that running deficits was wholly unconnected to the financial crisis, but there are far more obvious and direct causes than deficits. Are you suggesting that, had the US federal government a balanced budget, there would have been no housing bubble? If anything on the government side, it was a matter of regulatory failure and a long-standing, overwrought policy of encouraging homeownership through various programs and incentives. But I don’t see how those things were particularly caused by deficit spending.

  45. Tom Hickey, thanks for bearing with me as I realize I am very ignorant of all economics. I am just a lay person who is shocked by the “deficits don’t matter because they don’t lead to insolvency” interpretation as it is so divergent from my “deficits do matter a very great deal because they lead to financialization” impression I have got. I guess my objection is with any use of perpetual deficit spending rather than with MMT which as you say is just an explanation of the mechanics of fiat currency. My guess is that a lot of the “orthodox” quasi-gold-standard mythology was drummed up to try and dissuade politicians from indulging in the perils of perpetual deficit spending. To use your nuclear analogy, I’m firmly in the “deficit spending no thanks” camp!

  46. WHQ, the US housing bubble was presumably funded by cheap money flowing from Japan as a consequence of the budget deficits in Japan. Deficit spending has to cause asset price inflation unless people put cash under the mattress. In our globalized economy an asset price bubble can spring up far from those that feed it with deficit spending.

  47. To use your nuclear analogy, I’m firmly in the “deficit spending no thanks” camp!

    Which, under current economic conditions, puts you in the “deep recession/depression with mass unemployment and attendant human suffering” camp. I don’t say this to insult, but that’s how it goes.

    As always, government spending, deficit or otherwise, should be targeted to the most public good, and taxation, to the extent necessary, should do the least harm. That we have failed on those counts does not implicate necessary deficit spending or the truth of MMT. To the extent that, all other things being equal, spending less on blowing people and things up on the other side of the world serves to reduce the deficit, I’m all for it.

  48. Deficit spending has to cause asset price inflation unless people put cash under the mattress.

    Which they are now doing – firms and households. You are espousing MMT.

  49. MMT is not a theory to illuminate anyone about “the dire dangers of running continuous deficits” – it describes how the monetary system operates in reality. This exposes much of the neo-liberal/conservative economic thought as pure ideology without basis in fact. This is a powerful tool to understand – it takes some time.

    In fact, it was most likely the lack of deficits (in the US, the “Clinton surplus”) that led to the financialization of the economy – the net financial assets of the economy were constrained by the reduction in government spending and people took on too much private debt. Yes, there was also deregulation of the financial sector – but that was a political/policy decision unrelated to MMT.

    How MMT is used in the hands of those in power is another story – but we have to get the public to understand that what they believe to be economic constraints are in fact political – and that there are tools currently in place that can fix things much faster than they have been led to believe.

    I am unsure whether the political leaders (even those that we think might be the “good guys”) are aware of MMT – in some cases they seem to, other times they show complete ignorance.

    One way I have been thinking about our schizophrenic political system is that when it comes to military/homeland security policies, the entire government embraces MMT. When it comes to social spending, “well, we have to find the funding”.

  50. WHQ, the US housing bubble was presumably funded by cheap money flowing from Japan as a consequence of the budget deficits in Japan.

    It may have been funded in some part by that, but it wasn’t the only cause of funding source. Capital inflows to the housing/mortgage sector were not a necessary consequence of Japan’s deficits (or anything else, without the lax oversight that allowed it). There were many failures that allowed this to happen. Japan’s deficits were neither necessary nor sufficient to create the housing bubble, even if they contributed to the unnecessary problems. Spending can be properly targeted and net spending can be employed under the proper conditions, and another country’s deficits are not under our control. Our financial system is, or at least should be.

  52. In fact, it was most likely the lack of deficits (in the US, the “Clinton surplus”) that led to the financialization of the economy – the net financial assets of the economy were constrained by the reduction in government spending and people took on too much private debt.

    This is an excellent point.

  53. stone, the type of monetary system is not the cause of financialization. Financialization is extreme rent-seeking. Through a variety of subterfuges documented by investigators like William Black, Frank Partnoy, Janet Tavakoli, and Elliot Spitzer, rent-seeking has increasing replaced return on productive investment as the place where big money flows into. One of the subterfuges lies through state capture using legalized bribery (campaign finance and lobbying), political advertising, propaganda funding, and media subversion. Through this channel, laws and regulations are shaped to “industry standards” and justified on the basis of specious economics.

    A subsidiary problem is what Prof. Black calls “control fraud,” that is, CEO’s running their shops for personal and crony gain using fraud as a primary means. Add to this collusion of the central bank, rating agencies, Treasury, etc. and you have a recipe for disaster, which took place in 2008 and is ongoing. As Black et al have been insisting, this is chiefly a forensic problem rather than an economic one. The system is corrupt and so many people are corrupt, or least ignobly self-serving, stretching to the highest levels, Add to this sad state of affairs, economic theories that promote this type of behavior, and it becomes almost impossible to fix it, because the public has no idea what is going on, who is responsible, and who to hold accountable.

    All this is no mystery. It is well documented. It is just not getting media attention, and you have to ferret it out yourself. The great advantage of MMT is understanding it enables your see where the economics is off. But a lot of this is legal and political, rather than economic. Influential people get laws passed and regulations changed that serve their interests, and when they isn’t enough, they just run fraudulent operations. This isn’t just a sink hole; it is a stink hole.

  54. Tom Hickey, surely financialization is limited under a system where asset price inflation is limited. If the monetary system is one where deficits lead to insolvency then asset price inflation is limited and so financialization is limited. If the monetary system is one where deficits can be perpetuated then unlimited asset price inflation leads to unlimited financialization. The mark of a decent monetary system is one where doing what is right in money terms leads to what is right in human terms. To me it is much easier to have a system of wealth redistribution then to try and keep financialization at bay in an environment of perpetual asset price inflation.

  55. But, stone, who here is arguing for (excessive) perpetual asset price inflation? (Some inflation is normal.) You seem to think MMT requires deficits under any and all conditions and that it ignores the problem of inflation. It does neither.

    One of the problems I think people have in interpreting what is written on this blog is that what is often demonstrated and emphasized is in reaction to existing bad policy. When, for example, there are pushes for austerity during recessions, the response is to point out that austerity only makes things worse than that deficit spending is required. The emphasis on deficit spending is in reaction to what is happening in world right now. It’s not the end-all, be-all of MMT. The point isn’t that deficits don’t ever matter or that there are no reasons under any circumstances for governments to reconsider their levels of net spending. The emphasis that you see on this blog is in response to the dogmatic belief that some magic debt-to-GDP ratio is doom, far worse than the mass unemployment and human suffering that could be aleviated through deficit spending when the private sector is withdrawing money from the economy. It’s not “Deficit spending! Just because … regardless of the conditions.”

  56. stone, as I said above, the world was on a gold standard prior to the Great Depression, which was caused by asset inflation. “Sound money” did not prevent the asset inflation that resulted in debt deflation, which was asset led and then went viral. There was relatively little consumer credit at the time. Most of the leverage was in assets. For example, speculating in stocks on margin was popular at the time. My father got hit big by it, so I am well aware of this. If a gold standard cant’ do it, what kind of a monetary system do you think can prevent asset inflation?

    Money can be used to purchase what is demanded. If assets are demanded excessively relatively to supply, they will rise in price, no matter how the money is generated. The problem is not money. It is leverage, and that has nothing to do with the monetary system. The recent asset inflation was not caused by deficits. The funds resulting from deficits are rather small in comparison with amount of money generated through bank lending. Banks lent imprudently. When banks lend against their capital (assume risk), they generate money (deposits) that gets spent, very often on assets. The way to control this problem is to deal with leverage. The economy was too highly levered prior to the Great Depression, and it was too highly levered in 2008. This is controlled by controlling the asset side of bank balance sheets. e.g., by higher capital requirements. The major problems are not in deficits as you seem to think. They are in finance, banking, and shadow banking, along with the moral hazard that systemic risk involves.

    I am sympathetic to your cause, as I suspect many people here are. But I don’t think you have the economics right to accomplish what you want to see happen socially.

    The idea that deficits “don’t ever matter” is not MMT. MMT says that the absolute size of the deficit is immaterial because the correct number is relative to other factors, mostly capacity utilization as reflected by employment.This is the measure of waste and foregone opportunity that is occurring, and it can be measured. It is huge in a crisis such as this, and it threatens to be persistent.

    Just as importantly, MMT says that it is not the size of the deficit that matters, bur rather the quality – how the funds are targeted. Proper fiscal policy in a crisis might be to inject funds at the bottom where they will be spent immediately on consumer purchases and to provide middle class tax relief to help people rebuild their broken balance sheets, while at the same time using targeted taxes to siphon funds off where dislocations may appear, such as in particular asset classes. MMT is well aware that financialization is one of the major problems at present and has proposals for dealing with it, for example.

  57. Tom Hickey, cheers for the explanations. My impression though was that the “sound money” advocates both wanted a limited money source (eg a gold standard) and also a curb on leverage (no fractional reserve banking). I also got the impression that the “resolution” of the great depression was the redistribution of wealth caused by world war II. I am still left wondering whether a combination of “sound money” and no inheritance of wealth (with a ban on proprietary trading by banks) might be the best hope for a sustainable economy. If you are saying that government deficits play only a small part in increasing private wealth then I’m in even more of a muddle about MMT than I realised. I got the impression that after the 2008 crash, the banks were recapitalized and then the stock markets reinflated by high frequency trading platforms of investment banks. Surely that is a case of the fiat monetary system being brought into action to maintain asset prices so that matters could continue from where they left off (ie a state of spiralling financialization)?
    I get the impression that so long as money for investment has scarcity value, the private sector can function well but as soon as there is a glut of money for private investment it becomes dysfunctional due to financialization. My fear is when the state sector steps in to make up the shortcomings of the dysfunctioning private sector, the required public spending adds to the glut of money for private investment creating a vicious circle. I similarly see the value of government bond issuance as being a way to drain private investment money and so mitigate the glut.

  58. stone: “I realize I am very ignorant of all economics.”

    Like you, I am a lay person. 🙂

    stone: “the US housing bubble was presumably funded by cheap money flowing from Japan as a consequence of the budget deficits in Japan.”

    What cheap money flowing from Japan? Don’t we have a trade deficit with Japan? Isn’t money flowing the other way?

    stone: “Deficit spending has to cause asset price inflation unless people put cash under the mattress.”

    As the sectoral balances indicate, if the export-import balance remains constant, deficit spending equals non-gov’t savings. One thing that means is that if people save less and spend more, presumably generating asset inflation by increasing demand, deficit spending will decrease accordingly. Can we talk of deficit spending as a cause in that?

    IIUC, in our current circumstances, people want to spend, but cannot afford to. Effective deficit spending would put money in their hands so that they can afford to buy goods and services from each other. We may say that deficits would increase aggregate demand, but the deficits would facilitate demand, not provide the impetus. No?

    stone: “I am just a lay person who is shocked by the “deficits don’t matter because they don’t lead to insolvency” interpretation as it is so divergent from my “deficits do matter a very great deal because they lead to financialization” impression I have got.”

    Where did you get that impression? Wasn’t there a lot of financialization in the 1920s, too? Under the gold standard?

    stone: “My guess is that a lot of the “orthodox” quasi-gold-standard mythology was drummed up to try and dissuade politicians from indulging in the perils of perpetual deficit spending.”

    You can’t exactly tell that from the Reagan go-go years, or the Bush II years, either. I mention that because the quasi-gold-standard mythology is being pushed by people of the same political ilk as Reagan and Bush II. Historically, hard currency has favored creditors, while fiat currency has favored debtors. Greenspan once commented that the world’s central bankers know that they have fiat currencies, but act as though they were on the gold standard. My guess is that they do so because, in their heart of hearts, they favor creditors.

  59. Min: the “cheap money from Japan” I was on about is described in http://en.wikipedia.org/wiki/Carry_(investment)
    “By early year 2007, it was estimated that some US$1 trillion may have been staked on the yen carry trade.[4] Since the mid-90’s, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies.[5] These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries.”

  60. stone: “I got the impression that after the 2008 crash, the banks were recapitalized and then the stock markets reinflated by high frequency trading platforms of investment banks. Surely that is a case of the fiat monetary system being brought into action to maintain asset prices so that matters could continue from where they left off (ie a state of spiralling financialization)?”

    I got the same impression, more or less, except for that part about continuing from where they left off. I thought that the reason was so that matter could continue without a disaster.

    Having a fiat currency certainly facilitated the bailouts. If we had been on the gold standard, things would be much worse. However, having averted disaster, the powers that be decided to let the brunt of the crisis fall upon ordinary citizens, accepting high unemployment (despite what they say) and household indebtedness. Having a fiat currency would have allowed Main Street to be bailed out as well as Wall Street. That has not happened, and those who now cry for “sound” money are helping to insure that it will not happen, that economic inequality will increase, not decrease.

  61. If you are saying that government deficits play only a small part in increasing private wealth then I’m in even more of a muddle about MMT than I realised.

    Owing to the $-4-$ requirement that deficits be offest by Treasury issuance, all the nongovernment net financial assets created by deficit expenditure get saved as Treasury bonds/bills.

    I got the impression that after the 2008 crash, the banks were recapitalized and then the stock markets reinflated by high frequency trading platforms of investment banks. Surely that is a case of the fiat monetary system being brought into action to maintain asset prices so that matters could continue from where they left off (ie a state of spiralling financialization)?

    This had nothing to do with deficits or “the fiat money system.” This was accomplished by the Fed through 1) “forbearance,” that is, letting the banks off the hook on matters like solvency, and 2) “providing liquidity” through setting historically low interest rates so the banks could resume lending profitably to recapitalize. This was an action of the Fed (monetary) not Treasury (fiscal). However, instead of lending, the banks used the low rates and advantageous spreads to gear up again. The “bailout” was fiscal, however, and MMT’ers hold it was unnecessary.

    Fractional reserve requirements are essentially meaningless, since banks don’t need reserves to make loans. Reserves are needed for clearance and requirements after credit extension, not before. The talk about “fractional reserve banking” is lot of brouhaha about nothing, engaged in by people that don’t know how the system operates.

  62. @stone: Thanks for the heads up about the carry trade. 🙂

    Correction:

    I said, “As the sectoral balances indicate, if the export-import balance remains constant, deficit spending equals non-gov’t savings.”

    That is not what I meant. IIUC, that should be, “As the sectoral balances indicate, if the export-import balance remains constant, new deficit spending equals new non-gov’t savings.

  63. stone, the yen carry trade and now the dollar carry trade are due to low rates set by the “independent” central bank (small group of unelected and unaccountable technocrats). MMT holds that fiscal policy is generally more appropriate than monetary policy, too. In addition, at least some MMT’ers recommend ending central bank “independence” and control over intrest rate setting, and relying on fiscal policy instead.

    BTW, Here is a post by MMT’er Lynn Parramore that may be of interest to you.

  64. Question for Panayotis and Bill:

    I am interested in getting a better grasp on the determination of long term interest rates. MMT focuses on the interbank rate and the closest I’ve seen to an explanation of long term rates is that they are related to current and expected future interbank rates. (http://www.mosler.org/wwwboard/messages/2148.shtml). For more discussion see: http://www.interfluidity.com/v2/603.html. I was wondering if you could point me to a concise discussion of the factors, while taking account of monetary operations in the real world.
    Thanks

  65. Tom Hickey, I thought that a key element of what Bank of Japan did was QE ie the government buying its own bonds. That gave an immediate influx of cash to the global banking system. The UK and the US also conducted QE more recently. Anyway surely even if the debt is all held as bonds and paid off the bond holders will have made a profit (from interest payments) and that is money added to the global banking system. I also got the impression that this site was a big advocate of deficit spending without debt issuance. A near zero interest rate policy is required by a large government debt. Otherwise interest payments would spiral out of control. Japan could never have a >2xGDP government debt and not have a near zero interest rate surely unless all of the debt was held by the Japanese government and so all of the interest was paid back to the Japanese government. I think I also saw somewhere that US bonds were transferring from the Chinese government to the UK government. Basically a kind of cryptic QE where the UK and USA governments hold each others bonds. I suppose zero interest rate bonds held by the private sector could in principle soak up the proceeds of government debt but basically banks would much rather keep the cash and use it for leverage of trading activities. I hope I’m not utterly muddled about this.

  66. Tom Hickey, I thought that in the 1920’s there was a fractional reserve limit on what banks could lend. I thought that the “sound money” brigade were not wanting to go back to the 1920’s but rather to a novel/primeval system where banks really could not create money ie an inelastic system with no cyclic leveraging then deleveraging (as in the gold standard days) nor the current continuous leveraging and more leveraging. I guess that if wealth is inherited such a system would in a generation or so lead to a Haiti like situation of a handful of landlords exacting a meager rent from a mass of below-subsistance peasants. I just wonder whether our current set up is also inexorably also heading in that direction but via an intervening phase of financialization. Perhaps the Haiti like proportion of the world will gradually spread until the banks have nothing left to feed off. To me it looks like wealth inheritance is the root problem and the history of economic development is one of trying to get elbow room within it.

  67. stone, banks need reserves for settlement purposes _only_. Banks do not use cash/reserves for leverage or trading or any purchase of any asset (apart from government bonds). This means that the only thing banks can buy with reserves is some stuff from the government because then they have to pay with reserves or cash. Any activity within private sector simply shifts government financial assets around. And as a consequence of it, it does not really matter how much government financial liabilities sit in private sector because central bank will always provide reserves to settle private sector transactions.

    This goes without saying that fx-market operates on margins which are huge compared to any other market. They are huge because you collateral (currency you bought) is super-liquid and can be liquidated without any cost at any point of time. So all you need to enter an fx-transaction is a bit of initial deposit and a bit of government asset can get you a leverage of x100 and even more

  68. OK Sergei, my understanding was that under Basel II, retained profits build bank Tier1 capital (based again on wikipedia I’m afraid! http://en.wikipedia.org/wiki/Capital_requirement) and that generating such profits involved for instance borrowing Japanese Yen at near zero interest then making high interest paying loans. Without the Japanese cheap money, the profits could not have been made to build the Tier1 capital to allow more loans to be made. Isn’t it also true that the more money deposited, the less competition there is between banks to offer a high interest rate to depositors so the greater the profit they can make when loaning money out? Was the whole carry trade phenomenon a myth? If not then surely it is empirical evidence that Japanese cash created US loans. Surely banks must get something for allowing people to make deposits or they wouldn’t offer it as a service.

  69. ” Otherwise interest payments would spiral out of control.”

    Once again you are failing to look at the balance sheet from both sides.

    Firstly when a central bank first issues bonds it does it via an auction, not at par. So at that point the stream of interest is capitalised (A £100 bond with 2% interest for 15 years is worth paying more than £100 for if 2% is better than you can get elsewhere). So interest isn’t a cost from the issuer’s point of view. It’s just converting capital into a future income stream at a discount rate.

    Secondly the discount rate is set by the same issuer. It is lending money to banks at that interest rate. So it gets the discount rate from the banks and gives it to the bond owners as interest. Any difference is then just annuitisation of the original cost (hence the ‘pull to reversion’ in a bond).

    There’s no doubt a bunch of mathematics that defines this precisely. The money in bonds is merely in speculating on changes in the discount rate over time. Other than that they are really a tool for annuitisation – ie paying private pensions.

  70. Neil Wilson, I think the requirement for a very low interest rate if the government debt is multiples of the GDP is described in http://krugman.blogs.nytimes.com/2010/07/17/i-would-do-anything-for-stimulus-but-i-wont-do-that-wonkish/ . Are you saying that Japan could have high interest rates and have a 2.5x debt (held outside the government) to GDP ratio without the ratio rapidly increasing at an ever faster rate? Do you disagree with the broad idea that if government spends more than it removes, by taxation and debt issuance, then that puts money into private ownership and so the amount of private money saved or invested will increase? To me either that point is wrong (and I’m in an utter muddle), or it is correct but doesn’t pose a danger (and I’m in an utter muddle) or it is correct and it does pose a danger.

  71. stone, check out Monetary Operations 101 by Scott Fullwiler. It’s a brief PowerPoint presentation.

    To adjust monetary policy the cb sets the overnight rate and the discount rate. QE, unless nongovernment decides to hold more currency instead of bank reserves, which is unlikely and hasn’t happened this round, just changes the composition of the cb’s assets.

    While some argue that low rates led to malinvestment, other, e.g. Bill here, argue that the effect is limited and that low rates did not cause the housing bubble, for example. The driving force of Ponzi finance was fraud, as documented by Bill Black, Frank Partnoy, Janet Tavakoli, and Elliot Spitzer, for example, and specifically “control fraud,” or the running of financial institutions by CEO’s as fraudulent operations, as Prof. William K. Black describes it. This was made possible by regulatory capture and incentivized by moral hazard. In short, the system is corrupt and needs to be reformed at the top or this behavior will continue and increase, leading to more looting and more crises. As Black, says this is much more a forensic problem than an economic one. The latter was a direct result of the former.

    The important point is that MMT holds that monetary policy (interest rate setting by the cb) is a blunt and ineffective instrument, which, moreover, produces winners and losers, and the winners are the financiers and the losers are the public. MMT recommend using fiscal policy instead, which can be tightly targetted to where it will be the most efficient and effective. The depends on a macro model based on operational reality. See Scott Fullwiler, The Sectoral Balance Model of Aggregate Demand-Revised

  72. stone, banks’ profits are recorded in domestic currency. Any profit that banks make comes from leverage of non-bank sector of domestic economy. Government injected money (budget deficit) is supposed to reduce financial leverage of non-bank sector of domestic economy. The carry trade which presumable pushes asset prices higher and therefore leads to mark-to-market gains does not come for free. It is a zero-sum game. To understand it just have a look at some Eastern European countries where mortgages were typically given in CHF to happy borrowers and where banks are now staring at their soaring risk costs while the whole story gets sexier by the day in anticipation of Basel 3.

  73. stone, following up on Sergei, if it were the yen carry trade that funded the housing bubble, then it would be Japanese banks, not US banks, that would bear the brunt of it. One can argue that low US rates were involved but not Japanese rates. I linked above to Bill’s debunking of the idea that US rates were causal.

  74. stone, read the many comments on that Krugman thread by MMT’ers and sympathizers, especially James K. Galbraith, Paul Davidson, Scott Fullwiler and JKH. Krugman’s case is full of holes.

    The US government is not financially constrained. The only constraint is real, that is, effective demand exceeding real reasources (supply) to meet it or inflation will result. That’s not going to happen anytime soon with a large output gap and historically high unemployment/underemployment. The interest on the tsy offset also adds to nongovernment net financial assets (spending power), which is needed now. The interest on the debt goes toward the deficit and the US as currency issuer will never be unable to meet its payment schedule. The bod vigilantes are not only silent now, but the historically low rates indicates that the bond market is calling for further stimulus, as Krugman has been saying.

    What Krugman says is that “eventually” the US will have to “address” the deficit. What the MMT’ers say is there is no empirical model indicating that debt is unsustainable for a monetary sovereign like the US, and 2) there is ample evidence that there is no arbitrary limit. They challenge the deficit hawks and deficit doves alike to prove what they are asserting. So far, no solid empirical evidence has been forthcoming, just theory based on questionable assumptions that lack an empirical warrant. It’s just ideological fluff. See Bill’s blogs on deficit and also on fiscal sustainability in the archive.

  75. Sorry about my still not getting it! In reply to Sergei,I thought that the crucial difference between the Japanese banks funding the US housing bubble and the Swiss banks funding the Hungarian housing loans was that the Japanese loans were very short term and were converted to USD by US banks before being leant to the US home owners. So the US banks made short term loans from Japanese banks and used them to fund long term loans to US homeowners. In contrast the Swiss banks lent direct to the Hungarian homeowners who then needed to pay off the loans in Swiss Francs. So Japanese banks could just walk away and not make additional short term loans to US banks. Surely that was what the “credit crunch” that burst the bubble consisted of.
    To Tom Hickey: You say yourself “the interest also adds to nongovernment net financial assets (spending power), which is needed now.” The first half is of that sentence is exactly what I’ve been trying to say except that I’m saying more spending power is NOT what is needed now. What is needed is more spending power with customers relative to that of investors. The interest just adds to the spending power of investors and so pushes the ratio in the opposit direction to that required. Investors have the potential to be capable resource allocators but only if value investing isn’t swamped by bloated volatile asset prices and if customers have purchasing power.

  76. Tom Hickey, you say that financialization is a problem of dishonesty rather than a structural economic problem. I agree that any dishonesty is always a problem but I’m also sure that even if everyone was totally honest, it would cause severe problems having a glut of money for investment. It takes a lot of work to manage wealth, the army of people who work in wall street and the city are some of the hardest working most educated people on the planet. That army of people could be involved in productive employment or recreation if the proportion of GDP from financial services was back to as it was in the 1960s. Also effective private sector resource allocation is impossible if asset prices are vastly greater than earnings from those assets. If we had no money of any kind, it would not just be lack of honesty that stopped people from doing the work that was needed, it would also be the fact that people would not be able to sense what needed to be done. The same becomes true when asset prices become over inflated.

  77. stone, what you say about the yen carry trade and US banks makes no sense. The US banks did not need to borrow to lend. They lend against their capital. If they borrowed and immediately paid it off short term, that would be functionally equivalent. But they did not need to borrow in the first place. They create the funding when they lend against capital at risk to them (loans create deposits). You are unclear on how money gets created in the US by government (vertically) and banks (horizontally). That is at the basis of the MMT understanding.

    o Tom Hickey: You say yourself “the interest also adds to nongovernment net financial assets (spending power), which is needed now.” The first half is of that sentence is exactly what I’ve been trying to say except that I’m saying more spending power is NOT what is needed now. What is needed is more spending power with customers relative to that of investors. The interest just adds to the spending power of investors and so pushes the ratio in the opposit direction to that required. Investors have the potential to be capable resource allocators but only if value investing isn’t swamped by bloated volatile asset prices and if customers have purchasing power.

    Again, you are not understanding this properly. When government disburses funds, e.g., through the automatic stabilizers it goes into people’s pockets that will spend (food stamps, unemployment insurance, etc.) This is the solution that MMT recommends. When the Fed lowers interest rates, it is encouraging the banks to lend to consumers and businesses for investment. But the creditworthy borrowers aren’t interested in borrowing, and the others aren’t creditworthy. Also, when demand is weak, business has no incentive to borrow to invest, even at low rates. Thus, it is true that the wealthy can use the low rates to lever up, and this can lead to assets price inflation in certain areas. But we aren’t seeing that happen either, although it can be argued that it happened at the time of the bubble. MMT would say that the problem was not the low rates, but rather the loose leverage requirement (40 to 1) and the lax regulation to prevent accounting fraud, fraudulent underwriting, and a host of others bad practices. MMT recommends tighten up the requirements and enforcement to prevent cheating, changing incentives to reduce moral hazard, and use taxation selectively to discourage financialization.

  78. Tom Hickey, you say that financialization is a problem of dishonesty rather than a structural economic problem. I agree that any dishonesty is always a problem but I’m also sure that even if everyone was totally honest, it would cause severe problems having a glut of money for investment.

    A glut of money leads to inflation. The “glut” at the level of asset prices was the result of abusing leverage and shady dealing, largely in the “shadow” banking system, where there is little to no regulation or oversight. This resulted in a run up in asset prices and then commodities rather than consumer products and wages, owing to some peculiar circumstances this cycle, but asset prices generally rist more quickly that other prices, and wages rise last. Moreover, asset appreciation in is not considered inflation officially, so no action is taken to control it.

    MMT’s solution for controlling this is to recognize the disconnect in price action (bubbles) and use taxation selectively to withdraw funds that are driving asset prices up, instead of raising interest rates, which results in business contraction and increasing unemployment. Moreover, the problem of excessive asset appreciation is largely the result of abusing leverage and various kinds of fraud, enabled by deregulation and lax oversight and enforcement, which involve capture. So this is a legal and political issue as well. Bubbles should be prevented from forming by removing the conditions under which they form in financial assets, which is always imprudent or fraudulent lending practices, incentives to make short term profits that will not be clawed back, and abusing leverage. Bill Black and others have set this forth in detail. It is well known and can be corrected, but that involves confronting powerful vested interests politically and legally. So far the president and the rest of the politicians have not had the stomach for this, since they get their campaign cash from the people they would be going after.

    It takes a lot of work to manage wealth, the army of people who work in wall street and the city are some of the hardest working most educated people on the planet. That army of people could be involved in productive employment or recreation if the proportion of GDP from financial services was back to as it was in the 1960s.

    Exactly what Bill has been saying in blog after blog. Basically, MMT’ers propose returning to traditional banking, since banks are public-private partnerships and the recent spate of “financial innovation” has not only not contributed to welfare but detracted from it seriously by causing depression-level contraction and unemployment. The mathematicians, scientists and engineers that went to Wall Street of late would be more gainfully employed in the professions for which they were trained. If financialization were ended, then they would return whence they came, and the country and world would be far better of for it.

    Also effective private sector resource allocation is impossible if asset prices are vastly greater than earnings from those assets. If we had no money of any kind, it would not just be lack of honesty that stopped people from doing the work that was needed, it would also be the fact that people would not be able to sense what needed to be done. The same becomes true when asset prices become over inflated.

    Again, this is exactly what MMT’ers have been saying, as well as proposing ways to solve this problem by ending financialization and increasing effective demand at the lower tiers (greater equality of income and wealth), which would lead to increased productive investment. MMT addresses this fiscally, with targeted government expenditure and taxation, as well as proposing ways to eliminate or at least greatly reduce financialization.

  79. Tom Hickman, I think my understanding of the Yen carry trade and US banks concures with everything in https://billmitchell.org/blog/?p=9075. Bill writes there: “The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place”
    So with the Yen carry trade, the US banks repeatedly took out three month low interest loans via interbank lending. They used those to profitably settle the high interest loans to US homeowners. The resultant retained profits of the US banks increased the Tier I capital of those banks enabling them to make more loans. The Japanese banks also profited from their side of the trade so increasing their TierI capital and allowing them to make bigger loans via interbank lending. Were it not for the carry trade, the US loans would have needed to be bailed out at the discount window penalty rate which would have not led to profits for the banks and so the loans would not have been entered into in the first place. The banks could have made the loans unprofitably -which is hardly an option they would take and if they were to do so it would rapidly eat into their retained profits and so their Tier I capital and so their ability to lend.

  80. Tom Hickman, I’m still not sure what you propose should happen to the glut of money that builds up in private savings and investments as a result of government money creation. If regulations were enforced that reduced leverage then that would absorb some of the government created money. However you are proposing a continuation of the inexorable increase in government created money. You seem to say that somehow regulations could be devised that would constrain that money in such a way as to prevent it from causing harm. I just don’t get how you can have private money for investment that has scarcity value and so can exert the essential private sector resource allocation role that is the basis of what money is for and yet at the same time have a vast growing glut of private money. The only way I can see to deal with that problem is to maintain an appropriate stock of private money which is another way of saying running a budget that balances. You could come up with a host of rules such as only certain people could invest in equities or housing or whatever but surely that would be a disaster. Creating money and then constraining it to the extent that its capacity for harm was annulled seems fanciful to me.

  81. “I’m still not sure what you propose should happen to the glut of money that builds up in private savings and investments as a result of government money creation”

    If it’s in savings and investments, then that is like carbon dioxide tied up in carbonate rocks. It’s only an issue when it gets released and that only happens slowly.

    “However you are proposing a continuation of the inexorable increase in government created money. ”

    That’s because there is an inexorable increase in people and productivity. Money is just oil in the engine – you need enough to stop it ceasing up. It’s people, productivity and transactions that’s the fuel for the engine.

    If people, productivity and transactions change such that demand exceeds supply, then you need to destroy money via taxation and interest rates to keep things in balance. If the private sector is having one of its investment frenzies then the government sector will be running a surplus to take the froth off.

    Remember you are talking macro level here. You can have scarcity at micro level while having sufficient at macro level.

  82. keith Newman,

    I just saw your question. The comment section of this blog does not allow a long elaboration on this huge subject. However, here are some points.

    1. At the micro level of behavior the interest yield is a topic related to capital asset pricing and portfolio balance theory. At a more elementary level, see a textbook of Finance Theory, or for a more advanced analysis, see J. Cochrane, Asset Pricing and using stochastic theory, see Karatzas and Shreve, Brownian Motion and Stochastic Calculus, and Shreve, Stochastic calculus for Finance (I,II). An alternative approach is to consider the interest rate required by savers/investors as equal to the opportunity cost of the productivity of labor time, whose income is invested and not consumed if it can bring an equivalent yield to the real wage earned by this labor time.

    2. Given a multiple of assets with different characteristics there is an aggregation problem as we analyse at the macro level. A method used for analysis is the term structure of interest rates, where terms can differ in terms of maturity, duration (trade dealing), floating/fixed rate composition, repayment scheduling, domestic/foreign currency denomination, collateral and other arrangements such as swaps, etc. However, for simplification purposes it is assumed that maturity is strongly and positively related to the other terms and is used as an index to examine the structure. The long tail of maturity is considered to have more of these terms as an approximation. Furthermore, as we move towards the long tail the factors of liquidity and risk rise and additional factors beyond these have an influence including inflationary expectations, exchange rate volatility, probability of default, etc. As we move towards the long tail these factors get entangled, volatility increases and pure uncertainty/conservation emerge that bounds estimation. At an elementary level hypotheses used to examine this structure is expectations, expectation augmented residual and segmentation theory that splices the structure into tranches of analysis.

    3. An othe issue in connection with the above is whether monetary policy can have a stable transmission from/towards the LT rates. Given the complexity, volatility and uncertainty/conservation conditions the transmission channels (credit, portfolio balance, etc.) via the substitution distance of the structure of rates, receives a lot of interference and becomes unstable. The control relationship of monetary reaction becomes problematic and unsustainable as at any point these factors can counterbalance the monetary policy stand of monetary policy regarding target interest rates.

    I hope this is enough.

  83. stone, if the loans/derivatives that blew up were connected to Japanese banks as originators of the funds, those banks making the loans would have been on the hook. There is no evidence I see for that having happened of which I am aware. Generally speaking, the yen carry trade works by borrowing yen at a very low rate ans putting the funds in, e.g., US Treasuries at a slightly higher rate. This is a no brainer interest arbitrage.

  84. Tom Hickey, are you saying you doubt that banks make long term loans funded by a series of short term loans from interbank lending? Remember Northern Rock the UK bank who did little else and so came unstuck when the banks making the short term loans to them stopped doing so leaving Northern Rock requiring money lent by the UK government at the penalty rate. The Japanese banks making the short term loans via the carry trade were able to indirectly flood the USA and UK with cheap credit until they were worried that it was all going to blow up. Once they were worried they made no new interbank loans, the outsanding loans were paid off immediately before the crisis really unraveled and so they were not on the hook.
    Neil Wilson, I guess the rub is that your understanding is that excessive money in savings and investements is like carbon dioxide in carboniferous rocks and my understanding that it is one of the most damaging and dangerous perils facing the world.

  85. Stone,
    Was Nothern Rock a ‘bank’ or a ‘building society’. Wiki has them as a ‘building society’. There may be key differences between how a ‘building society’ can achieve funding (would use the com paper mkt) vs a true ‘bank’ (only capital constrained, uses interbank lending only to borrow regulatory required settlement balances/reserves).

    In the US here, many so-called ‘banks’ (Lehman/Goldman/Countrywide, etc) were not really ‘banks’ in the technical definition…that truned out to be a big part of the problem with getting them help when it was really needed imo.

    Resp,

  86. stone, you misunderstand fx-markets and carry trade. Carry trade by definition is the difference between carry costs (or gains) of holding two different assets. In case of currencies the logic is based in difference in interest rates one can make holding each. However, nothing is free carry trade included. This means that as long as you are on the right side of fx movements your “carry” trade is positive. The word carry is in quotes because it is much more a bet on fx-rate movements than it is a gain on interest rate difference between two currencies.

    Now consider banks borrowing yen and giving it to mortgage borrowers in the US. First of all, I do not know about US but I seriously doubt that there was a broad practice of Japanese yen denominated mortgages. This is different from Europe where Eurozone (not Swiss!) banks were borrowing short CHF and lending it to HUF-based borrowers. In any case, in such transactions there is a clear fx-risk whether you call them carry trade or not. This risk felt really nice to all borrowers as long as fx-rates moved in there direction and nobody cared about such risk. Now the tide has reversed and fx-borrowers found themselves seriously underwater, cannot sustain fx-losses which are being transfered to banks since eventually it was banks who borrowed foreign currency.

    If you borrow in foreign currency and want to eliminate fx-risk then your forward fx-rate will be calculated the following way: you take current fx-rate plus interest rate differential between currencies (including any expected changes) plus time horizon and you arrive at forward fx-rate. You hedge this risk and … bingo! … you are out of the carry trade back into your domestic currency. Nothing is for free, I am sorry. If you think you are smarter than fx-market then good luck. Unfortunately most fx-borrowers have no clue what they are doing. And when fx-rate goes seriously against the borrower like it is now then it is banks who takes the fx-loss.

    And this whole story assumes still abundant short-term financing in foreign currencies for banks. Which is, actually, not so much the case any more.

  87. stone, I suspect you you are confusing the terms “interbank lending” and “carry trade.” Interbank lending occurs within a banking system, like the Federal Reserves System, to which banks operating under US charters belong to settle account among each other in bank reserves denominated in the currency of that system, e.g., in the US, the dollar.

    The interbank lending takes place in the interbank market in this way: If you borrow from you bank for a mortgage, the bank creates a deposit in your name in that amount. This creates a liability for the bank, and the bank enters the loan as a receivable as a corresponding asset on their books. You pay for the property with a check drawn on your deposit account, and that check is deposited in another bank by the seller. Before finally crediting the seller’s bank credits the seller’s deposit account, the bank must clear the check for bank reserves in the interbank system, so it sends the check to the clearing house at the regional FRS. The check clears in the interbank system at the regional FRS bank, where you bank’s reserve accounted is debit in that amount and the seller’s bank’s reserve account is credited. When the check clears, then the transaction is finalized. The seller has the credit in a deposit account, a liability for the seller’s bank, and the seller’s bank has the bank reserves from your bank and enters this as a corresponding asset.

    Your bank must either have the excess reserves available to do this, or else borrow them on the interbank market at the going rate, in the US, the Federal Funds Rate (FFR) that the Fed sets and maintains through Open Market Operations (OMO). The Fed also stands by as lender of the last resort to loan the reserves for settlement at the discount window at a penalty rate, if need be. This is not the normal channel and is frowned on, since it indicates that the bank using the discount window is not well managed. Thus, borrowing at the discount window does not happen in the normal course of events, but rather as an exception.

    The carry trade is as Sergei describes. In the yen carry trade, one entity borrows from a Japanese bank at low rates owing to the deflationary environment prevailing in Japan, and they uses the funds to gain a better rate of return, e.g., in interest rate arbitrage as I described above. The profitability and ultimately the viability of this is dependent on changes in the fx rates. This is a sophisticated trade and generally it is the hedge funds that use these kinds of vehicles.

    As I said, there is no indication that a great deal of the funding that led to the housing bubble came from the yen carry trade. Rather, it came from banks extending loans through their banking privilege and then getting the loans off their books quickly through securitization. While Fannie and Freddie participated to some degree, it was a lot less than the right makes out. Later in the bubble especially, this often involved using the “shadow banking system.” Shadow banking is not regulated the way regular banking is, so the leverage involved could be very high and there was virtually no oversight.

    Owing to Ponzi finance and the complicity of the rating agencies, much of which was not only imprudent but also fraudulent, this whole scheme blew up as borrowers could not meet their obligations, taking down the financial system due to systemic risk, i.e., a domino effect of interdependent counter-party obligations resulting from hedging risk. It turns out that many of the firms involved knew from the start that this was unsustainable and so they hedged against the inevitable losses by buying CDs, for instance, from firms like AIG. Sharp operators like Goldman made big money on both sides of the trade.

    You seem to think that US banks used the yen carry trade to beef up their capital so that they would have more capital against which to loan. There is no evidence of which I am aware that they used this, at least widely. They could make much more more quickly using prop trading at high leverage. They did not need loans from Japanese banks to fund these operations. I have been following people like Bill Black and Janet Tavakoli who write about this in detail, and I have seen nothing about the yen carry trade being involved at all. I admit that I don’t know everything, however, so if you have specific evidence, please cite it and I’ll take a look and see what I think.

    I realize that there some people who are claiming that the yen carry trade is at the bottom of everything and that when the world finally wakes up and realizes that Japan is insolvent, the yen carry trade will unwind suddenly and all the world’s assets will suddenly plunge in value. This is just another fantasy, along with many similar ones about hyperinflation going to destroy us all very soon

  88. Matt,

    Northern Rock was a ‘bank’, in that it was a public listed company with shares. It used to be a building society until it demutualised.

    It would have been better stopping as a building society.

    There is very little operational difference between banks and building societies in the UK any more. It’s really just a description of their ownership structure.

  89. stone,

    “Remember Northern Rock the UK bank who did little else and so came unstuck when the banks making the short term loans to them stopped doing so leaving Northern Rock requiring money lent by the UK government at the penalty rate.”

    That is the normal function when a bank is short of reserves to clear the system. It was the losses on the loans that made the bank insolvent and meant that it ended up nationalised.

    It was the media stirred hysteria over the government funding the liquidity requirements of the bank and its effect on the ‘deficit’ that was the problem. That caused the run on the bank.

    The ‘lender of last resort’ bit was very badly explained, and that is because the government was a hostage to fortune – since it had hung its credibility on a bunch of financial ratios that were now in tatters.

    All banks and building societies lend long and borrow short. It’s only when the yield curve inverts (as it did when the wholesale funding market dried up) that they get into liquidity problems. That’s why we have a lender of last resort with infinite capacity in its own currency.

    ” my understanding that it is one of the most damaging and dangerous perils facing the world.”

    Your understanding is borderline hysteria based on no evidence. You should work to balance your view.

  90. Tom Hickey, are the links in http://ftalphaville.ft.com/blog/2010/05/28/246016/the-pictorial-speculative-yen-carry-trade/ any help? It seems to me hard to argue that 1trillion USD of credit appearing in the economy had no effect.
    “The BIS methodology is a bit complex, so we’re summarising. In order to put on a yen carry trade you generally need to swap your dollars for yen. Someone has to provide that yen swap for you, and that tends to be the Japanese banks. According to the authors, it’s estimated that Japanese banks have supplied upwards of $1 trillion worth of yen to the swap market over the last few years.”
    They also have a post about the current USD carry trade (rather than the pre-crisis yen carry trade). http://ftalphaville.ft.com/blog/2009/11/25/85211/debunking-carry-trade-denial/
    ” this suggests that CP is not being used to finance any active, economic purpose in the Land of the near-Free Loan itself – an inference further reinforced by the fact that domestic financial CP outstanding has plummeted to what is at least a 9-year low. Thus, the correlation between funding and forex hints that the raising of dollars for use abroad is indeed what is at work.”
    My basic take on this is simply that money can flow around the world and so a credit fueled asset boom can spring up far from where a large amount of cheap money was produced.

  91. Neil Wilson I mostly agree with your advice to me: “Your understanding is borderline hysteria based on no evidence. You should work to balance your view.” I do need to stop getting so freaked out by this but I do think my hysteria is based on evidence. Please read http://foodfreedom.wordpress.com/2010/07/17/food-bubble-how-wall-street-starved-millions-and-got-away-with-it/
    Money is power and letting money accumulate is letting power accumulate. By its very nature money gravitates to those who are most single minded and merciless in obeying it. When capital is scarce in relation to earnings, allocation of capital drives efficient allocation of resources. When money for investment is endlessly abundant it fails to do that and just sloshes around the world causing destruction.

  92. Sergei,

    “you take current fx-rate plus interest rate differential between currencies (including any expected changes) plus time horizon and you arrive at forward fx-rate.” There must be a typo, instead of “plus” you mean “multiply” time horizon. Thank you for your analysis.

  93. stone: My basic take on this is simply that money can flow around the world and so a credit fueled asset boom can spring up far from where a large amount of cheap money was produced.

    The yen carry trade did contribute to the “global pool of hot money” that was estimated to be around 60T during the go-go times. But there were a lot of things that contributed to that, a great deal of it involving financialization and inequality of distribution. Money flowing around the world freely is what neoliberalism calls “free flow of capital.” It is one of the pillars of neoliberalism, along with “free markets” and “free trade.”

    What MMT is calling for ending financialization and increasing the global balance of demand and productive investment through more equal distribution. Curtailing the absolute amount of money is not the problem. Things weren’t any better under a gold standard. Then it was just a matter of which countries can accumulated most of the gold through “beggar they neighbor” mercantilism. The problem is how the funds or gold are flowing. In short, the incentives are out of whack.

    As long as this kind of inequality is permitted in the global economy, the result will be the same, no matter what they absolute amount of money is. There has been no system ever devised to preclude this mismatch. Correcting it was the basic idea of Marxism, and we see how well that worked out. The new people in control just appropriated the spoils for themselves and their cronies and minions, just like the old people in charge did.

  94. Panayotis, I realized after sending the comment that word “plus” is confusing and I should have used “and” instead. Obviously, I used word “plus” not in mathematical sense. Sorry for this.

  95. Tom Hickey, cheers for continuing to help me muddle through on this. We both seem to agree that inequality will prevent any form of economy from working and also that Marxism and neolibralism have both been a disaster. My sticking point continues to be that my understanding is that long term deficit spending does not evenly increase the absolute amount of money (ie does not cause a similar increase in nominal consumer prices and nominal asset prices/level of savings). Rather long term deficit spending increases wealth in real terms (relative to earnings) and that that wealth accumulation prevents capitalism from functioning. I’m still not shaken from my sound money+redistribution ideas quite yet!

  96. Tom Hickey, I’m curious to know what proportion of the $60T “global pool of hot money” came from horizontal stretching out of the $1T yen carry trade money ie If the cheap money from Japan had never been there, how much smaller would the global pool of hot money have been? What struck me about the whole thing was that Japan spent the deficit money on fairly benign projects such as building bridges (largely unwanted) and creating extra layers of officialdom. The Japanese themselves were all so scared by the previous Japanese stock and property bubble collapses that they kept their money as cash in the bank. From then on the money fueled a destructive USA property boom and bust, then a wheat price spike and is still out there. It seems to get more cruel with every transfer.

  97. stone, these issues are also discussed over at Warren Mosler’s The Center of the Universe. There is a thread just beginning there that may be appropriate to your concerns and you may wish to surface them there.

    Reinhart and Reinhart paper.

  98. Panayotis:
    Thanks for the concise and very helpful summary. Unfortunately I do not have the time to go through the vast litterature on the topic and in any event it seems the current financial crisis is negating some of it anyway.
    There seem to have been a number of conumdrums (or more correctly conumdra!) in that short and long term rates have been moving in different directions. An example: in Canada recently the short term rate has been increased by 0.5% while the 10 year rate has dropped by about the same. I realise this can be explained by a change in expectations.
    I’ve been looking at some of the Federal Reserve Bank of San Francisco papers and economic letters on the topic and finding them quite interesting although my limited grasp of the field concerns me. A number of that regional Fed’s papers reach conclusions that are not on message with respect to the Federal Reserve Board.

  99. Keith,

    link_http://www.bankofcanada.ca/en/mpr/pdf/2010/mprjuly10.pdf page 9 of the document / page 15 of the pdf seems to suggest a tight relation with the US yields.

  100. stone: My sticking point continues to be that my understanding is that long term deficit spending does not evenly increase the absolute amount of money (ie does not cause a similar increase in nominal consumer prices and nominal asset prices/level of savings). Rather long term deficit spending increases wealth in real terms (relative to earnings) and that that wealth accumulation prevents capitalism from functioning. I’m still not shaken from my sound money+redistribution ideas quite yet!

    What keeps capitalism from working is, well, the idea that capital is somehow the most significant factor of production. This implies that labor is subordinate to the “needs” of capital. What happens is that price becomes determinative instead of income. Capitalism seeks to limit the cost of labor (the going wage is a price), and this limits income, hence, equitable distribution. For example, recent productivity increases have been relegated to capital, with labor not participating at all proportionately. This accumulated capital has not been directed to increased productive investment, but rather to speculation in assets. Couple this with the increased financialization (rent-seeking), and wage-earners (distributed income) are getting the short end of the stick.

    The real problem that is developing is with resources, in particular, energy. Energy is one of the chief factors of production, too. Investment in energy production has been lagging, and the investment in non-carbon energy sources has been very low. Global demand is outpacing global productive capacity. With any significant recovery, there are likely to be energy bottlenecks and shortages that could drive cost-push inflation.

    I think that you are focusing in the wrong direction for the solutions that we are both looking for. Nonconvertible fixed rate (fiat) currency regimes also monetarily sovereign government to address domestic problems fiscally, which they could not do, at least as easily, under a fixed rate system. Japan avoided a debt driven deflationary depression through its policies, and they now admit that they were mistaken in not publicly recapitalizing their banks. They are warning the US not to make the same mistake they did, or the US will be mired in disinflation if not deflation for years. The US needs to go in deeper fiscally, not retrench. But it needs to do so intelligently, instead of letting the perps who created the crisis control the outcome, as now happening owing to political corruption.

    The financial problem with the current view of capitalism lies in allowing practices in the name of “capitalism” that are antithetical to capitalism, which involves putting capital at risk through productive investment in search of a return through profit from consumption. This involves creating the effective demand for products that enable transactions in the marketplace, as Henry Ford and Thomas Edison realized and contemporary “capitalists” have forgotten or ignored. If the large amount of capital had been committed to productive investment and creating effective demand, then everyone in the world would be better off, including the capitalists.

    The capitalists just wanted to get a lot better off very quickly, the consequences be damned. They felt secure in taking outsized risks due to the moral hazard resulting from systemic risk. They knew that if things when sour, government would have to bail them out instead of letting the global economy sink down the drain. They were also confident that they had the political clout in a thoroughly corrupt system to avoid accountability. And they have been right so far.

  101. stone: I’m curious to know what proportion of the $60T “global pool of hot money” came from horizontal stretching out of the $1T yen carry trade money ie If the cheap money from Japan had never been there,

    As far as I can tell, the yen carry trade was used mostly by hedge funds for arbitrage. The yen carry trade was/is relatively immaterial, just as the US carry trade is now. The humongous amount of money comes mostly from money creation in the commercial banking system through credit extension and its amplification through leverage and “financial innovation.” For example, the total amount of derivatives is estimated at 600T US.

    Most importantly from my perspective, I haven’t seen anything indicating that the GFC was remotely related to the yen carry trade. The bubbles in assets have been explained in ways that don’t involve the yen carry trade at all. The problems arose from fast-dealing and overreach, enabled by capture of the apparatus of the state. This was a breakdown of capitalism.

  102. Tom Hickey, I still think there is a very simple way to have capitalism act constructively and that is to not have a huge glut of money chasing too few constructive investment opertunities. A glut of money will all by itself create destructive investment opertunities (exploiting asset price volatility) and provide the means and incentive to use political power to create more. Surely if there was so little money available for investment that the stock markets shrunk back down to valuations that paid out 12% annual dividends you would start getting capitalists simply acting as concerned owners of the companies rather than having the stock markets being a mix of index tracker ETFs being preyed on by index arbitrage high frequency trading. You also wouldn’t have money available for all the other destructive bubbles.

  103. stone: I still think there is a very simple way to have capitalism act constructively and that is to not have a huge glut of money chasing too few constructive investment opertunities.

    Everything has consequences. How do you propose to do this?

  104. A bit offtopic but while many people are on still on this post I have a question to experts.

    Balance sheet of FED shows securities at face value (notes 2-4 in link_http://www.federalreserve.gov/releases/h41/Current/). Obviously, FED does not buy them at face value but since it is a balance sheet the question is then where the offsetting value on the liabilities side is. And also why does FED show them at face value rather cost value. Any link to a methodology document?

  105. Tom Hickey: The yen carry trade was/is relatively immaterial … The bubbles in assets have been explained in ways that don’t involve the yen carry trade at all.

    Actually, that is not really true. Sure, asset bubbles can grow due to increasing leverage and without any carry trade however the effect of carry trade _was_ to decrease going costs (low yielding currency) with the difference between two yields being capitalized in asset prices. Carry trade is very likely to be an igniting factor in asset bubbles but I agree it is not the decisive one.

  106. Sergei, I agree, to my mind an asset bubble needs both people willing to get into hopeless debt and also bountiful cheap credit. USA had the former and Japan the later and the carry trade put them together.
    Tom Hickey, I think that if in the UK and USA asset price inflation were viewed as a problem by policy makers then many policies would be different. Preventing proprietary trading by banks would be a start as would tighter credit conditions. Making dividends tax free would make the earning potential of stocks more significant. The recent UK change in the law saying that private pensions did not need to be converted into annuities is one change in the wrong direction. Using state money to give every new born in the UK a stockmarket trust fund was just New Labour’s way of pumping up stock prices. A beneficial change would be if state pensions could be greatly extended. These just annul the money paid in and then pay out with debt created at the time of paying out. Inheritance tax could be much higher and it could be encouraged to convert all assets into an annuity as one reached old age. Any stimulus money could be in the form of a negative income tax (ie a fixed sum paid out to everyone with an offsetting increase in higher rate income tax for the highest earners) rather than as quantative easing. If it was widely understood that the state was able and willing to pay out good state pensions then I think people would be more relaxed about a trimming down of asset prices. A severe political hurdle is that the UK has set itself up as the world’s financial hub. So what is good for the world economy is probably not good for the UK at the moment. I guess much of the demand foreigners have for GB£ is to pay for hedge fund performance fees. If we hurt speculation we in the UK are going to find it much harder to pay for oil, ipods, migrant fruit pickers, foreign doctors and nurses etc etc (fruit pickers wont value sending GDP back to Romania, foreign doctors will not value GDP to pay off the training they got in Spain/India etc). Another problem is that there has to be either a world wide consensus on keeping asset prices low and preventing accumulations of wealth or else flows of capital around the world have to be effectively thwarted. I guess that is hard when so many companies are multinational. I guess China spending their USD on paying people in the Congo to build roads, sewers etc is their way of trying to create more customers able to pay for Chinese goods. I really have no glimmer of an understanding of what China is up to though. Didn’t Bill Gates say the Chinese are his kind of capitalists. What to make of that though I have no idea.

  107. Sergei, I agree, to my mind an asset bubble needs both people willing to get into hopeless debt and also bountiful cheap credit. USA had the former and Japan the later and the carry trade put them together.

    Absolutely not. The problems began back in the Reagan Administration, before the yen carry trade entered the picture. A number of factors contributed to the asset bubbles in the US that finally blew up, and the yen carry trade was peripheral to them. The yen carry trade certainly was not a necessary factor. The asset bubbles that occurred could have occurred and likely would have occurred without the yen carry trade.

    stone, I think that you don’t realize that you are arguing against your own objectives. Ending the yen carry trade would not materially affect the conditions you are complaining about. I see that I am not going to convince you of this, so I’ll leave it at that.

  108. stone, I think that if in the UK and USA asset price inflation were viewed as a problem by policy makers then many policies would be different…

    We can find some agreement here. I have been contending that the asset run-up was a result of a lot factors – financialization, state capture/corruption, deregulation, perverse incentives, control fraud, systemic risk, moral hazard, economic rent-seeking, etc., as well as bad macro and mistakes/misrepresentations about monetary economics. These are the things that need to be addressed, and the starting point is getting the money out of politics and closing the revolving door that links industry, finance, the military, and government (Eisenhower’s “military-industrial complex”). Focusing on the yen carry trade as the primary cause is just a diversion from this monumental task as far as I am concerned. Just about everyone in the US that is working on this seriously agrees. These are not ideas I cooked up. And no one is talking about the yen carry trade as having been a significant factor. So let’s focus on what we can find some agreement on.

  109. Hi Ramanan,
    Thanks for the reference re yields. Indeed the Bank of Canada is very influenced by US yields in part because of the effect on our currency. The value of the Can$ is mainly affected by the discrepancy between the two ”policy yields” and commodity prices. You’ll note in the graph on page 9 it is usually the US rate that is changed first then the Canadian one. Right now however the Canadian overnight rate has been increased twice in the absence of a change in the US rate, with a third possible this week. Our economy is doing relatively well (GDP back to pre-crisis levels and overall employment nearly back up there too, although the unemployment rate is 2% higher). The Bank of Canada is sending a signal to households to reduce indebtedness, currently at record levels. It has also returned to previous monetary operations functioning by increasing the two corridor overnight rates. For a little more than a year, until mid-June 2010, the overnight rate was the rate paid on excess settlement balances (set at $3 billion) but since then the corridor system has been reestablished with settlement balances at zero. The effect on long term rates has been imperceptible despite the increase in the overnight rate, hence my interest in this topic.

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