Friday lay day – Is MMT applicable to the Eurozone?

Its my Friday lay day and I am catching up on reading today. But one thing I have had to complete by today is the introduction to the German Translation of my friend Warren Mosler’s 2010 book – The Seven Deadly Innocent Frauds of Economic Policy. The publisher wanted an introduction for the German readership that helped them relate the discussion in the book to the reality in Europe – given that the Economic and Monetary Union is a perverted hybrid of a fixed exchange rate/fiat currency system that works for no-one really. So you may be interested in reading my introduction. Then a dose of the master guitarist completes my Friday blog.

In 2004, the late John Kenneth Galbraith published his last book which he called the The Economics of Innocent Fraud: Truth for Our Time which analyses the principle “frauds” that blur our understanding of who benefits and who loses as a result of modern corporate capitalism.

It is certainly an interesting book and brings together in a relatively short narrative the themes he had researched and written about for the span of his long productive academic life.

The term “innocent fraud” was reprised in the title of Warren Mosler’s short book also the frauds (myths) that are analysed are quite different though not inconsistent with those identified by Galbraith as worthy of commentary.

Galbraith focuses more on the institutions of capitalism and the way the capitalist hegemony is sustained through skillful though misleading use of language and the manipulation of the capitalist class of the public debate.

Warren Mosler’s book is a gem in translating very difficult and often abstract concepts about the way modern fiat currency monetary systems function into a language and narrative that is accessible to the intelligent layperson not schooled in the turgid jargon of economics.

It also provides a coherent and evidence-based framework for understanding the capacities of a national government that issues its own currency and the opportunities and options that such a government has to improve the well-being of the citizens of that nation through the maintenance of economic stability and efficiency.

As Mosler writes his analysis focuses on the “the operational realities of our monetary system”, which should, in his view, form the basis of any economics study.

The book is, however, largely silent on issues pertaining to the class aspects of the capitalist system and the dynamics that emerge from those aspects, a theme that is central to Galbraith’s analysis.

The two perspectives a thus essential for a broader understanding of the way modern capitalism has evolved and how the monetary system operates.

Warren Mosler contends that the public debate and subsequent economic policy decisions are driven by a series of interlinked myths and the policy choices that are made would not be sustainable politically if the nature of these myths was exposed and the public understood what the real options available to government were and the consequences of each.

The ‘7 innocent frauds’ are clearly delineated by Mosler.

First, the fraudsters claim that governments, like households, have to live within their means. The means are the financial resources they can muster through taxation or borrowing. However, the household analogy is flawed at the most elemental level.

A national government such as the US or Australia is never revenue constrained because it is the monopoly issuer of the currency. Household spending is always financially constrained because it is the user of the currency that the government issues.

Such a government can never run out of money and thus never needs to generate tax revenue or issue debt in order to spend. Mosler explains in detail what the role of taxation and government borrowing plays given that the government can spend its own currency at will.

A corollary of this myth is the oft-repeated claim that fiscal deficits are inflationary. Mosler clearly shows that all spending in a monetary economy, whether private or public, is open to inflation risk. If nominal spending growth outstrips the capacity of the economy to respond by producing real goods and services, then the result will be that prices will start going up.

But if the goal of the government is to ensure there is full utilisation of productive resources, then the idea that it will keep increasing deficits beyond the point where the net government spending fills the spending shortfall left by non-government savings is ridiculous.

Second, the public is regularly apprised of the claim that fiscal deficits have to be repaid and this requires onerous future tax burdens, which force our children and their children to pay for our profligacy. This personalisation of public policy – the deficits will damage our own future generations – is a powerful metaphorical device designed to disabuse us of supporting on-going deficits.

Mosler shows clearly that not only do fiscal deficits underpin economic growth now and contribute to the creation of public infrastructure that provides a flow of benefits for many generations into the future, but that it is absurd to think that we can bring forth future production and consume it today.

Each generation gets to choose its own tax rate and production at some future date will be consumed at that date. What will determine the material well-being of the future generations is the availability of real resources in the future and the productivity rates that transform those resources into goods and services.

A key part of that future potential is how well educated and trained the future workforce is. It is ironic that the ‘innocent frauds’ target government spending on education and health which undermines the capacity of our youth, who will become the future workforce, to become more productive than ourselves. Mosler points out this inconsistency.

Third, the fraudsters argue that government borrowing competes with the private sector for scarce available funds and thus drives up interest rates, which reduces private investment – this is the so-called ‘crowding out’ hypothesis that undergraduate students are indoctrinated with in the mainstream teaching programs in economics at our universities.

The corollary is that public use of scarce resources is wasteful because governments are not subject to market discipline.

It is well-known in heterodox economic circles that the building blocks that support the textbook ‘crowding out’ theories have no application in the real world. John Maynard Keynes, among others, long ago showed that total savings are dependent on levels of income and that fiscal deficits stimulate increases in national income which also increases the pool of saving.

So the idea that there is a scarce pool of savings that the government and private industry fight is flawed.

Those that study organisation efficiency and the related areas also categorically dismiss the claim that what is public is inefficient and what is private is efficient. The attribution of efficiency to ownership is erroneous. The Global Financial Crisis most recently demonstrated how poorly private sector decision-making and resource allocation driven by ‘markets’ can be. There are many other glaring examples of how the ‘market’ fails and it is only the resources that the public sector has available to deploy that saves the world from economic meltdown.

Mosler provides a deeper understanding to all this by drawing on his experience in banking to show how banks create deposits through loans, which means that any credit worthy borrower will be able to access credit irrespective of the state of the government deficit.

In fact, if anything, on-going fiscal deficits, through their positive impact on bank reserves (as national income rises), places downward pressure on market interest rates, the exact opposite dynamic to that assumed by the erroneous crowding out theory.

He also demonstrates that it is the central bank that sets the benchmark interest rate.

Fourth, Mosler debunks the claims that the US Social Security system which encompasses pensions and health care will go broke and that those in need will be deprived of the benefits of that system. While the analysis is about the US institutional system the fact remains that once we understand that a currency-issuing government is not financially constrained, it is a simple step to also appreciating that any public service can be sustained into perpetuity up to the limits of the real resources available to it.

A currency-issuing government can not guarantee a first-class health system for all into perpetuity. The real resources that might be required to ensure that status may not be available. But if they are, then we also know that the government can always buy them.

In that context, the issue of pensions and health care become political. There is no financial reason why the government cannot ensure there are adequate pensions offered to older people or first-class health care – real resources permitting.

Mosler demonstrates that the constraints on government are real not financial.

Fifth, the book debunks the claims that the US trade deficit “takes away jobs” and robs the economy of national income generating output. This myth is tied in with the idea that foreigners fund the American government and may, at some point, stop buying US government debt, which would immediately bankrupt the government.

The book argues that trade deficits, which result from imports being higher than exports, are actually beneficial in material terms. They mean that foreigners are willing to sacrifice more real goods and services than they expect back in return from the nation which means the citizens of the nation are better off.

Living standards are measured in real terms.

It is true that trade alters the pattern of resource usage in a nation and some jobs might disappear as capitalist enterprises see advantages in producing elsewhere. That is the logic of capitalist – to pursue surplus value wherever they can get it.

But, thinking back to the earlier discussion, the US government can, in Mosler’s words:

ALWAYS support domestic output and sustain domestic full employment with fiscal policy (tax cuts and/or govt. spending), even when China, or any other nation, decides to send us real goods and services that displace our industries previously doing that work.

This is not to say that changes in the industrial composition of output are smooth and painless. Workers in the industrial belt of North America have certainly faced the cold winds of capital mobility.

But the resources left idle by these changes can always be brought back into productive use by appropriate government fiscal strategies, even if other supports also have to be put in place (such as, re-training) to make the transitions smooth.

Mosler also demonstrates why the claim that China funds the US government is inapplicable to a fiat currency system. He turns the argument around and notes that “Instead, it’s the foreigners who are dependent on our domestic credit creation process to fund their desire to save $U.S. financial assets”.

Sixth, and related to the third is the analysis of the claim that the US needs “need savings to provide the funds for investment”. In the 1930s, economists such as Michał Kalecki knew that ‘spending brings forth its own savings’. This curious phrase just means that when a household, firm or government spends, output and income is generated to provide the goods and services to match the sale.

As noted above, when income rises so does saving. The opposite is true. Keynes talked about the “paradox of thrift” which was his term to describe what happens when politicians extol the population to save more. The paradox is one of several fallacies of composition (errors in logic) that the mainstream economics textbooks fall into when trying to apply what might be true at the individual level to the entire economy.

So if one person is disciplined enough to save more of their weekly income, then their saving to income ratio will rise. The impact on total sales in the economy will be negligible. But if all people attempted the same outcome, total sales would drop significantly, and firms would lay off workers as they cut production. Income would drop in the economy and total savings would drop as a consequence.

The fraud also fails to understand the the banking system creates loans when credit-worthy customers request them. They do not need prior deposits to create the loans and the reserves to back the loans are created afterwards with a final resort to central bank loans always being available if the banking system cannot generate the reserves themselves.

Seventh, Mosler considers the claim that “higher deficits today mean higher taxes tomorrow”, a common argument used by conservatives to attack the use of fiscal deficits by governments.

He ties this claim in with his earlier analysis, which shows that a currency-issuing government is not in need of tax revenue in order to spend.

The use of the term – Innocent Frauds – is Mosler’s generous interpretation of the way that these myths emerge and are sustained in the public domain. Following Galbraith, Mosler takes the softer view, that these myths are the product of ignorance and that:

… those perpetuating the fraud are not only wrong, but also not clever enough to understand what they are actually doing. And any claim of prior understanding becomes an admission of deliberate fraud – an unthinkable self-incrimination.

Among this list of dolts who push ‘innocently’ these tawdry lies are “mainstream economists, the media, and most of all, politicians”.

One could easily dispute the presumption of innocence. There is ample evidence that across each of these cohorts a more sinister agenda pervades – one that is centred on class control and developing conditions that permit the maximum redistribution of national income to the top end of the income distribution.

Many of these myths pressure us into believing that our governments are bankrupt, that our grandchildren are being enslaved by rising public debt burdens and that hyperinflation is imminent among other maladies that result from governments running fiscal deficits.

Many are perpetrated by conservatives, some of whom were direct beneficiaries of bailout packages in the early days of the crisis. They were silent then as the public handouts were directed to them.

Mosler should have included the role of the think tanks in his cast of liars. The organisations receive massive funding from conservative sources and pump out these ‘frauds’ on a daily basis and brief journalists to spread the lies.

There is really nothing innocent about it. But that is another story.

Mosler’s contribution, which is US-centric, is to show, in a readable, anecdotal narrative, that the major claims that are used to attack government deficits are incorrect and reflect a poor understanding of how the actual fiat monetary system in the US operates and the capacities that the currency-issuing US government has within that system.

It is an eccentric account from a person who has worked within the top echelons of the US financial system and used his sharp mind to get to the bottom of how that system operates.

The question then is whether this US-centric analysis is applicable more generally – that is, is this a general theory.

For German readers, the question is more specific: How is this analysis relevant to the economies of the Nineteen Member States of the Economic and Monetary Union (EMU)?

Mosler’s analysis falls within what is now termed Modern Monetary Theory (MMT), that has been articulated by a number of economists over the last two decades or so.

A cursory consideration of it might lead to the conclusion that it was a Keynesian approach, given the logic lends support for continuous fiscal deficits to ensure there is full employment. The State is considered central to the achievement and maintenance of economic prosperity and financial stability.

However, MMT is only superficially ‘Keynesian’, even though that term is difficult to pin down anyway and can mean different things to different people.

MMT draws on a number of previous theoretical approaches – the ‘standing on the shoulder of giants’ – is clearly applicable here.

It is a system of thought that allows us to understand how a fiat currency monetary system operates and the central role that government can play in a modern monetary economy.

Modern monetary economies use money as the unit of account to pay for goods and services. An important notion is that money is a fiat currency, that is, it is convertible only into itself and not legally convertible by government into gold, for instance, as it was under the gold standard or later versions of the gold standard.

What is mostly ignored in mainstream economic commentary is that in August 1971, the monetary system agreed at the famous Bretton Woods conference in July 1944, which required the central banks of participating nations to maintain their currencies at agreed fixed rates against the US dollar, collapsed.

The system proved unworkable and when President Nixon abandoned the convertibility of the US dollar into gold, most nations moved to a fiat currency system.

Most of Europe did not as the operation of the convoluted Common Agricultural Policy would have become unworkable under a system of floating exchange rates within Europe.

The nations of Europe were in a bind. The long debates on European monetary integration were always distorted by the obsession with maintaining fixed exchange rates among the European economies, despite history and repeated experience, making it evident that such a system could not be easily maintained, given the trading disparities between the mercantilist Germany and the other major European economies.

Various systems after the collapse of the Bretton Woods system were tried in the 1970s and 1980s (for example, the ‘snake’, the EMS) and all largely failed and imparted a recessionary bias to the nations that were running trade deficits.

For those nations that had adopted the fiat currency system and allowed their exchange rates to float, these trade imbalances were sorted out through exchange rate movements which freed domestic policy to target domestic outcomes.

Within a fiat currency system, the government has the exclusive legal right to issue the particular fiat currency.

Further, given that this money is the only unit which is acceptable for payment of taxes and other financial demands of the government presents the government with a range of options. Mosler’s book eloquently articulates many of these options.

We know that the government is not just a ‘large household’. The latter is the user of the currency and must finance its spending beforehand, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire (raising taxes).

Clearly, a fiat-currency issuing government is always solvent in terms of its own currency of issue.

MMT also teaches us that the purpose of State Money (fiat currency) is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain.

Government achieves this transfer by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save.

If the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save the manifestation of this deficiency will be unemployment. The basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions in force at any particular time.

In my current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale (published May 2015) – I provided a detailed analysis of the evolution of the EMU from the end of the Second World War and an appraisal of its performance and possibilities.

The ‘Innocent Frauds’ that Warren Mosler identifies are also used in policy debates within the Eurozone to justify, first, the flawed design that was finalised during the Maastricht process, and second, the crippling austerity that has seen millions of people rendered jobless unnecessarily.

The neo-liberal policies of deregulation and the demonisation of the use of discretionary fiscal deficits (government spending greater than tax revenue) created the crisis in the first place, and now the same sorts of policies are prolonging it. The current policy approach has institutionalised economic stagnation, widespread retrenchment, and the deterioration of working conditions and retirement pensions.

Millions of European workers are now unemployed, youth jobless rates are around 60 per cent in some advanced nations, inequality and poverty rates are rising, and massive daily losses of national income are being endured.

The dramatically high youth unemployment rates will ensure that the damage will span generations and undermine future prosperity as a cohort of jobless youth enter adulthood with no work experience and a growing sense of dislocation from mainstream societal norms.

So what can European policy makers and citizens learn from reading Warren Mosler’s economics book?

It is clear that nations within the Eurozone are unlike nations such as the US, Britain, Japan, Canada, Australia and others. The latter group, which form the majority of nations in the world, are characterised in the following way:

1. The national government (whether in a federal or non-federal system) has the fiscal authority to spend and tax to regulate overall spending such that the economy can avoid recession. Such a government can never go broke and can always honour its liabilities as long as they are denominated in the currency of issue.

2. The central bank sets the interest rate and works within the national government structure to ensure the currency on issue is sufficient.

3. The exchange rate floats to absorb fluctuations in trade and capital flows.

The Eurozone chose to create a hybrid version of the fiat monetary system, which was always doomed to fail given its particular eccentricities.

In the earlier years after World War 2, the discussions of economic and monetary union were along the lines that a federal fiscal authority with the capacity to provide public spending buffers to help nations facing asymmetric negative demand shocks would be an essential part of any effective design.

The Werner Report of 1970 deemed the development of this federal capacity to be essential to the success of any plans to move to a common currency.

The conclusion of the 1977 MacDougall Report was that the state of European politics, especially the unwillingness of France and Germany to truly cede their national fiscal capacities to such a federal authority in such ways that the latter could function effectively, was such that an economic and monetary union should not proceed.

In 1972, for example, the Governor of the Danish Central Bank said:

I will begin to believe in European economic and monetary union when someone explains how you control nine horses that are all running at different speeds within the same harness.

It was not until the onset and emerging dominance of University of Chicago-style Monetarism that the debate on European integration veered off onto its disastrous course marked, initially, by the passing of the Single European Act in 1986, then the release of the Delors Report in 1989, which paved the way for the Maastricht Treaty in 1992.

What eventually allowed the ‘nine horses’ to be harnessed together was not a diminution in Franco-German national and cultural rivalry but rather a growing homogenisation of the economic debate.

The surge in Monetarist thought within macroeconomics in the 1970s, first within the academy, then in policy making and central banking domains, quickly morphed into an insular Groupthink, which trapped policy makers in the thrall of the self regulating, free market myth.

Keynesian-type policies, which empowered government to stimulate domestic demand and reduce unemployment were inconsistent with the rigid European Monetary System (EMS) which was dominated by the mercantilist policies of Germany. Accordingly, the nations like France had to engineer on-going domestic recession to maintain the agreed exchange rate parities.

By the time Maastricht came along, the European debate was firmly aligned with the inflation-obsessed German position that strict fiscal rules were necessary to reign in the freedom of the individual nations.

Justifying these claims were arguments consistent with Mosler’s ‘Innocent Frauds’.

So while the EMU created a system-wide European Central Bank, that sets the interest rate and can issue the currency without limit, the design eschewed the creation of a federal fiscal capacity, principally as an ideological expression of the growing disdain for government fiscal interventions.

The national governments not only surrendered their currency sovereignty and now use a foreign currency (the euro) but also accepted the harsh fiscal rules which constrain them from responding in an effective way to a major economic crisis.

The surrender of their own currencies meant that the Member States were now at risk of insolvency and thus dependent on the on-going funding from bond markets should they wish to spend more than their tax revenue.

A pure fiat currency nation such as the US is not dependent on the bond markets for funds. It can always access the currency that it issues through appropriate arrangements with its central bank.

The Eurozone nations, cannot access the ECB in this way, because the Treaty deliberately banned any notion of ‘bailouts’ or the direct purchase of the Member State debt by the ECB.

So a key source of financial stability and economic prosperity – the capacity of government to use its currency-issuing capacity to advance public welfare – was deliberately denied to the Eurozone Member States by the political process.

This denial reflected the dominance of the ‘free market’ Monetarist ideology, which wanted smaller government and less restrictions on the private sector. It reflected a shift away from government for the people to government for capital.

The Member States of the Eurozone thus became more like the states in a federation – such as California or New South Wales. They could raise taxes but their spending was limited by their revenue and the fiscal rules that were introduced.

However, in a federation like the US or Australia, the existence of a powerful federal fiscal capacity allows the national (federal) governments to redress spending shortfalls in particular states or regions, which overcomes, to a large extent, the fact that the states are without their own currency.

That capacity was deliberately denied to the Eurozone with, now, obvious negative impact.

The other key aspect which follows from that status as a ‘state in a federation’ is that the Member States surrendered their capacity to alter their exchange rates to absorb external trade and capital imbalances.

Nations like Australia and the US allow their rates to vary and this means their domestic economies do not have to experience recession when there are large trade deficits.

In the Eurozone, the concept of internal devaluation entered the narrative, which is the other way that external imbalances can be dealt with in theory. So a nation that wants to lift is export competitiveness can either allow its exchange rate to depreciate (as in Australia or the US) or cut wages and prices domestically with a fixed exchange rate.

The former mechanism is not without costs but promotes a boost to exports and internal dynamics that are usually beneficial (for example, import substitution). How much adjustment exchange rate movements offer is a matter of debate but they are typically more effective than attempting to lift competitiveness through austerity and harsh cuts to wages and working conditions.

That approach can reasonably be seen to be a ‘race-to-the-bottom’ as it fosters a low-wage-low-productivity mentality which undermines future prosperity.

The important point to understand though in trying to relate Warren Mosler’s analysis to the everyday experience of the Eurozone is that even though the Eurozone masters chose to artifically limit the economic capacities that Member States enjoy and refused to introduce a European-wide fiscal capacity that had the currency power (in tandem with the ECB) to ensure that spending growth could be sufficient to maintain prosperity, the underlying dynamics of the monetary system are the same in all economies.

Modern Monetary Theory (MMT) does not just apply to the US. It allows us to understand what the consequences of particular monetary system design parameters will be.

So it is clear what the impact of the denial of a European-wide fiscal capacity has been. We can understand that by relating the principles discussed in Warren Mosler’s book, for example, to the specific European context.

While the institutional arrangements in the Eurozone are eccentric, spending still creates the incentive to produce and create income, which also leads to employment growth. A shortfall of non-government spending will cause recession unless it is offset by an expansion in net government spending (deficits).

Artificially limiting government deficits opens up the likelihood that the government becomes incapable of offsetting declines in non-government spending.

We have seen that demonstrated throughout the Eurozone.

The principles that allow us to understand why the mainstream economic claims are ‘Innocent (or otherwise) Frauds’ can be applied to any economy or group of economies.

They are equally false when applied to the Eurozone once we take into account the institutional differences and rethink the logic.

So from the principles developed in Modern Monetary Theory (MMT), it is clear that recession in Europe could have been avoided had the ECB used its currency issuing capacity to fund all Member State deficits up to the level necessary to offset the fall in non-government spending after the GFC began.

Mass unemployment arose in Europe because the government deficits were too small. In the specific institutional context, this meant that the ECB had to overcome the bond market aversion to fully fund the necessary deficits and use its currency issuing capacity accordingly.

Music – Jimi Hendrix – Little Wing – live

This is what I have been listening to this morning while I have been working. Sometimes one needs to return to the masters.

There have been lots of imitations of this song by Jimi Hendrix, first recorded on the fabulous – Axis Bold As Love – album, released in 1967, although I didn’t get it until 1968, such were the delays in getting the latest in Australia.

I actually ran into a guy the other day who worked in one of the only import record shops in Melbourne in the late 1960s. It was interesting comparing notes. He is now interested in Modern Monetary Theory (MMT) and works as a journalist.

All the covers of the song (including, I am sorry to say (with flame suit on) that of SRV) are secondary to the original (with lyrics).

This version which has a life of its own – freer than the album version – comes from a 1968 live concert recorded at the Cafe A Go Go on March 17, 1968 in New York.

Appearing with Jimi Hendrix were Paul Butterfield (harmonica), Elvin Bishop (guitar), Harvey Brooks (bass), Al Kooper (organ), Herbie Rich (sax), Buddy Miles (drums), Phillip Wilson (drums) and James “Jack” Tatum (sax).

The musicians (Hendrix aside) were part of the Paul Butterfield Blues Band (Butterfield, Bishop and Wilson) and the Electric Flag band, which held a residency at the Cafe A Go Go between March 7 and 17, 1968. Jimi Hendrix turned up on the last night and look what happened.

My version of the concert is on the album ‘Blues at Midnight’ which was released by Midnight Beat Records, Luxembourg in 1995.

It is something else really. We have really missed a lot from his early death.

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Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.