Economists are part of the problem not the solution

Welcome to 2010. Today, in the overcast summer that we are enduring here, in between other things I am finishing off, I was in my office reading about how mainstream economics actually saved us from a major depression over the last 2 years. Far from having to hang their heads in shame, the article indicated we had all embraced Keynes and glory be the day. I also read a counter to that which outlined what further needed to be done. I concluded neither writer really had grasped what has been going on and both would benefit from exposure to modern monetary theory. Not a lot has changed overnight. Happy new year!

Financial Times economics writer Martin Wolf is back from holidays. I think he would have been better staying on vacation more or less permanently. In his article (December 29, 2009) – The challenges of managing our post-crisis world, Wolf outlines some key areas where the world has to avoid complacency and instigate fundamental reforms.

After some personal remininsces, Wolf concludes that “… civilisation is as fragile as glass. Moreover, when chaos comes, the worst of human nature will almost always emerge …” He goes on to say that:

At an emotional level, these views shaped how I have responded to the financial catastrophe of the past few years. I was convinced that, without the policy responses we saw, the world would have experienced a still greater depression. Policymakers could not stand idly by while such calamities unfolded. We could not, in such times, even take the survival of civilisation itself for granted. Never before had I felt more strongly the force of John Maynard Keynes’s toast “to the economists – who are the trustees, not of civilisation, but of the possibility of civilisation”.

The point of all of this is that we allegedly are confronting “huge challenges at a time of great global transformations” and “(s)omehow, we must manage to sustain a dynamic global economy, promote development, deliver environmental sustainability and ensure peaceful and co-operative international relations”.

While us practictioners of the dismal science have limited scope, as Wolf points out, to stop ” nuclear weapons from falling into the hands of terrorists or terrorist regimes” (hasn’t America already got them? – see recent Chomsky news) among other catastrophes that might undermine “civilisation”.

But Wolf suggests us economists have some use – to help the world economy “return to health” … “That is, as Keynes would surely have said, the contribution economists ought to be able to make. What else can they be good for?”

The full quote (which Wolf lifts from) is provided in Roy Harrod’s 1951 book The Life of John Maynard Keynes (published by Harcourt Brace and Co., New York). On pages 193-194 you read:

I give you the toast of the Royal Economic Society, of economics and economists, who are trustees not of civilization, but of the possibility of civilization.

Harrod, who was a friend of Keynes said that the quote was in fact a toast he made after his farewell speech in 1945 at the Council of the Royal Economic Society. Keynes was retiring after 33 years of service as the editor of the Economic Journal, the Society’s major publication.

There was an on-going and vigourous debate about the concept of civilisation in the 1920s and into the 1930s. This followed World War 1 when the British intelligentsia were fond of discussing how civilisation was to be protected from the barbarism of the Germans.

Keynes was at Cambridge at the same time as the art critic and writer Clive Bell who in 1928 published Civilization: an Essay (published by Harcourt Brace and Co., New York). They were friends and part of the London Bloomsbury group. Bell mostly wrote about aesthetics and the value of art. As an aside, Bell was married to the sister of Virginia Woolf to whom Civilization is dedicated.

In Civilisation (it is worth reading at some point in your life), Bell argues (not that successfully) that civilised societies have to maintain an elite group in their leisure (they wouldn’t work!) to safeguard and promote higher values. Remember it was written following World War 1 when the British intelligentsia were on about protecting their values from those of the Hun!. To my German friends, that was the language actually used – BMW – doesn’t that stand for Bob Marley and the Wailers.

Some interesting points from the book are that Bell considered utilitarianism, the then catchcry of neo-classical economics to be rather contemptuous (page 169). He earlier says that civilised societies always “sacrifice style to comfort … [as] … an inevitable consequence of the sense of values” (page 71).

In that regard he noted (page 62) that the concept of “productive efficiency” is dubious because it usually promotes ambitions that are “more obvious and immediate” at the expense of values which are “more subtle and remote” but closer to what a civilised society is.

In this sense he juxtaposes (page 260) the higher values of civilisation with the “the creed of the producers. Those who hold it have no will to civilization. But they have power.”

The members of this elite must be free of the need to work but will at times be called upon in the public debate to define what good is – “the disseminators of culture are a group of men and women of whom most create no tangible work and leave no eximious monument …” (page 121).

However, it is this passage in Civilisation, which has been pinpointed, as being the source of Keyne’s link between civilisation and the economist – the link he made in his famous Royal Economic Society toast. It appears on page 250:

Those who use authority, like those who create wealth, can be civilized but not completely civilized. They must be of the second order. The mere exercise of power, the coercing of others, will tinge a man with barbarism. My praetorians, my policemen, my administrators and magistrates, and I myself if I am to be an efficient ruler, which, however, I decline to be – must be content to be the imperfectly civilized guardians of civility. Fortunately there are in the world a number of people who appear not only to enjoy ruling (an all too common taste), but to enjoy ruling well … and if in fact they generally fail that is not the result of malevolence but of stupidity. It should not be impossible for a civilized elite by bringing intelligence and education into fashion partially to remedy this …

Compare the toast made by Keynes where he talks about the “trustees” of civilisation whereas Bell uses the term “guardians” of civility. It was clear at the time that Keynes considered economists to be among this elite group who would bring their “intelligence and education” to keep the masses on track.

However, in the historical context, Bell would never have agreed that economists were of such a quality as to be in his leisured elite. It would be worrying if we were to believe the proposition that if we didn’t take the advice of economists without question then we will undermine our civilisation.

But Keynes clearly thought economists had something to offer although in some modest way. The profession certainly took the first idea to heart (something to offer) but didn’t stay humble for very long.

Indeed, we have worked steadily at undermining civilisation by taking heed of the advice of mainstream economists. To a large extent that is why we are in this mess.

Anyway, if you are interested you can find a lot of literature about his old debate.

However, Wolf’s just seems to think it is worth quoting Keynes without context, and he quickly moves from “civilisation” as if we are to take Keynes’ proposition at face value.

He then says:

In an article published in the FT this week, Arvind Subramanian of the Peterson Institute for International Economics, argues that economics has redeemed itself by rescuing the world economy from the crisis. I agree, but only up to a point. Many economists argued that the measures were unnecessary, or even harmful. Moreover, these extraordinary interventions have not returned the patient to health. They have merely prevented him from dying. We now must heal five chronic conditions, instead of survive last year’s brutal heart attack.

The Subramanian article that Wolf mentions – The Triumph of Ecoomics – was reprinted HERE on December 29, 2009.

Subramanian argues that the “greatest Depression that could so easily have happened in 2009 but did not is the tribute that the world owes to economics”. My question is which ones? He says that:

In 2008, as the global financial crisis unfolded, the reputation of economics as a discipline and economists as useful policy practitioners seemed to be irredeemably sunk. Queen Elizabeth captured the mood when she asked pointedly why no one (in particular economists) had spotted the crisis coming. And there is no doubt that, notwithstanding the few Cassandras who had correctly prophesied gloom and doom, the profession had failed colossally.

He notes that mainstream economics had promoted “a belief system that elevated markets beyond criticism” and policy makers had deregulated financial markets to the point that they couldn’t see the crisis coming.

That is one of the major issues to emerge from this crisis. The policy makers did not even have the data available to them to see the extent of the risk that was building up. From a modern monetary theory (MMT) perspective there were clear signs brewing in the late 1990s as governments persisted in deregulating financial markets and raising the fetish of budget surpluses to “academy award” status.

But the day to day (real-time) data that was needed to understand the web of failures that was inevitable was not considered important by the neo-liberal policy makers to collect or monitor. Never mind we were told – markets self-regulate.

As I noted in an earlier blog – Being shamed and disgraced is not enough – former US Federal Reserve boss Alan Greenspan actually thought markets would even deal with liars, crooks and frauds efficiently. However, the only way this could happen would be for massive bankruptcies to follow the corporate failure with huge losses and lots of innocent people suffering collateral damage. And in all likelihood, the fraudsters escape with the booty.

Further, as I have noted often the old teaching structure in economics is not suited to educating students to understand anything about what has happened in the world economies the last few years. Quite the contrary in fact. The textbooks represent a denial of crisis and a eulogisation of equilibrium and market-created wealth. Chapters on government regulation are typically negatively constructed.

So if all of this is what Subramanian is referring to then I agree with his point.

Subramanian then suggests that crisis are inevitable:

But crises will always happen, and … will elude prognostication. Most crises, notably the big ones, almost always creep upon us from unsuspected quarters; that is perhaps the very definition of a crisis … So, if the value of economics in preventing crises will always be limited (hopefully not non-existent), perhaps a fairer and more realistic yardstick should be its value as a guide in responding to crises. And here, one year on, we can say that economics stands vindicated.

This comment interested me because it is one of those statements that are made from the straitjacket of mainstream economics. By that I mean, that crisis would be very limited and short-lived if the way we thought about the balance between public and private activities in the economy changed.

When you set up a system which promotes a decline in public employment capacity a decline in public scrutiny of key markets, then it is true, crises – either of a financial or real origin – will occur with regularity and cause damage to the well-being of individuals.

But if there is considerably more scope for public activity as a built-in part of the wealth generating process then while private sentiment swings will drive variations in private spending, the consequences of these swings need not be severe. For a start with an in-built Job Guarantee, the swings would have less severe employment consequences that without such a capacity.

We were caught out this time because as noted above our government didn’t see it coming (because they had closed their eyes) and they had fallen so much into the obsession that monetary policy was the answer to counter-stabilisation issues that they took some time to get their head around the obvious palliative intervention – to revive their fiscal policy capacity, which had been undermined by years of ideological attacks by mainstream economists.

Subramanian then outlines why economists rescued us. He says that the:

… recession of the late 1920s in the US became the Great Depression, owing to a combination of three factors: Overly tight monetary policy; overly cautious fiscal policy (especially under Franklin D Roosevelt in 1936 when tighter fiscal policy led to another sharp downturn in the US economy), and dramatic recourse to beggar-thy-neighbour policies, including competitive devaluations (as countries went off the gold standard in the 1930s) and increases in trade barriers worldwide. The impact of this global financial crisis has been significantly limited because on each of these scores, the policy mistakes of the past were strenuously and knowingly avoided.

First, it is true that monetary policy was eased (interest rates were cut fairly quickly). But the hangover remained. There was an on-going mis-trust of fiscal policy and an obsession that monetary policy was the main policy tool in town.

The hangover emanated from the ridiculous claim that “inflation targetting” had been a success (see this blog for more on that).

As a consequence, policy makers thought monetary policy could do more “salvage work” if unconventional means were used.

They also thought they had understood the Japanese recovery in the late 1990s as being due to “quantitative easing” even though the Japanese policy makers, themselves knew, that it was fiscal policy that restored some semblance of growth to their economy.

Notables such as Bernanke and Krugman and others have all made incorrect statements in the last 18 months about Japan as they did in the 1990s.

But, in this regard, and consistent with the fact that mainstream economics totally misunderstand the way banking operations work – the early policy emphasis was focused on “quantitative easing” with the result that trillions of different currency units around the world were substituted for other privately-held financial assets to “give the banks some money to enhance their lending capacity”.

This just created a massive build up of reserves (the so-called expansion of central bank balance sheets) and little gains were observed. Further, it led to arcane and falsely-constructed debates about whether these reserves would be inflationary and the fear campaigns mounted. Economists were involved in perpetuating these false statements which reflected their total ignorance of monetary operations.

The fact that banks don’t lend out reserves anyway seems to have escaped them. This operation had some benefits (may have reduced longer-maturity investment rates) but patently failed to stimulate lending. Why? Because the lack of lending had nothing to do with a lack of liquidity. Banks have been cautious in their lending because risk has risen and further there has been a dearth of credit-worthy customers (in their assessment) coming through their doors.

So the early reliance on massive monetary policy shifts – both conventional and “unconventional” – has not in my view been a glowing reference for the economics profession. See the blogs – Quantitative easing 101Building bank reserves will not expand creditBuilding bank reserves is not inflationary – for more discussion on this point.

Second, it is clear that fiscal interventions then occured in significant proportions reversing the previous disdain for net spending as as vehicle for salvaging an aggregate demand failure. Much of the swings into deficit, however, reflected the automatic stabilisers built into fiscal settings and so no credit can be given to economists who may have been advising policy makers.

In fact, as the deficits rose a growing “squawk squad” of mainstream economists, started advocating for fiscal rules to be urgently installed that would have negated even the beneficial moderation provided by these automatic stabilisers. They also increasingly demanded “exit strategies” in total denial of the fact that with private demand so weak and fragile any move to withdraw the discretionary (and automatic) stimulus would have not only plunged the world into a double-dip recession but would have increased the deficits even more.

This “squawk squad” has largely intimidated governments everywhere into modifying their fiscal interventions to the point that they are not sufficient to fill the spending gap left by the private withdrawal. So we have seen a drawn out and unnecessarily damaging recession and now the signs of a very slow and tepid recovery.

All that could have been avoided with properly scaled fiscal interventions. So the economists in general haven’t anything in this regard to be proud of.

Yes, there was a lot of talk about John Maynard Keynes and he was quoted more in the last two years by commentators than in the previous 30 years. During the last 30 years any mention of “Keynesian” strategies would have been laughed out of town by the mainstream economists. I have now 30 years of personal professional experience as a testament to that!

Further while Subramanian correctly notes that governments provided “massive public demand for goods and services where private demand had collapsed under the weight of indebtedness and non-functioning credit markets”, he doesn’t seem to realise that the current debate among economists still fails to understand why that private debt grew so substantially.

There is very little recognition that the private sector was squeezed of liquidity by the moves to fiscal austerity by governments around the world. The only way the economies could continue growing (with the exception of those who enjoyed large net export surpluses) with government increasing their fiscal drag on spending was for the private sector to go increasingly into debt.

In that sense, all the claims now that governments need to get back into surplus as soon as they can denies the underlying accounting dynamics that link the government and non-government sectors. It is this ignorance by economists that will set the scene for the next crisis.

Subramanian also notes there has not been a wide-scale move to “beggar-thy-neighbour policies” although he also indicates that the “exception to this rule was the large-scale assistance to the financial and automobiles sectors especially in the US”.

He then notes that these monetary and fiscal responses were “were crafted across the globe … in emerging market economies and developing countries as much as in the industrial world”. In saying that he conveniently ignores the fact that in the vast majority of cases the IMF agreements imposed on low income countries during the recession were pro-cyclical and their made things worse. Please read my blog – IMF agreements pro-cyclical in low income countries – for more discussion on this point.

I agree generally that the large fiscal responses have stopped the world economy from collapsing into a decade-long Great Depression II. But the conduct of economists has been begrudging at best. The worst of them have just denied that the fiscal intervention was required. Many, like John B. Taylor in the US have argued it has made matters worse!

And the majority of the rest have begrudgingly become “Keynesians” for the time being because any other position would have made them look more ridiculous than they already were looking given their denial leading up to the crisis that anything was wrong. But they are all poised, on a daily basis, waiting for the time they can say these deficits are dangerous and need to be cut. Then they will swing back into text-book mode and they will deny deficits have an on-going role to play in allowing the economy to grow with private saving desires being achieved.

Then you will hear the mantra “budgets have to be balanced across the cycle” or “higher surpluses are need to pay back the debt more quickly”. Then you will appreciate the expression that the leopard cannot change its spots!

So now back to the chief economist of the Financial Times, Martin Wolf, who to repeat, said this in reaction to Subramanian positive judgement in favour of economists:

Moreover, these extraordinary interventions have not returned the patient to health. They have merely prevented him from dying. We now must heal five chronic conditions, instead of survive last year’s brutal heart attack..

I agree with Wolf’s assessment that “the patient has not returned to health”. That is very clear – there has not been a death but a hospital full of very sick patients remains.

So what is the way ahead? Wolf has five suggestions.

He says:

First, we have the ongoing force of the balance-sheet recession in the US, UK and a number of other significant high-income countries. It is overwhelmingly likely that the highly indebted parts of the private sectors of these countries will seek to lower their indebtedness and raise savings over an extended period.

I agree but probably not with the inference. There is no doubt that the private sectors in most countries are going to have to reduce their debt levels and that means they are going to have to learn to save again – which they clearly are (as a sector) if the latest national accounts being published by various nations is anything to go by.

But the important point which we will come to next is that this imposes a responsibility on the government sectors in these countries – and that folks – is to run continuous deficits of a sufficient magnitude to ensure that aggregate spending matches that required to maintain high levels of income and employment so that the private sector can save. Only where net exports are so strong will this rule be altered.

So this leads us to Wolf’s second areas that need healing:

Second, we have, quite rightly, substituted public sector borrowing for private sector borrowing, on an unprecedented scale, for peacetime. This can continue for some time, but not forever, as the US and UK come to look like Italy, but without Italy’s healthier private sector finances.

Now we are heading into confusion. You will first note that his first area of healing (reducing private debt) requires that governments run deficits and provide the income growth necessary to allow the private sector to save.

You will also understand that governments around the world unnecessarily burdon themselves with the constraint that they have to borrow (usually) $-for-$ from the private markets when they net spend. This practice is a hang-over from the gold standard days that are long gone.

There is no financial necessity for governments to do this at all. There are advantages to the non-government sector in doing so however. They get an interest-bearing and risk-free financial asset – a guaranteed annuity, which they can hold or use for other purposes (such as pricing more risky derivative assets). But the government gets nothing from the “borrowing”.

Indeed as I have already demonstrated several times – the government just “borrows” back the funds it injected into the economy via its net spending. As they say – its a wash. Please read my blog – On voluntary constraints that undermine public purpose – for more discussion on this point.

But, given they behave in this way, it follows that debt levels will always rise when net spending rises. But there is never any solvency risk in this which makes Wolf’s claim that “this can continue for some time, but not forever” just inapplicable. The fact is that the private sector could increase debt forever, service it at very low interest rates as long as there was a need to generate that much net spending.

The other fact is that the net spending growth should stop once the economy reaches full employment and the spending gap is closed. That is when the rise in deficits will reasonably stop. The reality is that they will be artificially pulled back by governments under pressure from the “squawk squad” of economists who give them advice or give advice to others, who politically pressure the governments, well before full employment is reached.

The other interesting point that tells me that Wolf doesn’t really understand the way the national accounts operate lies in his statement that the UK and US will “come to look like Italy, but without Italy’s healthier private sector finances”.

The higher deficits in Italy have allowed the private sector to have healthier finances by providing spending stimulus over time to generate income growth (and private saving). The fact he doesn’t tie the two together is very telling.

It also disqualifies him from quoting Keynes in some positive manner because one of the essential insights that Keynes provided was that saving was a function of income and income was a function of spending. And when private spending was deficient, public spending had to grow and fill the gap.

As an aside, I also think the US and UK would be better off “looking like” Italy, which is arguably, in the context of our earlier discussion, eminently more civilised than they are. After all, Italy is the home of Campagnolo! And yes, okay, there is more than beautiful bicycle components – there is the art and the literature and the joie de vive.

Wolf’s third healing suggestion is:

Third, despite modest – and, quite possibly, temporary – reductions, the US, UK, Spain and other erstwhile bubble economies continue to have large structural current account deficits, with substantial offsetting surpluses in China, Germany, Japan, the oil exporters and several other countries. Yet, so long as these external deficits continue, the countries concerned must be running ongoing financial deficits in either the public sector, or the private sector, or both. In other words, the domestic balance-sheet problem is likely to become not better, but worse, without global rebalancing.

Well the national accounting is correct. If the country is running a current account deficit then the sum of the private domestic balance and the government budget balance has to be in deficit.

The further point is that if you then want the private balance (net saving) to be in surplus then the government has to be deficit. If not the income adjustments will make sure this holds. The causality of how these balances are generated in not mechanical, however.

Presumably current account deficits reflect the voluntary decisions of mostly private agents (firms and households) which we would consider to refect their assessment of their best interest. Further, a current account deficit is a good thing for a country in material terms as I have noted previously – see this blog among others.

So then if you want the private sector to participate in a growing economy, enjoying the fact that some foreign economies want to accumulate financial assets in your own currency and are willing to net ship real goods and services to you to achieve that desire, and – you want the private sector not to accumulate large levels of indebtedness – then, quod erat demonstrandum – you have to be prepared for continuous government deficits.

To consider this situation to be a deterioration, as Wolf obviously does, is to fundamentally misunderstand the relationships between the sectors. A rising budget deficit does not – as a matter of definition – indicate a worsening situation.

In some cases, it might reflect a fall in private spending and a failure of governments to act so that the automatic stabilisers push the deficit up. That would not be a nice situation.

But in other situations where the government is pro-actively managing fiscal policy to maintain high levels of employment given the flux in private spending a rising deficit would indicate the exemplar of responsible and prudent fiscal management.

The real costs that we have to worry about are real losses in output and employment. We should never worry about the size of the budget deficit in isolation of those real concerns.

The case for global rebalancing is a different issue and I will write a separate blog on this another day. It is largely a beat-up. But that will address Wolf’s fourth point about China and its “addiction” to trade surpluses. Eventually the Chinese people will deal with that I suspect although it is sometime to go before they will have the capacity to do.

Wolf’s fifth area of healing is:

Finally, the financial system remains damaged. Not only does it still own vast quantities of the “toxic assets” its “talented” employees created, but the world is not addressing the structural causes of the crisis. In some ways, the oligopolistic banking system that has emerged from the crisis is riskier than the one that went into it.

I agree with this point. The US bailouts, in particular, have not provided the necessary leadership in financial reform. The evidence is that the US Governemtn on Wall Street is back to their old tricks when they should have been fundamentally forced to restructure.

But moreover, there is no sign (and none I have seen in Wolf’s writings) that there is a serious intent on actually changing the concept of a bank away from the speculative units they have become under lax neo-liberal period and back to being institutions which only exist to serve public purpose.

Please read the following blogs (among others) –″>Operational design arising from modern monetary theory – Asset bubbles and the conduct of banks Breaking up the banks – where I deal with the reforms that would be necessary to restructure the financial system so that it only serves public purpose and promotes or engages in no other activity.

Wolf certainly has shown no leadership in his columns in this regard. As an aside, I have seen E-mail exchanges between Wolf and a financial markets professional (who understands MMT) and Wolf’s position is simply untenable.

Finally, let me provide my own quote from Keynes. In Chapter 24, in his concluding notes to his grand tome The General Theory of Employment, Interest and Money, he said:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back … Sooner or later, it is ideas, not vested interests, which are dangerous for good or evil.

This is why we have to keep advancing modern monetary understandings. For this body of literature consistently predicted the crisis and also provides you with an understanding of why we are recovering.

Saturday Quiz tomorrow

Yes, it has survived the advent of the New Year and the 2010 edition of the Quiz will be lethal! Modern monetary theory has to advance.

PS: Cultural note – Dear Americans, if you are uncertain about some of my jibes then assume I am mostly joking! best wishes, bill

This Post Has 27 Comments

  1. Bill,

    This is slightly oblique to topic, but I’d be interested to hear your thoughts on the fiscal theory of the price level.

    I’m not that familiar with it, and really haven’t thought about it much. My guess is that it doesn’t square with MMT. If that’s the case, I’d be interested in understanding where it’s wrong, the degree to which it’s wrong, and how MMT corrects it from an analytical perspective.

    My interest arises partly from this paper:

    The paper is fairly short. Maybe you’re already familiar with it.

    If you have time, I’d been interested also in your views on the thesis of the paper, which seems interesting, but again I suspect is inconsistent with MMT. I’d like to understand how.

  2. Great way to start of twenty-ten Bill

    It really seems to me that the hardest part of your thinking, for most of the economists and politicians you……………mock (rightly) , to understand is the circular nature of things. Your comment about Keynes insight that savings comes from income, which comes from spending seems to get lost. They seem unable to see that the spending which leads to the savings necessarily must come from outside the private sector to avoid a zero sum reshuffling of the deck chairs. ONLY the \”deficit\” spending from govt will increase financial wealth in the private sector. Of course this insight would lead too many to abandon the mantra of \”the government cant create wealth\”, so in many cases it probably is willful ignorance.

    Have a great day

  3. JKH,

    If I may . . . I spent a bit of time on that subject and had planned to do a paper on it but always had other obligations. Pavlina Tcherneva did a paper last year regarding MMT and FTPL here:

    In short, FTPL considers the scenario where a govt doesn’t obey its intertemporal budget constraint, which is called “non-Ricardian” fiscal policy. They certainly have some things consistent with MMT, particularly that the govt is the currency issuer and the ultimate effect of deficits is inflation, not necessarily default. They do miss some important things, though, such as how interest on the national debt is (or at least can be) set (and the importance of the exchange rate regime for that) and the horizontal/vertical money distinction central to MMT.

    There’s a good deal of controversy among neoclassicals regarding FTPL, namely regarding the question of whether the intertemporal budget constraint can be violated (it revolves around whether this is an equilibrium condition or an identity, with pro FTPL arguing the former, and against arguing the latter). FTPL assumes that the fiscal authority sets the real primary surplus (which is a bit strange) and that the pricel level adjusts accordingly. The papers in the literature are rather lengthy and theoretically dense; the shortest, clearest intro to FTPL I’ve seen is by John Cochrane here:

    Note that MMT does not suggest that the fiscal authority does, should, or can violate the intertemporal budget constraint. Instead, it argues (1) the interest on the national debt is or at least can be a policy variable, so the supposed inflationary consequences of rising debt coming from unbounded growth in debt service don’t need to actually occur (see my paper “interest rates and fiscal sustainability” at cfeps for this) and (2) the MMT-preferred approach to fiscal policy-functional finance-is actually intertemporally balanced or is in other words actually “Ricardian”; Godley and Lavoie demonstrated this here ( even though they actually don’t specifically discuss this point (they simulate a functional finance fiscal policy accompanied by high interest rates and show that this doesn’t create unbounded growth in debt service . . . they’ve made a few assumptions to get this result, but I don’t think changing those would change anything of consequence). Marc and I discussed this a few months ago and he agreed. Pavlina and I have been planning to do a paper together that elaborates on all of this but again have too many other things going on for now.


  4. JKH,

    Not qualified to speak too much about it plus don’t mean to interrupt your conversation with Bill but here is what I have to say:

    The fiscal theory as far as price level is concerned, is very different from MMT as you have put it. I also looked into Michael Woodford’s work briefly on the “Fiscal Theory of the Price Level” since he seems to get the Fed operations right, looks at the combined liabilities of the CB/Govt. which Bill does frequently in this blog. (Digressing: he seems to get it that the private sector uses the unit of the Central Bank’s liability but says somewhere that he can’t find the reason, just missing Chartalists’ basic principle)

    One way to contrast neoclassical authors and Modern Money authors is that the fomer always talk of “agents” maximising some utility functions. They seem to ignore the “Flow of Funds” and balance sheets of the various sectors of an economy. Assuming that a Modern Money scholar is speaking to an audience which understands reserve accounting, she or he may explain the government sector’s interaction with the private sector in the following way:

    “One sector’s deficit is another’s surplus. If we slice the economy into the government sector and the private sector, the government sector’s deficit is the private sector surplus and vice versa. This is at the level of flows – if we include stocks as well, the private sector’s financial assets is equal to the public debt. The private sector also holds real assets which have no liability. The public debt, however is not really under the control of the government. It depends amongst other things, the propensity to save. When the private sector saving desire is satisfied, it increases consumption but it also leads to higher taxes. It is the behaviour of the private sector which decides the government debt. However this is not guaranteed to provide full employment to the private sector because they have their financial constraints. The future is uncertain and depending on the future generation, the public debt can move in either direction compared to the GDP and it is just a number. Prices are the result of a complex struggle between capitalists, workers and rentiers. However, fiscal policy can play an active role in both full employment and price stability.”

    Now of course you know all this but why I am I saying this ? The reason is that there is no talk of surplus. There is no PVing uncertain quantities from the future. Imagine this situation – slowly the new generation which is yet to start working decides to have a culture of saving. The public debt will zoom though its not a problem – just a number. After a while, another generation arrives and has a different culture and the public debt goes down. It is totally outside the control of the government – unless if the government goes into a deep fiscal austerity mode. But then, it will lose the next election!

    So NPVing future government surpluses(!) seems weird to me. I think Woodford even talks of the government being in deficits forever, so I don’t know why this school of thought talks of surpluses. Maybe “primary surplus” is the technicality? At a judgement level, I think they seem to just fall prey to the notion that “something has to be returned”.

  5. My previous argument implicity assumes taxing wage increases higher than productivity growth.

  6. I am not trained in economics, so I am not familiar with how governmental “intertemporal budget constraint” is used technically. What appears to me from looking up the term is that it is based on an analogy with nongovernment finance, which is, of course, contrary to MMT’s verticality. In addition, IBC seems to not to be technically specified but is left rather open-ended. This looks suspiciously like a norm intruding.

  7. Greg, It is also my experience is that most people don’t easily get the vertical/horizontal distinction. I don’t know why that is, but there is definite resistance akin to emotional attachment. As I recall, this distinction was fundamental to the Bill/Steve Keen debate, too.

  8. Yes, Ramanan is correct about the stock/flow consistency issue.

    However, there is a point to the intertemporal budget constraint. Namely, if the interest rate on the national debt is greater than nominal GDP growth, then the PV of future primary surpluses has to equal the current national debt in order for the debt ratio to stay constant. (Again, this is explained in detail in the cfeps paper I noted at 12:09.) Of course, a constant debt ratio isn’t necessarily all that important, but exploding debt service is potentially inflationary. However, the basic assumption that interest rate on the debt is greater than nominal gdp growth, taken for granted by neoclassicals, misses the fact that the rate is a monetary policy variable (or can be) under flexible exchange rates (witness US now and Japan the past few decades with large deficits and interest rates remaining fairly anchored to the cb’s target). Indeed, the US on average since 1940 has had the averge interest rate on the debt LOWER than nominal GDP growth (the only exception was 1979-2000, when the Fed obviously pursued a policy of keeping the target rate above nominal GDP growth on average). And, as with any constant growth rate formula, if the growth rate is smaller than the interest rate, then the formula becomes meaningless; much the same becomes true with the intertemporal budget constraint.

  9. Dear Detroit Dan

    Good question actually (it is hard to pin down in exact words):

    A beat up is slang for “making a mountain out of a molehill” (but with a malicious angle to it) – which sort of means that you try to make something appear more important than it is and attack it to score points.

    Usually used in the context of a “media beat up” where there is really no story of any substance to be told but they splash the front cover with some report anyway.

    best wishes

  10. Hi Scott,

    Very interesting. In the G&L model, people do not seem to save more in order to pay more taxes later and continue consuming but this leads to higher taxes later because of higher economic activity, rather than a tax rate increase. So it is quote-unquote-Ricardian. The asymptotic nature is interesting as well. Instead of the government retiring some debt when it goes into a primary surplus, it continues paying interests and it is such that interest payments = primary surplus

    Michael Woodford seems like an interesting person though he is a neoclassical. In this paper he talks of pegging the yields in wartime. So unlike other neoclassicals, he seems to know that it can be done.

    I however, don’t understand “non-Ricardian” in this sort of terminology. Any example you have?

  11. Hi Ramanan

    Non-Ricardian just means you don’t try to keep the debt ratio stabilized, basically, or, in other words, that you violate the intertemporal budget constraint. In the G/L paper, the functional finance is Ricardian because interest on the national debt, and thus the debt ratio, stabilize. How? What’s actually happening is because interest on the national debt is affecting spending, as soon as agg spending is stabilized at full employment GDP the deficit stops rising. Ultimately, the govt in G/L is running primary surpluses, even if there is an overall deficit, such that the debt ratio stabilizes. If you need me to be more precise, let me know. None of this is explained in G/L’s paper, but that’s what’s happening. The link with Ricardian Equivalence, which you are describing, is the govt’s primary surplus/deficit does change in the long run to stabilize the debt ratio.


  12. Thanks for the help with “beat-up”. I look forward to a post on the case for global rebalancing, even if it is largely a beat-up.

    I also enjoyed the discussion of monetary policy and interest on the national debt…

  13. Woodford does know central bank operations better than most, and has for some time. The problem is that, like others in the DSGE tradition, he ignores the financial system and stock/flow consistency. Charles Goodhart has done some of the best critiques of DSGE, particularly with regard to the transversality condition in those models, which makes the assumption that all private sector agents pay off their debts and never default (which means everybody’s debt is risk-free). It’s truly amazing to me that over the last few years we haven’t heard hardly any (if any at all) neoclassicals condemn DSGE models as Goodhart has with regard to this assumption at the very least. Woodford has never responded to Goodhart’s critiques in this regard, even though they have been in the same room together in at least a few instances when Goodhart was detailing his objections. And Woodford did respond to or at least acknowledge other points Goodhart made in the same papers, but never to his critique of the transversality condition (at least to my knowledge, though I haven’t kept up with this for about a year now).

    As an aside, note how neoclassical models assume the private sector never defaults, but the currency issuer can. It’s not very difficult to understand how the profession missed the buildup of financial fragility the past several years, and the fact that they can’t abandon these models keeps them from seeing the solution.

  14. You are right Tom about the vertical horizontal distinction.

    I had never heard of that concept until I started exploring this and Warren Moslers site. Its just never been in the mainstream language. Getting people to question their notions about the financial system is the hard work that needs to be done. It does seem that slowly, maybe very slowly….
    ………….but surely there are some faint voices that are starting to be heard.

  15. Hi Scott,

    Thanks for your reply. Yes I understand your explanation of the paper. I have read and analyzed their work in the case where “p=1” (no price changes) so could browse through fast to get an idea of whats happening there – keeping your points in mind. So the simulated debt/gdp ratio in real terms converges to a value according to the parameters chosen but you are saying that the graph having a slight uptrend is also realistic – probably more realistic.

    I was going to remind Bill of the funniest para of 2009 – his take on “transversality” – taken his post GIGO:

    It means nothing that is germane to real life. It assumes we know everything out into the future and can discern economic conditions out there in time space and make decisions now that will maximise the outcomes over our lifetimes. I am sure you are all good at doing that. I get up each morning and consult the vector of prices and quantities in 2020 just to make sure all my plans today are optimal.

  16. Scott, thanks for pointing me to your paper showing how the IGBC concept is based on “sound money” as an arbitrary economic norm that is inappropriate in a nonconvertible floating fx regime.

  17. I liked this one from Michael Hudson on Krugman on Samuelson as a funniest of 2009, too.

    “In this respect Mr. Samuelson’s theories can be described as beautiful watch parts which, when assembled, make a watch that doesn’t tell the time accurately. The individual parts are perfect, but their interaction is somehow not. The parts of this watch are the constituents of neoclassical theory that add up to an inapplicable whole. They are a kit of conceptual tools ideally designed to correct a world that doesn’t exist.”

    Elegant Theories That Didn’t Work

  18. Hello, I’m new to this blog and MMT in general; Tom Hickey and another individual who calls himself Zanon over at Simon Johnson’s website, “The Baseline Scenario,” introduced me to some of the basic concepts a few weeks ago (so far I’ve taken three Saturday Morning quizzes and got a 3/5, 4/5, and 5/5). As a fairly recent college graduate who took quite a few economic history courses along with a fair bit of economic theory as well I find it more than a little disappointing that I had never even heard of MMT until having the basics explained to me in the comments section of a popular blog (and I went to a pretty good American university too). So far I’m really enjoying learning about MMT, but there are a few things I’m having a little trouble with. As this post is mostly about private, public, and current account surpluses/deficits I will confine myself to questions about MMT’s views on debt.

    In your post above you write: “(reducing private debt) requires that governments run deficits and provide the income growth necessary to allow the private sector to save.” After reading several previous post, especially “On voluntary constraints that undermine public purpose,” I think I understand the basic idea that MMT considers “public sector deficit spending = private sector savings,” to be an accounting identity. Conceptually I get it, but I was wondering if anyone could point me towards some hard evidence showing the existence of this identity? Something like a graph overlaying private and public sector debt levels over time. Also, what about the example of the Clinton years? During Clinton’s two terms weren’t there government budget surpluses, increases in real wages for most workers, and dramatic increases in corporate profit margins? How does that square with MMT claims that public sector deficit spending must equal private sector savings as a matter of principal? Am I misunderstanding the accounting identity or would proponents of MMT claim the gains of the mid 90’s should be considered mostly the illusory result of a leveraged stock/credit bubble?

    The other question I wanted to ask was about debt and inflation. Modern Money Theorists seem to be arguing that since public sector deficit spending funds private sector savings inflation is largely under the control of the central bank. If by some miracle private commercial and investment banks suddenly started lending out the billions in reserves they are sitting on today the federal reserve could just suck all the money out of the system by raising the federal funds rate, selling bonds in open market transactions, or some other such mechanism. The fact that big commercial banks are not lending out their reserves seems to be prima-facie evidence that inflation is not a threat, and therefore government should engage in some sort of fiscal policy response, be it direct job creation, a pay-roll tax holiday, or something else, to make up for the gap in private sector AD. But what if the problem was a more permanent loss of productive capacity caused by a supply shock? Isn’t that the Austrian malinvestment story? We built all these useless houses and now the nation is poorer? If we start deficit spending in an environment where our capacity to produce goods and services has been seriously impaired then the result will just be inflation. Not that I believe a word of it. Everything with the Austrians seems to be about penance and suffering, a very Malthusian world view (very fitting that Malthus was a Parson; I wonder if there have been any surveys asking about the religious views of Austrian economists). I guess my question is what evidence could one use to determine the kind of recession we find ourselves in now?

    Lastly, I just want to say thank you to Professor Mitchell for creating this blog. This is probably the most interesting discussion of economics I’ve encountered since reading “The Worldly Philosophers,” by Robert L. Heilbroner as a Freshman in College. Keep up the great work.

  19. NKlein . . . not to pre-empt Bill, but if I may . . and good questions!

    Regarding “hard evidence” you might look at the “Strategic Analysis” section at, as they have used this accounting identity since the late 1990s to assess the US private sector. Also, I did a post here ( that provided the data and also described the fundamentals of the approach.

    Regarding central banks and inflation, Bill did a couple posts a few weeks ago here ( and here ( that addressed the issue at length. I also addressed the issue this summer here ( and here ( In short, banks don’t lend reserves (except in the federal funds market, but this is mostly to meet reserve requirements where applicable and clear/avoid overdrafts), actually, so you are missing the mark from the start (again, no worries . . . we’re here to help!). Instead, loans create deposits while reserves are primarily used to settle payments. Again, this is all explained in the links I’ve provided.


  20. Thank you very much for your response Mr. (Dr.?) Fullwiler. Your post with the graph overlaying changes in private sector savings rates with changes in the deficit was exactly what I was looking for. I think I’m going to have to read the post a few more times though before I can fully understand how to reconcile the increasing real wages, corporate profit margins, employment levels, etc…of the 1990’s with the dramatic decrease in private net savings depicted in the graph. Just two small questions, how are you measuring “private net savings,” and where does the historical data you use come from?

    In regards to my second question, I just finished the “Building bank reserves is not inflationary,” post and while I think I understand the mechanism by which central banks introduce currency into the broader economy I still have some questions about the implications of introducing that new currency into the economy. I probably did not express this well in my comment above, but what I was trying to get at was that regardless of how the newly created reserves enter the broader economy isn’t there a chance the creation of new money could cause inflation? I get that regular commercial/investment banks don’t lend out reserves (I think this is part of the whole vertical/horizontal relationship between the public and private sector Tom Hickey was trying to explain to me on the Baseline Scenario), but if the federal government were to create new money, either via direct fiscal stimulus or indirect monetary policy (crediting commercial banks $1 trillion in additional reserves for largely worthless mortgage backed securities for example), couldn’t that lead to inflation if the U.S. economy’s productive capacity had been impaired (what my intro to economics textbook would call an inward shift in the economy’s production possibility frontier)? And isn’t that the Austrian’s argument? The U.S. is less productive than it was before the economic crisis, and it will continue to be less productive until the malinvestment is purged. There may not be any nominal constraints on the government’s ability to print money, but at some point if you continue to spend in the face of reduced productive potential there’s going to be inflation, no? I don’t think that’s going to be happening anytime soon, but how would a MMT judge whether or not an inflationary episode is imminent? What criteria do you use? TIPS spreads? Long-term bond yields? The Austrians would probably make fun of you by saying the tooth fairy.

    One last thing. I’m a high school social studies teacher and I sometimes teach advanced placement (intro college level micro/macro) economics to twelfth graders. Do you know of any relatively non-technical textbooks that incorporate a MMT perspective into the curriculum? As I get a firmer grasp of the fundamentals I’d like to incorporate some of what I’m studying here into my class (assuming my A.P. lets me). In your post where you overlay changes in private sector savings rates with changes in the deficit you mention the book “Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth,” but is that a textbook? I’m really not looking for anything too complicated; I want to say that’s because I don’t want to confuse my students, but to be honest it’s probably more for my own sake than anyone else =)

  21. Hi NKlein

    Please feel free to call me Scott. Regarding net saving, etc., start with this paper ( as it goes into the derivation of the identity, which comes from the NIPAs. Feel free to ask questions on the blog post there or here (Bill did a piece on the same topic about the same time that I linked to in my post . . . you might read that over to get more questions answered, and it might be an appropriate place to post questions you might have).

    I’m short on time, so will leave your other questions to others. The short answer to the second question is that, yes, government deficits or creation of bank credit for the purpose of spending can certainly result in inflation, though we’re nowhere near that danger now, obviously. Putting this into the graph from the post in your first question, govt deficits shifts the GSFB(-) line right, and credit expansion for spending shifts the NGFB(+) curve right. I know you had more detailed questions than that here, but I have to stop there for now.


  22. I just want to be clear about how I’m using the terms “new money,” and “reserves,” here. Prior to the financial panic commercial/investment banks had large amounts of mortgage backed securities on their balance books. These securities counted as assets. Suddenly the value of these assets crashed and the treasury exchanged these bad assets for new securities. I’ve been considering that money creation. Treasury and the Fed purchased those mortgaged backed securities in the hope that recapitalized banks would start to lend again.

    MMT considers this thinking wrong-headed. Banks are not reserve constrained, they can go out and lend to anyone they consider to be a good credit risk and borrow from the Fed later if they need to meet their reserve requirements. The problem now is that for some reason the banks aren’t considering anyone a good credit risk (probably because the Fed is paying the banks interest on their excess reserves and short-term nominal rates are so low they can get a better deal playing the temporal arbitrage game). The point I was trying to make is even if the government were to bypass the banks completely (by dropping money out of helicopters for example), couldn’t that still lead to inflation if the economy’s productive capacity had been impaired. In my comment above I think I was using the term “reserves,” incorrectly, at least from a MMT point of view. I’m going to have to work on re-learning vocabulary if I’m going to be posting here I guess.

  23. Hi NKlein . . . quickly, and sorry for brevity

    “MMT considers this thinking wrong-headed.”

    It’s not MMT, really. It’s accounting and real-world bank operations.

    “Banks are not reserve constrained, they can go out and lend to anyone they consider to be a good credit risk and borrow from the Fed later if they need to meet their reserve requirements.”

    Banks aren’t reserve constrained, but they are capital constrained. If there are a bunch of bad loans, that eats up capital and regulatarily banks are limited by their capital in expanding their balance sheets. Problem is, nearly everyone thinks the reserves matter, so that’s why you see our focus there. But you can’t forget about capital.

    “The problem now is that for some reason the banks aren’t considering anyone a good credit risk (probably because the Fed is paying the banks interest on their excess reserves and short-term nominal rates are so low they can get a better deal playing the temporal arbitrage game). ”

    Fed paying interest on rbs has nothing to do with it because BANKS DON”T LEND RESERVES. They’re earning virtually nothing on the rbs anyway (0.25%), so it’s not like the early 1990s when they could sit on Tsy’s earning over 7% to rebuild their capital. But even if they did “sit” on rbs or Tsy’s, our point is this doesn’t mean operationally that they could lend more if they didn’t “sit” on them.

    “The point I was trying to make is even if the government were to bypass the banks completely (by dropping money out of helicopters for example), couldn’t that still lead to inflation if the economy’s productive capacity had been impaired.”

    Yes, obviously, if you spend beyond the productive capacity.

    “In my comment above I think I was using the term “reserves,” incorrectly, at least from a MMT point of view. I’m going to have to work on re-learning vocabulary if I’m going to be posting here I guess.”

    Again, it’s just the actual accounting terminology, not anything particular to MMT. Since financial transactions affect financial statements, we’re just using the actual correct vocabulary for describing that. Unfortunately, most don’t given economists strange avoidance of accounting.


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