In austerity land, thinking about fiscal rules

I am now in Maastricht, The Netherlands where I have a regular position as visiting professor. It is like a second home to me. The University hosts CofFEE-Europe, which we started some years ago as a sibling of my research centre back in Newcastle. My relationship with the University here is due to my long friendship and professional collaboration with Prof dr. Joan Muysken who works here and is a co-author of my recent book – Full Employment abandoned. Our discussions last night were all about the Eurozone and I was happy to know that most of the Dutch banks are now effectively nationalised as part of the early bailout attempts. It is also clear that the ECB is now stuck between the devil and the deep blue sea. If it stops buying national government debt on the secondary markets those governments are likely to default and the big French and German banks the ECB is largely protecting will be in crisis. Alternatively, every day it continues with this policy the more obvious it is that the Eurozone system is totally bereft of any logic. Once the citizens in the nations that are being forced to endure harsh austerity programs realise all this there will be mayhem. The other discussion topic was the possible revision of the fiscal rules that define the Maastricht treaty. That is what this blog is about.

On the plane coming over here – in between reading Swedish detective novels and designing my macroeconomic simulation model that I am presenting here I watched the movie The Most Dangerous Man in America which is the story of Daniel Ellsberg and the way he leaked The Pentagon Papers to the press in the early 1970s. The leak exposed that four US presidents (Truman, Eisenhower, Kennedy and Johnson) had systematically lied to the American people which ultimately had the effect of putting their troops in fatal jeopardy. 58,000 US soldiers died in the Vietnam sham which was a lie from the start. I note that 2 million Vietnamese also died.

The point is that the lies also extend to the way the top office runs the largest economy in the world and to the top office in most countries.

Anyway, there has been a lot of discussion among the commentators of this blog about the constraints that different sectors face in the course of their decision making. While I welcome comments and diversity of perspective and certainly I welcome technical corrections in conceptual matters I have found some of the discussion to be somewhat at odds with my desire to achieve a perspicacious understanding of how the different sectors (government and non-government) work in a modern monetary system.

The clear intent of some of the inputs has been to suggest that Modern Monetary Theory (MMT) which I have helped to develop as a principle part of my academic work is somehow “simplistic” and misleads people into believing that the government sector faces different constraints to the non-government sector. One comment concluded that the government sector in a fiat-currency issuing nation is financially constrained just like a household. To which I say – BS – which is the polite way of saying rot!

Understanding what a sovereign government is

We often need reminding of just what a sovereign nation is. The distinction between sovereignty and non-sovereignty is crucial to understanding how the monetary system operates and the options that the government has under the two states. For example, the financial press call Greece a sovereign nation when it clearly doesn’t issue its own currency, has to take the interest rate set by the ECB, and uses a currency that is not floating (for it) in the foreign exchange markets (that is, bears no direct relationship to its net exports and net capital flows). That is not a sovereign nation.

Essential background reading includes the following blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3
Then you should read these more specific blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3.

A national government in a fiat monetary system has specific capacities relating to the conduct of the sovereign currency. It is the only body that can issue this currency. It is a monopoly issuer, which means that the government can never be revenue-constrained in a technical sense (voluntary constraints ignored). This means exactly this – it can spend whenever it wants to and has no imperative to seeks funds to facilitate the spending.

This is in sharp contradistinction with a household (generalising to any non-government entity) which uses the currency of issue. Households have to fund every dollar they spend either by earning income, running down saving, and/or borrowing. Clearly, a household cannot spend more than its revenue indefinitely because it would imply total asset liquidation then continuously increasing debt. A household cannot sustain permanently increasing debt. So the budget choices facing a household are limited and prevent permanent deficits.

These household dynamics and constraints can never apply intrinsically to a sovereign government in a fiat monetary system.

A sovereign government does not need to save to spend – in fact, the concept of the currency issuer saving in the currency that it issues is nonsensical. A sovereign government does not need to borrow to spend. A sovereign government can sustain deficits indefinitely without destabilising itself or the economy and without establishing conditions which will ultimately undermine the aspiration to achieve public purpose.

Further, the sovereign government is the sole source of net financial assets (created by deficit spending) for the non-government sector. All transactions between agents in the non-government sector net to zero. For every asset created in the non-government sector there is a corresponding liability created $-for-$. No net wealth can be created. It is only through transactions between the government and the non-government sector create (destroy) net financial assets in the non-government sector.

This is an accounting reality that means that if the non-government sector wants to net save in the currency of issue then the government has to be in deficit $-for-$. The accumulated wealth in the currency of issue is also the accounting record of the accumulated deficits $-for-$.

So when the government runs a surplus, the non-government sector has to be in deficit. There are distributional possibilities between the foreign and domestic components of the non-government sector but overall that sector’s outcome is the mirror image of the government balance.

To say that the government sector should be in surplus is to also aspire for the non-government sector to be in deficit. In a nation such as Australia, where the foreign sector is typically in deficit (foreigners supplying their savings to us), the accounting relations mean that a government surplus will always be reflected in a private domestic deficit. This cannot be a viable growth strategy because the private sector (which faces a financing constraint) cannot be in deficits on an on-going basis. Ultimately, the fiscal drag will force the economy into recession (as private sector agents restructure their balance sheets by saving again) and the budget will move via automatic stabilisers into deficit.

The relationships between a sovereign government and the non-government sector cannot be defied. Private debt build up can allow the government to run surpluses for some time (when the balance of payments is in deficit) but not for very long.

Sub-national governments who use the currency of issue are akin to a household in that they face financing constraints. The only (and major) differences between a household and a sub-national government is that the latter typically has the power to tax (or levy fines) and can thus access cheaper funds in the debt markets as a consequence. While a sub-national government does have some risk of insolvency the reality is that it is extremely low and close to zero.

Accordingly, the concept of fiscal sustainability involves a conceptualisation of a government which is free of financial constraints and has a range of possibilities that are not available to any non-government entity. It would never invoke a notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!)

Further, given the non-government sector will typically net save in the currency of issue, a sovereign government has to run deficits more or less on a continuous basis. The size of those deficits will relate back to the pursuit of public purpose.

I also note that some people do not like the term “fiat”. It is what it is – a legislative statement (the “fiat”) that the currency of issue is required to extinguish non-government tax liabilities and is issued under the legislative power vested (as a monopoly) in the national government. It is a totally appropriate term for what it describes. The currency has no intrinsic value. Its value is given by the fiat held and dispensed by government.

With that discussion in mind, the following constraints can be usefully identified.

A sovereign government is never intrinsically financially constrained. If you think otherwise then I am sorry to say that you do not understand the nature of the monetary system. Yes, the government may impose a voluntary constraint on itself – for example:

  • It might say that it has to borrow a matching sum from the private bond markets and put it in some bank account at the central bank before it can spend that sum.
  • It might say it has to have a matching sum of tax revenue in some bank account at the central bank before it can spend that sum.
  • It might say the Treasurer has to run three times around the block and count up to a number in 2s before it can spend the sum of the Treasurer’s recitation.

All that and more might form part of the day-to-day institutional machinery that regulates the transactional relationship between the government and non-government sectors. But none of these “constraints” are financial in nature and they stand in denial of the essential or intrinsic characteristics of the fiat monetary system.

These constraints are ideological and/or political in nature and have no intrinsic standing when the underlying (true) fiscal capacities of the government are considered. A sovereign government can never be revenue constrained because it is the monopoly issuer of the currency. It is only when it imposes these voluntary (unnecessary) constraints on itself that it might appear to be revenue-constrained. But those constraints are only to be understood within the flawed logic that led to the ideologically-based restrictions. They have no standing outside of that and certainly no standing in relation to the underlying characteristics of the monetary system.

The only economic constraint that a sovereign government then faces is what we term the real constraint. Nominal public spending may be unlimited in capacity but given that the object of such spending is to garner public control of real goods and services then clearly the availability of these goods and services for sale becomes a binding constraint at some level of economic activity.

The government desires to access these real goods and services so that it can advance its conception of public purpose which is derived from the socio-economic mandate it received upon its election. Clearly, if the government was to push nominal spending beyond the capacity of the economy to respond by increasing real output then it would be in breach of this responsible charter – all it would be doing is promoting inflation once there was no capacity for the economy to grow further in real terms.

So the inflation barrier becomes the real constraint on government spending. This is obvious but then the question becomes what is that barrier? There is a huge disparity of views with the mainstream macroeconomics paradigm – dominated by the flawed concept of the NAIRU adopting much slacker levels of real resource utilisation than would be the case if an employment buffer stock capacity – such as the Job Guarantee.

If there is a buffer stock of jobs unconditionally available at a fixed wage then the national government can always afford to provide them and in doing so they create a nominal anchor that provides for stable inflation.

Some people claim that there is another constraint on a sovereign government that MMT ignores to its detriment – the external balance. The claim is that fiscal policy will promote a worsening external situation which will ultimately see the currency collapse and inflationary pressures and foreign debt escalation forcing the government to move towards surplus to stabilise the economy.

But how does this stop the national government from using fiscal policy to maintain the highest levels. The may be constraints on the overall economy arising from external sources. MMT always acknowledges that the only way a nation can enjoy the real terms of trade benefits associates with an external trade deficit (more real goods and services entering the nation from abroad and going the other way) is because, in a macroeconomic sense, the foreign sector desires to accumulate financial claims (bits of paper) denominated in the local currency.

It is clear that this desire can change and if it disappears then the flow of imports into the economy will contract as quickly as the desire to accumulate the financial claims contracts. It is surely a constraint on citizens living in the local economy. One day they are enjoying lots of imported gadgets and the next they are being forced to go without them (in a macro sense). That is an external constraint. The desires to accumulate financial claims in the local currency are the desires of foreigners – and can change. So what?

But that doesn’t impose any intrinsic constraint on the government capacity to use fiscal policy to advance public purpose. Except in extreme cases where all food is imported, the government can always employ any idle labour to the benefit of domestic production regardless of the external situation. A depreciating currency places no constraints, for example, on a sovereign government unconditionally offering a minimum wage job to anyone who wants it.

A depreciating currency also sets in play forces that reduce the underlying terms of trade effects on the nominal exchange rate anyway and serve to reinforce expansionary fiscal policy not threaten it. Some might say the threat of imported inflation renders fiscal policy hostage to the exchange rate.

First, the actual impact of price rises arising from depreciation is dependent on how significant imports are to the total consumer price index. Mostly, the impact is low. Clearly, when there is a major supply price shock the situation is different.

The inflation of the 1970s was not the same beast that the deficit terrorists are telling us is just around the corner now. In the mid 1970s there was a huge price rise in oil as the OPEC cartel flexed its muscles and knew that the oil-dependent economies had little choice, at least in the short-run, but to pay up. This represented a real cost shock to all the economies – that is, a new claim on real output. The reality is that some group or groups (workers, capital) had to take a real cut in living standards in the short-run to accommodate this new claim on real output.

At that time, neither labour or capital chose to concede and there were limited institutional mechanisms available to distribute the real losses fairly between all distributional claimants. The resulting wage-price spiral came directly out of the distributional conflict that occurred. Another way of saying this is that there were too many nominal claims (specified in monetary terms) on the existing real output. This is sometimes called the “battle of the mark-ups”; the “conflict theory of inflation” or the “incompatible claims” theory of inflation. Sometimes this is referred to as “cost push” inflation because its initial source is a push upwards in costs that are then transmitted via mark-ups into price level acceleration especially if workers resist the real wage cuts that capital tries to impose on them – to force the real costs of the resource price rise onto labour.

Ultimately, the government can choose to ratify the inflation by not reducing the nominal pressure or it can break into the wage-price spiral by raising taxes and/or cutting its own spending to force a product and labour market discipline onto the “margin setters”. The weaker demand forces firms to abandon their margin push and the weakening labour markets cause workers to re-assess their real wage resistance. That is ultimately what happened in the 1970s.

However, under a Job Guarantee policy, the labour market slack required to discipline the wage-price spiral would manifest as a redistribution of workers into a fixed price employment sector (the JG) rather than under a NAIRU approach (the current approach) that forces workers into a buffer stock of unemployed. MMT tells us that the welfare losses of the latter are much large than under the former.

MMT also tells us that the national government can always afford to buy the services of any idle labour that wants to work. But the important part of the inflation control mechanism in the JG is that the government should not buy this labour at “market prices” but rather pay a living minimum wage. At any time the private sector can re-purchase the labour services by paying a wage above this.

Anyway, now that I am travelling in the lands of austerity the issue of voluntary constraints is central in my mind. The British government has decided that it doesn’t like its sovereign status and wants to bolt itself down with some pre-conceived notions of fiscal prudence. We are already getting a sense that the impacts of this approach will be very destructive. We have seen Ireland leading the way in the how to damage the economy by relinquishing government sovereignty.

So this discussion led me to think about fiscal rules again. A lot of readers have written to me asking me to explain in more detail why I am totally opposed to the use of such rules. One response is simple: they generally don’t work if they are designed to impede government actions. When they do work in the way the designers intended they are destructive. But to understand these points I though a little simulation exercise with some narration might help.

Please read my blog – Fiscal rules going mad … – for more background discussion on fiscal rules.

So many readers write to me wanting me to specifically explain my abhorrence to what they think are reasonable fiscal rules – that is voluntary constraints imposed on the government’s budget inputs and/or outcomes in the interests of “discipline”. I actually always thought that in a democracy the ballot box was the disciplining device and in between elections we wanted governments to act in our best interests according to the mandate that they won at the time of the election.

It would appear to me to be the anathema of democracy to constrain our elected representatives to rules determined by faceless officials who are not accountable to us for their actions. In that context, I always find it curious that the freedom loving Americans who never cease to tell us non-Americans how strong their democracy is yet also seek to constrain their governments with mindless rules.

As an aside, the Daniel Ellsberg story I noted at the outset certainly should disabuse anyone of the notion that America represents a robust democracy!

In terms of fiscal rules, consider the Maastricht treaty which says that the budget deficit of any member nation has to be below 3 per cent of nominal GDP. Should the deficit exceed that then the government has to contract its discretionary fiscal stance in an attempt to bring the deficit down below that ratio. Apparently some one has constructed the 3 per cent as something meaningful. The imposition of that rule is in fact arbitrary – there is no hard analysis which suggests 3 per cent is “better” than 4 or 2 or 3.5 per cent.

To get some background on fiscal rules, you might like to read the paper – Fiscal rules OK>? – published in January 2009, by the Centre-Forum which is a UK-based “liberal think tank”.

At the outset they note that:

After 16 consecutive years of economic growth, the UK is now facing the sharpest downturn in a generation. The crisis is also wreaking havoc with the public finances. Government debt is set to spiral to levels not seen since the 1970s. This explosion in debt represents a failure for Labour’s economic policies, above all its promise to bring order to fiscal policy through the application of strict rules. But the Conservatives are wrong to think that their proposed ‘independent fiscal council’ would be any more successful …. there is no straightforward definition of what constitutes ‘good’ fiscal policy … Fiscal policy is a political issue. The question of how to tax, spend and borrow cannot be deduced by technical calculation. There is no simple answer to whether 40, 50 or 60 per cent of GDP is an unsustainable level of debt. Labour used the fiscal rules to divert voters’ attention from the political choice that was being made for them: of higher long term debts in return for investment in public services.

And in that statement and what follows you see the classic deficit-dove perspective emerging that is often characteristics of the progressive or “liberal” response to neo-liberalism. I do not find it a compelling response at all.

First, there is no intrinsic meaning to the term “wreaking havoc with public finances” when applied to a sovereign national government. There is meaning to an analysis that traces a rising budget deficit to the response of automatic stabilisers which signal that the real economy is slowing and unemployment is rising. That is a “bad” situation and the rising deficit is the canary. But equally, a rising budget deficit might indicate a demonstration of leadership by the government committed to smoothing the business cycle and using its discretionary spending and taxation capacities to maintain high levels of activity in the face of fluctuations in private spending. The is a “good deficit”.

So the havoc was being wrought in the real sector. An emphasis on what the canary was doing largely distracts us from the nature of the budget balance and biases the public debate towards having to “fix the deficit”. This is not a productive route to take because it immediately plays into the hands of the neo-liberals and confines the discussion to what the deficit should be – in isolation to what is happening elsewhere in the economy.

Further, discussing the possibility that a public debt ratio could be unsustainable is the hallmark of a deficit dove. What do they mean by unsustainable? That is, forget the calibration, what could it mean in concept? For a sovereign government no ratio would ever be unsustainable even though within the typical ranges that the business cycle historically swings very high debt ratios are highly unlikely.

Unsustainable means that the government faces a solvency risk. No sovereign government can ever be insolvent unless it borrows in foreign currencies. Please read that as never! So if unsustainability means something else then it would be good to have that clearly articulated.

Does it mean that the income payments involved in servicing a growing debt ratio will become excessive? Excessive in relation to what? Certainly not in nominal terms because a sovereign government is never revenue constrained. So perhaps the payments will push the growth of nominal aggregate demand beyond the real capacity of the economy to absorb it via real production increases. Any component of nominal spending growth – private, external or public – might be implicated in that risk. Why single out interest-servicing payments?

But if that was the case then the government has the capacity to eliminate that risk fairly quickly. For example it could reduce interest rates and/or increase taxes. Yes, you might ask – with independent central banks how would it achieve that? Well it could legislate to make the central bank part of treasury if it really wanted to. But the point is that this “unsustainability” – is nothing intrinsic to public debt. If the nominal aggregate demand hits an inflation barrier then functional finance tells us the government should do something about that.

You pick up the implicit biases in the Centre-Forum paper when you read that:

In contrast to monetary policy, there is no economic or political consensus about the goals of good fiscal policy.

The so-called consensus about monetary policy is a purely neo-liberal construction. The shift to constructing monetary policy as the primary vehicle to maintain inflation stability and in doing so, use unemployment as a policy tool rather than a policy target (the NAIRU unemployment-buffer stock approach) is only acceptable among mainstream economists. Monetary policy hasn’t always been seen in that way.

If you examine the legislative acts that set up central banks you will see that they were typically entrusted with maintaining full employment, price stability and external stability. It is only during the neo-liberal period that this focus has narrowed to maintaining price stability. The way they have avoided the obvious criticism that they have abandoned their charter to maintain full employment, given that they have used unemployment capriciously as a policy tool, is to redefine what full employment is.

This is the NAIRU ruse – the full employment level of unemployment just rises or falls to suit their rhetoric. In that way they can always say they are acting within their original charter despite the reality that they abandoned it years ago. Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

MMT has a very clear construction of what full employment means – it requires there be sufficient jobs and working hours to match the preferences of the workers at the current wage levels.

The Centre-Forum paper then defines what it considers to “to describe the character of good fiscal management”. First, good fiscal management involves:

Achieving low borrowing costs – High and unpredictable borrowing undermines confidence in the financial markets, which punish the government by charging a greater interest charge for lending.

I do not care to describe “good fiscal management” in terms of ideologically-motivated practices such as debt-issuance and the arrangements surrounding that which give unnecessary power to the recipients of corporate welfare (the bond markets). Rather good fiscal management should allow the government to pursue its mandate without being threatened by the sectional interests (bond markets) which rarely coincide with the overall national interest.

Second, the Centre-Forum paper says good fiscal management involves:

Avoiding a ‘deficit bias’ – The benefits of short term fiscal profligacy usually accrue to the current government, leaving future administrations to repay the debt. This produces a bias in favour of deficits. It can also allow the concerns of the present to unfairly outweigh those of the future, undermining fairness between the generations.

This “characteristic” is based on the fallacious nation that the “debt-burden” associated with deficits is borne by the future generations (especially if the net spending associated with the debt is underpinning current consumption – such as transfer payments). This notion is a mainstay of mainstream macroeconomics and assumes that the government pays back its debt by raising taxes at some future period.

Of-course it is very rare that a government ever pays back its debt (in a macroeconomic sense).

Third, the Centre-Forum paper says good fiscal management involves:

Smoothing the economic cycle – Government tax and spending decisions can increase macroeconomic volatility by boosting demand during upswings and cutting back during downturns. Even when macroeconomic stability is delegated to an independent central bank, excessive government deficits can compromise this independence by forcing it to raise rates to head off an inflation threat.

Any government can misuse its fiscal capacity and engage in damaging pro-cyclical net spending changes. This is exactly what the austerity packages are doing at present – contracting the government’s contribution to overall spending at the same time as the economy is in recession. That is the height of irresponsible fiscal behaviour.

But one should not assume that running a deficit during a growth period or expanding net public spending (that is, increasing the deficit) is poor fiscal practice. It all depends on the state of non-government spending and the extent of idle resources in the economy. A pro-cyclical policy response when there is high unemployment and early stages of a private recovery is sound practice.

Governments should not, however, push aggregate demand beyond the capacity of the economy to absorb it in real terms. But why would a sensible government want to do that anyway?

Fourth, the Centre-Forum paper says good fiscal management involves:

Stimulating government investment – Public investment has benefits that accrue over many years. Governments in financial difficulty find it easier to cut potentially beneficial investment plans than current spending: responsible fiscal policy should avoid such short sighted behaviour.

I largely agree that public infrastructure development is a sound fiscal goal in the sense that it allows higher quality public services to enhance the lives of the citizenry and allows private activity to lever off the capacity created (for example, road, transport and port systems etc).

I also agree that governments who are alleged (by neo-liberal standards) to be in “financial difficulty”) cut capital works because the effect of these cuts are less obvious in the short-term. The point that should be borne in mind is that what a neo-liberal defines as “financial difficulty” is usually nothing of the sort. A sovereign government can never get into “financial difficulty” as long as it doesn’t borrow in a foreign currency.

So typically governments who claim they are in “financial difficulty” are in fact just asserting an ideological distaste for public deficits (which suggest larger government access to available real resources) and a desire to allow the market to operate in a less fettered manner. I don’t share that ideological distaste which doesn’t mean I am uncritical of government involvement in the economy. My position is simple. The fact is that government is a central player in a modern monetary system whether you like it or not. I would rather design processes where the democratic scrutiny of the citizens operating with much greater access to information about government decision-making “keeps the bastards honest”.

As an aside, the “keeps the bastards honest” epithet was the motivation for the formation of a political party in Australia in the 1970s – The Democrats – who showed over time they couldn’t be honest themselves and have now faded into electoral oblivion.

The Centre-Forum paper says that:

The purpose of fiscal rules is to bind a government into responsible behaviour that may not always be in its short term interests.

They discuss the concept of “time inconsistency” which was at the centre of the orthodox attacks on the use of discretionary fiscal policy. This idea suggests that what the government might hold out in one period as being desirable may be jettisoned in another period (as an election approaches). So apparently, running a budget surplus is deemed to be desirable because it allegedly keeps interest rates low and avoids imposing debt-burdens on future generations. But then during an election campaign the pork barrelling to attract votes may lead to governments abandoning that earlier commitment.

If you think about this for a moment you will realise how dependent an evaluation of whether the government is being capricious depends on the validity of the original promises and the identification of legitimate changed circumstances. A government running a tight fiscal position in the face of a major private sector spending boom may be responsible. But it doesn’t make it irresponsible a year later to run a very expansionary fiscal stance if private spending has collapsed.

This would only be considered “irresponsible” and “time inconsistent” if you held the position that any fiscal response to counter-stabilise the business cycle was undesirable. Which of-course is the position that the deficit terrorists seek to impose on governments to the detriment of the overall economy.

Given elections are regular – the ultimate judge of whether the government is behaving capriciously should be the informed voter. Imposing inflexible rules on government that prevent it reacting to legitimate changes in economic circumstances is a denial of the purpose of fiscal policy. Which of-course is the intent of those who seek to impose fiscal rules in the first place. They don’t want fiscal policy used in any discretionary sense.

So when the Centre-Forum paper says that:

Fiscal rules are designed to encourage governments to stick to their original tax and spending plans by increasing the political cost of breaking past commitments, or even making it a statutory requirement complete with penalties for non compliance.

You can immediately appreciate the ideological nature of the rules. The government would only incur a political cost in changing fiscal tack to suit the spending decisions of the non-government sector if the citizens were misled into believing that fiscal policy was not a valid policy instrument. If instead of focusing on the deficit the media focused on the change in unemployment (as an ultimate evil) then the public would make very different political judgements of their governments.

So fiscal rules are part of the ideological machinery that the conservatives use to keep governments from advancing full employment. Ultimately, full employment is seen not to be in the interests of some sections of society who can make fortunes despite there being significant labour underutilisation. Somehow this lobby has been able to convince us that keeping a large proportion (in Australian currently around 13 per cent; in the US around 17 per cent) is in the interests of society. As a result governments have not been under any political pressure to do anything about the blatant waste of human resources and potential that the neo-liberal policy framework has generated.

The Centre-Forum paper acknowledges that:

Policymakers face a number of potential trade-offs when drawing up fiscal rules. One influential analysis concludes that eight properties mark out an effective rule: it should be well defined, transparent, simple, flexible, adequate, enforceable, consistent and efficient. But it is impossible to design a fiscal rule that meets all possible requirements. A simple, transparent and enforceable rule such as ‘governments that fail to achieve a budget surplus over the year will be dismissed’ clearly lacks flexibility; however, if it were amended to permit some discretion for a crisis, it would no longer be well defined, simple or transparent.

The arbitrary nature of the fiscal rules in place in the Eurozone are clear. Germany and France were early violators of the Maastricht Treaty rules even before the crisis. The current EMU nations in breach of the rules would have found themselves in that state merely as a result of the automatic stabilisers so severe was the aggregate demand collapse. So the design of the Maastricht rules does not distinguish between discretionary changes in the budget to GDP ratio and those driven by the business cycle which are in most cases beyond the control of the national government.

Further, the ECB is now acting in total violation of the Lisbon treaty arrangements for the Eurozone (no bailout clauses etc) but at the same time are invoking the Maastricht fiscal rules as a way of penalising certain governments and forcing them to adopt harsh austerity programs. The inconsistency is palpable.

The point is that unless the rules are embedded in the constitution of a nation in an inviolate manner (free from further political manipulation) they will always be used to advance the ideological agenda of the dominant political coalitions.

As the Centre-Forum paper notes “(i)t is difficult to find evidence that any particular fiscal institutions have helped budgetary consolidation” which should be considered alongside the knowledge that there is also no evidence that monetary policy designed along specific inflation targetting rules has led to any differences in the trajectory of inflation (stability, persistence, level etc) when compared to nations who do not indulge in this approach.

Please read my blog – Inflation targeting spells bad fiscal policy – for more discussion on this point.

In other words, the two main macroeconomic policy planks of the neo-liberal era are not supported by any robust and accepted empirical evidence. That should tell you all you need to know about the motivation behind this sort of policy advocacy.

The Centre-Forum paper then provides a review of the British experience with fiscal rules. At one point they once again display their ideological baggage when they claim:

A key objective of fiscal policy is to convince the markets that the government will not act in a profligate manner. This ought to produce lower borrowing costs.

That has only become a “key objective of fiscal policy” in the neo-liberal era which allows the (undemocratic and self-serving) bond markets the power to determine macroeconomic policy settings. An understanding of MMT tells you that the government can control its own borrowing costs any time it chooses (and even not borrow at all with no negative consequences). In that sense, what the bond markets think should never enter the government’s mind.

The key objective of fiscal policy is to ensure that public purpose is maximised and that requires high and stable levels of employment with secure wages and conditions. It requires a high standard of public service provision. It requires a stable financial system. The conduct of fiscal policy should only be considered in that light.

Another negative aspect of the move to impose greater fiscal constraints on sovereign governments has been the rise in importance of Public Private Partnerships (PPPs) or as the Centre-Forum paper terms them Private Finance Initiatives (PFIs).

Governments claimed they had “run out of money” (given the impinging fiscal rule) and so sought to involve private funding of public infrastructure development. In this blog – Public infrastructure 101 – Part 1 – I provide some detail of these scams that have largely redistributed public spending to certain private sector corporations and paid much more than was necessary for the provision of the public infrastructure and services, which have often been of inferior quality.

PPPs are a total scam.

The Centre-Forum report claim that there:

… are some valid economic reasons for introducing private finance into the provision of public services: private sector incentives can improve efficiency.

The vast array of available empirical evidence does not support that claim as noted above and in the blog I referred to.

Finally, the latest conservative ploy is to suggest that politicians should not be responsible for the fiscal rules but rather “independent” bodies (such as the Office of Budget Responsibility in the UK). This call is consistent with the neo-liberal preference that central banks be “independent” of the political process.

As discussed above – this trend represents a further incursion on the democratic rights of the citizenry. It amounts to the installation of some panel of “philosopher kings” who know better and should determine outcomes independent of the democratic process. I do not support such arrangements. They are purely designed to advance the neo-liberal ideology and narrow sectional interests (which will rarely coincide with broader notions of public interest).

Anyway, I thought that discussion might broaden our understanding of fiscal rules from a MMT perspective. I also suggest you read the companion blog – Fiscal rules going mad … – for more background discussion on fiscal rules.

What happens when you impose an inappropriate fiscal rule

I built a simplified macroeconomic model to simulate some plausible scenarios. It is simple so that the essential points can be conveyed. I have much more complicated models available to me which will give the same result (more or less) but would take a book to explain and in the interests of being inclusive to all comers who visit my blog I don’t think that would be productive.

To show you a simple example of what happens when you impose a seemingly inoffensive fiscal rule here is a simple open economy macroeconomic model incorporating a spending system that allows us to simulate a collapse in aggregate demand (motivated by a sharp decline in private investment), a subsequent counter-cyclical response by the government, a violation of a simple (but current) fiscal rule, and then two policy paths: (a) no fiscal rule imposed; and (b) obey the fiscal rule and take a self-defeating path to scorching the economy.

We follow this economy for 10 periods starting with a private-debt motivated investment binge allowing growth to occur even though the national government is pursuing a budget surplus. The external sector is initially in deficit (exports are less than imports).

The structure of the simple model is described as follows with the national income-expenditure identity providing the overarching organising framework within which we propose some simple behavioural relationships (consumption, imports etc).

National income (GDP) is:

GDP = C + I + G + (X – M)

which means that total output and income (GDP) is equal to aggregate demand – the sum of the household consumption (C), private investment (I), government spending (G) and net exports (X-M). Exports (X) add to domestic spending while imports (M) drain it.

Disposable national income (Yd) is:

Yd = GDP – T

Taxation (T) is given by a simple proportional rule involving a simple tax rate (t) and income (GDP):

T = t x GDP

In the model the proportional tax rate is assumed to be 0.15, which means that the government takes out 15 cents of every dollar of national income generated. The small x just means multiplied by.

Private consumption (C) is determined by disposable income which is the net income (1 – t) x GDP:

C = MPC x (1 – t) x GDP

where MPC is the marginal propensity to consume (set at 0.8). In figures this means that:

C = 0.8 x 0.85 x GDP

which says that for every dollar of national income that is added total consumption rises by 0.8 x 0.85 or 0.68 – that is, 68 cents.

Private saving (S) is simply:

S = Yd – C

It is thus a residual of disposable income after aggregate consumption is determined. But as income goes up saving also rises and vice versa.

Imports (M) are also considered to be proportional to GDP so:

M = MPM x GDP

where MPM is the marginal propensity to import (set at 0.2), which means that for every extra dollar of GDP imports rise by 20 cents.

The spending aggregates I, G and X are assumed to be determined outside of the model by firms, government and foreigners, respectively. They are thus assumed to be exogenous – or given in any period. The other aggregates C and M are what economists call endogenous variables because they depend on the overall solution of the model – that is, we have to solve for GDP before we know their value but, in turn, the solution for GDP depends on C and M. This is the nature of a macroeconomic system – it is a simultaneous multi-equation system.

The spending multiplier is the extra spending that would occur when an autonomous expenditure source changes. So we ask the question: What would be the change in income if I or G or X changed by $1? I won’t derive the equation for the multiplier here for the sake of simplicity but its value is 1.9 and its equation is given with no further explanation as:

k = 1/(1 – MPC x (1-t) + MPM)

So the higher is the MPC the lower is the tax rate (t) and the lower is the MPM the higher is the multiplier. That makes sense because taxes and imports drain spending from the income generating system. So as income responds positively to an autonomous injection, the smaller are the drains via taxation and imports and the higher the induced consumption – the higher is the second round spending effect which then continues to generate further income increases.

Please read my blog – – for more discussion on this point.

For summary, the behavioural parameters assumed were:

  • Marginal propensity to consume = 0.8 (so consumers spend 80 cents of every new dollar they receive).
  • Marginal propensity to import = 0.2 (so for every dollar of national income generated 20 cents leaks to imports).
  • Tax rate = 0.15 (so for every dollar of income generated 15 cents go to taxes).
  • Spending multiplier = 1.9 (which follows from the previous three assumptions).

I could clearly make the model more complex but the results would not be very different. Some will suggest the model is overly simplistic because it is a “fixed price” model and assumes supply will just meet any new nominal spending. That is true by construction and is a reasonable description of the state of play at present.

There is no inflation threat at present due to the vast quantities of idle resources that can be brought into production should there be a demand for their services.

Some might argue the external sector is too simplistic and that the terms of trade (real exchange rate) should be included in the export and import relationships. In a complex model that is true but in the context of this model the likely changes would just reinforce the results I derive. There is no loss of insight by holding the terms of trade constant.

Some might argue that the interest rate should be modelled and I reply why? The implicit assumption is that the central bank sets the interest rate and it is currently low in most nations and has been for some years. With no real inflation threat, the short-term rates will remain low for some time yet.

As to long rates (and the rising budget deficit) – show me where the significant rises in budget deficits (for a sovereign nation) are driving up rates. They have actually been falling as a consequence of very strong demand for public debt issues (almost insatiable) by bond markets and the quantitative easing efforts of the large central banks.

For an EMU nation, long-rates are within the control of the ECB as has been demonstrated once it started buying government bonds in the secondary markets. So leaving monetary policy implicit and fixed in this model doesn’t lose any insight or “fix” the results in my favour.

For those of you who love data as much as I do the following tables show the aggregates over the 10-period simulation for the simple economy model. Combining this information with the model specification you could easily construct your own spreadsheet although you can download mine more quickly – Clear the following file link sectoral_balances.

The top table is the situation when no fiscal rules are applied. It is clear that the government continues to support the economy as private spending recovers due to positive expectations associated with growth. The growth, in turn, allows tax revenue to eventually return and outstrip government spending and the budget balance goes below the “fiscal rule” limit by Period 10 but in an environment of growth in income and output.

This table shows the same economy but with the fiscal rule applied and forcing the government to cut back spending from Period 7 in response to the budget deficit exceeding the self-imposed 3 per cent of GDP rule limit. The differences between the economies shows up after this period and is stark.

The analysis that follows presents some salient graphs to highlight the differences.

The first graph shows the evolution of the main macroeconomic aggregates: Private consumption, Private investment, Government spending, Private saving and Tax revenue with and without the fiscal rule being applied.

The economy is growing initially because the private sector is borrowing heavily to fund its spending (there is also an external deficit). As investment begins to collapse in Period 2 and beyond the economy quickly goes into recession (see accompanying tables and graphs).

The government responds by increasing spending and the budget moves into deficit as the increase in government spending is combined with a decline in tax revenue.

As the expanding budget deficit restores modest growth business investment also starts to recover in Period 6 and the consumption and saving continue to recover.

The blue lines (post Period 6) then chart what the response is when the government maintains fiscal support. All the aggregates improve and by Period 8 government spending growth flattens as the private spending recovery is entrenched.

The red lines (post Period 6) record what happens to the aggregates as a result of the application of the fiscal rule. You can see the sharp decline in discretionary government spending immediately starts to impact on its ability to collect tax revenue. This is because GDP (and income) growth declines again as the fiscal support is withdrawn.

The loss of tax revenue accelerates post Period 7 because investment, which was beginning to recover reacts to the loss of fiscal support and starts collapsing again.

You will also note that the decline in government spending is being outstripped by the decline in tax revenue which implies (see later graph) that the budget deficit is rising again despite the austerity measures.

Private consumption and saving also decline because of the double-dip GDP response (that is, national income declines again).

The next graph compares the evolution of the budget deficit as a percent of GDP (bar) superimposed on percentage GDP growth (line) with and without the application of the fiscal rule. The 3 per cent rule line is also shown. As the economy contracts due to the investment collapse in the second period, the budget quickly goes into deficit. The government continues to stimulate the economy as investment and exports fall and by Period 6 the budget deficit is in violation of the fiscal rule.

The responsible government response is shown in the left-panel – continuing to support growth which by Period 7 is also attracting a revivial in private investment spending. GDP growth continues as investment and exports recover and the budget deficit is below the fiscal rule limit by Period 10 and the economy is back on to “trend” growth as the fiscal contraction (the stimulus) declines.

The application of the fiscal rule is shown in the right-panel. The reaction to the budget deficit ratio going above the rule limit is to contract discretionary government spending and the impact is immediate on GDP growth. There is a slight improvement in the budget deficit ratio but the following period the economy double-dips as investment also declines again because firms realise that the dramatic withdrawal of the fiscal support to the recovery will damage their prospects of realising sales.

GDP growth continues to be negative as the recession deepens. The budget deficit ratio rises slightly as tax revenue collapses faster than the government is cutting its spending. The application of the fiscal rule fails to achieve any of the stated aims. The budget deficit ratio rise, GDP growth becomes negative and private investment declines.

The next graph shows the evolution of the sectoral balances over the 10 periods. The sectoral balances are derived directly from the simple model above and are accounting statements that must be true.

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Combining that with our initial GDP expenditure identity (that is, equating the two different views of GDP) we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero and are described as follows (noting they are usually expressed as a per cent of GDP):

  • The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
  • The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
  • The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

The evolution of the balances over the 10 periods is largely self-explanatory given the previous discussion relating to the other graphs.

The next graph shows the sectoral balances superimposed on real GDP growth for the scenario where no fiscal rules are applied (top panel) and where the rule is applied (bottom panel).

Once again the previous discussion should provide you with the explanation of what is happening here.

Conclusion

I typed this up while flying, sitting on the Eurostar and trying to sleep but not being able to! That is why it is a bit longer than usual. It is also a reflection of work I am doing for our upcoming macroeconomics textbook (with Randy Wray).

Anyway, more normal transmission will resume tomorrow.

That is (certainly) enough for today!

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This Post Has 98 Comments

  1. “Governments should not, however, push aggregate demand beyond the capacity of the economy to absorb it in real terms. But why would a sensible government want to do that anyway?”

    Because you can create the illusion of wealth for a short period via asset inflation and credit expansion, and that buys votes. It happens every election.

  2. Isn’t a fiscal rule just a misguided policy target? You can say ‘keep deficit at 3%’ or you can say ‘keep unemployment under 2%’. They are both targets.

  4. Dear Neil Wilson (at 2010/09/30 at 19:41)

    You asked:

    Isn’t a fiscal rule just a misguided policy target? You can say ‘keep deficit at 3%’ or you can say ‘keep unemployment under 2%’. They are both targets.

    Except that the government can keep unemployment under 2 per cent if it chooses but it may not be able to keep the deficit under 3 per cent. There are some things that a sovereign government can actually do.

    best wishes
    bill

  6. bill you said:

    “A national government in a fiat monetary system has specific capacities relating to the conduct of the sovereign currency. It is the only body that can issue this currency. It is a monopoly issuer, which means that the government can never be revenue-constrained in a technical sense (voluntary constraints ignored). This means exactly this – it can spend whenever it wants to and has no imperative to seeks funds to facilitate the spending.”

    Under this definition, a country which runs a voluntary exchange rate peg (such as China) but is still the monopoly issuer of the currency would seem to be classified as a “sovereign” nation.

    This is in contradiction to what you previously stated about Russia (which was a sovereign currency issuer with a voluntary fx peg) when the ruble crisis occurred. You claimed they were not a sovereign nation because of the voluntary constraints they had imposed.

    Do you consider China to be a sovereign currency issuer?

  7. bill said:

    “The inflation of the 1970s was not the same beast that the deficit terrorists are telling us is just around the corner now. In the mid 1970s there was a huge price rise in oil as the OPEC cartel flexed its muscles and knew that the oil-dependent economies had little choice, at least in the short-run, but to pay up……the resulting wage-price spiral came directly out of the distributional conflict that occurred.”

    Examination of the inflation data from the early 1970s will show you that inflation was on the rise well before the OPEC oil price rise in 1973. What caused this first spike in inflation?

    An alternative theory to the one you have outlined above is that the oil price increase was actually in response to an already existing inflation problem which had been building throughout the late 1960s. In fact there was probably no single neat cause of the inflation of the 1970s, but a number of things played important roles, including monetary effects as well as the oil price increases.

  8. As I understand it, the central concept of MMT is that a sovereign government has no barriers to limit its own spending in local currency given it can run whatever level of money supply it wishes. Interestingly the rating agencies do recognise this as they assign foreign and local (sovereign) ratings to issuing bodies (eg. the Australian states) which have the ability to tax and/or issue local currency.

    The problem I see with MMT is that while in theory a sovereign nation can print all the money they want, in the real world no other nation would ever deal with that nation in LOCAL currency due to the unknown scarcity of that currency. Let’s say NZ suddenly adopted MMT policies and wished to set an unemployment target of 2% so they embarked on a job guarantee program which created an annual budget deficit of 20% of GDP to create and maintain this target.

    Presumably the more the government expanded the money supply the lower the NZD would go against its trade partners. Would it be fair to say that the rest of the world would refuse to deal in NZD terms and as a result NZ companies would have to buy and sell goods based on USD or some other (gold?) standard?
    Would it be naive to not think NZ inflation would skyrocket?

    It just seems to me that MMT is a hard sell to the rational thinker due to the central theme of unlimited local money supply.

  9. bill said:

    “The only economic constraint that a sovereign government then faces is what we term the real constraint.”

    “So the inflation barrier becomes the real constraint on government spending. This is obvious but then the question becomes what is that barrier?”

    Bill, if you were put in charge of the federal budget, how would you measure the real constraint? How would you know whether or not you could increase government expenditure?

    Would you advocate an inflation target?

    This is one thing that a lot of MMT sceptics (like myself) would probably like to hear more about. What is the real constraint on government, how do we measure it?

  10. Ray: “Printing money” is not so different from “debt-financed” deficit spending – and the lower interest rates are, the closer it becomes. Currency is just a 0% nanosecond maturity bond. They both have the same effect – being the only way net financial assets can increase. And everybody is deficit spending now, just not enough. MMTers key policy goals are demand support and full employment, not Zero Interest Rate / “print money”, which is more of a means than an end.

    That “the unknown scarcity of that currency” would cause a plunge in its foreign exchange value does not follow at all. All (fiat) currencies trading against each other have unknown scarcity at present – and because so much money is bank money, not high-powered government money, not even the government controls the scarcity. So “Presumably the more the government expanded the money supply the lower the NZD would go against its trade partners.” is just not right. (Of course it would be right if NZ went nuts and mailed everyone a Trillion NZD check every day – but we are speaking realistically.) There’s a good chance the NZD would appreciate.

    China followed a MMT / Keynesian recommended policy and had a nice big deficit to keep demand up and its economy humming.
    So did Australia, relative to the US, for a while.
    Is everyone abandoning the plunging renminbi? (Or wallpapering their houses with A$?) No, politicians are competing in demagoguery to denounce the Chinese for not letting the renminbi appreciate! (and the A$ is hitting highs against the US$)

  11. Ray: in addition to the points made by Some Guy, the U.S. monetary base went up by an unprecedented 150% in 2009. The effect on inflation was around zero. See here:

    http://research.stlouisfed.org/fred2/series/BASE

    Conversely, inflation can get out of hand with money supply increases NOT being the main cause, as I think Gamma above suggests. It’s a bit more complicated than “print money and you automatically get a Mugabwe scenario”. But it’s not VASTLY more complicated. I could explain it all (as I see it) to an intelligent 17 year old in ten minutes.

    Having said that, I agree with you that MMT is what you call a “hard sell” because of the money printing element. For that reason I’d like to see MMT advocates being a bit more careful what they say.

  12. Hi, Bill- fascinating blog….

    “At that time, neither labour or capital chose to concede and there were limited institutional mechanisms available to distribute the real losses fairly between all distributional claimants.”

    “It is only during the neo-liberal period that this focus has narrowed to maintaining price stability.”

    I would suggest that these are closely connected. It turned out to be quite difficult to tame inflation, at least given the intellectual mindset of the time, and we turned to rather brutal monetarism to kill the beast, as it were.

    My question is.. what are the ideal institutional mechanisms that would resolve an external price shock? Government spending is rather sticky.. it can’t just renounce its economic demands to restore more of the pie to the private economy. So what would you see as an efficient way to mitigate a shock/inflation that is democratically coherent and leaves the government share of the economy reasonably stable? It sounds like the state has to engineer general deflation via tax rises/spending cuts to stop the spiral, while the private parties duke it out as they usually do anyhow. But that can be difficult to do in a political system.

  13. I’m still convinced that the real constraint is the ballooning glut of savings that is added to with every deficit. Bill seems to regard adding to the glut of savings year on year decade on decade as some unquestionable duty we must all obey. If savings of high powered money are now >100x GDP and that is giving a damaging liquidity glut, then what on earth will it be like when savings are>1000x GDP. Remember much of that “GDP” is actually from the handling of those savings (the FIRE sector) so the ratio of real economy GDP to savings is even more out of whack.

  14. stone– I agree that the savings (by the wealthy) – consumption ratio is out of kilter and contributed to our great recession. More of the fiscal stimulus in the U.S. needs to go to putting people back to work and boosting the income of lower and middle class Americans. Is this what you have in mind?

  15. Ralph Musgrave: you say that “U.S. monetary base went up by an unprecedented 150% in 2009. The effect on inflation was around zero. ” My understanding was that the 150% increase in monetary base offset what otherwise would have been a huge asset price correction that would otherwise have wiped out the ramp up in asset prices that came from leveraged ponzi malinvestment upto 2008. Whilst it is true that consumer prices were not involved, it was a massive intervention to prop up those who leach off asset price inflation.

  16. Gamma, the real constraints are the spare capital, labour resources when an economy is run below full potential, bar around 2% allowing for frictional job-change etc unemployment.

    Read up the stuff on the Job Guarantee as this takes automatic fiscal stabilisers to their logical full extent.

    Stone, how can the ‘ballooning’ private sector debt mountain be a sign of a ‘ballooning’ savings ‘glut’?

  17. Stone:

    “I’m still convinced that the real constraint is the ballooning glut of savings that is added to with every deficit. Bill seems to regard adding to the glut of savings year on year decade on decade as some unquestionable duty we must all obey. If savings of high powered money are now >100x GDP and that is giving a damaging liquidity glut, then what on earth will it be like when savings are>1000x GDP. Remember much of that “GDP” is actually from the handling of those savings (the FIRE sector) so the ratio of real economy GDP to savings is even more out of whack.”

    Yes most of us, for some reason, like to build wealth (don’t you?), but it is not because Bill Mitchell asked us to do so.

    Stone, don’t you think that as long as savings stay into their savings accounts there is not much pressure on the aggregate demand.
    During periods when private sector decides to spend more than its income (spending from its savings or spending on credit) government should just act in contra balance to cool off the economy by going in to surplus (raising taxes and/or cutting spending).

  18. Will Richardson says:
    “Gamma, the real constraints are the spare capital, labour resources when an economy is run below full potential, bar around 2% allowing for frictional job-change etc unemployment.”

    Yes I’m aware of what these MMT claims these real constraints are in theory. My question was: how do you measure them in practice? The unemployment rate, the underemployment rate rate, the inflation rate? I think you will have a very hard time coming up with a measure of the amount of “spare capital” (whatever that is) in the economy.

    If MMT is going to argue that governments should abandon their the current budget constraint, which is based on a nominal amount of spending each year in favour of a constraint based on the level of “available real resources” in the enonomy then it’s necessary to specifically define how you measure this “real” constraint.

    For example, do we say that governments can run deficits as long as inflation is below a certain level (what is this level)?

    Or as long as unemployment is above a certain level (2%)?

    Some combination of employment and inflation? What happens if high unemployment and high inflation occurs siimultaneously? Does this call for higher deficits to cure the unemployment or lower deficits to cure the inflation?

  19. thanks Some Guy and Ralph M.

    Just to clear a couple more things up.
    As we know, exchange rates reflect currency pairs. The NZD vs the USD for example. Using NZ as a good example for the MMT experiment because it is small (ie. it is not the US or China which are hubs of world trade and political importance). Indeed pretty much all nations are experiencing huge deficit spending so there are few stressed currency pairs. Perhaps the AUD is becoming stressed due to its much higher interest rate structure and high commodity prices.
    If the world suddenly recovered and governments all sought to balance budgets next year except NZ which decided to target 2% unemployment and double its budget deficit.
    There is an assumption that GDP would spike higher due to the stimulus being at work in the economy with a likely inflationary effect as idle capacity was employed and resources became more scarce until industry would produce more (including perhaps net immigration if there were skill shortages).
    I agree in this environment that the NZD would probably be neutral/higher against other pairs because the super strength of the economy would exert a positive NZD effect perhaps vs a negative effect due to the market disapproving of running such a large deficit in isolation to other nations.

    If however, the NZ government ran this deficit funded program in isolation to other countries for 5 yrs, attained its 2% unemployment but GDP now moved back to flat/negative because let’s say commodity prices had flopped and inflation had risen to 10% due to resource scarcity (resources that NZ could not easily produce).

    Under these conditions it seems likely the NZD would have a lot of downside.
    How would MMT deal with these set of conditions given its central theme if to maintain its 2% unemployment target (assuming we call that full employment)?
    thanks

  20. RVM said:

    “During periods when private sector decides to spend more than its income (spending from its savings or spending on credit) government should just act in contra balance to cool off the economy by going in to surplus (raising taxes and/or cutting spending).”

    This statement is ridiculous ?

    It’s governments going into surplus which forces the private sector to spend more than its income from savings and then resort to credit when the savings run out.

    The reason why the private sector spends more than its income is to maintain as much of their current standard of living as they can as their incomes fall.

    If the real-balance effect was in anyway significant you might have a point but there’s not an ounce of evidence to suggest that the real balance effects can counter the losses.

  21. “What is the real constraint on government, how do we measure it?”

    There’s no need to measure it if you have a JG – it is designed to be automatic. When unemployment rises, people will move to the JG. When private sector employment rises, people will move out of the JG. The scheme is designed to be as non-sticky as possible, with people allowed to move in and out of it relatively quickly.

    Likewise, if there is high inflation there will be pressure for the government to cut spending in the private sector (not JG!). This then squeezes the private sector with fiscal drag, moves people back into the JG onto a fixed wage, and lowers overall wages. That’s how the JG controls inflation.

    Of course, it’s difficult to predict exactly how much to cut spending, but the same goes for the NAIRU, the only other alternative out there. The JG method just means less human suffering.

    On a broader point, I understand a lot of people’s reluctance to embrace MMT – there will always be difficulties in any economic framework, and they do need to be addressed. But you are all asking for it to be perfect, while we are straddled with a horrendously wasteful system right now. I find it hard to understand how you could believe MMT to be a worse system than the current paradigm, especially when the golden era of economics, the post war boom, was so much closer to the basic direction of MMT than anything nowadays.

    stone:
    The government can only really control the macroeconomic environment with any certainty, not the microeconomic one. Keeping the unemployment rate down while keeping the money supply fixed would require a very delicate microeconomic balancing act. It’s far easier and more predictable to deficit spend than try to do some tricky redistributions, or force people to cap their net savings. The above model should show what happens when the government ties it’s hands with meaningless nominal rules – it’s counterproductive and destructive. Why apply a constant money supply constraint? How could it possibly help?

  22. A difficulty I have with MMT’s advocacy of fiat issue over borrowing as a method of “funding” deficits is not theoretical but programmatic. Let’s suppose that we have an economy with insufficient demand and higher unemployment and the government follows the course advised by MMT economists, of creating money sufficient to employ all the unemployed on a Job Guarantee on public works or similar. This brings the demand and employment levels up to full employment (which will be interpreted by investors as a Boom as Minsky said), workers move off JG employment into the revitalised private sector, etc. As a result private credit expands which expands the monetary supply (and its velocity, due to the boom). Since there was no government debt created, monetary policy is a less effective tool and government must then use fiscal policy (ideally, taxes targetted at overheated areas of the economy, speculation, the FIRE sector, etc) to withdraw money from circulation again to prevent inflation.

    BUT, governments these days are extremely reluctant to raise taxes, particularly on boom sectors which a) have deep pockets with which to lobby politicians and other decision makers and b) can portray themselves in a compliant (because bought) media as the saviours and creators (rather than beneficiaries) of economic growth. Australians can observe the recent debacle of the attempt to introduce a Mineral Resources Rent Tax on a sector which was undeniably booming, benefiting from economic rent, and distorting the economy, which still nearly brought down a fairly well-functioning government. No Australian government is likely to do anything along those lines again for a generation or so.

    It seems to me that the useful ideological function of deficits “funded” by government debt is that they give politicians an excuse/backbone to withdraw money from circulation during booms. The problem is that NAIRU/monetary policy ideas withdraw money in a way that creates unemployment and human suffering. What I would like to read (and I realise this is more of a political question than an economic one) is a clearer articulation of how MMT proposes to moderate boom conditions before they become over inflationary, which doesn’t necessarily rely on politicians having the courage to stand up to rent-seekers and speculators.

  23. Dear Bill

    I’m a bit lost by your reference to government options for dealing with cost-push inflation. It seems that you outline 3 alternatives: (1) the government can ratify the inflation by not reducing the nominal pressure, (2) it can break into the wage-price spiral by reducing its budget deficit, or (3) job guarantee.

    Please can you spell out in more detail what you mean by (1)?

    Many thanks

  24. Grigory Graborenko said:

    “:On a broader point, I understand a lot of people’s reluctance to embrace MMT – there will always be difficulties in any economic framework, and they do need to be addressed. But you are all asking for it to be perfect, while we are straddled with a horrendously wasteful system right now. I find it hard to understand how you could believe MMT to be a worse system than the current paradigm, especially when the golden era of economics, the post war boom, was so much closer to the basic direction of MMT than anything nowadays.”

    Great post.

    Neo-liberalism has failed to deliver for almost forty years and yet people are worried about MMT creating boom bust cycles, high interest rates, hyper-inflation, and higher taxes…blah blah blah.

    Their real concern with MMT is that it will reduce the gap between the top and the bottom and that is the pill the neo-liberals cannot swallow.

  25. JamesH: I think a far more effective backbone for the government would be the “arbitary” (in Bill’s view) fiscal rule that taxation has to match spending. However rvm says that most of us like to build wealth so that is reason enough to have taxes at a lower level such that savings build up. The idea that it is benign to let savings build up in bank accounts has been proved to be a dangerous mistake by the effect that the Yen carry trade had in the run up to the 2008 crisis. The Japanese ran deficits and Japanese savers kept the consequent savings as cash in Japanese bank accounts. The Japanese banks made short term loans to financial intermediaries who converted them into long term loans in USD, euros, GDP etc to fund the credit boom that lead to the bust. This caused $1T USD from the Japanese savers to help fund a moronic asset bubble outside Japan. This glut of Japanese savings did not cause the Yen to devalue because the carry trade loans were constantly rolled over so there was always more demand for more Yen. It also made profits for Japanese banks and that too helped support the value of the Yen. Deficit spending benefits (at least in the short and medium term) the nation that is deficit spending at the expense of the global economy. It is a bit like burning fossil fuels- the harm is not inflicted by climate change in the nation that is burning them any more than on the rest of the world. The attitude that people on here have that government printed money is a free lunch that we are all entitled to seems to me cruel and naive. No one ever gains financial power except at someone else’s expense. Money spent by the government to create aggregate demand can create real resources that would not otherwise have been made. Money remaining as savings due to government taxation not matching spending is financial power that would otherwise be in the hands of others.

    Will Richardson- “Stone, how can the ‘ballooning’ private sector debt mountain be a sign of a ‘ballooning’ savings ‘glut’?” As Bill says government deficits equate to non-government savings. The private sector debt mountains are alongside private sector savings mountains that equal the private debts together with the accumulated government deficit spendings.

  26. Grigory Graborenko says:

    “There’s no need to measure it if you have a JG – it is designed to be automatic.”
    “Likewise, if there is high inflation there will be pressure for the government to cut spending in the private sector…”

    Grigory, you’ve contradicted yourself here. My question is: how does the government know what the real capacity of the economy is, so they know whether they can increase spending or have to decrease it?

    Firstly you said there’s no need to measure it, everything is automatic, then in the next breath you say that the inflation rate is the measure.

    I understand the theory that as private sector employment falls, people will move from the private sector to lower paying JG jobs, thus restraining inflation but maintaining full employment. But what causes the movement? Obviously less final demand, which could originate from less government spending or higher interest rates, both of which are at the discretion of government.

    So what is the trigger to tighten? Inflation expectations? A current inflation rate above a certain level? What is that level?

  27. Burk wrote:
    “My question is.. what are the ideal institutional mechanisms that would resolve an external price shock?”

    I have been thinking about this too. If we assume that there might be an oil crisis and that in turn has caused numerous other resources / products and services to have inflated prices. My idea is that the government should respond to a supply shock by getting “bigger” (i.e. higher spending and higher taxes).

    A larger government would be able to ration scarce resources more efficiently and fairly, as happened in the UK during WW2. Apparently the UK population never had a more balanced diet (overall) than during rationing! The government could for example issue free travel warrants for public transport which would conserve fuel. They could also cut off power supplies to residential property during the daytime in summer months (but not to businesses). Either way the government would be in a better position to preserve the economy and jobs than private sector markets during a supply shock.

    Charlie

  28. Detroit Dan; I totally agree with your point that “More of the fiscal stimulus in the U.S. needs to go to putting people back to work and boosting the income of lower and middle class Americans.” If money goes to the most wealthy, it is either saved up or used to pay off debts and so prop up asset prices. If money goes to the least well off then they will spend it on goods and services that actually are needed. That creates jobs doing work that needs doing. I get the impression that most people on here also agree with us about that. The point where I get the impression I’m in disagreement with most people on here is whether that fiscal stimulus aimed at the least well off should be combined with equivalent taxes removing wealth from the most well off. I think it is important to do that despite the fact that in the short term at least the only benefit would be to the rest of the world and not to the USA. My impression is that there is one group of people saying that spending more than is coming in from taxes is ruining the global economy (which is true) and another group of people saying that the economy needs money in the hands of the least well off to create aggregate demand (which is also true). The two view points are perfectly compatible and do not contradict each other and yet anyone making one point seems to get answered by a reiteration of the other point. I sometimes wonder whether the problem is that people have money that they want to keep and that leads to mental clouding. So people who recognise that deficit spending is causing a liquidity glut that is wreaking the global economy have the solution that the government should spend less. On the other hand people who recognise that lack of aggregate demand is causing underutilization of resources also want to keep hold of money and so have the solution that the government should deficit spend. People say that economics suffers from the difficulty in doing experiments. To my mind astronomy and evolutionary biology have to deal with that and the crucial difference is that self interest does not cloud views about astronomy.

  29. Quote: “The inflation of the 1970s was not the same beast that the deficit terrorists are telling us is just around the corner now. In the mid 1970s there was a huge price rise in oil as the OPEC cartel flexed its muscles and knew that the oil-dependent economies had little choice, at least in the short-run, but to pay up. This represented a real cost shock to all the economies – that is, a new claim on real output. The reality is that some group or groups (workers, capital) had to take a real cut in living standards in the short-run to accommodate this new claim on real output.”

    I’m sorry but that is not what happened despite your promotion of the official IMF history. Your apologetics for 1970s austerity ignores the politics as to who wanted to transition from long term contacts to spot market pricing.

    Let’s go through actual history of what happen rather than myths promoted by apologists for the Oligarchy aka economists.

    1973: The Arab-Israeli Yom Kippur War in 1973 led to an Arab boycott of Britain and the U.S.A.
    The result was the “Rotterdam” spot market was set and it let western oil Cartels sell Arabian oil to buyers from the blacklisted companies at a substantial markup in price. In order keep these speculative market profits from the energy crisis was created and the myths about how the mean old Arabs where causing the rise in prices.

    There are many books that that tell actual history as well the many writings at the time that do the same.
    The “Hidden Hand of American Hegemony” by David Spiro is one and from 1974 you have “Global Reach – the Power of the Multinational Corporations” by Richard J Barnet and Ronald E Muller. The actual history of 1970s energy proves that the floating of the currency is manipulated by speculators using “market crises” that effectively deny governments sovereign control over currency using spot market and sudden hot money attacks.

    As a personal note, I must say that this blog is fascinating as Bill can be entirely correct about deficits and how PPPs are a scam but completely wrong about historical facts and currency stability. You keep finding many of the right answers despite having the wrong facts. It’s like anti-science that works.

  30. Lets not forget that Nixon dissolved the Bretton Woods arrangement in 1971 and the floating exchange rate disruption that event created most likely was expressed via inflationary trends.

    Of course, the US had to finally experience inflationary pressures after the relentless real economic spending of Korea and Vietnam.

    Also, many of realize that the “OPEC cartel” includes the old Anglo American conglomerates.

    MMT is not intended to be the unifying theory of all socio-political-economic thinking – it explains how the monetary system actually works today and provides insights into policy decisions.

  31. pebird: “MMT is not intended to be the unifying theory of all socio-political-economic thinking – it explains how the monetary system actually works today and provides insights into policy decisions.”
    If that is so, then some new name is needed for the “let’s deficit spend so as to meet our desire to net save” unifying theory of all socio-political-economic thinking that is given voice on all MMT websites I know of.

  32. Alan Dunn:

    “It’s governments going into surplus which forces the private sector to spend more than its income from savings and then resort to credit when the savings run out.
    The reason why the private sector spends more than its income is to maintain as much of their current standard of living as they can as their incomes fall.”

    Alan, IMO, at any given point in time and size of government private sector’s desires to save or to go into debt lead, and an MMT government reacts adequately to the changes of these desires so that full employment without inflation is maintained continuously. You are right that MMT government can take the leading role and force private sector to go into debt through budget surpluses but this should only happen when the new political will desires like so.

  33. “What I would like to read (and I realise this is more of a political question than an economic one) is a clearer articulation of how MMT proposes to moderate boom conditions before they become over inflationary, which doesn’t necessarily rely on politicians having the courage to stand up to rent-seekers and speculators”

    I have some sympathy with your point.

    However ‘borrowing’ doesn’t withdraw spending. You can take any bond in issue to a bank and borrow against it. Only taxation can neutralise a boom. (Interest rates being just a hidden form of taxation).

    But Job Guarantee is an automatic stabiliser. As people are hired off the base, the deficit spend drops away. As people start to net-spend rather than net-save the deficit disappears.

    The other option is a general land value levy that is operated by the central bank in the same way as monetary policy. This would be the lever by which taxes would go up to ‘control inflation fiscally on a monopoly resource’.

  34. “Grigory, you’ve contradicted yourself here. My question is: how does the government know what the real capacity of the economy is, so they know whether they can increase spending or have to decrease it?”

    You’re right – I can’t in all seriousness advocate a totally blind government. They certainly need to manage and measure something.

    The only real constraint on a government’s ability to pursue higher employment is unemployment. In other words, the government can only ensure full employment and nothing more. Up til then, it is *not* constrained. The JG doesn’t need a measure of employment to work – it’s automatic. Obviously we would like to keep track of employment numbers to show it’s working, but it can work to keep full employment without any intervention or triggers at all.

    The other policy aim of the government: price stability. What are the real constraints of the government when it comes to inflation? If inflation is negative, ie deflation, then the government can always bid up prices for market goods. So it’s not constrained in a real sense when fighting deflation. As for inflation, the government can raise taxes heavily or strip down private sector spending. Here the constraints are how much it’s already spending, and how much political power it has to enact austerity measures on the private sector. Political power is unmeasurable!

    “So what is the trigger to tighten? Inflation expectations? A current inflation rate above a certain level? What is that level?”

    So the metric you have to measure is the inflation rate. The ballot box should then decide what spending/taxation/inflation tradeoff is desirable. So the trigger for doing any of these things becomes how many votes the different economic policies by competing parties get.

  35. I have only see MMT explain how the US is not like 2 historical cases of hyperinflation. There are about 98 other cases to go to before you can say the US is not like any previous cases, and even then it is not a strong argument that the US is not at risk.

    Hyperinflation is not something countries choose to have, yet it has happened many times. It is a treacherous trap that many countries fall into. It is how fiat money dies. Since it is a real phenomenon it should be explainable in MMT terms. I think it is important and that MMT types have not given it the attention it deserves. I have tried to write up hyperinflation in MMT terms and would appreciate feedback from anyone:

    http://pair.offshore.ai/38yearcycle/#mmthyperinflation

  36. Vincent,

    Bill’s analysis has a great deal more depth than your article. You might try reading his Zimbabwe article.

  37. Bill goes into great detail about Zimbabwe’s history. He argues that the US is not like Zimbabwe, but none of the other 99 cases of hyperinflation was just like Zimbabwe, so this is not proving much.

    Bill is not looking at many cases and trying to develop a general theory of hyperinflation. He does not even count hyperinflation as different from normal inflation. In the end he is really just saying that Zimbabwe had a bad government and a wise government would not have done that. But it has happened like 100 times, even twice in America’s history. A wise economist would give a general explanation that governments could learn from so they don’t fall into the hyperinflation trap. 🙂

    In hyperinflation the increase in money also causes increases in money velocity and reductions in GNP, which compound to make prices increases go non-linear relative to the increase in money. This is very different from normal inflation. It is so different that simple adjustments in tax rates after hyperinflation starts probably won’t work. It comes on so fast that almost no country escapes once in the pull of hyperinflation.

    Again, hyperinflation causes the death of a fiat currency. It is important that any theory of fiat money have a good understanding of this phenomenon.

  38. “So the metric you have to measure is the inflation rate. The ballot box should then decide what spending/taxation/inflation tradeoff is desirable. So the trigger for doing any of these things becomes how many votes the different economic policies by competing parties get.”

    This basically describes the system we have now in Australia. Any government or opposition is free to come out with a policy to pursue a 2% unemployment rate at the cost of a possibly higher inflation. The government doesn’t need to stop issuing bonds for this to happen.

    The reality is that at every election the voters are happy to support the system that targets a 2 to 3% inflation rate and will tolerate unemployment at 5% permanently.

    Why do you think voters will suddenly change their preferences and start to demand lower unemployment at the risk of higher inflation, just because the government stops issuing bonds to cover budget deficits?

  39. Vincent,

    The problem you are having is that you are denying the ability to use of the levers that control inflation. To control inflation in a fiat monetary system you have to destroy money. Only taxation can destroy money – whether in its direct and unpopular fiscal form or its indirect and sneaky interest rate form.

    The length of Bonds are irrelevant. Cash behaves just like a permanent non-interest paying bond.. If bonds go short then central bank monetary operations will have to purchase the excess cash or lose control of their policy rate.

    Cash is just as effective as bonds at suppressing aggregate demand. Your assumption is that cash is always flowing and that bonds are always stocks. That is the flaw in your model. Cash can be stocks (in savings accounts) and bonds can flow (by borrowing against them at a bank). That’s why MMT suggests that bonds are superfluous.

    MMT says that the currency issuer has to issue sufficient ‘money’ to cover the currency users’ desire to stock that currency (ie net save) unless you want the economy to shrink. If you get into a situation where stocks are being liquidated and the currency users are net spending in aggregate, then the currency issuer has to withdraw ‘money’ if they don’t want the economy to expand any further.

    Failure to destroy money when the economy is at full capacity will cause an inflation. The fact that politicians find this ‘hard to do’ is their problem. That is what they have to do – like it or not.

    Bill covered it all here:

    https://billmitchell.org/blog/?p=10554
    https://billmitchell.org/blog/?p=381

  40. Vincent, cheers for the link and the connections to more opinions about hyperinflation. One thing that has really struck me is that the some of the current crop of oligarchs in Chile got their fortunes by buying up stocks at the depths of the hyperinflation they had (all assets prices collapsed in Chile because the hyperinflation left people needing to sell everything they had just to get food). So hyperinflation creates a bonanza for speculators who know how to play it even though in the case of Chile it was government ineptitude that created the hyperinflation rather than it being an intention. The deficit spending across the globe is creating a growing pool of savings that is making speculators more and more powerful. To my mind it is only a matter of time before speculators will be able to induce hyperinflations so as to profit from them.

  41. Imagine that everyone stopped buying US government bonds on Jan 1, and that during 2011 a total of $5 trillion in bonds came due, which are paid off in new fiat money. In this situation does MMT not predict inflation? In other countries this type of thing has caused inflation.

    Does MMT think that increased taxation could come up with an extra $5 trillion? They would have to collect about 3 times as much taxes as the currently do to get an extra $5 trillion. Does anyone think that could work?

    I thought MMT viewed bonds as a way to suppress aggregate demand. This is not so? Or only some MMT people think that?

  42. Hyperinflations start when people stop buying the government bonds and they have to make more fiat money to cover their deficit. Some MMT people think as long as there is not foreign debt, no supply shocks, and no indexing, there is no danger of hyperinflation. But the voters expect the government to take care of them, and the cost of doing this goes up with inflation. So government obligations (retirement, medical, current employees, military, etc) all go up with inflation. So it either takes huge cutbacks, like 40% of spending if that is the size of their deficit, or they print money when people stop buying bonds. Most go with printing.

    But when hyperinflation starts people will no doubt blame speculators.

  43. Vincent Cate, In terms of not being able to sell bonds, my impression was that over here in the UK, the UK government already buys most of the bonds from its self and pays the interest to itself. You have previously pointed out on here that that can be convieniently refered to as “printing money”. I think the MMT people do not count such “printing money” as a risk for consumer price inflation so long as the money gets directly through to the very wealthy who save it rather than spending it on consumables. In that way “printing money” enables GDP growth and allows goods and services to be aquired from the rest of the world for no effort by the country “printing” the money. Personally I consider it all an evil scam 🙂 and I don’t imagine it will be able to continue much longer. If I have misinterpreted MMT I’m sure we’ll get corrected.

  44. Vincent and stone,

    You have misinterpreted MMT. You may or may not get corrected. That you have ignored Neil Wilson’s helpful reply is not going to make others inclined to chime in. What good would it do?

    The information is available if you want to correct yourself.

  45. I did not ignore Neil Wilson. He said I was ignoring using taxes to control inflation. I then asked if people stopped buying US bonds and $5 trillion in bonds came due if MMT expected that increasing taxes would be able to cover that. Or if a new $5 trillion was printed to pay the bonds if MMT predicted that would be inflationary. This is how hyperinflation seems to start, the government can not sell bonds any more and has to print money for both the deficit and the bonds that come due. This makes for a sudden huge increase in the money supply and people see the value dropping and so use their money faster, so the velocity goes up. So I think this is an important question. I have read what I could find online and don’t see the MMT answer.

  46. stone:

    “I think the MMT people do not count such “printing money” as a risk for consumer price inflation so long as the money gets directly through to the very wealthy who save it rather than spending it on consumables”

    When has Bill ever advocated injecting fiscal support directly into the pockets of the rich? His favorite method of stimulus is the JG. This is minimum wage, full time work. Do you suppose billionaires will sign up? His goal is for the money to NOT be saved, and spent – thus producing a multiplier effect and flowing through the entire economy before eventually leaking due to saving (likely spread across different segments of society).

    The reasons this is not inflationary is because companies expand capacity before they expand prices when hit with larger demand.

  47. Stone pay attention to Grigory Graborenko’s comments because your interpretation of MMT is about as accurate as the Bush administrations interpretation of Islam.

    What’s even worse though is that you have a very limited understanding of the neo-classical synthesis that you endorse.

    If you cannot be bothered learning about MMT at least learn about the ideology you endorse.

  48. Vincent,

    It wouldn’t be incorrect to say you ignored most of Neil’s post. You in no way addressed his comments after the first paragraph. These comments speak directly to the questions you subsequently ask.

  49. Grigory Graborenko: Your very clear summary of what Bill advocates “thus producing a multiplier effect and flowing through the entire economy before eventually leaking due to saving (likely spread across different segments of society). The reasons this is not inflationary is because companies expand capacity before they expand prices when hit with larger demand.”-very clearly also has the two huge holes in the concept. The statement “likely spread across different segments of society” is blatent nonsense and it must take incredible shielding from the real world for you to believe it. Most of the people in the world have essentially no financial net worth at all. Since the breakdown in the Bretton Woods aggrement and the wholesale adoption of expanding currencies, the wealth ratio between the worlds richest 10000 people and poorest 2000000000 people has widened massively and will continue to do so so long as “leaking due to saving” is thought the appropriate final destination for money. Individual peoples modest savings “leak” to the financial services sector and a successive series of “leaks” lead to the wealth being controlled by a tiny group of people who are thereby able to direct and control the global economy and political system to suit their narrow interests.
    The second bit is just as blind to reality: “this is not inflationary is because companies expand capacity before they expand prices when hit with larger demand.”- The “companies” that have expanded to accomodate the “leakage to savings” are the FIRE sector companies. Before the breakdown of the Bretton Woods aggrement, financial services accounted for about 5% of the economy and were involved in socially useful work allocating resources to where they were needed within the real economy. The accumulated “leakage to savings” has created such a glut of money that it now takes 25% of the economy to handle it. What is more it is the most highly educated people who have been coopted by that useless expansion- those are the people who in a sane world would be at the forefront of doing the essential work that needs doing.

  50. Dear Jeff65:
    “It wouldn’t be incorrect to say you ignored most of Neil’s post. You in no way addressed his comments after the first paragraph. These comments speak directly to the questions you subsequently ask.”

    The other way to say this is that my subsequent questions were directly related to his other comments after his first paragraph.

    He is saying that MMT counts bonds and cash as the same as far as suppressing aggregate demand, where I had read that MMT says bonds are a way of reducing aggregate demand, for a time. So I ask him if $5 trillion of bonds were turned in for cash, does MMT think that is not inflationary? Because that is how hyperinflations start, people stop buying bonds and turn in old bonds for cash as they come due, causing the government to make lots of new fiat money. So historically this is very very inflationary (like 100 cases say yes and none say no). So if MMT believes that then it is clearly contradicted by the evidence. But again, I think Niel is wrong and that is not what MMT says. But either way, I find it reasonable to keep asking more questions.

  51. Oh, Niel also says that governments just need to increase taxes to control inflation. I explain that when bond sales fail and the whole deficit has to be covered by printing money, as well as for covering all the existing bonds that come due, that in this case raising taxes to destroy demand fast enough is just not possible. This is why hyperinflations start.

    His comment that, “Failure to destroy money when the economy is at full capacity will cause an inflation. The fact that politicians find this ‘hard to do’ is their problem. That is what they have to do – like it or not.” does not appreciate that raising taxes enough to cover all the bonds coming due is just not possible. In general the governments can’t even raise taxes enough to eliminate the deficit, let alone cover bonds if they can not “roll over bonds”.

    Again, hyperinflation is a real problem for fiat money in the real world. It does not look like MMT authors have really given it the attention it deserves. You can not just wait till inflation gets high and then increase taxes, by then it is too late.

  52. Vincent – of the array of hyperinflations and currency crises, I thought all involved a govt with ‘diminished sovereignty’ – ie either (a) they had significant foreign currency obligations, or (b) they’d pegged their currency, inviting speculators to try and break the peg.

    Do you know of exceptions?

  53. The two US hyperinflation (revolutionary war and civil war) did not involve pegs to foreign currency or debts in foreign currency. Those don’t seem to be necessary or even typical issues. The problem seems to be when deficits get to be over 40% of spending and then bond sales run into trouble.

  54. Note that neither dictators nor democracies really have a hard time choosing between defaulting on debts to foreigners and destroying the local economy. Foreigners lose, no hesitation. So logically that can’t do it.

  55. Same with a peg. If a peg to a foreign currency was destroying a local economy, and all you had to do was “un-peg” to save the day, then clearly they would un-peg. So that can’t be it either.

  56. Vincent – I imagine that for the old US hyperinflations gold was still important for ccy credibility in a way that it has ceased to be today, although I’m not familiar with the detail of those cases. Have there been hyperinflations with mainly domestic ccy govt obligations since 1971 (and not preceded by a war, for that matter)?

    I hear your rationale against the relevance of pegs, but I’m not sure that it works in practice: both sterling ERM crisis and ruble default stemmed from govts refusing to freely float the ccy in a misguided sense that a devaluation would be bad for their economy – until they were forced to un-peg. In retrospect, such policies seem to have been much more beneficial to foreigners at the expense of the domestic economy.

    The argument that having low foreign ccy exposures (and thus greater sovereignty) makes currency revulsion less likely, would presumably run as follows: because simply printing (or crediting accounts) COULD always ensure that most/all govt obligations are technically met, any adjustment in currency will necessarily be a gradual affair, rather than a radical and sudden outburst of revulsion.

    Aren’t you also struck by the fact that a concomitant of a large budget deficit is the private sector improving its balance sheet, which will strengthen the govt’s tax base (and ‘solvency’) going forward?

  57. I think the really troublesome obligations are all the voters who depend on the government for support. These are all the employees of the government, anyone on welfare, food stamps, unemployment, social security, etc. These people need a certain amount of real stuff to be comfortable. As the prices for real things go up, the government has to print more, which causes prices to go up, etc. If the government budget was just buying widgets, where they could easily cut back on the number of widgets, there would be no trouble. But in the real world it is supporting real humans who feel they paid into the system and should be taken care of now. Cutting a government budget in half can easily make a revolution, or at least cause some heads to roll. So instead they just print money. But eventually you get a black market where people are not using the local currency and not paying taxes. And eventually the black market is bigger than the legal market and has to be legalized so the government can start taxing it. Usually at this point the government comes out with a new currency and rules to keep the printing under control. And then nobody is using the old currency.

    People having more dollars on their books does not mean they are better off. If prices go up by 20% and you have 10% more money you are hurting. If you look at food and real necessities there is already inflation, but people’s paychecks are not going up. This is real pain and I think there will be more coming.

    Keynes claim, on page 6 of his book, was that by printing more money we could trick people into working for a lower real wage even though they would not agree to work for a lower nominal wage, thus making it easier to employ more people. The problem these days is that government employees all have Cost Of Living Adjustments (COLAs) so as they print more money the private sector gets poorer and the government guys get richer. Now government people are paid twice what private people are, but the taxes on the private people fund the government. This is a system ready to crack.

  58. Yes, there are many examples of hyperinflation. War is common to some. Many are due to socialist policies reducing GNP. Some argue that the government takeover of mortgage industry, government motors, price controls on healthcare, etc puts the US in the position of hurting their GNP like many of the hyperinflation cases. Along with hurting the GNP, socialist policies causes capital flight, and that means a risk of bond sales failing. The saying is “capital goes to where it is treated well”.

  59. It does not look like MMT authors have really given it the attention it deserves. You can not just wait till inflation gets high and then increase taxes, by then it is too late.

    The MMT model is pretty simple. Economics is about the production, distribution and consumption of real resources. Distribution occurs in modern capitalistic economies through market mechanisms using monetary means. The modern monetary system involves nonconvertible floating rate currencies for this purpose.

    A country’s GDP is computed three ways, all of which yield the same result – product, expenditure, and income. This can be represented in terms of stock-flow consistent macro modeling based on national accounts and official data.

    According to MMT, there three fundamental possibilities. The first is the one in which all the product at optimal capacity and full employment (accounting for frictional unemployment) is absorbed through expenditure by nominal demand, which is income-based, resulting in price stability. This is the policy goal.

    The second possibility is that effective demand exceeds the capacity of the economy to absorb it at full employment and optimal capacity. The result will be inflation. In this case, the policy should be to reduce effective demand by withdrawing nongovernment net financial assets through taxation to maintain price stability.

    The third possibility is that effective demand is insufficient to absorb the output of the economy at optimal capacity and full employment. The policy requirement then is to increase nominal aggregate demand by increasing nongovernment net financial assets through deficit expenditure to maintain optimal output at full employment.

    If policy conforms to these principles, which not unique to MMT since they are derived from Abba Lerner’s principles of functional finance (1943), government will maintain its policy goal of optimal capacity at full employment with price stability. Generally speaking, most of the job can be accomplished through appropriateautomatic stabilization. However, there are always unexpected occurrences and exogenous shocks. However, the functional finance principles for addressing these eventualities ad hoc remain the same.

    This is only meant as a general statement of the MMT position. MMT is a macro theory of considerable complexity, so the implementation of this policy-wise would be depending on modeling changing conditions using the sectoral balance approach and stock-flow consistent modeling developed by Wynne Godley. See Godley and Lavoie, Monetary Economics.

    Another important influence on MMT comes from Hyman Minsky’s work, and MMT recognizes the necessity to incorporate financial conditions into economic modeling. Minsky’s work also distinguishes between productive and non-productive uses of money. This is an important factor that is often overlooked in the focus on functional finance.

    Lerner’s principle of functional finance only say to use taxation to withdraw nongovernment net financial assets when needed to relieve inflationary pressure. Analysis such as Minsky’s reveal how to target taxes to produce the desired result, e.g., taxing economic rent instead of capital for productive investment. Similarly, fiscal policy would employ a targeted approach to take advantage of multiplier effects, and also to take advantage of opportunities for public investment and other means of advancing public purpose.

    In open economies under the present floating rate regime, country’s also have to be aware of the relative value of currencies and manage their affairs accordingly, especially if they are trade-dependent, which most countries are to some degree. For example, most countries are net exporters of some products and net importers of others. Owing to globalization, these are becoming more important factors.

    If a country acts irresponsibly, then there will be untoward consequences. These consequences wil manifest as warning signs to take policy action. If they are ignored, then problems will arise. For example, presently, the US is ignoring its huge daily losses from a wide output gap and extraordinarily high unemployment and underemployment, which are the signal to increase its deficit and target the expenditure using multipliers. And if the US were to become concerned with external leakage, it could decide institute measure for dealing with that, tariffs, for example.

  60. Now government people are paid twice what private people are

    This is according to Heritage Foundation and Cato Institute, right wing think tanks aka propaganda machines. They have been saying this for the past twenty five years. These figures are disputed. I

    But it is true that government employees fare better than their private counterparts, but they are often not as well as paid a employees of non-profits. However, the differential is far from double.

    Check out the pay scales at The Salary Reporter, for example.

  61. The saying is “capital goes to where it is treated well”.

    Capital responds to fear and greed. Then things are going well, capital flows toward greater risk in search of greater return, e.g., emerging markets and speculative vehicles. When things turn sour, then capital flees to safety, e.g., the USD and tsy’s.

  62. >These consequences will manifest as warning signs to take policy action.

    If people suddenly stop buying bonds and start buying up all kinds of real goods, it is too late to take policy action. The government has to make lots of new money (both to cover deficit and bonds maturing) as prices shoot up, things spin out of control and you get hyperinflation. This has happened many times to many countries. So what are the “warning signs” that this is about to happen?

  63. Hi Vincent,

    >If people suddenly stop buying bonds and start buying up all kinds of real goodsThis has happened many times to many countries.<

    Can you provide examples where risk averse bond holders turn into commodity speculators "suddenly"?

    What is the evidence that enormous USG spending over the last ten years is spooking bond buyers? Aren't long term yields at all time lows? What about Japan? When do the real facts start to sink in and change people's position?

    You can say "wait until x happens" but the actual facts right now don't support your position. The truth is that there have been a lot of people saying "wait until x happens" for a long time. How long do we have to wait?

  64. I believe that there is a great confusion here as to how monetary system actually operates. And this is what MMT is about above anything.

    Crucial part of monetary system is payment system. Stability of payment system is the overarching task of any central bank. It stands above inflation, employment or anything else. Without functioning payment system any economy will quickly collapse.

    The payment system globally has been undergoing a technological revolution that still goes on and will go on. In order to understand why payment system is critical to the real economy one has to understand the dichotomy between commercial bank monies and central bank monies. This leads to clear understanding of the structure of the interbank market including interactions between different agents that have accounts at the central bank (commercial banks, Treasury and local governments, foreign central banks, etc.) and how they interact with interbank market and with the interest rate policy of the central bank. As soon as one gets a clear understanding of this rather complex but simple system then all fears about “people stop buying bonds”, “liquidity driven asset price inflation”, wealth and taxes and so on will get clear as well. Without such understanding one will endlessly worry about hyperinflation “because there is too much central bank money around”.

    Central bank money (cash and reserves in the interbank market) is need only for final settlement of transactions. Typical interbank payment systems work on the net basis, i.e. all payments are netted before interbank transaction is made. The development of gross real time payment systems has led to unlimited and free intra-day liquidity provision by central banks. Only overnight amounts matter for interest rate policy. Not the volume and amount of transactions in the economy but overnight interest rates.

    The time when payment system worked as trucks and trains driving around with tons of cash is long gone. If you care about news then trucks and trains are no longer robbed. Central bank money is needed only for settlement, retail and wholesale. But it tells you nothing about economic activity and therefore inflation. The fact that people believe in quantitative theory of money and this belief drives financial assets prices up-up-up and higher is absolutely irrelevant for the consumer price inflation until it becomes a cost-push inflation. But then one just needs to limit speculation of commodities which was, is and will be outrageous but it has nothing to do with MMT.

  65. Vincent, appreciate you engaging. But whilst your scenario of public sector workers refusing to accept a real terms cut in benefits carries a certain abstract plausibility, I just don’t see this in practice. Here in Europe you see strikes from time to time, but the substantial public sector pushback has only come when the govt imposes massive adjustments (>10% cuts) on workers, as in the PIIGS – which are of course non-sovereign. An inflation ‘tax’ of up to 5% appears eminently feasible in practice.

    Sorry to be a bore, but I would really appreciate one example of hyperinflation (or even currency crisis) with a fully sovereign govt outside wartime. If you think hyperinflation could happen in the US, which currency would citizens dump USD for?

    The money supply is clearly central to your analysis. What do you make of Bill’s (and others’) arguments that the money multiplier is now meaningless, in view of the massive accumulation of reserve balances and fairly stable prices? Do you see the multiplier as effectively mean-reverting? And do you distrust the ability of taxation to cool an over-inflating economy? I’ve visited your blog but this wasn’t clear to me.

  66. If people suddenly stop buying bonds and start buying up all kinds of real goods, it is too late to take policy action. The government has to make lots of new money (both to cover deficit and bonds maturing) as prices shoot up, things spin out of control and you get hyperinflation. This has happened many times to many countries. So what are the “warning signs” that this is about to happen?

    Generally speaking the signs of impending economic and financial turmoil are second derivative effects involving major indicators like interest rate/yields, fx, inflation, employment, as well as leading economic indicators. These don’t often make large unexpected moves quickly short of exogenous shock and then extreme methods have to be imposed, as during wartime. For example, after Pearl Harbor the US went on a wartime footing, turning the economy into a command economy geared to full-on ramp up for war. This involved rationing scarce goods for example, and strong action against black markets developing.

    I find the notion that the US would suddenly go into hyperinflation, well, curious. Now, if you were arguing impending deflation, I would be more open to that. Presently, there are no signs of inflation, let along hyperinflation, while persistent disinflation is disconcerting, and the concern is that it could turn into deflation, especially should a shock occur.

  67. As I said, sometimes hyperinflation comes because a government moves toward socialism and bond investors flee. For example, Chile. Given how Obama screwed bond investors in Government Motors, I am surprised they have not already fled the US.

    The “excess bank reserves” are now earning interest from the government, which makes this just like a loan to the government or bond purchase from the treasury. So this reduces aggregate demand, at least in my understanding of MMT terms. 🙂

    When the USD falls I think all paper money will fall. People will buy real things, and drive the prices up. In Austrian terms this will be a “crack up boom”.

    Taxes generally can be used to reduce inflation. However, when people suddenly stop buying bonds the change in government money creation is too large for an increase in taxes to compensate for. It goes from printing just a part of the deficit to all of the deficit plus for all the bonds coming due.

    It is Keynes that thinks tricking people into working for lower real salaries by printing money is a good idea. And back in 1930s it probably did work better than now. And yes, sometime people will accept lower nominal salaries.

    From my reading the “wait till x happens” sign is a few years after deficits reach 40% of spending, which the US has now reached. The book on hyperinflation by Bernholz comes to this conclusion.

    Sometimes MMT people don’t seem to want to talk about hyperinflation, or they can’t see it as a serious possibility. I have started a blog at http://howfiatdies.blogspot.com/ and maybe we should continue this discussion there.

    — Vince

  68. Sergei- Thanks for the detailed stuff about central banks. I’m not sure I understand whether your last point relates to prices of “investment assets” such as equities, real estate, gold etc. My impression was that ever increasing levels of the monetary base does in practice lead to inflation of those in fits and starts on a global basis over a long (>decade) timeframe. If that view is in contention I would really like to be clear about that. Thanks.

  69. Yes, people think you go gradually from inflation to hyperinflation. But it does not always go like that. In Germany they had deflation then hyperinflation. Again, hyperinflation seems to come suddenly after bonds no longer sell.

    Given that US bonds are paying near 0% and the dollar dropped like 8% in September alone, people may suddenly decide they don’t want to hold dollars. If that happens the dollar will drop more, which will cause more people to decide they don’t want to hold them, etc. Could just happen this month. Does not need to slowly work up to more and more inflation.

  70. Vincent, doesn’t there need to be a widely used alternative currency for what you are saying to take place? In Chile I thought people whole sale abandoned the Chilian money and instead used USD. What would people jump to if they were to abandon the USD? The USA has its reserves mostly as gold so I kind of presumed that were speculators to try and break the USD, they would preceed it by causing the gold price to crash to say <$100 per ounce and have some alternative currency that the US did not have reserves of to hand for general people to try and get hold of. To be honest I hadn't thought USD hyperinflation was on the cards soon.

  71. The “excess bank reserves” are now earning interest from the government, which makes this just like a loan to the government or bond purchase from the treasury. So this reduces aggregate demand, at least in my understanding of MMT terms.

    Bank reserves do not affect aggregate demand, as Sergei pointed out, because they are only used for interbank settlement. On the other hand, the Fed’s support rate paid on excess reserves does not make up for the interest extracted from nongovernment through the QE purchase of bonds, so QE actually reduces nongovernment net financial assets, reducing aggregate demand. Otherwise, QE is about managing the yield curve, keeping long term rates low, largely to support housing, which underpins the economy.

  72. The US has like $13 trillion in debt and less than $1/3 trillion in gold. If people start turning in their bonds the US gold is not going to be able to help unless the price of gold goes up by a factor of 30, which it might.

    If people don’t have any other currency to use, they barter, or use gold or silver, or something else. If money is dropping in value really fast, anything else is a better store of value. If there are price controls and high taxes (say 20% VAT) and the currency is dropping in value every day, barter can easily work better. If I give you some canned food and you give me some fish you caught, neither of us is going to pay any VAT or be stopped by some law saying you can’t charge more than $1 million per lb for fresh fish. Hyperinflation is how fiat money dies. Now in a big “first world” city, this is going to get really ugly.

    Hyperinflation usually seems to “come out of nowhere” and surprise people.

  73. In inflation with price controls one thing that can happen is farmers just pay of their loans and only grow food for their own family. Farmers killing off animals or plowing under fields is common when governments try to control prices. Then other people can starve.

  74. Given that US bonds are paying near 0% and the dollar dropped like 8% in September alone, people may suddenly decide they don’t want to hold dollars. If that happens the dollar will drop more, which will cause more people to decide they don’t want to hold them, etc. Could just happen this month. Does not need to slowly work up to more and more inflation.

    What is actually happening in the world now is competitive devaluation, as everyone tries to export themselves out of the mess. The US is intentionally trying to drive down the dollar to gain export advantage and other countries, like Brazil, are complaining about it. The US had been assisting emerging markets by giving them open access to the US market, in expectation that eventually these countries would join the developed world and become large consumer markets that US businesses could exploit. That’s on hold now with the US leaking so many jobs in a downturn, resulting in social unrest and political problems.

    BTW, if the US should collapse either suddenly or slowly, the world would be plunged into an unprecedented depression. The threat of that is not from the direction of a currency collapse at this juncture but a debt deflation. There is a huge debt overhang and still shoes to drop. If you are into being concerned, this is what to be concerned about.

  75. Yes, as soon as the bond investors realize that the US is intentionally trying to devalue the dollar they should save themselves by leaving the dollar for hard assets. Some may already understand this. China has $100 billion less dollars now than a year ago, and lots more hard assets. The more that understand this, the more it snowballs. Will end in a crash of the dollar.

    Yes, the world is about to plunge into an into an unprecedented depression. It will be really really bad. All this because some people think there is no trouble with printing lots of money.

  76. Dear Vincent (at 2010/10/05 at 1:06)

    Well in many comments you have been predicting hyperinflation and now you are forecasting an unprecedented depression. It would be rude of me to ask what you are smoking!

    But I do think that your catastrophe scenarios have been well documented by you on my blog and you have got plenty of exposure to my readership for your ideas.

    Lets just say that if any sovereign economy experiences hyperinflation in the next five years I will donate 1000 (dollar-equivalent units) of the strongest currency at the time to a food for children charity as long as you agree to donate the same should there be no such episode.

    What do you say? I am confident what about you?

    But I think we have had enough discussion about hyperinflation here.

    best wishes
    bill

  77. Sure. If anyone wants to talk about hyperinflation more I would be happy to at http://howfiatdies.blogspot.com/

    Bill, as a hyperinflationist, I would rather have a friendly little bet for 1 oz of silver than for some paper with pictures of dead men on it. If any sovereign country in the next 5 years has hyperinflation, you send me 1 oz of silver, if not, I send you 1 oz of silver. Deal?

    — Vince

  78. Dear all,

    OT, but a question for the floor: I was in an “international monetary economics” lecture this morning, and the lecturer was discussing the balance of payment accounts. He kept talking about “net $ outflows”–flows of currency leaving the united states when it imports, which presumably float around for a bit before flowing back in. He gave one example of of a UK agent buying a $2k bond using £1k (at e=2$/£1), deposited in the bond issuers deposit account, which then exposed the issuer to exchange rate risk. This all seems a bit strange to me. Does the money actually leave?

    Cheers.

  79. Dear Vincent

    I offered the bet of 1000 dollar-equivalent units in the strongest currency at the time if any sovereign nation within the next five years experiences hyperinflation.

    Your version of the bet is 1 oz of silver to be at stake.

    You don’t seem to be very confident!

    best wishes
    bill

  80. Well, bragging rights are worth something. And 5 years from now 1 oz of silver could well be worth more than $1000 US dollars, if I am right.

    What do you mean “1000 dollar equivalent units”? Like if they replace 10,000 old dollars with 1 “new dollar” is 1000 dollar equivalent units then $0.10 in new dollars?

    Are you willing to bet 50 oz of silver and we both deposit our 50 oz with a mutually trusted third party who will be the judge?

  81. Oh, and how to you define inflation? Like if the CPI is going up 5% per month, which would be 80% per year if it lasted that long, does that count? Or just anything over 50% in one year? Or what?

  82. “Does the money actually leave?”

    The answer is “yes” and “no”. Frustrating response I know, but I will explain what happens and you can decide if you think it qualifies as “money leaving the country”.

    In the case of the US, some physical currency actually does leave the country (many US bills circulate overseas, in countries in Asia for example), but that’s not really what happens in general.

    When a country has a current account deficit (imports exceed exports) conceptually there is a foreign exchange mismatch with the rest of the world.

    Consider the case of the USA and China, and for simplification just imagine that they only trade with each other and no-one else. The US runs a CA deficit and China runs a CA surplus. Much if not all of the trade between the nations is denominated in USD, meaning every year (when all trades net out) on balance US importers are paying out USD to the bank accounts of Chinese exporters.

    But Chinese exporters don’t necessarily want USD, they want RMB so they sell the USD to buy RMB. As the Chinese central bank (PBOC) runs a sort of peg to a basket of currencies, they end up having to buy the USD for RMB (they can create an unlimited amount of RMB) in order to maintain their peg. The PBOC might then use the USD to buy USD denominated financial assets (usually bonds like Treasuries, mortgages, agencies).

    This is what is sort of what is meant by “money flowing out of the country”. You could say the money flows out but then flows back in as capital (when the dollars are used to buy bonds). Or another way to think about it might be that ownership of the money (or bonds) goes from US companies and citizens to Chinese companies and citizens (meaning it’s an outflow of financial assets from the USA).

    In this example the Chinese are running all the exchange rate risk (they are long USD/RMB). But it would be conceivable to have a scenario in which the US held the FX risk. This would happen if US entities (the Treasury or corporations) issued RMB denominated debt which was then bought by Chinese entities. The US would then be net short RMB/USD (equivalent to long USD/RMB).

    One interesting thing to understand is that whenever there is a current account mismatch (deficit or surplus) this creates an FX position somewhere in the financial system, which can’t be hedged away. The only way it can be eliminated is to generate the opposite current account position (surplus or deficit) at later date.

  83. Gamma, don’t you think the PBOC USD stake is just a bit like any nations nuclear bombs but in a financial sense? It gives the Chinese a financial “nuclear button” to keep the USA in line with. Am I right in thinking that the PBOC is quickly trying to also get large gold reserves? That is just so as to also have the USA gold reserves no longer being a (small) safety net for the USD.
    Vincent Cate- in any of the hyperinflations over the last century, have gold and silver coins been used by people as an alternative currency? I know that that is the marketing spin for gold and silver coins but is it nonsense?

  84. There can be no question that the 1970s oil price hike by OPEC was a major contributor (or even initiator) of inflation in the West (incl. Japan). Oil is not ‘just another commodity’, in advanced industrial economies. A sudden price rise would not have had the same severe effect if the product was bread, for example, instead of oil.

    But the issue of the 1970s inflation and oil imports, in general, perhaps merits a closer and more elaborate examination. MMT welcomes the kind of exchange involved in oil : We western nations obtain real goods (oil) in exchange for the fiat currencies (petrodollars) we send OPEC’s way. If real wages were kept somewhat steady (COLAs, etc) in that period, then the West, in general, actually rode that one out rather smoothly. Comments ?

  85. Vincent Cate: “Imagine that everyone stopped buying US government bonds on Jan 1, and that during 2011 a total of $5 trillion in bonds came due, which are paid off in new fiat money. In this situation does MMT not predict inflation?”

    I am a consumer of MMT, so I may well be mistaken. If so, then this will be a learning experience for me. 🙂

    I am not sure that “new fiat money” is how MMT would describe the situation. IIUC, paying off the bonds would happen as it already does, by debiting some savings accounts at the Fed (in the U. S.) by $5T and crediting other demand accounts by $5T, in a zero-sum operation. No new money would be created. New money is injected into the economy by the gov’t when gov’t spending exceeds its tax revenues, i. e., by running a deficit. The only effect on the deficit if people do not buy gov’t bonds is that the gov’t does not have to pay interest on bonds it does not issue. 🙂

    There were rumors earlier this year that the U. S. Treasury auction “failed” in February. These auctions are not exactly transparent, but it seems that there was some buying from unexpected and hitherto unknown quarters. There was (cognitive) speculation that the Fed found a proxy buyer, from whom it immediately bought the bonds the proxy had bought. (At one time the Fed could simply have participated in the auction, but now things are more complicated.)

    Anyway, suppose that the rumors are correct, that not enough outside buyers showed up for gov’t bonds. Who cares? It was a big non-event, wasn’t it?

    Vincent Cate: “In other countries this type of thing has caused inflation.”

    Causality is an interesting question. For people to suddenly stop buying a gov’t’s bonds indicates that something else was going on. How can we say that that something else was not the cause of the inflation?

    One thing that I find interesting about this is that the very thing that worries you, where the gov’t issues money instead of debt, is considered desirable by others, not just MMTers. After all, if we fund deficits by issuing dollars instead of debt, we do not have to pay interest on the dollars. Why should we pay for the privilege of having money?

  86. stone: “don’t you think the PBOC USD stake is just a bit like any nations nuclear bombs but in a financial sense? It gives the Chinese a financial “nuclear button” to keep the USA in line with.”

    What are the Chinese threatening to do? Buy our stuff? 😉

  87. Min, I have no idea whether the Chinese have any threat in mind, but were the PBOC to give out all the POBC USD holdings to the Chinese citizens so that they could be exchanged for RMB or Swiss Francs or whatever the individual Chinese people choose it would certainly reduce the ability of the USA to import oil etc unless I’m in a complete muddle about this. I haven’t thought it through but I don’t see why the ultimate threat might not be at least knocking the USD off its perch as the global reserve currency or even totally breaking the USD by inducing US citizens to demanding RMB not USD in payment for work and goods.

  88. Stone,

    “were the PBOC to give out all the POBC USD holdings to the Chinese citizens so that …”

    Establishing 1B foreign controlled bank accounts in the US would probably take years, the idustry is just not set up for processing that number of new account applications. Im guessing but that would probably be 5x the number of accounts that currently exist here in the US…on the other hand if the banks didnt outsource to India and had to hire a lot of clerks here domestically to process the applications it could help w the unemployment situation for a while I suppose….seems like a monumental task.

    Resp,

  89. Matt Franko, I think I must have had a glaring misunderstanding. If the PBOC hands out $3000USD to each Chinese person, does it require each person to have a US bank account simply for each Chinese person to exchange the USD for RMB? So when a Chinese company pays for oil using USD do they need a US bank account? Would the PBOC need to itself exchange all the USD to RMB if it were to want to cause a catastrophic USD devaluation? Cheers for your corrections.

  90. It would certainly drive up the price of oil and disrupt the world economy if the every Chinese citizen bought $3000 worth of oil. But where would they put it? And why would they do it? Gold, expensive brandy, hi-tech toys yes, but oil? More likely, they would try to exchange $3000 back for renminbi, which is what they use to live – and that’s how the PBOC got all those $ – from Chinese exporters exchanging it for something useful to them.

    Or they might use it to take a trip to the mysterious, inscrutable West – to that quaint and picturesque land, whose natives have the most bizarre customs on earth, called USA. How fleecing boatloads of Chinese tourists in the customary way would hurt the US, I don’t know. Probably would permanently upgrade the US level of Chinese cuisine. It would give a shot in the arm to the decaying economy of that increasingly backward land, run according to ancient supersitions and time-honored folkways rather than modern Chinese economic science, which coincidentally has sagely absorbed the wisdom of the ancient West and the unfathomable Americans, of Keynes-zi, Lerner-zi and recently, the younger Galbraith-zi).

  91. Some Guy, I know it all sounds daft but doesn’t the building up of $3T USD reserves sound just as daft and that is the actual reality? Is it just that the Chinese state want to build up market share and workforce expertise and they think that the USD peg is needed to enable that? I can’t help thinking back to the 1998 Hong Kong double play which entailed the US based speculators building up a war chest of HK dollars prior to executing the speculative attack. Could the Chinese USD reserves ever be employed for any such attack or threat of one on the USD?

  92. Stone,

    What would China achieve by aggressively selling their USD? Depreciation of the USD and appreciation of the RMB? This would hurt a big part of their export market. Most US politicians would probably welcome a stronger RMB / weaker USD. Of course it might be a different story if the USD collapses dramatically rather than depreciating gradually.

    I think the situation is “around the wrong way” for any sort of speculative attack to be possible. Most of these happen when a country is trying to keep their own currency too high (overvalued). When speculators attacked the GBP in the early 1990s it was because the UK government was trying to resist the depreciation of the GBP.

    In the case of China and the US, it is China who are trying to keep their currency low, not the US trying to keep their currency high.

  93. Gamma, I guess I supposed China might actually be acumulating the USD for the sake of getting them with the current consequent RMB undervaluation just being an unintended short term side effect. Isn’t it true that many countries (including China) consider that reconfigured SDR should be used for international trade rather than the USD? Perhaps China’s long term view is to put an end to the USD being stronger than it should be due to it (unfairly?) being the global reserve currency. The threat of a shock revaluation might be a way to arm twist about that.
    I suppose it might be more a case that an undervalued RMB is simply a kind of Job Guarentee and progressive tax rolled into one. The Chinese people with USD might be the wealthiest and so the poor RMB/USD exchange rate might be a kind of stealth tax intended to level off inequalties within China.
    Has anybody on here read the Song Hongbing currency wars book or know whether their is an English translation. I can’t read Chinese. Does it reflect at all anything sensible or is it just the Chinese version of all our crazy conspiracy nonsense?
    http://en.wikipedia.org/wiki/Currency_Wars
    http://sangecon.wordpress.com/2009/10/15/currency-wars-by-song-hongbing/

  94. Stone,

    “If the PBOC hands out $3000USD to each Chinese person,”

    I suppose they could issue 1B checks but those checks would have to ultimately be payable at a US bank imo. i dont think US banks are allowed to operate branches in China (yet), I think even if they could, the Chinese authorities would not allow them to run USD accounts for Chinese citizens…I think US banks may desire this, but they havent gotten it approved yet.

    Ive seen some good posts by Ramanan on the accounting for such foreign transfers/exchanges in general. It may be more complicated than perhaps you are implying.

    Resp,

  95. stone: \”I think a far more effective backbone for the government would be the “arbitary” (in Bill’s view) fiscal rule that taxation has to match spending.\”

    The problem is, that rule is pro-cyclical. Pro-cyclical policy is the problem, and has been for at least a generation. What you want is counter-cyclical policy, with increased taxation during boom times, increased gov\’t spending during busts and recessions. Matching taxation and spending does not help. (BTW, it is possible to legislate counter-cyclical policy. Humphrey-Hawkins does so, but it has not been strong enough.)

  96. I now realize what I put in my comment above about the exchange rate being against people changing USD to RMB was back to front- I’m very sorry for that bit of stupidity on my part.
    Matt Franko, thanks for the clarification.
    Min- if the balancing was over a business cycle rather than per year then couldn’t it be both counter-cyclic and balanced?

  97. stone: “if the balancing was over a business cycle rather than per year then couldn’t it be both counter-cyclic and balanced?”

    I think that counter-cyclical policy is the key. I say that because, strange as it may seem, a lot of policy makers embrace pro-cyclical policy. Why, I do not understand. And unless counter-cyclical policy is in place, balancing the budget means that the gov’t does not spend in the downturns, nor does it increase taxes in the upturns.

    For fiscally constrained gov’ts, like the U. S. states, that means that in good times they must build up financial reserves for the coming bad times (a “rainy day fund”). Almost every state has a balanced budget provision in their constitution, or balanced budget legislation. Strange as it may seem, some of them have laws that prohibit a rainy day fund! Most states found themselves in serious trouble as a result of the financial crisis and recession, and were blamed for not providing for the possibility. One of the right-wing anchors on CNBC asked a Connecticut politician why Connecticut had not prepared for a severe recession. He replied that if they had put money aside, the anchor would have been one of the first to criticize them for doing so. She laughed and admitted that he was right.

    Politically, it seems easier to enact counter-cyclical policy on the downside than on the upside. When people talk about automatic stabilizers, they mean unemployment insurance and the like. But what are the automatic stabilizers on the upside? A progressive income tax is one. At times the Fed has been willing to “take the punchbowl away”, but Greenspan was mostly an enabler, despite his warning of “irrational exuberance”.

    During the Reagan boom times, when Reagan promised to lower taxes, I wondered, “Haven’t these people heard of the Seven Fat Years and the Seven Lean Years?” In 1987, a few months before the stock market crash, a friend asked me what I had against Reagan. I replied that Reagan had taken the U. S. from the world’s largest creditor nation to the world’s largest debtor nation in 6 years. The deficit ballooned under Reagan. That is why Cheney said that Reagan had showed that “Deficits don’t matter.”

    People see the debt and deficit going up in both good times and bad. That is why they are so concerned about balancing the budget and call for fiscal discipline. But if we had counter-cyclical policy, not only would the business cycle be less of a problem, so would the debt. In fact, balancing the budget to any degree of strictness, even over a business cycle, may not be a good idea. But bubbles lead to busts. We need to enact automatic stabilizers on the upside, before the next boom. (I do not think that MMT always calls for counter-cyclical policy, but IMO that is the right political framework.)

  98. Min I’ve been greatly struck by how a select group of people actually manage to exploit the boom bust cycle. They manage to time asset sell offs so as to buy in the troughs and sell at the peaks. If governments were not procyclic, then the overal economy would be much better but such people would loose their major source of funds. An very clear document describing such a wealth management method is the Wellcome Trust 2009 annual report (can be googled for- is on the web). Because they are a charitable trust they have to disclose. I thought though that most ultra wealthy people do the same thing but keep it private. I presume they have very great political influence.

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