The dying embers of New Keynesian reasoning

Lawrence Summers is a New Keynesian economist. That means something. While there are nuances that exist between members of that school of thought, mostly to do with policy sensitivities and speeds of adjustment, the New Keynesian paradigm has demonstrated clearly that it is incapable of capturing the macroeconomic dynamics in any consistent manner, despite it being the dominant approach in the profession. So, it is no wonder when Summers provides opinions the underlying logic he demonstrates is similarly flawed. Unfortunately, he keeps getting important platforms to express these opinions, which continues to blight the public policy debate. He was at it again when he started lecturing the US Federal Reserve Bank on the conduct of its asset-purchasing program.

Recall that Lawrence Summers, signed a memorandum in December 1991, when he worked at the World Bank, that indicated that it would be economically efficient to send toxic waste from advanced countries to the lowest wage countries in Africa.

Recall during his time as a bureaucrat in the Clinton Administration that that he was directly involved in a number of highly questionable matters.

Don’t forget that he and Rubin when they ran the US Treasury were resistant to the idea that the US should participate in the Kyto protocol – see the National Archive documents accompanying this briefing – Kyoto Redux? Obama’s Challenges at Copenhagen Echo Clinton’s at Kyoto (December 18, 2009).

And during this period, think about Summers and his role, with Robert Rubin and Alan Greenspan before the GFC to promote increasing financial market deregulation and his demonisation of Brooksley Born, who became the head of the US federal Commodity Futures Trading Commission.

She tried to warn the US government of the increasing dangers of unregulated financial markets and was undermined by Summers.

I wrote about that in this blog post – Being shamed and disgraced is not enough (December 18, 2009).

And, the Enron scandal – Larry Summers’ Enron Problem (November 12, 2008).

Recall that Lawrence Summers was warning the US government that it was dangerous to continue to be ‘dependent’ on China to fund the US deficits by purchasing government bonds.

And don’t forget that he has coveted the position as boss of the Federal Reserve (to succeed Ben Bernanke)

And many more instances of flawed analysis and judgements.

Most recently, Summers and his New Keynesian mates (such as, Kenneth Rogoff) have been beating up the inflation mania story – which I addressed in this two-part series:

1. Is the $US900 billion stimulus in the US likely to overheat the economy – Part 1? (December 30, 2020).

2. Is the $US900 billion stimulus in the US likely to overheat the economy – Part 2? (December 31, 2020).

I have made this point before, but the public debate is biased against progress because characters like Summers can continue to command a platform and are given elite access to the public via the mainstream media, even when there is a litany of failed steps and poor predictions.

Anyway, onto the recent Op Ed, which appeared in the The Washington Post (August 26, 2021) – Opinion: It’s time for the Fed to rethink quantitative easing.

There we learn about a number of key differences between the way a New Keynesian economist thinks and the way an Modern Monetary Theory (MMT) economist understands reality.

Summers starts by drawing an analogy between Vietnam and Afghanistan and economic policy.

I won’t pursue that, but, I don’t think any American that has been close to policy has anything much to say about either US war defeat.

Both were disastrous choices from the outset and were always doomed to failure.

Yes, I know that the US could have nuked both countries and claimed victory. I have been told that before. But that doesn’t get us very far.

The point Summers is making in terms of economic policy is that one should have a long-term vision of where the policy will take us rather than adjust it “incrementally … to avoid near-term pain”.

I agree with that statement.

Knee-jerk adjustments to policies that are well thought out, just to appease the uninformed media etc is poor practice.

But I disagree with his conclusion that:

… continuing quantitative easing … has gone on for too long … [and] … cannot be justified and presents its own danger.

My disagreement goes under the conclusion to his logic – the New Keynesian logic.

First, he claims that:

Quantitative easing is a policy of creating money in the form of providing interest-paying reserves to banks and buying up Treasury bonds and other government-guaranteed securities.

Which is highly misleading.

Usually, we consider money to be a means of payment.

Commercial banks, operating under government license, are typically required to hold accounts with the relevant central bank, which contain balances that are used as part of the ‘settlement’ process to reconcile daily transactions across banks.

Banks don’t loan out reserves and do not need reserves to make loans.

Loans create deposits, which, in turn, are liquid funds that can be spent to purchase things.

Say Bank A makes a loan to Customer A who buys something from Seller A who also banks with Bank A. All the transactions are dealt with within the accounting system of Bank A and no reserve transactions are involved.

If Customer A buys off Seller B who banks with Bank B, then Banks A and Banks B reconcile the transaction through electronic accounting adjustments to their respective reserve balances at the central bank.

Reserve accounts are also adjusted if a customer asks their bank for actual ‘cash’ (physical notes and coins).

While only the central bank can create reserves, any individual bank can acquire them from another bank, which might have an excess, relative to their expected ‘clearance’ needs on any one day.

But, if there is an overall shortage of reserves in the banking system, then the central bank is the only source and it, historically, has provided those reserves through open market operations (buying government debt instruments, usually, from the banks).

Similarly, an excess reserve situation can only be resolved if the central bank drains them by selling government debt (usually).

I explain in this early introductory suite of blog posts why central banks will mop up excesses or provide in the case of shortages:

1. Deficit spending 101 – Part 1 (February 21, 2009).

2. Deficit spending 101 – Part 2 (February 23, 2009)

3. Deficit spending 101 – Part 3 (March 2, 2009).

Mainstream economists call reserves ‘high powered money’, because they think somehow the provision of reserves then drives (multiplies) into a higher money supply (broad money).

This is the flawed money multiplier idea, that New Keynesians still teach in their university courses.

I considered that idea in this blog post – Money multiplier and other myths (April 21, 2009) – among others.

The point is that what Summers wanted to then say is that QE, which involves the central bank purchasing financial assets held in the non-government sector, was designed to pump cash into the system – “clearly warranted when bond markets were illiquid” – in his words.

The mistake then mainstream economists make is to assume bank lend is ‘reserve-constrained’.

It is not, as described above.

Loans create deposits and any necessary reserve consequences of the transactions that follow the loan creation follow after the fact and are not part of the lending process.

QE does affect asset prices in the maturity segment that the central bank is buying the assets within (say, 3-year bonds, or 10-year bonds).

The higher demand for the bonds resulting from the central bank purchases pushes up prices and drives down yields on those assets (returns), which then by competitive forces, realigns all returns on all similar financial assets in that temporal segment of the market.

In that way, QE, arguably, influences aggregate spending – by changing the ‘cost’ of borrowing.

The sale of assets in exchange for bank reserves does not increase or decrease the bank’s ability to make loans on demand from credit-worthy borrowers.

The impact that QE has, if any, is via the interest rate effect, which is then effective or not, depending on the interest-rate sensitivity of spending (consumer and business investment, primarily).

Summers wants the reader to assume banks are reserve-constrained in their lending practices – a major plank in New Keynesian monetary theory.

The fact is they are not and this flaw in reasoning then leads to a range of false conclusions.

Why does continuing QE make “little sense today”?

Well, according to Summers:

It is unwise at a time of unprecedented growth in federal debt and prospective deficits, along with record-low real long-term borrowing costs. If ever there were a moment to increase longer-term borrowing, it is now.

Effectively, Summers is thinking of QE as funding government deficits (“since the Treasury is the economic owner of the Fed and receives its net income, when the Fed substitutes short-term bank reserves for longer-term debt, the government is unaccountably “terming in” the debt and shortening the maturity of its liabilities”).

And he thinks it is better, with interest rates so low, for the government to fund itself with debt than with central bank reserve creation.

The way I have expressed that is in terms of mainstream logic.

Every bit of it is incorrect at the most elemental level.

The US government can always instruct the US Federal Reserve to make certain transactions in favour of the Treasury.

There are voluntary institutional arrangements that are embedded in law (rather than being inherent) that provide an accounting trail for these transactions but the US central bank can create reserves out of thin air and can facilitate the creation of deposits within the non-government banking sector out of thin air to facilitate government spending.

Note that the two capacities are not equivalent.

When the government spends some bank account is marked up (a deposit account somewhere) to reflect the transaction.

The reserve accounting that follows depends on who holds the deposit account, what they do with it, and whether more than one bank is involved (as above).

But the fact that the US central bank now holds a large slab of government debt as a result of buying it up in the secondary market, means that the liability inherent in the debt instrument that is a Treasury liability is now held and due to the central bank (an agency of government).

The interest flows go from government left pocket to government right pocket, which then go back to the left pocket under current institutional arrangements.

The non-government sector is not involved after the primary issuance and the initial QE secondary bond market transaction.

Which means that, even under current institutional arrangements, the government is ‘funding’ its own expenditure and is not reliant on issuing private bond markets at all to ‘fund’ its spending.

But deeper down, into intrinsic capacity territory, these accounting arrangements are smokescreens, and we know that a currency-issuing government can always spend what it likes, whenever, and if the rules intervene, it can change the rules or invoke exceptions, emergency powers, whatever.

The point is that Summers is perpetuating the New Keynesian myth that the US government is financially constrained and spends non-government money that it borrows in one way or another.

In relation to QE, ask yourself the question: Where does the non-government sector get the net funds from to buy the government debt in the first place that it then sells back to the central bank?

Tracing the provenance of the funds leads you back to previous fiscal deficits that have not yet been taxed back.

A wash as they say!

The government really just borrows its own prior spending back.

Summers’ second point somewhat contradicts his first, because, now he recognises that any stimulative effect comes via the interest rate effect rather than providing reserves that can be loaned out (which was his first inference).

We are asked: “Why is this still a sensible objective when job openings are at a record high, inflation is running well above the Fed’s target, and housing inflation is not yet reflected in official indices even though the average new tenant is paying 17 percent more than her predecessor?”

Job openings might be rising but there are still, at my last count, 5,702 thousand jobs short from where it was at the end of February 2020, and, even then, February 2020 was hardly a point of full employment.

There is still massive poverty to be dealt with in the US society.

The urban systems in poorer segments of the city require massive injections of funds.

Perhaps his opening line about Afghanistan might be reworked to recognise that the US government wastes massive amounts of public spending on its external terrorist activities – illegally invading countries and then arming their enemies as they conduct inglorious exits.

There is an argument for dramatic recomposition of US government spending, especially in relation to climate change imperatives, but my assessment is that there is still considerable spare capacity in the US economy that needs to be absorbed before any hint of fiscal austerity is entertained.

And I don’t think rampant inflation is likely to ensue (see links to my blog posts on that topic above).

His third point that QE inflates asset prices which “supports the wealthy who hold these assets, rather than the bulk of the population, at a moment of nearly unprecedented inequality” has currency but only tells us that the government should stop speculating in financial assets and cut to the chase and use the capacity of the central bank to facilitate government spending directly without the charade of issuing debt in the first place.

If the government still wants to issue the debt, then just instruct the central bank to buy it up in the primary issue.

Then the charade is open to all.

He then morphs back into his inflation hysteria arguments, which I have dealt with elsewhere.

Conclusion

New Keynesian thinking is the old way.

It will take time for all economists to recognise that.

But its ongoing failure to deliver credible policy advice is slowly but surely eroding its credibility.

Summers will retire eventually.

Which will be a service to the world.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.