I read an article in the Financial Times earlier this week (September 23, 2023) -…
There was an Op Ed last week from an Australian academic who attacked Modern Monetary Theory (MMT) along the lines that its proponents are “a bunch of cranks” and practice “charlatanism”. He also considers us to be sellers of “snake oil” and other nasty things. It was an extraordinary public intervention given that the argument was based on assertions drawn from an intermediate mainstream macroeconomics textbook, bereft of historical understanding and bereft of any real knowledge of the way the monetary system and the institutions within it (government, central bank, commercial banks) actually work. The MMT critique went like this: (a) misrepresent MMT through attributing claims to its proponents that are not remotely to be found in the literature; (b) claim you are not misrepresenting the MMT literature by selective quotes that are not actually consistent with the misrepresentations; (c) bring in one liners from textbooks that have been demonstrated to have no real world application and are patently wrong in many key elements of the banking system and the way bond markets operate; (d) call us fools for not knowing any of this. Well, it doesn’t take long into the article to realise who the fool is. The other point is that MMT is now clearly at the stage of development where the mainstream think they have to attack us and put us down. That is the next stage in our development (following years of being totally ignored). Progress is being made.
Here is a song to get us in the mood. It is from Steeleye Span – Who’s the fool now – from the Live At A Distance CD.
While the theme of the song is the ravages of drink, it could equally apply to the delusion that Groupthink invokes.
First, I prefer not to deal with the Conversation through their portal. In the past, I have found their editorial policy to be restrictive and selective of issues they want to promote rather than what the authors want to write.
Further, the editors get paid while the authors do not. If the model is to be voluntary then everyone should be bound by the same rules.
So my reply is here.
The Conversation also holds itself out as promoting “Academic rigour, journalistic flair”.
In the case of the article by a University of New South Wales academic, Richard Holden (January 19, 2017) – Printing more money isn’t the answer to all economic ills – there is very little evidence of “Academic rigour”.
So, in this case, I guess the editors abandoned their corporate mission to only publish articles that have a solid basic in logic and fact.
Instead, in this case, they published an Op Ed that is so deeply flawed that it is hard to know where to engage.
Holden starts with ad hominen – which you always know signals that there is very little substance to follow. In this particular case, zero substance.
Modern Monetary Theory (MMT) academics like Randy Wray and myself and long-standing financial market makers like Warren Mosler are dismissed from the outsets as “a bunch of cranks”.
Warren Mosler, for example, has created some of the most innovative trades and products in the history of financial markets and has a deep practical knowledge of the banking and finance industry.
While I only ‘talk the talk’, he has walked it.
Holden, himself, has no published track record in macroeconomics or monetary economics and his teaching does not involve macroeconomics. So, his intervention is hardly from the perspective of the cutting edge and his reliance on simplistic textbook notions is evidence of that.
The other point to note from the outset is that Holden pulls the second mainstream economics ploy that Modern Monetary Theory (MMT) is not gound in mathematical exposition and is therefore deficient.
He wrote as a put down to follow the “bunch of cranks” insult that:
For starters, it is not formal, it is made in prose and is subject to all the pitfalls that come with attempts to make precise statements with imprecise tools.
Many critics of Modern Monetary Theory (MMT) use this line of attack as it appears to be a scientific refutation based on the authority of mathematical reasoning.
Remember the New Keynesian attack from Simon Wren-Lewis (March 16, 2016) – MMT: not so modern – where he opened up by saying that:
MMTers also seem curiously averse to equations.
Remember Tom Palley’s 2013 attack that (Source):
MMT-ers have failed to provide a formal model that explicates their claims …
The mainstream promote the idea that an economic proposition that is not backed up by some mathematical expressions is clearly inferior and likely to be wrong.
Suffice to say that the great works of Marx and Keynes, among others would be disregarded if the inclusion of mathematical squiggles was the demarcation criteria between deficient and sound analysis.
But it is also not correct that MMT economists have avoided formal expressions when they consider them to be useful in advancing comprehension.
For example, in my 2008 book with Joan Muysken – Full Employment abandoned – there is a lot of mathematical exposition, where appropriate and effective.
Further, the expression Garbage-In, Garbage-Out applies in this case.
A formal mathematical model is just a logical construct following the rules of mathematics. Whether it has traction with the real world is another matter all together and that depends, in part, on the assumptions we start with to ‘set up’ the formal model.
So if we start by assume there is a ‘representative agent’ (representing us all to overcome intractable aggregation problems) that is always rational and maximising and who follows the formal dictates of rational expectations (which assume on average the guesses about the future are always correct) and can ‘solve’ complex intertemporal (across time) maximising problems that require understanding of the techniques, such as random process, measure theory, Lebesque integrals, Ito Calculus and the rest, then it is pretty certain, the output from such an exercise will be nonsense.
Hence, the failure to predict the Global Financial Crisis or even see that there was any problem at all developing.
The evidence is clearly that people within social systems do not behave remotely like the ‘single person’ (agent) in the mainstream macroeconomics models.
The introduction of rational expectations into the literature (in the late 1960s but the idea really gathered pace in the late 1970s) led to mainstream economists talking endlessly about ‘forward-looking maximising behaviour’.
John Muth (1961), who introduced the idea to economists, claimed (p.316) that:
I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory …
[Reference: Muth, J.F. (1961) ‘Rational Expectations and the Theory of Price Movements’, Econometrica, 29(3), 315-35.]
In other words, when we make guesses about the future, we are assumed to be acting as if we know the actual data generating process that will deliver that future. We are sometimes wrong but on average our errors net to zero – which means we have more or less perfect foresight.
William Poole summarised the literature in this way (p.468):
The rational-expectations hypothesis is that the market’s psychological anticipation … [future price] … equals the true model’s expectation …
[Reference: Poole, W. (1976) ‘Rational Expectations in the Macro Model’, Brookings Papers on Economic Activity, 2, 463-514.]
The economic modelling task then came down to the following steps:
1. Assume – that is, assert without foundation – that all persons are rational and deploy rational expectations. They interact within efficient, competitive markets (that is, where prices shift to balance demand and supply to ensure the configuration of outcomes (resource usage) is optimal for all.
2. Write some mathematical equations reflecting this.
3. Solve the equations for the unknown outcomes.
4. Shock the ‘solution’ with some policy change and ‘prove’ it is ineffective because as a result of (1) all agents predict in advance the shock and act to negate it.
5. Write ridiculous articles that claim that fiscal policy is ineffective.
The New Keynesians add some price stickiness to this format of reasoning but end up with identical long-term results (when the stickiness goes).
Arthur Okun (hardly a radical economist) once mused that if the mathematical depiction of decision making represented by the rational expectations literature was correct then all the economists on payrolls around the world were redundant because even the person delivering the post ‘knew’ the underlying economic model that generated the empirical observations we call economic data.
While reflecting on the usefulness of rational expectations, James Tobin noted in 1980 that (p.796):
Herbert Simon and others have accumulated considerable evidence to support the hypothesis that decision makers, from students and consumers to executives and statesmen, use “rules of thumb” in the face of uncertainties and complexities that defy detailed anaylsis and explicit optimization. Decision making itself is costly. The rules that simplify decisions are not unalterable, of course, but they tend to persist unless the environment is perceived to have changed drastically or they yield disastrous results.
[Reference: Tobin, J. (1980) ‘Are New Classical Models Plausible Enough to Guide Policy?’, Journal of Money, Credit and Banking, 12(4), 788-799.]
There has been a long-standing tradition of institutional researchers who have understood that individuals do not behave in the way depicted by these streamlined mathematical frameworks deployed by economists. The more recent behavioural economics research has ratified the conclusions of those past understandings.
Tobin had earlier written (1972, p.13):
Lucas’ paper provides a rigorous defense of the natural rate hypothesis, and the study’s rigor and sophistication have the virtue of making clear exactly what the hypothesis requires. The structure of the economy, including the rules guiding fiscal and monetary policy, must be stable and must be understood by all participants. The participants not only must receive the correct information about the structure but also must use all of the data correctly in estimating prices and in making quantity decisions. These participants must be better econometricians than any of us at the Conference. If they are, they will always be – except unavoidable mistakes due to purely random elements in the time sequence of aggregate money demand – at their utility- and profit-maximizing real positions.
The was a touch of humour here but the point he was making was obvious. The sort of requirements that these mathematical models that mainstream economists deploy place such unrealistic demands on human reasoning that they are of little use in understanding what actually goes on in the real world.
[Reference: Tobin, J. (1972) ‘The Wage-Price Mechanism: Overview of the Conference’, in Eckstein, O. (ed.) The Econometrics of Price Determination, Board of Governors of the Federal Reserve System and Social Science Research Council, Washington, 5-15.]
But research communities that become crippled by the onset of Groupthink avoid these intersections with reality.
The modern New Keynesian models, which priortise so-called mathematical rigour over reality, fail at the most elemental level to capture key questions – such as unemployment.
They work out that their optimising models (which are simplistic so as to be mathematically solvable) are incapable of capturing real world dynamics.
So, notwithstanding the air of rigour, the New Keynesian results are still always conjunctions of abstract starting assumptions and ad hoc additions to make any traction with reality.
That is, they make stuff up (for example, put lags into relationships that cannot be derived from their first optimising principles etc).
This indicates an important weakness of the New Keynesian approach. The mathematical solution of the dynamic stochastic models as required by the rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions.
But then, the claimed theoretical robustness of the New Keynesian models give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.
This general ad hoc approach to empirical anomaly cripples the New Keynesian models and strains their credibility. When confronted with increasing empirical failures, proponents of New Keynesian models have implemented these ad hoc amendments to the specifications to make them more realistic.
I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.
Even mainstreamers like Willem Buiter described DSGE modelling as “The unfortunate uselessness of most ‘state of the art’ academic monetary economics”. He noted that:
Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution … and the New Keynesian theorizing … have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck … the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling … excludes everything relevant to the pursuit of financial stability.
The essence of a community trapped by Groupthink.
Among other blogs covering these issues, see:
1. GIGO …
The obsession with formal modelling, despite the fact that economists, parading as hard scientists, generally use relatively inferior mathematical tools, really hides the fact that there is little substance in the analysis.
I remind readers of the observation by American (Marxist) economist Paul Sweezy who wrote in the 1972 Monthly Review Press article – Towards a Critique of Economics – that orthodoxy (mainstream) economics:
… remained within the same fundamental limits … of the C19th century free market economist … they had … therefore tended … to yield diminishing returns. It has concerned itself with smaller and decreasingly significant questions … To compensate for this trivialisation of content, it has paid increasing attention to elaborating and refining its techniques. The consequence is that today we often find a truly stupefying gap between the questions posed and the techniques employed to answer them.
Not much has changed since 1972 in this regard.
Mathematics is just a language – one of many. Sometimes it helps to sort out problems that other languages cannot solve. Usually that is not the case, especially is a social science like economics.
The use of formality is only justified if it simplifies what cannot be easily said in words. Otherwise, it just perpetuates the idea that economics is just a cult of the cognoscenti who have learned a few elementary rules of pure mathematics.
It is used as a faux authority to discourage people who are outside the camp, from challenging the assertions.
So when a mainstream economist opens a critique of a new idea (outside the Groupthink mob rule) by claiming there is no formal mathematics being used, it is equivalent to Donald Trump saying, during the primaries in Detroit (March 2016):
Look at those hands, are they small hands? And he … [referring to Rubio] …. referred to my hands, ‘if they’re small something else must be small.’ I guarantee you there’s no problem, I guarantee it.
A macho sort of my theory is ‘bigger’ than yours because we use mathematics, when, in fact, the very use of the techniques might cripple any chance the approach has of reflecting on reality.
So Holden starts with the insult, followed by the ‘mine is bigger than yours’ gambit – a sure sign of a loser.
Once he gets to attempted substance, it is as though he is quoting from a very poor second-year (intermediate) undergraduate macroeconomics textbook.
He characterises Modern Monetary Theory (MMT) in this way:
Modern monetary theory, a term coined by Australian economist Bill Mitchell, says the following: (1) Countries that control their own currency cannot default on sovereign obligations because they can always print more money. (2) Thus, said countries can provide unlimited resources, pay for whatever they want, and create full employment. Nirvana, here we come!
MMT is far more than this but even this characterisation misses the nuances.
1. Countries that control their own currency never have to for financial reasons (which is different from “cannot default”) default on any outstanding liabilities issued in that currency.
This has nothing to do with having a Mint that can print bank notes. Governments do not spend by running printing presses.
2. MMT does not say that a currency-issuing government “can provide unlimited resources”. Rather, it distinguishes between financial and real capacity. Such a government can only purchase what is for sale (real resources) in that currency of issue. There is nothing unlimited about it.
They can always create full employment, however, if the available unemployed labour chooses to work in return for a wage. A currency-issuing governemnt can always provide that monetary wage.
Whether any incomes generated in the economy translate into higher material standards of living depends on the availability of real resources, which are not unlimited.
So Holden is not off to a very good start.
He seems to think it is erudite to ask – “if it is so easy to fix a nation’s economic ills – just run the printing presses round the clock – then why doesn’t everyone do it”.
Well, the “printing press” scare reference notwithstanding, there is a simple question of ideology to deal with. This is something that mainstream economists deny is important.
In her 1962 book Economic Philosphy, Joan Robinson tried to “distinguish ideology from science” and concluded that “An ideology is more like an elephant than like a point”, the latter being a logical abstraction, which “has position but no magnitude”.
She said that economics was a “branch of theology” in the sense that the role of mainstream economics is to maintain social control in a similar way that the traditional religious institutions had served.
The dominant neo-liberal ideology has led to an abandonment of full employment in favour of sustaining a pool of underutilised labour that creates downward pressure on wages and has led to the redistribution of national income towards profits over the last three decades.
There are strong vested interests that militate against governments using their fiscal capacity to create full employment.
But moreoever we lived through several decades immediately after the end of the Second World War, when unemployment was at its frictional level (people moving between jobs) and there was zero underemployment. This full employment period was marked by governments using their fiscal capacity actively to ensure there were enough jobs.
There were informal buffer stocks of jobs throughout the public sector, where anyone could get a job on almost any day if they so desired. Those buffers were abandoned as the Monetarist onslaught took hold in the late 1970s.
Paul Ormerod wrote in his book Death of Economics that the Post-WWII period of strong GDP growth, balance of payments stability, and high investment could have occurred without the low unemployment (pp.202-03):
The sole difference would have been that those in employment would have become even better off than they did, at the expense of the unemployed.
The higher tax rates and buoyant government sectors allowed the flux and uncertainty of aggregate demand to be shared.
While the bulk of the OECD has abandoned this method of sharing, some economies have maintained high levels of employment into the current period.
Most significantly, Ormerod wrote that:
… the countries which have continued to maintain low unemployment have maintained a sector of the economy which effectively functions as an employer of the last resort, which absorbs the shocks which occur from time to time, and more generally makes employment available to the less skilled, the less qualified.
A Job Guarantee-type capacity.
A commentator that there was no reason why Australia could not introduce a “job guarantee with full employment”, to which Holden responded “… when exactly did we have “full employment” …?
He was told by another commentator that “we had a full employment policy prior to 1975”, and Holden responded “and what was the unemployment rate then?”
He was told that “Avg unemployment from 1945-46 to 1973-74 was 2%”.
To which he responded “not at all clear – please provide the data” and then went onto to smugly challenge the commentator with “should we print money like crazy then” to get lower unemployment.
Which brings up the next problem.
Clearly Holden’s field is not macroeconomics nor is it labour economics. Everyone expert in those fields know that there is an irreducible minimum unemployment rate governed by the frictions of moving between jobs. 2 per cent was about that minimum.
We called that full employment because anyone who wanted a job could find one and any employer who wanted a worker could hire one.
The problem is that students of economics in the neo-liberal era are not required to study economic history as part of their education. So we have a generation of PhDs in economics, particularly those from most mainstream American programs, who have very little understanding of history and what has gone before them.
They are trained up in mathematical models – assume this, tweak this, find this – that is equivalent to ‘counting the number of angels on the top of a pinhead’.
But they are not at all savvy about history and the experience it brings. Holden discloses that naivety when he demanded the commentator provide data to prove that the average unemployment was 2 per cent in the Post World War 2 period up to the mid-1970s.
Professional standards should dictate that anyone who claims to profess an intellectual discipline (such as a professor of economics) be well-read in the wide-fields encompassed by that discipline, which in this case, spans history of economic thought (and the philosophy of science), economic history and the intersection of economics with other social sciences, such as sociology and psychology.
It is just basic required knowledge for a professor of economics to know that Australia’s unemployment rate was at or below 2 per cent with zero underemployment for more than 3 decades following the Great Depression.
A stunning ignorance was revealed in that particular interchange. But it was not the exception.
His main argument is summarised by this paragraph:
But here’s the essential substantive problem. Suppose a government wants to pay for some “stuff”. If the government prints money and doesn’t back that by issuing bonds then there is inflation. That inflation leads to the government needing to print more money to pay for the stuff. Which leads to more inflation. And pretty soon that leads to wheelbarrows of cash being pushed around, hyperinflation, the destruction of all savings in the economy, and (in some notable cases) world war.
Okay, Weimer Republic overtones.
He even intones the Zimbabwe case. An understanding of history tells us that these two historical episodes, where hyperinflation became a problem were largely driven by supply contractions (first) followed by excessive nominal demand.
In the latter case, the supply contraction was sourced to the farm takeovers that Mugabe enforced, which reduced productive capacity by more than 50 per cent. Other problems then emerged.
Please read my blog – Zimbabwe for hyperventilators 101 – for more discussion on this point.
But lets go through the monetary operations that he claims will be inflationary. I have done it many times before but here is a summary.
The mainstream macroeconomic textbooks always introduce the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation.
In the real world, however, government spending is performed in the same way – crediting bank accounts – irrespective of the accompanying monetary operations.
The mainstream (which Holden represents) then claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so.
This is the essence of Holden’s claim that government deficit spending not backed by bond issuance is inherently inflationary.
The claim is that spending via ‘money creation’ adds more to aggregate demand than spending via bond sales, because the latter forces up interest rates which crowd out some private spending.
All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.
So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?
Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the ‘cash system’ which then raises issues for the central bank about its liquidity management. The aim of the central bank is to sustain a particular target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
The alternative, which is now in vogue after the GFC, is that the central bank can offer a return on overnight reserves which reduces (or eliminates) the need to sell debt as a liquidity management operation.
In other words, the excess reserves remain in the banking system and are rewarded with a competitive return provided by the central bank.
Which sounds awfully like an interest-bearing asset to me.
If the central bank does conduct open market operations (swaps government bonds for excess bank reserves), there is no sense that it is helping to finance government spending.
The bond sales are a monetary operation aimed at interest-rate maintenance.
But in terms of the government deficit spending not matched by primary bond issuance, all that happens is that M1 (deposits in the non-government sector) rise without a corresponding increase in bond liabilities.
It is this result that leads to the MMT conclusion that that deficits increase net financial assets in the non-government sector.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury ‘borrowing from the central bank’ and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target.
If debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the long-standing solution of the Bank of Japan).
There is no difference to the impact of the deficits on net worth in the non-government sector.
But, mainstream economists (like Holden) claim that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
- Building bank reserves does not increase the ability of the banks to lend.
- The money multiplier process does not describe the way in which banks make loans.
- Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.
The private banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and real productive capacity.
It is totally fallacious to think that private placement of debt reduces the inflation risk.
Think about it this way.
Assume there is surplus productive capacity – that is, firms have the capacity to produce more goods and services if their sales improve.
1. Case 1 – a private entity (firm or consumer) gets their credit card out and goes shopping. They come homewith an armful of purchases and prices don’t move a bit. Firms respond to the increased orders from shops for more inventory by increasing production.
2. Case 2 – a government official places a procurement order to a firm for some “stuff”. The products are delivered and prices don’t move a bit. Firms respond to the increased orders from shops for more inventory by increasing production.
When was the last time, a checkout operator in a shop asked you whether you were a government or a non-government purchase?
The point is that all spending carries an inflation risk. Public spending is not privileged in any way over private spending in this regard (or vice versa).
The economy responds to increased nominal demand by utilising its productive capacity and bringing unused capacity back into production. When nominal spending outstrips that capacity then firms have only one option left – to increase prices.
The evidence is that they do not increase prices before full capacity is reached because they fear they will lose market share.
At full capacity, as long as nominal spending grows in proportion with the growth in new capacity (from capital formation investment) then the money supply can continue to grow (to match the larger nominal transactions) without any price pressures.
Holden thus reveals he fails to understand that bond-issuance does not reduce the inflation risk of spending. The other way of thinking about that is that the funds to buy the bonds are part of the non-government wealth portfolio and were not being spent anyway. All that the purchasers do is swap one asset (presumably one that is not earning interest) for the bond, which does.
But then think about the case where the central bank pays interest on excess reserves and the treasury does not issue bonds.
That is equivalent to issuing bonds.
What actually happens is that the funds are conceptually moved from one account at the central bank (non-interest earning reserves) into another account (bonds or interest-earning reserves).
So when Holden berated a commentator with this smug retort:
… don’t you understand the difference between printing money and printing money backed by bonds. really?
We know whose face the egg was plastered all over and then some.
He further entrenched himself in embarassment when he was asked by a commentator to explain how a rise in a fiscal deficit of $1 without being matched by a bond sale would be inflationary.
His smug response was:
sure. MV = PY
And at that point you know he has his second-year textbook open and either doesn’t know how stupid that response was or thinks everyone else is so stupid that they won’t see through it.
The accounting statement MV = PY is what is known as the Quantity Theory of Money (QTM), the main theory of inflation prior to the release of Keynes’ General Theory (which demolished it).
It still hangs around among the ignorant or those who have anti-government agendas to push.
Mainstream economists use the QTM to link the expansion of the money supply with accelerating inflation. It is the most intuitive part of the neo-liberal story and the one that resonates with the public. That is why they continue to promote it, despite it being nonsensical to do so.
While the QTM was formulated in the 16th century, the idea still forms the core of what became known as Monetarism in the 1970s.
First, a small bit of theory. The QTM postulates the following relationship: M times V equals P times Y, which can be easily described in words as follows. M is a symbol for how much money there is in circulation, that is, the money supply. V is called the velocity of circulation in the textbooks but simply means how many times per period (say a year) the money supply ‘turns over’ in transactions.
To understand velocity, think about the following example. Assume the total stock of money is $100, which is held between the two people that make up this hypothetical economy. In the current period, Person A buys goods and services from Person B for the $100 it currently holds. In turn, Person B uses the $100 to buy goods and services from Person A.
The total transactions equal $200 yet there is only $100 in the economy. Each dollar has thus been used ‘twice’ over the course of the year. So the velocity in this economy is two.
When we make transactions we hand over money, which then keeps being circulated in subsequent purchases. The result of M times V is equal to the total monetary transactions in the economy per period, which is a flow of dollars (or whatever currency is in use).
The P times Y is the average price in the economy (P) times real output produced (Y), which sums to what we call nominal Gross Domestic Product (GDP). The national statistician estimates the total sum of all the goods and services produced to get real GDP and then values this in some way using the price level to get a monetary measure of total production.
So P times Y is the total money value of the output produced in the period.
At this level, the relationship M times V equals P times Y is nothing more than an accounting statement that says that the total value of spending (M times V) in a period must equal the total monetary value of output (P times Y), that is, a truism.
It is true by definition and thus totally unobjectionable.
How does the QTM become a theory of inflation? The answer is that the mainstream economists use a sleight of hand.
The Classical economists, who pioneered the use of the QTM, assumed that the labour market would always be at full employment, which means that real GDP (the Y in the formula) would always be at full capacity and thus could not rise any further in the immediate future.
They also assumed that the velocity of circulation (V) was constant (unchanged) given that it was determined by customs and payment habits. For example, people are paid on a weekly or fortnightly basis and shop, say, once a week for their needs. These habits were considered to underpin a relative constancy of velocity.
These assumptions then led to the conclusion that if the money supply changed, the only other thing that could change to satisfy the relationship M times V equals P times Y was the price level (P).
The only way the economy could adjust to more spending when it was already at full capacity was to ration that spending off with higher prices. Financial commentators simplify this and say that inflation arises when there is ‘too much money chasing too few goods’.
The problem with the QTM is that neither of the assumptions that are required to making it a theory of inflation hold in the real world.
First, there are many studies which have shown that velocity of circulation varies over time quite dramatically.
Second, and more importantly, capitalist economies are rarely operating at full employment. They typically have spare productive capacity.
The Classical theory essentially denied the possibility of unemployment. The fact that economies typically operate with spare productive capacity and often with persistently high rates of unemployment, means that it is hard to maintain the view that there is no scope for firms to expand the supply of real goods and services when there is an increase in total spending growth.
If a firm has poor sales and lots of spare productive capacity, why would it hike prices when sales improved? The evidence is that they act as ‘quantity-adjusters’ rather than ‘price-adjusters’.
Thus, if there was an increase in availability of credit and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing the supply of goods and services to maintain or increase market share rather than push up prices.
In other words, an evaluation of the inflationary consequences of increased spending in the economy should be made with reference to the state of the economy.
If there is idle capacity then it is most unlikely that an increased nominal spending growth will be inflationary. At some point, when unemployment is low and firms are operating at close to or at full capacity, then any further spending growth beyond the growth in productive capacity will likely introduce an inflationary risk into the policy deliberations.
MMT emphasises that conditionality.
So when Holden challenges a commentator:
… do you seriously question that expanding the money supply massively leads to inflation?
I, for one, do seriously question the proposition.
The historical evidence is very clear. There is no clear relationship between money supply movements and inflation. And that is because capacity utilisation varies as does velocity (the former being more important).
This discussion comes to a head when Holden quoted a deceased economist Zvi Griliches as saying:
… one can only get so much lemon juice out of a lemon …
True but the analogy is fraught. If the lemon is forever growing (subject to cycles of growth) then the lemon capacity is also growing.
And on this theme, Holden responded to the claims that he was mispresenting MMT with this:
Here’s Mitchell in his own words: “the Federal government is not financially constrained and can spend as much as it chooses up to the limit of what is offered for sale. There is not inevitability that this spending will be inflationary and it does not necessarily require any increase in government debt”.
maybe he is misrepresenting himself?
He kept repeating that quotation as if it was a sort of trump card (no pun).
When he was confronted on this by several commentators, Holden chose not to respond. How could he? He had nothing sensible to say.
He just repeated the quote as if I was walking the plank in my own words.
Well the quote is fine and succintly captures the point that Holden seems to miss.
1. The currency-issuing government can spend what it likes as long as there are goods and services for sale in the currency it issues. That cannot be denied.
2. “Up to the limit of what is offered for sale” is the operative conditionality.
3. That means that as long as there is ‘real resource’ space (a central MMT proposition), there is unlikely to be an inflationary spike following the government purchases, just as there won’t be in the case of private purchases.
4. Selling government debt to match the deficit does not alter the ‘real resource space’ on iota.
Holden appears to wound up in his certainty to realise that when he wrote:
… the problem with modern monetary theory is that, in short, there is only a finite amount of real economic resources that can be extracted through seigniorage …
He is really quoting core propositions of MMT.
And then he blows his cover (that he is representing MMT faithfully) when he issues his challenge:
Please state a formal, precise, economic model in which a monetary authority can extract an infinite amount of real resources through seigniorage. Or be quiet.
Here is a character, full of bravado, but light on knowledge telling us to be quiet.
But, moreover, my challenge to him is to produce within the academic MMT literature any evidence that we have written (or said) that the government “can extract an infinite amount of real resources” by spending without matching bond issues.”
That assertion has never been made by any one of us and is anathema to our understanding of the way the monetary system and the government within it operates.
Moreover, I could write a mathematical model which did show that a monetary authority could do that. I would start with the assumption – assume an infinite array of real resources; and so it would go.
Nothing at all to do with the real world but full of infinitely-lived maximising agents acting rationally and optimising outcomes.
But that isn’t far off what these precise (which become ad hoc quickly) mainstream macroeconomic models actually look like.
I could go on but that is enough.
Holden finished as he began, with insults. Defeated from the start – blabber – then back to the aspersions. Good work.
I wonder how Mr Holden understands Japan.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.