This Tuesday report will provide some insights into life for a westerner (me) who is…
During the GFC, a new phenomenon emerged – the ‘We knew it all along’ syndrome, which was characterised my several mainstream New Keynesian macroeconomists coming out and claiming that some of the insights provided by Modern Monetary Theory (MMT) economists were banal and that their own theoretical framework already accommodates them. The pandemic has brought a further rush of the ‘We knew it all along’ syndrome. Apparently, mainstream macroeconomics is perfectly capable of explaining the fiscal reality the world has found itself in and there is no need to MMT, which, by assertion, is saying nothing new. These sorts of statements are not coming from Facebook or Twitter heroes who might have done a few units in economics or even acquired a degree in the discipline. They are coming from senior professors in the academy. The curious thing, which really lifts their cover, is that if you examine the academic literature you won’t find much reference to these sorts of ‘insights’ at all. What you find, and what students are taught, are a completely different set of propositions with respect to fiscal policy. So if they ‘knew it all along’ why didn’t they ever write about it? Why is their published academic work replete with conclusions that run contrary to the conclusions MMT economists make? You know the answer. These ‘knew it all along’ characters have just been caught out by the poor empirical performance of their paradigm and now they are trying to salvage their reputations and position by trying to blur history. They really should be sacked.
I was sent an Op Ed – Should governments obsess about debt? Yes, say traditionalists. No, says the theory – from three Australian economics professors yesterday which typifies this issue.
It was published on July 7, 2020 in Crikey, which is a self-style ‘with-it’ sort of on-line news source.
There is another version that was published subsequently, which has minor variations but which is substantially the same.
The three authors have at various times in Op Eds or social media made ridiculous attacks on MMT. They seem to have a thing about it.
Their approach in this Op Ed is to simultaneously reduce both ‘conventional economics’ and MMT to absurdly simplistic and incoherent characterisations.
That sort of reduction is characteristic of most of the MMT critiques I have ever read.
For example, the authors write that MMT proponents argue:
… we should not worry about budget deficits at all.
Now here we have to be clear.
MMT is not what Twitter advocates say it is.
Social media is not the domain where you define an academic discourse.
I know some social media activists feel slighted when I criticise their vehemence etc but that is the reality.
We can forgive a well-meaning activist or popular literature writer for stylising and being simplistic.
But the source of what MMT is can only really be found in the academic literature that the main economists have produced.
And for mainstream economists seeking to find out what MMT is, that is where they should research.
What some popular book or Tweet might say is one thing.
But an academic should never use ‘quotes’ or inferences from those sources an authoritative statements on an academic development.
The Crikey authors defy that professional convention because they have a point to make which cannot be made if one consults the academic literature.
No MMT economist, writing in the academic literature, has ever said that fiscal deficits do not matter nor should we disregard them.
It is simple academically dishonest to say otherwise.
Of course, fiscal deficits matter!
They are the lynchpin for government to ensure the economy can reach and sustain full employment and maintain high levels of material well-being.
I outlined an easy version of what the appropriate fiscal position should be in this blog post – The full employment fiscal deficit condition (April 13, 2011).
There is much more detail in our textbook – Macroeconomics (published 2019) – and other academic papers.
Clearly, the Crikey authors have never consulted the academic literature or decided it was too inconvenient for their purpose to render it accurately.
The fiscal position is crucial in any modern monetary economy.
We should always worry about it because it is the way in which non-government saving decisions can be ‘funded’ by government while still maintaining levels of economic activity that will generate full employment and other beneficial outcomes (productivity growth etc).
That ‘funding’ comes from the fiscal deficit filling the non-government spending gap (the difference between income and spending) and maintaining aggregate spending at levels sufficient to generate sales that, in turn, ensure unemployment is at its irreducible minimum.
In our academic work, MMT economists have gone to great analytical depth to outline how fiscal policy works and provides that non-government ‘funding’.
So it is a falsehood, at the most elemental level, to write that MMT says “we should not worry about budget deficits at all”.
Which means that any further inference based on that erroneous conclusion is likely to be equally flawed.
The Crikey authors then seek to invoke a characterisation of MMT based on that introductory falsehood.
In doing so, MMT makes two claims: one weak and one strong.
The weak claim is that a country that can issue debt denominated in its own currency, say dollars, can always finance a shortfall between its spending and its revenues. The central bank can, at the press of a button, create unlimited new dollars. Because of this a government can never fail to make payment on dollar-denominated liabilities. In this sense, there can never be a problem financing government deficits … This is neither a new nor a controversial idea. It is well accepted by central bankers, treasury officials, academic economists, and other experts — even if it is not well understood by various politicians and commentators who are all too quick to talk as if the government budget is just like a household budget. It is not.
Several points emerge here.
First, the idea that governments have to seek funding first before they spend is developed here.
And certainly an array of accounting structures within government have been created to give that impression.
I wrote about that phenomenon in this blog post among others – On voluntary constraints that undermine public purpose (December 25, 2009).
But, this is not the way MMT conceives of the fiscal process.
Once the government initiates a spending choice it is ‘funded’. Some operational process is triggered where cheques are sent out or bank accounts are credited and that currency is in the system – buying things, etc.
All the other things that might accompany that process are not funding in the conventional meaning of the word.
Second, if it is understood by all that the “central bank can, at the press of a button, create unlimited new dollars” why do mainstream economists including Nobel Prize winners (so not “various politicians and commentators”) publish regular articles about governments running out of money and debt thresholds beyond which the government can no longer ‘fund’ itself and all the rest of the related garbage?
Well the answer is that they know that central banks can do that but they render it taboo because they assert it causes accelerating inflation.
So, it is not really a real world option, even though it is available.
Which then raised further questions.
Why do most central banks do it these days without there being any consequence of accelerating inflation?
The New Keynesian model says that inflation should be accelerating at present, and, certainly well before now in Japan, which has seen the Bank of Japan essentially buying all the government debt that has been issued for many years – certainly long enough for the mainstream predictions to play out.
If the model has no credibility in an empirical sense, then it doesn’t matter that they knew the central bank could do this.
What matters is whether their ‘model’ correctly understood the consequences over time of central banks pressing buttons and creating unlimited new currency, which is now the norm.
And it is there that the mainstream model that these authors use fails dramatically.
The main central banks have been trying for years to elevate their inflation rates with little success.
The scale of the QE that has been undertaken should have, using any feasible elasticities of money demand etc, driven prices sky high at an increasing rate if the New Keynesian model had any credibility.
So the Crikey authors might know the obvious.
But they don’t know why the reality departs from their textbooks.
That is where MMT economists have the edge. They have more or less correctly predicted the current reality and have been much more successful in capturing the macro dynamics than the mainstream economists who have made systematic errors in inflation predictions for years now.
Third, the Crikey authors might be now willing to admit that the government ‘budget’ is not a household budget and that academic economists and other experts know this but then they might want to explain why the opposite assumption often frames academic research papers and statements by economists.
The idea that the government faces a budget constraint akin to that faced by the household in microeconomic choice theory has a long history in the ‘conventional economics’ literature.
It arose as a result of mainstream economics questioning the implications of the work of John Maynard Keynes and trying to make sense of it within conventional, neoclassical microeconomic theory.
That micro theory focused, among other things, on the choice of the consumer between goods and services and saving, and between labour and leisure.
In the first choice decision, it was held that consumers wanted to maximise satisfaction faced with a budget (financial) constraint.
So there was a maximising calculus proposed where the household or individual ration their financially constrained spending to make themselves feel the best.
The attacks on Keynesian macroeconomics accelerated during the 1950s, as Milton Friedman and other neoclassicists, disputed Keynes’ essential insight that real wage cuts would not improve employment, which was a notion derived directly from neoclassical micro theory of the labour market.
Keynes’ view ran counter to the optimising calculus that the micro theory advanced and placed central to their analytical approach.
So to the neoclassical economists, Keynes must be wrong because his views violated the assumptions that individuals were rational and maximising and free markets would deliver optimal outcomes if those individual motivations were allowed to work out.
As a result, there was a lot of effort expended in trying to render the Keynesian macroeconomics consistent with the microeconomic principles that the mainstream held on to in a religious manner.
The way this proceeded in the 1950s, but especially the 1960s, was to formalise the government to replicate the individual consumer in the sense that it was financially constrained by its ‘budget constraint’ and there were thus consequences arising from choosing between one form of ‘finance’ or another.
Don Patinkin wrote about it in his 1956 book – Money, Interest and Prices.
Bent Hansen also referred to it in his 1958 book – The Economic Theory of Fiscal Policy.
In 1965, David Ott and Attiat Ott published an article in the Journal of Finance (XX, March, 71-77) – ‘Budget Balance and Equilibrium Income’.
A definitive article was published in the Journal of Political Economy (Vol 76, No 1, Jan-Feb, 1968) – A Simple Macroeconomic Model with a Government Budget Restraint – by Carl F. Christ.
Don’t be mislead by mainstream economists about this.
The underlying aim of this literature was to unify the microeconomics of consumer demand with the macroeconomics – to render them consistent and obedient to the same analytical principles.
There were nuances but the underlying unity was clear.
In choosing a mix of monetary and fiscal policies, government authorities (including the central bank) are bound by a government budget restraint. This restraint is less severe than a private individual’s or firm’s restraint because government authorities can issue fiat money. Nevertheless, the government budget restraint is important.
The nuance then is that governments can “issue fiat money”.
At the level that Christ introduced the idea, one could easily understand that all this ‘constraint’ was referring to was an accounting statement that when the government spends it also does a range of other things – has tax revenue, issues debt, or instructs its central bank to credit bank accounts – and the sum of the spending will ultimately add up $-for-$ to the other things.
In our academic writings, MMT economists make it clear that as an accounting identity that is obvious.
Christ says that the government is not free to assign values in its fiscal process to all the ‘other things’ because once it sets tax rates and debt issuance, and a spending level, then what is left for the central bank to cover is determined by the accounting identity.
That is also obvious for that is what an accounting framework ensures – additive consistency.
But Christ then manipulated a highly stylised ‘model’ where the results really depend on the assumptions that the analysis is based on to conclude that a “Long-run static equilibrium requires a balanced budget”.
As a statement about the real world, this conclusion carried virtually no relevance.
But the mainstream economists seized on the framework, extended it, and concluded all manner of things about the dangers of fiscal deficits.
Which really formalised the antagonism in modern New Keynesian macroeconomics to continuous use of fiscal deficits.
The ‘government budget constraint’ (GBC) was characterised as a financial constraint and an analysis of its features (in these stylised models) would lead to all sort of negative outcomes if deficits occurred and were not offset by surpluses over an economic cycle.
In my 2008 book with Joan Muysken – Full Employment abandoned – we wrote:
In general, mainstream economics errs by blurring the differences between private household budgets and the government budget. For example, Barro (1993: 367) noted: ‘we can think of the government’s saving and dissaving just as we thought of households’ saving and dissaving’. This errant analogy is advanced by the popular government budget constraint framework (GBC) that now occupies a chapter in any standard macroeconomics textbook. The GBC is used by orthodox economists to analyse three alleged forms of public finance: (i) raising taxes; (ii) selling interest-bearing government debt to the private sector (bonds); and (iii) issuing non-interest-bearing high-powered money (money cre- ation). Various scenarios are constructed to show either that deficits are inflationary if financed by high-powered money (debt monetisation), or that they squeeze private sector spending if financed by debt issue. While in reality the GBC is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.
The point is that the modern interpretation of the GBC, and the one that is overwhelmingly taught in universities, is that unless the government wants to ‘print money’ and cause inflation it has to raise taxes or sell bonds to get money in order to spend.
Moreover, the inference is that taxes and bond sales provide the government with funds it doesn’t already have that enables it to then spend those funds.
The Crikey authors can hardly say that Robert Barro is not an ‘expert’ in the way they would classify that category. He is a full professor of standing and a modern proponent of the Ricardian Equivalence idea that has been highly influential (unfortunately) in economic debates and papers since the 1970s.
And there it is in print – the government budget is like a household budget. No fundamental difference. That idea permeates mainstream economics whether the Crikey authors wish to admit it or not.
If everyone who is expert in economics knows it is not so, why is the analogy still used in academic papers.
What is missing is the recognition that a household, the user of the currency, 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.
The government is the source of the funds that the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances) as we have seen in the previous section.
Clearly the government is always solvent in terms of its own currency of issue.
Related to this issue is another – the crowding out myth.
If mainstream economics captures all the insights of MMT, ‘we knew it all along’ and so MMT is, as the Crikey authors opine, unnecessary to support an argument for fiscal stimulus then why are there so many mainstream economists who write as if fiscal deficits are dangerous.
Stanley Fischer, who is one of the leading mainstream macroeconomists and William Easterly, also a very senior mainstream economist with influence, published an article in the World Bank Research Observer (Vol 5, No 2, July 1990) – The Economics of the Government Budget Constraint – which is representative of the way the New Keynesian approach depicts fiscal policy.
Yes, they recognise that the government can get the central bank to type some keys and issue currency, which they erroneously call “money printing”, as if the way government spending enters the economy differs according to the accompanying monetary operations (it does not).
But that is hardly what the Crikey authors might depict as ‘knowing it all along’ and hardly absorbs the key MMT insights, making the latter redundant.
They explore the mainstream depiction of “the consequences of the method by which the budget deficit is financed”.
After the usual GBC mechanics, Fischer and Easterly conclude that:
Money printing is associated with inflation; foreign reserve use is associated with the onset of exchange crises; foreign borrowing is associated with an external debt crisis; and domestic borrowing is associated with higher real interest rates, and possibly, explosive debt dynamics as borrowing leads to higher interest rate charges on the debt and a larger deficit.
This is the New Keynesian perspective.
This is what the Crikey authors would teach their students in core macroeconomics courses.
No MMT economist would teach this in any course other than History of Economic Thought.
Why the difference?
Because if you would be hard pressed to consistently match the Fischer-Easterly predictions with reality.
Where is the inflation in Japan? Why are interest rate movements and bond yields not skyrocketing given the continuous and large fiscal deficits?
And one cannot conclude that eventually they will accord with the mainstream prognosis.
Japan has been running large deficits for years with the Bank of Japan buying most of the debt and it sells 10-year bonds at negative yields and inflation is benign.
MMT economists will tell you that the ‘crowding out’ story (higher interest rates from fiscal deficits squeezing non-government investment spending) denies the reality of the banking system.
Banks will loan funds via deposit creation to any credit worthy borrower. The definition of what is credit worthy might vary over the cycle as risk conditions change but there is no finite pool of savings that the government competes with private borrowers over.
Fischer and Easterly also claim after some New Keynesian mumbo-jumbo that:
At some point it will be impossible for the government to sell its debt, and the process will have to be brought to an end by cutting the budget deficit.
So when will the Japanese government find it impossible to sell its debt?
Why are bid-to-cover ratios typically high – meaning that private bond investors fall over themselves to get hold of the debt?
The Kyodo News International feed from June 1, 2004 – Bid-cover ratio for 10-year JGBs hits record high of 59.4 – announced:
The Finance Ministry on Tuesday conducted an auction for 10-year Japanese government bonds that drew the highest bid-cover ratio on record, reflecting the high coupon rate of the offer.
The ministry auctioned 1,615 billion yen worth of the No. 260 JGBs with a coupon rate of 1.6 percent. Bids totaled 94,322.6 billion yen and 1,587.6 billion yen of them were accepted, bringing the bid-cover ratio to 59.4.
The ratio is an all-time high for 10-year JGBs and is much higher than the previous record of 18.6 set in the January 2003 auction.
The strong reception reflects the 1.6 percent coupon rate, which represents the first raise by the ministry in two months and is the same as in September last year when interest rates were rising sharply.
The coupon rate is considered attractive as the growth of long-term interest rates is expected to be curbed against the backdrop of rising crude oil prices and the slowing rise of stock prices that have caused a cautious outlook for Japan’s economic recovery.
There were even higher bid-to-cover ratios in the months that followed as the coupon rate hovered between 1.6 and 1.3. Eventually the ratio returned to more normal levels.
Here is the graph of the monthly bid-to-cover ratios for the 10-year Japanese government bond from Issue No 119 (Auction date April 5, 1989) to Issue No 363 (Auction date July 1, 2021). I excluded the massive outliers between 2002 and 2004 from the graph to provide a more usual view of the movement in this ratio. All excluded values were higher than 8.
The historical data is available – HERE.
The point is obvious – the ratio is usually well above 2, indicating that there are usually always strong demand for the bonds issued by the Ministry of Finance.
And, by any stretch of the imagination, the fiscal aggregates in Japan have exceeded anything that mainstream macroeconomists thought was possible.
So the question is (following Fischer and Easterly’s claim): When will it become impossible for the Japanese government to sell its debt?
The reality is that they will always have high demand.
If the Crikey authors teach their students that fiscal deficits push up interest rates, which all the orthodox macro textbooks teach, then they ‘didn’t know it all along’ and MMT insights go much deeper than their crude representation that we only say governments can get central banks to print money.
The Crikey authors then focus on inflation and say that the “real constraint is inflation” (on government spending) and “the more sophisticated MMT proponents … agree with conventional economics on this point.”
No, the mainstreamers are now agreeing with us.
For years, they responded to our work by first of all focusing on the government running out of money, of deficits driving up interest rates, etc.
So, I suppose it is progress that they now conclude that the “important constraint facing a government is not how to cover liabilities denominated in its own currency” and the main focus should be on inflation.
But I know that is not what they teach their students – the GBC and all the Fischer-Easterly analysis remains dominant – and moribund.
And I agree, that “the real question is, when and under what circumstances is a government likely to run into the inflation constraint”.
The Crikey authors then assert that while conventional economists have an intrinsic understanding of the inflationary process:
… proponents of MMT don’t have much to say about when the inflation constraint will bind or what consequences follow if it does.
Well, go back to Japan and all the mainstream predictions of accelerating inflation.
None have come to fruition over three decades.
Is that some anomaly or is it that the mainstream theory is bereft.
Why is inflation accelerating from the demand-side in the US, Europe, UK and now even in Australia, as the respective central banks buy increasing quantities of government debt?
That is a question an MMT economist does not ask because they know the answer is largely irrelevant for explaining the inflationary process, despite it being central to the orthodox approach.
The Crikey authors provide another crude characterisation of the MMT inflation view – a reverse-L supply curve where no price rises are experienced before full employment and then only price rises after that as nominal demand increases.
Others have tried to make the same claim.
I covered that point in this blog post – When the MMT critics jump the shark (April 16, 2019) – and in greater, more technical detail in our Macroeconomics textbook.
In the textbook (Chapter 16) you will find this narrative:
… all firms are unlikely to hit full capacity simultaneously. The reverse L- shape simplifies the analysis somewhat by assuming that the capacity constraint is reached by all firms at the same time. In reality, bottlenecks in production are likely to occur in some sectors before others and so cost pressures will begin to mount before the overall full capacity output is reached. This could be captured in Figure 16.3 by some curvature near Y*, thus eliminating the right-angle as prices begin to rise before reaching Y* (full capacity). We consider this issue in more detail in Chapter 17.
Chapter 17 provides more detailed discussion of this point.
So the accusation from the Crikey authors that MMT economists exhibit “simplistic thinking” about the consequences of inflation is just another straw person type criticism.
We also analyse in detail the implications of inflation on income distribution, real wages, etc, which the Crikey authors accuse us of ignoring.
They also pose the question: “can inflation spiral out of control even when an economy is below capacity?”
It can and I have written about that a lot in the past.
While mainstream economists were trying to explain the hyperinflation as the result of excessive ‘money printing’ by the Bank of Zimbabwe and out of control deficits, my analysis showed that even with fiscal surpluses, the hyperinflation would have occurred so great was the supply shock arising from the collapse of the agricultural sector output.
No mainstream analysis provided those insights.
Finally, the Crikey authors claim that their current advocacy of “the need for ongoing fiscal stimulus is very compelling” and “In this sense we come to a similar conclusion to many MMT proponents”.
But their point is that they “get to this conclusion through purely conventional economic thinking.”
And, according to them MMT does “a profound disservice” to progressive policy goals (like Green transition or a larger social safety net) by making it transparently clear that “government mechanically supplies enough currency to cover liabilities denominated in its own currency” and can never run out of that currency.
The point is that ‘conventional economic thinking’ will accompany a short-term acceptance of fiscal deficits to deal with “the largest recession since the Great Depression” but will accompany that acceptance with all sorts of warnings that go back to the GBC and the alleged consequences.
There will be statements about the need for higher tax collections.
There will be predictions of higher interest rates, and bond investors demanding higher bond yields.
There will be predictions of intergenerational inequities as the kids have to pay back the debt the government incurred (by higher future taxes).
And there will be (and are) predictions that the central banks will have to get rid of their large holdings of government debt because any further QE will not on cause inflation to accelerate but also distorts the bond markets.
No MMT economist will be making those predictions and I will stand corrected in a decade or so if I am wrong.
So far in more than 25 years of doing this stuff, I have not been systematical wrong about my predictions, which are quite converse relative to the mainstream predictions.
So it matters how you come to a conclusion, which might be similar to a conclusion that the rival paradigm reaches. The surrounding body of knowledge is what matters.
And the Crikey authors really have nothing to offer that is worthwhile – its all been said and taught before and it is usually quite wrong in its predictive capacity.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.