The divide between mainstream macro and MMT is irreconcilable – Part 2

This is Part 2 of a three-part response to an iNET article (September 6, 2018) – Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them?. In Part 1, I considered what we might take to the core body of mainstream macroeconomics and used the best-selling textbook from Gregory Mankiw as the representation. The material in that textbook is presented to students around the world as the current state of mainstream economic theory. While professional papers and policy papers might express the concepts more technically (formally), it is hard to claim that Mankiw’s representation is not representative of what current mainstream macroeconomics is about. Part 1 showed that there is little correspondence between the core propositions represented by Modern Monetary Theory (MMT) and the mainstream. Yet, the iNET authors want to claim that the differences between the two approaches to macroeconomics only really come down to a difference in “assignment of policy instruments” – jargon for MMT prefers fiscal policy while the mainstream prefers monetary policy as the primary counter-stabilising tool. Given the lack of conceptual and theoretical correspondence demonstrated in Part 1, it would seem surprising that there is really only just this difference in policy preference dividing MMT from the mainstream. If that was the case, then what is all the fuss about? Clearly, I consider the iNET article presents a sleight of hand and that the differences are, in fact, significant. So, in Part 2, I am tracing how the iNET authors came to their conclusion and what I think is problematic about it. This discussion will spill over into Part 3.

As an aside, I received several E-mails overnight of the hostile variety claiming that I was just cherry-picking quotes from Mankiw’s textbook to create a straw person representation of mainstream macroeconomics.

I was told that the iNET authors were operating at a much more sophisticated level than that expressed in undergraduate textbooks.

Well, sorry, but the iNET article explicitly says:

The economic analysis behind MMT’s fiscal-policy argument is essentially the same as that used by orthodox policymakers and in undergraduate textbooks. The different conclusions drawn by MMT and the mainstream in policy do not come from a different understanding of the economy …

It is better that you read things carefully before firing off personal invective via the E-mail system to people you do not know.

The iNET authors clearly think that the mainstream undergraduate textbooks provide students with an “understanding of the economy” and that MMT work is compatible with that understanding.

It is not. Not even remotely. Which is why Part 1 of this series evolved in the way it did.

The iNET language …

Part of the ‘we knew it all along’, ‘there is nothing new here’ approach to a paradigmic challenge is to express the challenge in the language of the dominant paradigm that is resisting the challenge.

That is a powerful strategy because the language (and associated framing) is loaded in favour of the incumbent. Just using mainstream macroeconomics terminology biases the reader towards accepting the legitimacy of that position.

In this context, the iNET task is to convince the reader that there are minimal differences in substance between MMT and mainstream macroeconomics so that all the talk that MMT represents “a radical departure from the views held by most policymakers and academic economists” is incorrect.

So, relax, all you cosy mainstream macroeconomists, the barbarians that are threatening to storm the ramparts are benign. They just have some odd policy ideas.

That is effectively, the iNET position.

To begin, the iNET article characterises the MMT position in this way:

If a government seeks to adjust the budget position to bring output to potential, it can do so regardless of the current budget deficit, debt-GDP ratio, or similar measures of fiscal space.

Already, you can see the problem.

MMT economists never consider these (or “similar”) ratios, financial aggregates to be “measures of fiscal space”.

That is mainstream ‘sound’ finance language and is one of the differentia specifica between MMT and the mainstream body of thought.

MMT economists consider ‘fiscal space’ to be only defined in terms of availability of real resources that can be purchased using the currency capacity of the government.

Within the ‘sound finance’ approach, mainstream economists continually consider fiscal space to be exhausted even when there are high levels of unemployment.

For example, the most recent IMF statement on the topic – Assessing Fiscal Space: An Update and Stocktaking (June 15, 2018) – presents an analytical framework that is anathema to the way an MMT economist constructs the concept.

It defines ‘fiscal space’ in terms of “two main considerations”:

  • financing – the extent to which the government can expect to have access to market funding at reasonable rates.
  • sustainability – the extent to which public debt and annual financing needs (composed of the budget deficit and repayment of debt coming due) of the government remain sustainable.

This is their so-called “holistic approach”.

So, from this approach, a nation can be assessed to have no fiscal space if bond markets determine they want higher yields even if unemployment is at 20 per cent.

The IMF produce Table 5 (page 18) where they allocate nations they have simulated their ‘new’ (read: old) approach on.

So we learn, for example, that Malaysia – which issues its own currency through the central bank, Bank Negara Malaysia and floats it on international markets – has “limited” fiscal space and Japan, the UK and the US have “some” fiscal space.

In 2010, for example, the IMF estimated that Japan, for example, had no fiscal space left (Source). Good luck with that!

The IMFs methodology lumps together Eurozone nations (that use a foreign currency) with currency-issuing nations, and nations that float their currencies with nations that peg them, and nations whose governments borrow in foreign currencies and nations that do not.

It is a ludicrous, ideological exercise.

But it is core ‘mainstream’ macroeconomics.

In MMT, there is always ‘fiscal space’ when there is mass unemployment and idle capital even if the bond markets are demanding high yields from government debt issuance and fiscal deficits and public debt ratios are already at elevated levels.

Quite simply, the bond markets have no influence over this assessment. The government can always deal them out of the game whenever they wish in one of two ways:

1. Stop issuing debt (preferred).

2. Instruct the central bank to buy debt to control yields – as many central banks have been doing for decades.

Mainstream macroeconomists believe that fiscal space declines after a recession if the government has used fiscal stimulus to arrest the decline in non-government spending.

Even those mainstream economists who are willing to allow governments to run up cyclical deficits in a recession (and Mankiw, by the way, is one of them), demand that governments ‘pay back’ those deficits in the upswing by running surpluses and restoring the ‘fiscal space’ eroded in the downturn.

A most recent example of this sort of mainstream reasoning was discussed in this blog post – Fiscal space has nothing to do with public debt ratios or the size of deficits (August 30, 2018).

This sort of reasoning is anathema to MMT economists. The fact that a government has run a large (historically) fiscal deficit during a recession in no way reduces its capacity to respond to a downturn in non-government spending in some future period, even if, the fiscal position remains in deficit.

Governments do not ‘pay back’ past deficits. Deficits are flows of net expenditure. They are not stocks. Once the expenditure has flowed it has flowed. Move on to the next day. The currency-issuing capacity doesn’t alter as a result of yesterday’s flow.

To better understand the concept of fiscal sustainability and disabuse yourself of the false claim that it is somehow related to deficit history or public debt ratios, the following introductory suite of blog posts will help:

1. Fiscal sustainability 101 – Part 1 (June 15, 2009).

2. Fiscal sustainability 101 – Part 2 (June 16, 2009).

3, Fiscal sustainability 101 – Part 3 (June 17, 2009).

They explain how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.

So the iNET article doesn’t get off on a very good footing. Language and framing is everything. There is no shared view of the concept of fiscal sustainability between MMT and the mainstream macroeconomics.

Create a sleight of hand …

The iNET authors reach the conclusion that:

The economic analysis behind MMT’s fiscal-policy argument is essentially the same as that used by orthodox policymakers and in undergraduate textbooks. The different conclusions drawn by MMT and the mainstream in policy do not come from a different understanding of the economy, but from a different view of the capacities of policymakers, and in particular, of what kinds of policy errors are likely to be most costly.

So this is the current ‘we knew it all along’ strategy – the differences between MMT and the mainstream can be distilled down to a preference for fiscal (MMT) or monetary (mainstream) policy.

The inference is that both ‘schools of thought’ share the same “understanding of the economy” but have different views about people who implement policy and the costs of their mistakes.

We read this as saying – well now that is decided, let us all pack up and go home, and leave the mainstream macroeconomists to get back to their important work – training the elite of policy society and all the rest of it.

The problem is that their conclusion is flawed at the most elemental level and as we will see is as damaging for mainstream economics as it is irrelevant to MMT.

How do they reach that conclusion?


They simply redefine mainstream macroeconomics by deleting everything important that defines its theoretical posture (and the implications of that posture).


They redefine MMT to be simply ‘functional finance’.

And, along the way, they ignore all the important differences between the two ‘schools of thought’.

As I said, that was easy.

First, the iNET authors conclude that “MMT does not constitute a settled body of thought with fixed premises and conclusions”.

There is no further discussion provided to justify that assertion.

I am one of the MMT originators and I have a very “settled body of thought” and use it everyday in my work.

Second, to avoid getting into the “several distinct elements” in MMT, the iNET article just reduces the comparison to “a program for macroeconomic policy” where:

… we are interested in the macroeconomic policy component: the argument that fiscal policy can and should be used to close an output gap regardless of the current debt-GDP ratio and fiscal position.

So they are not interested in “making an assessment of MMT as a whole” – because if they did they could not conclude that it shares the same “understanding of the economy” and, apart from some differences in policy emphasis, is essentially the same as mainstream macroeconomics.

And you see this further in their advice that:

Because we are interested in the logic of the functional-finance position rather than in MMT as a body of thought, we make only limited references to MMT literature here … Our primary interest is in the merits of the functional finance position in the abstract.

Okay, so the article is not really about MMT at all despite the title.

When I started studying macroeconomics we were told by mainstream lecturers that the work of John Maynard Keynes (in the General Theory) was really just a special case of Neoclassical theory and was operational when wages and prices were downwardly rigid (that is, didn’t fall when their was excess supply).

As a consequence of this ‘conclusion’, mass unemployment was due to excessive real wages and could be cured if money wages were allowed to fall in the face of the excess supply (unemployment).

The orthodoxy had distilled Keynes’ ‘radical’ rejection of Neoclassical theory – its monetary origins, its conception of the labour market, its flawed concepts of saving, and more – down to being a meagre ‘special case’, which is triggered when some assumptions (price flexibility) are altered.

And until Monetarism emerged in the late 1960s, the so-called Neoclassical Synthesis dominated.

Of course, Keynes himself had rejected the ‘special case’ tag and was at pains to show that his anti-Neoclassical results held (effective demand, involuntary unemployment etc) even if wages and prices were flexible in both directions.

But in dealing with Keynes in this way, the Neoclassical (dominant) school of thought was able to abstract from all the conceptual and theoretical differences that Keynes had advanced to show the fatal flaws in the dominant paradigm in economics.

And they were able to reduce the debate down to a matter of wage and price flexibility. And so, mass unemployment was seen to be a problem of minimum wages, excessive trade union power, other legal constraints on wage cuts etc.

All of the insights that Keynes provided on uncertainty, institutional reasons for downwardly rigid wages and more were essentially lost to several generations of students.

If students had read the core works they would have concluded that Keynes was proposing a radical departure from the mainstream economics of his day.

They would have known that the dispute was about a fundamentally different understanding of the economy and that the mainstream approach was logically flawed and as a result could not represent a plausible explanation of reality.

But the mainstream textbooks, which have evolved into the likes of Mankiw etc, pushed the Synthesis approach and so modern New Keynesians still consider that fiscal policy has some function because wages and prices are ‘sticky’ (rigid) – so the ‘special case’ sort of reasoning.

But they then revert to full Classical thinking that fiscal policy is totally ineffective in the ‘long run’ once wages and prices adjust up or down.

The iNET approach has disturbing overtones to that sort of classification tactic.

Let me be absolutely clear – the way in which an MMT economist understands the economy is irreconcilable with the body of work that mainstream economists hold out as their ‘understanding’ of how the system works.

And it gets worse.

And this time, their attempt to evade what are the essential differences between the two ‘schools of thought’ raises major issues for mainstream economics, which I think economists in that camp would rail against.

The iNET authors turn to what they represent as the “mainstream side” or “orthodox policy macroeconomics” which are:

… the practical heuristics that guide policy makers and are reflected in undergraduate textbooks, as opposed to DSGE and related models of intertemporal optimization that are the basis of most current macroeconomic theory.

Note again the appeal to textbook wisdom.

But the point here is that the standard New Keynesian model that is taught to students as if it represents the way the economy and the monetary system operates is cast aside here.

The iNET authors just want to represent the orthodox position with some “simpler, more reduced form models that are (explicitly or implicitly) drawn on by public officials and public and private-sector forecasters, as well as by academic economists when engaged in public discussions”.

This is no small step.

A reduced form is a set of equations that emerge when one ‘solves’ the system of equations that (in this case) are purporting to capture the structure of the economy.

I won’t go into this in any more detail as it is very complex and opens up all sorts of issues such as identification of unknown structural coefficients from the reduced-form and the ability to extract information from the reduced-form that provides unique knowledge of the underlying structural form, which represents the basic theoretical position.

The advantage of the reduced form is that it can be easily estimated using econometric techniques. But the problem is whether the estimates of the unknowns in the reduced form can provide any knowledge of the theoretical structure, which, after all, is what the exercise is about.

So to be clear, the theoretical component is expressed in what we call the ‘structural form’, which is a series (system) of equations.

The reduced form is derived from the ‘solution’ of the structural form (the underlying theoretical structure) and results in the endogenous variables (those to be solved) expressed as functions of exogenous variables (those that are already known and not part of the solution to the system).

The point is that we cannot get a practical reduced form that fits the real world data from the basic New Keynesian (mainstream) theoretical model.

I have discussed the implications of this before – see blog post – Mainstream macroeconomic fads – just a waste of time (September 18, 2009).

And this is a crucial issue.


New Keynesians claim that their approach integrates so-called real business cycle theory elements (intertemporal optimisation, rational expectations, and market clearing) into a stochastic dynamic macroeconomic model, and because they build this on first principles (rationality, maximisation etc) the results they derive are ‘optimal’ and ‘welfare maximising’.

These ‘virtues’ are then held as the authority and New Keynesian economists are continually casting aspersions on other analytical approaches (within, say, the Post Keynesian tradition) that they claim lack ‘rigour’ because they lack the so-called ‘microfoundations’ (rationality, maximisation etc).

But to integrate those elements into a formal (mathematical) structural system of equations, which they claim adequately represents the economy, the New Keynesian specifications have to be overly simplistic and reliant on behavioural assumptions (rationality, information processing capacity of individuals, foresight, etc) that no self-respecting social scientist that actually studies human behaviour would consider to be credible in the least.

But without that simplicity and highly stylised (and ridiculous) assumptions about human behaviour, the mathematical solutions would be impossible.

I know this is tricky for non-economists but stay with it.

Then the problems begin.

Because the ‘optimal’ theory, specified in the basic structure (Calvo pricing, rational expectations, intertemporal utility maximising behaviour by consumers, who face a trade-off between consumption and leisure, etc) cannot say anything much about real world data, the empirical models are modified (adjustment lags are added, etc).

For example, in the applied world of macroeconomics there is usually a lagged dependence between output and inflation. However, in the standard New Keynesian model, so-called ‘Calvo price-setting’ (one of their assumptions about firm behaviour), which represents the microfoundational behaviour, does not allow lagged inflation to influence current inflation.

So the theoretical model cannot yield an empirical model that can be estimated to simulate policy options.

There are many examples of these anomalies.

It is virtually impossible to builds these ‘modifications’ into their theoretical models from the first principles (intertermporal optimisation, etc) that they start with.

How do New Keynesians deal with them?

Ad hocery enters the fray and we see econometric models with these lags built in – the primary justification being empirical.

Why is this problematic?

Well you cannot have it both ways!

The mainstream proponents want to claim virtue based on the fact that their models are rigourous (based on assumed microeconomic behavioural foundations) but then respond to empirical anomalies with ad hoc (non rigourous) tack ons.

These ad hoc responses have no correspondence to the theoretical properties of their models.

The results they end up producing in empirical papers (that feed into policy advice) are not ‘derivable’ from first-order, microfounded principles at all.

Their claim to theoretical rigour fails.

At the end of the process there is no rigour at all. It becomes a false authority that they hide behind to justify their assertions.

But the New Keynesian economists still consider reality to be in accord with their underlying theories with short-run imperfections generating the anomalies.

The claim is flawed but that is how they traverse the void between their theory and the reality of the real world they want to discuss.

And, the theoretical representation is far removed from anything the an MMT economist would consider adequate or valid. There is no correspondence with the way an MMT economist considers the underlying behavioural characteristics of the economy and its participants and the ‘microfounded’ vision presented by a New Keynesian.

Not so long ago, I considered these problems in relation to the work by Simon Wren-Lewis and Jonathan Portes on fiscal rules in the UK – see the blog post – The New Keynesian fiscal rules that mislead British Labour – Part 1 (February 27, 2018).

However, by ignoring these ‘microfoundations’ in their representation of the mainstream macroeconomics, which really means they are attempting to discuss the New Keynesian framework, the iNET authors are making a clean break between the empirical world and the theoretical world.

In other words, their representation of mainstream macroeconomics, which they then use to compare MMT with, cannot be traced back to the underlying New Keynesian theory at all.

But by ignoring the structural components of New Keynesian economics, the iNET authors deliberately blur the distinction between mainstream macroeconomics and MMT.

That is, of course, the only way they can make the claims that the substantive differences lie in differences in opinion about policy assignment.


But, as we will see in Part 3 (tomorrow), the failure to discuss the microfoundations etc and DSGE characteristics of mainstream macroeconomic models, also impacts on the claims by the iNET authors that:

… we are focused on what might be called “orthodox policy macroeconomics” – the practical heuristics that guide policy makers and are reflected in undergraduate textbooks, as opposed to DSGE and related models of intertemporal optimization that are the basis of most current macroeconomic theory.

Orthodox policy macroeconomics use DSGE modelling frameworks and bastardised New Keynesian models.

Think about the Brexit analysis from the British Treasury and the National Institute of Economic and Social Research.

Where do you think they came up with their (highly inaccurate) estimates of the short-run consequences of Brexit from? You guessed it.

Where did the IMF come up with their “growth-friendly” projections during the disastrous Greek bailouts? You guessed it.

So we cannot easily just abstract from these underlying theoretical components of mainstream macroeconomics and claim we are just talking about “orthodox policy macroeconomics”.

And, as we will see, even if in the short-run, there is what we might call ‘observational equivalence’ between what a New Keynesian might project and what an MMT economist might project – say that spending creates income – the interpretations of those short-run states and how they impact on future aggregates is so vastly different between the two ‘schools of thought’.

As the title indicates – the divide between mainstream macro and MMT is irreconcilable.

That is enough for today!

(c) Copyright 2018 William Mitchell. All Rights Reserved.

This Post Has 14 Comments

  1. That the authors could claim with a straight face that Keynes’ theory is a special case of the neoclassical theory suggests that they did not read Keynes closely at all since they should have noticed that Keynes contended that neoclassical theory was a special case of his more General Theory. Words fail me.

    I would like to be able to say that it beggars belief that these microfoundationalists have never noticed that there is no derivation from micro to macro. Physicists would love there to be a derivation from quantum mechanics to relativity, as that would give them the unified theory they yearn for, but they know there is none. This just illustrates the physics envy of mainstream economists. Pathetic. Sociologists felt this envy in the 1930s but gave it up eventually as a bad job. Time for economic physics eviers to do the same.

  2. I saw on Twitter that Arjun Jayadev was open minded and comitted to read Bill’s response. We’ll see what happens.

  3. I’m certainly glad to not know iNET. On a productive note, you probably should’ve mentioned what DSGE means and how it relates to micromodels, someone might get a bit lost about that at the end.

  4. I checked the end of the Jayadev & Mason article and there is a comment by Steven Hail put there by a commenter to the article. Hail agrees with Bill and provides an answer to the question of what divides mainstream macro and MMT and, similarly to Bill, says, “a very great deal indeed”. Hail’s comment is on a Facebook page, which I do not use. I perhaps ought to point out that Hail mentions his own recent book in his comment as a go-to reference to aid in answering the question.

  5. Chewitup, I will be very interested in seeing what Jayadev has to say. I expect not much.

    In the comment by the second commenter to J&M’s article, who is at the University of Stuttgart, the first sentence claims that both mainstream macro and MMT are axiomatically false. I don’t know what this means unless the commenter is contending that the axioms of MMT are empirically false. I didn’t know that MMT had been finitely axiomatized. I’ll bet that this will come as a surprise to Bill. 🙂 I’ve had a look at this chap’s other comments on MMT and they seem to me to be bizarre, whereas J&M’s are oddly peculiar.

  6. A lot of thinking and math based on false assumptions at the beginning- Zen and the Art of Motorcycle Maintenance. Gloss over and minimize fundamental truths and intimidate everyone with the complexity of thought. Most things in life have a direct line from simple observable truth to explanation and line of action.

  7. DSGE models. Another fine mess to model a NP hard complex system as a Polynomial.
    But it gets worse, they fill the models with functions which don’t exist in the real world.

  8. The Arjun Jayadev and J. W. Mason argument seems to amount to “framing” along the lines of “my Dad’s wiser than your Dad because he’s known about MMT all along and doesn’t consider it amounts to anything new of any significance”. Isn’t this argument straight out of Simon Wren-Lewis’s and Thomas Palley’s play books?

  9. My impression was that Jayadev and Mason were saying that people such as John McDonnell’s economics policy advisers in the UK and MMT people needn’t think that there was as unbridgeable gulf between how they each viewed economics. John McDonnell’s economic policies are already very counter to what Mankiw’s text book recommends so Mankiw is quite outside either camp that Jayadev and Mason are hoping to reconcile.

  10. @prof bill mitchell – The authors are now claiming on their twitter that its not a fully comprehensive review of the literature. It was just the authors clarifying their understanding of their differences. So why publish it to the wider public? Seems like they are either disingenuous or are completely naive about the impact of works like this on the wider public.
    Here’s the tweet –

  11. Dear Laney (at 2018/09/12 at 6:21 pm)

    Yes, thanks.

    I saw the original Tweet from iNET – see graphic that follows:

    iNET Tweet September 6 2018

    That signals iNET’s intention to try to capture some relevance from the growing traction that Modern Monetary Theory (MMT) is making in the public debate.

    It doesn’t suggest that the work was just some notes for the authors.

    They specifically claim the article is about the theoretical foundations of MMT. It wasn’t at all. The Tweet is fake promotion.

    iNET is a disgrace and that particular article I responded to doesn’t alter that perception.

    best wishes

  12. Is the situation that people such as Meadway and Simon Wren-Lewis align themselves with the mainstream rather than MMT and yet understand the economy in a way that isn’t based on the theoretical base as described in Mankiw’s textbook but rather on their own understanding that actually is much the same as the base behind MMT? So they are sort of undeclared shadowers of much that lies behind MMT. They are sort of Post Keynesians but calling themselves New Keynesians? I’m just struggling to get my head around this and especially struggling with the aggro this all seems to be generating as I’m such a fan both of Bill Mitchell and also of JW Mason and certainly of John McDonnell.

  13. the mainstream approach was logically flawed and as a result could not represent a plausible explanation of reality.

    I think Bill underestimates the insidious nature of the “logically flawed”.

    A logical flaw can be used to explain anything plausibly. Black is white, the currency issuer needs financing, you can’t just print money, even if you did you would cause hyperinflation, even if it doesn’t cause hyperinflation that is just because the money is going to efficient private consultancies.

    No problem here, move right along.

  14. Larry, re comment on Sept 11, 2018 (19:31)
    I would agree. It certainly appears that the Neo-classisists in economics (aka the mainstream) only wanted to drag Keynes respected name into their assault on reason, which incorporates a campaign relying heavily on linguistics. The mathematical theory itself is utter BS for practical purposes; garbage in garbage out!

    Ironically, both quantum theory and relativity, itself a refinement on the classical understandings of gravity, are two mathematical (albeit in the case of Quantum mechanics very abstract) models derived entirely from careful experimental observations of nature and yet they have not been unified so far despite great minds trying.
    Einstein, a major contributor to quantum mechanics, feeling fully supported by the weight of experimental evidence that guided it’s development, could not come to grips with some of the odd predictions of the theory such as quantum entanglement. In his words “how can we know everything about a system without knowing anything about it’s parts?”

    Einsteins worries about quantum mechanics somehow being in error, later proved unfounded; the unifying theory will have to incorporate or predict quantum behavior in some way.

    Both theories are extremely accurate within the domains they encompass, and are very useful because of their ability to calculate the outcomes of virtually all practical experiments, and, an engineer can use them to develop new technologies that actually work. Anyone with a bit of mathematics and sound mind can learn to use either theory to make their own accurate predictions.
    None of this can be said of neo-classical economics and there will be no grand unification between it and MMT.

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