The complacent students sit and listen to some of that

Today I have been working in the Australia’s national capital Canberra. I have been discussing the work I am doing to develop a new geography for Australia based around the concept of functional economic regions with the Australian Bureau of Statistics which is currently seeking to revise their own geography along similar lines. You can find out about this work if you are interested via the CoffEE Functional Regions homepage. It will provide you with quite a different perspective on my other research interests beyond macroeconomics. Anyway, on the plane I was reading some monetary analysis and recalling a blog from the weekend by our favourite (not!) macroeconomics textbook writer. I started humming Take the power back to myself as I considered the damage this sort of textbook is doing to the minds of our students and the future policy makers.

The title credit for today’s blog comes from Rage against the Machine – Take the power back – sing along with it – get angry – mount the rage!

In the right light, study becomes insight
But the system that dissed us
So called facts are fraud
They want us to allege and pledge
And bow down to their God
The present curriculum
I put my fist in ’em
Eurocentric every last one of ’em
See right through the red, white and blue disguise
With lecture I puncture the structure of lies
Installed in our minds and attempting
To hold us back
We’ve got to take it back
We gotta take the power back
The teacher stands in front of the class
But the lesson plan he can’t recall
The student’s eyes don’t perceive the lies
Bouncing off every fucking wall
His composure is well kept
I guess he fears playing the fool
The complacent students sit and listen to some of that
Bullshit that he learned in school
We gotta take the power back
No more lies
No more lies

Now we can begin.

First, some background. In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.

In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.

The second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

The very next paragraph gets to the message he wants students to take away “because changes in the money supply can profoundly affect the economy”. Why? That is easy, “(o)ne of the Ten Principles of Economics … is that prices rise when the government prints too much money”. Please read my blog – Do not learn economics from a newspaper – for more discussion on why these principles are just an ideological brainwashing exercising.

Now if you were to learn economics from a course using this textbook and you passed your exams because you quickly learned that dissent was futile and it was far better to regurgitate the rote-learn back to the mindless lecturer dishing the stuff up – then where would you be? Would you be fully prepared to contribute productively to society and use your economic knowledge to advance public purpose?

The answer is clear. You would be no-where other than confused and economically illiterate. You would be ill-equipped to say anything sensible about how the actual monetary system operates.

The other problem is that there is a high probability that you would also have gained some anti-social tendencies. There is a strong research literature that demonstrated that when economics students are asked to play the prisoner-dilemma game (where cooperation generates the best overall outcome) they take the selfish (inferior) option more often than other students. They also are more selfish at the end of their economics studies than before they started. (a good reference to some of this work is Frank, R.H., Gilovich, T. and Regan, D.T. (1993) ‘Does Studying Economics Inhibit Cooperation?’ Journal of Economic Perspectives, 7(2), 159-72).

Learning economics from books like Mankiw not only is an exercise in deception but also changes personalities and leads to behaviour such as we saw in London last April when the highly paid bankers taunted G-20 protesters targeting the RBS by waving ten pound notes at them from out the windows of their offices. Psychologists have concluded that mainstream economists display the same sort of antipathy towards their fellow citizen as sociopaths.

So it is very important that … “we gotta take the power back”

The fact is that in a modern monetary system, central banks do not and cannot control the money supply. So why would you make this myth a centrepiece of the chapter on central banking in your textbook? The clue is that mainstream macroeconomics wants to hang on to the Quantity Theory of Money as their explanation for inflation which allows them to sheet the responsibility for inflation back onto government.

In this way, they can advance the evils of inflation and advocate tight constraints on government policy. It is all part of the pro-market, small government ideology dressed up as economic theory.

In the 1980s, under the dominant influence of Milton Friedman and his Chicago loonies a.k.a. as Monetarists, policy makers convinced themselves that they could control the money supply as the textbook (including Mankiw’s) told them.

They had a growth version of the quantity theory (a rule of thumb) which in simplistic terms said that m(dot) = p(dot) + y(dot) where, m(dot) was the rate of growth in the money supply and p(dot) was the inflation rate and y(dot) was the rate of growth in real income. So if you were expecting real output growth to be 3 per cent per annum and you wanted inflation to be 1 per cent then the central bank had to restrict the growth in the money supply to 4 per cent.

This was the era of monetary targetting where the crackpots really came to the fore. Australia, in fact, was one of the first to embrace the Monetarist sham – in 1976 just after Malcolm Fraser stole the national government from Whitlam (to see what that was about go HERE.

Driven by the advice from a few rabid right academics (some of whom taught me when I was a student) and also an increasingly “monetarist” economics press, the government starting trying to contract the “money supply”.

They missed every target after 1978 and unemployment and inflation didn’t budge. But moreover the innovations in the banking system which accompanied the deregulation of the financial system – another neo-liberal agenda – further undermined their other agenda – the attempt to control the money supply. They were certainly a clever lot.

With the fall of the conservative government in 1983, the new Labor government (which really fine-tuned the neo-liberal assault on the economy while masquerading as the Workers’ party) maintained the belief in monetary targetting. But it was clearly futile and was finally abandoned in 1985. Then the next big obsession – inflation targetting started to take hold. We have had a bad run of it that is for sure.

The same experiments occurred elsewhere while the Monetarists held sway. They all failed. But given that crucial period of history where empirical realities completely killed a principle mainstream economics belief, you would have thought Mankiw would acknowledge it in his textbook. I couldn’t find one reference to monetary targetting in Mankiw’s text – yet he is trying to tell students that that is what central banks can achieve.

In a fiat currency system with flexible exchange rate, the central bank conducts monetary policy primarily by setting the short-term interest rate. The other operations that have been observed in the current crisis (the so-called quantitative easing) are rarely used strategies. The core day to day business of the central bank is to anchor the yield curve. It never seeks to control the money supply which it recognises is endogenously generated.

After outlining the role of the central bank, Mankiw then says:

So far we have introduced the concept of “money” and discussed how the Federal Reserve controls the money supply by buying and selling government bonds in open-market operations. Although this explanation of the money supply is correct, it is not complete. In particular, it omits the central role that banks play in the monetary system.

What follows are several pages outlining the money multiplier where a bank “loans out some of its reserves and creates money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

Even Mankiw’s depiction of open market operations as a central bank vehicle for increasing the money supply is erroneous. As noted above, his students are taught that the central bank purchases government bonds from private banks for “cash” which then expands via the money multiplier (the fractional reserve model).

However, what really happens when an open market purchase is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.

One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.

The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.

The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.

The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.

Please see the following blogs – Deficit spending 101 – Part 1Deficit spending 101 – Part 2 and Deficit spending 101 – Part 3 – for further discussion about these points.

Which brings me to the latest Op Ed from Mankiw in the New York Times (January 16, 2010) entitled – Bernanke and the Beast.

Before you read the article please read these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further information.

Mankiw has been reading his own textbook too much I think. His opening gambit is:

IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.

Let’s start with first principles. One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.

A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.

As our friend Ramanan said the other day – this is scary stuff.

Mankiw has to stir the emotions first to make sure all the Pavlovian reactions are primed. So how better to continue this theme but by wheeling in those hoary old mainstays – Weimar and Zimbabwe (which is the new Weimer). He tells us:

Those two lessons go a long way toward explaining history’s hyperinflations, like those experienced by Germany in the 1920s or by Zimbabwe recently. Is the United States about to go down this route?

I urge you to read the blog – Zimbabwe for hyperventilators 101 – to see how misconstrued and trite this statement is. In both cases, a severe contraction in aggregate demand was required to avoid nominal inflation because there was a massive supply side contraction (scrapping capacity etc).

The current situation in the United States or most other places I know is not remotely like those specific country situations that are continually but wrongfully paraded before us as truisms.

It is here that Mankiw starts to get caught up in the mindless mechanical application of his textbook theory. He notes there are “large budget deficits and ample money growth” and cannot resist saying “Such a large deficit was unimaginable just a few years ago”.

Yes, the swing in the world economy which has driven the automatic stabilisers into delivering the current deficit outcomes (notwithstanding the discretionary increases in net spending as well) were “unimaginable” a few years if one was beguiled by the neo-liberal Chicago line that the “business cycle is dead”.

The mainstream mantra continually was telling us that the self-regulating market would be stable and deliver unprecedented wealth to us – just as long as government butted out and left the “boys” alone do their work (most of these economists are “boys” given the blokey sociology of the profession).

But from a modern monetary theory (MMT) perspective the current deficits are not large or small but a necessary response to the decline in private spending. In most cases, the fiscal response has been inadequate if we are to judge the rise in unemployment as a sign that significant spending gaps still remain.

Mankiw then notes that “(t)he Federal Reserve has also been rapidly creating money. The monetary base – meaning currency plus bank reserves – is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years”.

Yes, bank reserves have risen because the central banks have been buying long-maturity assets under the quantitative easing programs and have been publicly claiming that this was a strategy to give banks more capacity to lend. It is hard to know whether they believe their own public rhetoric – some do some cannot possibly – but the claim was always false.

The only way quantitative easing may have helped increase bank lending was if it reduced long-term yields so much that investment opportunities began to look favourable. It is highly unlikely that this would have been a significant impact because expectations of likely returns on investment projects have been pessimistic.

The experience in the UK where the Bank of England has been obsessed with QE yet credit hasn’t budged indicates that it is more a dearth of credit-worthy customers than anything else that is curtailing lending rates. The banks never had a liquidity constraint. Loans generate deposits and the accompanying reserves follow as a matter of course – even if they are supplied by the central bank if all else fails.

So then Mankiw asks as if in disbelief:

Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t terribly worried about inflation. What gives?

What gives? The answer lies in an erroneous understanding of how the monetary system operates rather than any peculiar or perverse outcome. If Mankiw had bothered to understand how fiat currency systems actually operate and the way net public spending impacts on the “cash system” and how central bank operations work then he would not have posed such a question.

We have had none of the classic ingredients for high inflation. Unemployment is extremely high around the world, and capacity utilisation rates are low. Aggregate demand has fallen off a cliff and the budget deficits have largely risen as an indication of the flagging non-government spending.

Inflation (as opposed to price pressures in a particular asset class) becomes a problem when nominal aggregate demand outstrips the real capacity of the economy to respond to it in terms of increased production of goods and services. The rising budget deficits have only been partially filling the spending gap – we are nowhere near “overfilling” the spending gap.

As long as there are idle labour resources and unused capital the economy can continue to respond in real terms as firms facing largely constant costs in the relevant range of production seek new profit opportunities.

Further the rise in bank reserves was never going to be inflationary. We will return to this soon.

But Mankiw’s guess to his “non-problem is that:

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.

As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.

So “banks will start lending out some of their hoards of reserves”? Which planet does that monetary system operate on.

The role of bank reserves is to facilitate the clearing house or payments settlement. Bank reserves are the only acceptable vehicle for managing the final settlement of all transactions.

The unique value of bank reserves lies in their operational significance for monetary policy. The central bank clearly sets the interest rate and generally aims to ensure that the overnight (interbank) rate is equal to it. In this context, bank reserves dynamics impact on monetary operations and require the central bank to issue debt or pay a return on reserves to maintain control over its monetary policy target rate.

It also demonstrates that bank reserves are near-equivalents to public debt issuance a point that is lost to mainstream economists.

To understand why increasing bank reserves will not expand credit or introduce inflationary pressures into the economy you have to understand the operational aspects of the monetary system which are at the core of MMT and which mainstream macroeconomics fails to depict in any coherent manner.

QE is largely incapable of stimulating lending because lending is not reserve constrained. The clue is in understanding the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.

In normal times (that is, not during this significant economic crisis) monetary policy is “defined exclusively in terms of a short term interest rate” where the central bank signals that it will set a “policy rate” – this is the central bank’s estimate of the rate that will achieve its policy goals. However, the central bank then has to engage in liquidity management operations to ensure the target rate is maintained in line with what is called the “reference rate” (usually the overnight rate in the interbank market).

So the liquidity management operations provide technical support to the central bank in pursuing its target interest rate aspirations.

MMT allows you to understand, in turn, the link between the impacts of government spending and taxation that arise in the fiscal policy domain and the liquidity management operations. If you read Mankiw’s textbook and/or any mainstream macroeconomics textbook you will learn nothing about these links. The fact is that the standard textbook representation of monetary policy and fiscal policy is mis-specified and this leads to false conclusions about the impacts that each domain of policy has. A classic false conclusion is that fiscal deficits cause interest rates to rise.

Another classic false conclusion – apropos of Mankiw’s current worries – is that the rise in fiscal deficits and/or bank reserves will be inflationary. This misconception simply arises from a mis-perception of the links between the liquidity management operations and the impacts of fiscal policy on bank reserves. It also reflects a fundamental misunderstanding of the nature of bank reserves.

MMT tells us that when the government spends it credits bank accounts (or issues cheques which end up in the bank settlement system) and after the completion of the myriad of non-government transactions the manifestation is an increase in bank reserves. Conversely, when the government collects taxes it debits bank accounts (or accepts cash/cheques) and this results in a $-for-$ decrease in bank reserves.

These are vertical transactions between the government and non-government sector and thus create or destroy bank reserves – or net financial assets. Logically, when the government runs a fiscal deficit (spending is in excess of tax receipts), the impact on bank reserves is a net positive – overall reserves expand. Conversely, when the government runs a fiscal surplus (spending is less than taxation receipts), the impact on bank reserves is a net negative – overall reserves contract.

With that understanding, it is easy to understand how the liquidity management operations of the central bank, though separate from fiscal policy, are nonetheless, intrinsically linked to it.

Mankiw’s textbook would tell you that the link is created because the fiscal position adopted by the government “has to be financed”. However, that is a basic mistake and mis-contruction of the way a government of issue operates. It is the common error that mainstream macroeconomics textbooks make. A sovereign government that issues its own currency does not need to finance its spending. So the chapter in Mankiw on fiscal policy is another “lie”.

All the financial machinations (debt-issuance, taxation) that might look on the surface to be “financing operations” are in fact nothing of the sort. The rhetoric of the government might lead one to conclude that debt-issuance is a financing operation – but a basic understanding of the liquidity management operations tell you otherwise. There is a disconnect between the political stance of the government and its central bank and the reality of their daily operations..

The central bank sets the price of reserves that it makes available on demand from the commercial banking system. The interest rate that the central bank sets is largely independent of the amount of bank reserves in the system because the central bank can choose the method of remuneration it provides to banks for holding these reserves.

The central bank signals to the non-government sector what its current intended policy stance is – that is, the announced policy or target rate. They can buy and sell unlimited amounts of reserves at whatever price it chooses to set should this be required.

How does this work?

Whenever there are reserves beyond the minimum required for settlement purposes, the banks will seek to lend these reserves out in the interbank market to get a better return (above the support rate paid by the central bank, which could be zero). The competition among banks to rid themselves off excess reserves drives the interest rate down to the support rate but because it is a system wide excess the banks, themselves, cannot eliminate the surplus.

So in this situation, the clear implication is that the central bank loses control of its target short-term interest rate and has to intervene to choke of the interbank activity. Consistent with MMT, there are two broad ways the central bank can manage bank reserves to maintain control over its target rate.

First, central banks can buy or sell government debt to manage the quantity of reserves so that the commercial banks do not try to eliminate excess reserve positions in the interbank market. So it offers the commercial banks an alternative near-equivalent asset to the bank reserves which earns a competitive return. This asset is a government bond. So debt-issuance is properly understood to be a means by which the central bank maintains control of its policy target interest rate.

So the debt-issuance stops the interest rate from falling to the support rate in the face of budget deficits. Budget deficits per se do not put upward pressure on interest rates. The monetary operations associated with the liquidity management operations stop the interest rates from falling but that is a different matter altogether.

Importantly, debt issuance is a monetary operation to deal with the banks reserves that deficits add and allow central banks to maintain a target rate. Mankiw doesn’t tell his students anything about this essential monetary operation. Once you understand all that you will also grasp why the relevant chapters in mainstream macroeconomics textbooks and most of the so-called informed commentary on fiscal and monetary policy is erroneous in the extreme.

Second, the central bank may offer a support rate on excess reserves which overcomes the need of the banks to seek competitive returns in the interbank market. So in this case there is no need to sell public debt to the commercial banks. By setting the support rate equal to the policy rate the central bank is offering the equivalent to the a government bond to the commercial banks. The payment short-circuits any need the commercial banks have to eliminate their excess reserve holdings and they will happily sit with large stocks of reserves instead of seeking alternative interest-bearing assets (such as public debt).

The other important point to connect relates to the impact of fiscal policy on the reserves. We know that fiscal deficits create excess reserves. In this case, they create a dynamic in the liquidity (or cash) system whereby the interest rate is bid down via interbank market competition (as above). This forces the central bank to issue debt to the commercial banks (to drain the reserves) or pay a support rate equivalent to the policy rate if it wants to maintain that particular monetary policy stance.

Further, these liquidity management operations conducted by the central bank have no implications for commercial bank credit creation. Building bank reserves will not expand credit.

Many economists believe that an increase in bank reserves will expand credit and spending will expand too fast (relative to output) – the so-called “too much money chasing too few goods”. This was a common claim made in Japan in the late 1990s when Japan was supporting spending with rising deficits and running a zero interest rate campaign (by leaving excess reserves in the cash system). At the same time deflation was the problem and interest rates didn’t budge.

But the fear was that the expansion of bank reserves would increase bank loans and thus be inflationary – according to the erroneous logic that automatic links expanding credit with inflation. At the time, quantitative easing failed to stimulate lending in Japan and is currently failing to stimulate lending in the UK, for example.

The point is that quantitative easing is not really capable of stimulating lending. You have to understand the banking operations that link monetary policy to bank reserves.

Those who believe that the expansion of bank reserves provides banks with additional resources to extend loans assume wrongly that banks need reserves in order to make loans. So we have heard over and over again in the last period that the reason that bank lending is down is because banks are illiquid. So QE was seen as a strategy to redress this “illiquidity” and increase the banks’ willingness to lend.

This is the money multiplier nonsense again. It quite simply does not describe the system we live in. Bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.

Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. The loan desk of commercial banks has no interaction with the reserve management desk as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit.

The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.

So Mankiw’s “quandary” is in fact a non-issue and just a reflection of his own ignorance of the operations of the monetary system.

Mankiw, however, thinks otherwise:

For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.

And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well. Higher interest on reserves would discourage bank lending and prevent the huge expansion in the monetary base from becoming inflationary.

But will Mr. Bernanke and his colleagues make enough use of these instruments when needed? Most likely they will, but there are still several reasons for doubt.

First, the central bank can drain the reserves if it wants. So what? The real issues is that their existence doesn’t matter anyway.

Second, the central bank always had the “pay interest on reserves” tool available. Other central banks, such as Australia have paid support rates on overnight reserves for years (25 basis points below the policy rate).

Further, there is no necesary reason why interest rates in the US will rise as the economy recovers. The Federal Reserve controls these rates. If you read Mankiw’s text book you will come away thinking that the private markets (via some far-fetched IS-LM model) set the interest rate. In our monetary system it is the central bank that sets the rate at whatever level it wants. So as the economy recovers, it may push up rates.

Whether this discourages bank lending depends on the price the central bank chooses to provide reserves to the banks and the reaction of borrowers to the rising borrowing costs. In a growing economy with raised expectations of improving revenue flows it is unclear in normal movement ranges whether interest rate changes have much impact on aggregate demand at all.

But all of this presuposes that the existing (unusually large) stock of bank reserves is a problem that has to be dealt with to prevent inflation.

The fact is that there is no problem of the type that Mankiw is suggesting.

Mankiw then lists several reasons why inflation might be about to break out. He says Bernanke might like some inflation to drive down real interest rates. There are no grounds for assuming that is the case at all. It is one of those arguments often used with zero proof to support it.

Then he claims that:

… the Fed could easily overestimate the economy’s potential growth. In light of the large fiscal imbalance over which Mr. Obama is presiding, it’s a good bet he will end up raising taxes for most Americans in coming years. Higher tax rates mean reduced work incentives and lower potential output. If the Fed fails to account for this change, it could try to promote more growth than the economy can sustain, causing inflation to rise.

What exactly is a “large fiscal imbalance”? In relation to what? With the labour market delivering over 10 per cent unemployment rates and no sign of a significant reduction in the near future the only thing an informed analyst would conclude is that aggregate demand is deficient and given private spending is flat that conclusion leads to the obvious observation that the budget deficit is too small relative to GDP. If that is the “imbalance” he is referring to then I agree wholeheartedly.

Taxes might rise in the future but unless the US government falls prey to the deficit terrorists who insist (spuriously) that they rise to “pay for the deficit” the will only rise if there is a need to reduce the purchasing power of the private sector – to balance demand.

Further, I know his textbook has a section on the “damage” taxes have to work incentives but the well-crafted research literature has not been able to find such an effect. The only thing that will lower potential output will be a stalled rate of investment (both public and private). At present, private capital formation is very flat in most nations and one of the roles that the budget deficits have to play is to fill the spending gap now to increase investor confidence that a recovery will continue and offer them profitable opportunities.

It is obvious that if government policy “tries to promote more growth than the economy can sustain” inflation will result. Whether monetary policy can do that is moot. I don’t think changes in interest rate levels within normal ranges are an effective way to influence aggregate demand.

There is thus very little in his logic here that should convince anyone that inflation is lurking.

Mankiw then plays his final hand. It is pathetic:

Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.

So the “markets” don’t think there is an inflation threat. The data shows that deflation is more likely to be the problem. Yet, because the textbook says that inflation should be a problem (given fiscal and monetary settings) then “its hard for anyone to be sure”.

Nothing is certain that is for sure. But the fiscal and monetary policy settings are just a reflection of how far out of whack the non-government sector was allowed to get as a result of the religious belief that self-regulated markets would always deliver the optimal outcomes.

Once the spiral of private debt emerged helped along by fiscal austerity then we were bound to get a dramatic “correction” – and the policy settings are reflecting that. Indeed, not to put a finer point on it, the obsessive pursuit of budget surpluses and the sole reliance on monetary policy to target only one policy outcome (inflation) were the actual policies settings that were “so far outside the bounds of historical norms”.

Now the policy settings have reacted to that abnormal neo-liberal period and the adjustment is under way.

But if we really understand the operations of the monetary system as outlined above, we can easily dismiss Mankiw’s inflation fears. If increasing bank reserves doesn’t increase bank lending and the reserve are close substitutes for short-term government debt then how can they be inflationary?

To understand how inflation occurs you have to analyse the state of aggregate demand relative to productive capacity. Credit growth manifests as increased spending. In itself that is not inflationary. Nominal spending growth will stimulate real responses from firms – increased output and employment – if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.

So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity. Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).

Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.

But these processes have nothing to do with the existence of bank reserves. It also has nothing to do with any support rate that the central bank might offer on overnight bank reserves.

It is not the monetary policy setting but rather the final spending in excess of productive capacity that causes inflation. However, this would depend on how sensitive aggregate demand is to interest rate movements. A build up of reserves certainly accompanies a net fiscal injection but this has nothing intrinsically to do with what happens to spending growth in relation to the real capacity of the economy.

However, if interest rate changes do impact on spending such that low interest rates are more expansionary than higher interest rates, then a fiscal expansion and a zero interest rate policy will be stimulatory. But this is not the same thing as saying these policy changes will be intrinsically inflationary as is asserted by the mainstream. It just means that the extent of the fiscal injection that is required to achieve full capacity utilisation is reduced. The government always has the capacity to balance aggregate spending to match the capacity of the economy to absorb it.


I know I have covered these propositions before but they are so misunderstood that you cannot just leave them pass by each time. Repetition, repetition – a slow process of grinding away until more and more people get it. My blog is growing significantly in readership as the months go by and so regular repeating themes are a deliberate strategy on my behalf.

Mankiw starts by asserting a problem based on his erroneous textbook reasoning. It turns out to be a non-problem because the textbook reasoning was wrong anyway. As it turns out the data also supports the view that the textbook reasoning is wrong.

So then Mankiw invents some reasons why the textbook reasoning will ultimately turn the non-problem into a real problem. Of-course, these inventions themselves are misrepresentations of the system and so he just gets himself further in the mud.

He finally acknowledges the data is telling him something that his textbook understanding cannot cope with but soothes himself by making the inflation threat anyway. Fine, if that is how you get through the day!

But this is one of the worst Op Ed articles I have ever read. Given that, I would advise all economics students who are forced to use this macroeconomics textbook and those that are like it to demand the lecturer in charge of their macroeconomics course refund them the full purchase price and then immediately tender his/her resignation to the Vice-Chancellor or relevant at the university in question.

Students should start being outraged by the abuse of their intellects. Remember …

We’ve got to take it back
We gotta take the power back
The teacher stands in front of the class
The complacent students sit and listen to some of that
Bullshit that he learned in school
We gotta take the power back
No more lies

That is enough for today!

This Post Has 43 Comments

  1. Additional Quantum of Rage offering:

    The only utility of bank reserves is in their substance as settlement balances. A quantum of reserves as settlement balances is only slightly more useful than the same quantum of treasury bills that can be sold immediately for settlement balances. Indeed, with a central bank support rate in place, excess reserves begin to take on the effective duration and price characteristics of treasury bills. Bank reserves have virtually nothing to do with bank credit risk management, including all decisions on new loans where any degree of credit risk is involved. Mankiw is fundamentally confused in that he can’t distinguish properly between central bank reserves and bank (risk) capital.

  2. Bill,

    excellent! That is all in one place that I am going to print N times and distribute in the office. Not sure I would be already able to write it myself but at least I did not have question marks flashing in my head while reading. I think I am making progress 🙂

  3. I agree with you on all counts monetary however I disagree with you slightly on your views of fiscal spending to pick up the consumption slack. Money is just a medium for exchanging the goods and services produced by an economy. GDP is the (very flawed) way we approximate the production of our economy. The government sector currently accounts for 45% of the demand for goods and services. If you take away the redistribution portion (transfer payments, interest) that number is 32%. Where we may differ, depending on the specifics of the spending, is in our judgement of the effectiveness of that 32% of government spending as well as the equity and incentives provided by the other 13% of transfer payments and interest.

    I am of the opinion that, much more often than not, government allocates resources much more inefficiently and with much less accountability than the free enterprise system. That is not to say that there are not many examples of worthwhile public investments- The Eerie Canal comes to mind- but that for the many worthwhile public investments there are many more investments that do not produce a sufficient bang for the buck.

    Furthermore, I think you tend to mistakenly over-simplify the economy in just as the efficient market hypothesis disciples do with respect to assumptions about rational actors. You say there is excess capacity in the system and so govt has to step in and fill that void with G. But what is that capacity? If there are a large amount of mortgage brokers, real estate brokers, homebuilders, and car salesman out of a job should the government really step in to employ these people in their old positions? If a lack of demand for sky-scrapers, shopping malls, and hummers means overcapacity in steel, should we not let those resources be used for other purposes? And do we have any way to predict or plan what those other purposes will be?

    Economic progress- growth- is the result of the interaction of millions of individuals cooperating with each other in pursuit of their own enlightened self-interest. By advocating more government involvement (or, alternatively, corporate welfare) you are advocating an economy geared towards Big Men (Google it) and not a more egalitarian horizontal structure. My assertion is that the combination of govt policy, fiscal policy, and poor monetary policy creates massive distortions and amplifies the business cycle. The latest multi-decade inflationary boom has so distorted the allocation of capital that the adjustment (deflation) necessary to reallocate capital and bring asset prices in line with cash flows is an extraordinarily painful one. But that doesn’t change the fact that a deflation is what is necessary (perhaps with a strong safety net) to reposition the economy for growth.

  4. Bill correctly says that quantitative easing has little effect because the resulting addition to bank reserves has little effect. An additional reason QE has little effect, seems to me, is that it does not change the total value of the private sector’s net financial assets.

    There was a witty article in the U.K.’s Guardian newspaper almost exactly a year ago making similar points to those made by Bill. See:

  5. Dear K

    Yes, the child will grow up (sooner or later) and realise that his/her statement in the third frame “there is no income to cover his costs” was something his father or mother had told him and they had studied economics using Mankiw’s textbook. The child will grow up and realise that a fiat currency issuing government is not revenue-constrained and “sooner or later” will feel that he/she was grossly mislead in his/her childhood.

    His childhood embrace of neo-liberalism will catch up with him and he will have a difficult period then feel the freedom of having achieved a better understanding. Meanwhile the budget deficits will go on supporting non-government saving desires and high employment levels.

    The cartoon shows great insight – thanks.

    best wishes

  6. “I know I have covered these propositions before but they are so misunderstood that you cannot just leave them pass by each time. Repetition, repetition – a slow process of grinding away until more and more people get it. My blog is growing significantly in readership as the months go by and so regular repeating themes are a deliberate strategy on my behalf.”

    Keep up the repetition. I am gradually understanding more of what you are saying.

    Mankiw’s textbook was used in my introductory University Economics class, so I have some learning to do.

  7. Outstanding. Thanks for this one, Bill. It puts so much of the core ideas behind MMT in one place.

    Keep grinding!

  8. Bill I don’t believe we can dismiss the possibility of increasing inflation rates.

    Your argument rests on the assertion that inflation cannot occur while there is spare capacity (unemployment) in the economy. How then do you explain examples where high inflation and unemployment occur together, such as in Venezeula today, or in many parts of the world in the 1970s?

    In Australia, we have never reached the level of full employment you define (2%) over the last 25 or 30 years, and yet we have experienced persistant generalised price inflation. It is clear (to me) that there is another factor which influences the price level (to a greater or lesser extent and over the long term), and that is the quantity of money.

    For example, consider the situation in Australia since the introduction of the $A in 1966. If you look at the year-on-year percentage change in the amount of currency circulating in the private sector and subtract the level of real GDP growth, the resulting series reasonably tracks the year-on-year change in the CPI.

    Now it could be argued that change in prices lead the change in money supply. That is, the amount of money circulating in the economy adjusts to whatever is required, and price changes are entirely determined by aggregate supply and demand….but where is the evidence for this? I don’t know the answer, but I believe there is some evidence that growth in money the supply enables price increases.

    Is it correct to say that the level of bank reserves have no bearing on the level of bank lending? As you point out capital requirements rather than reserve requirements are the way banks are now primarily regulated. Under these capital adequacy requirements I reserves are considered to have zero risk weighting, like government bonds. So isn’t it fair to say that large excess reserves enable banks to expand lending if they desire?

  9. Gamma,

    Your argument rests on the assumption that we have fixed exchange rates, a gold standard, and that the the loanable funds framework is somehow relevant in a modern money economy.


  10. No Alan, I’m not assuming anything like that. But if you have an answer to any of my questions I’d love to hear them.

  11. Gamma,

    If you are talking about 1966 then it’s implicit that you are talking regulated banking, Gold standards, fixed exchange rates and a loanable funds framework as well.

    Rather than listen to me why not just read as much as you can from the Coffee website and perhaps some writings from the mainstream and simply make up your own mind.

    Right or wrong usually doesn’t come into the equation for most people anyway.

  12. Gamma,

    To understand “money supply” you have to understand how bank loans work. If you lend me $100 and if we have an account at the same bank, the bank just reduces your deposits by $100 and increases mine by $100. So far, so good. However if the bank lends me $100, it doesn’t have a secret account from which it moves the $100. It just increases my deposit at the bank by $100 and in exchange, takes my signature on a piece of paper and records it as an asset worth $100. It doesn’t “give” the money which others have “given” the bank. Others who have a bank account still have what they have. So an act of lending increases money supply. This has nothing to do with what its reserves position is. Banks in most countries have a reserve requirement but banks lend first and then look for reserves. The market for reserves cannot by itself create reserves – some part of it is required and the rest excess but the total amount of reserves cannot be changed by banks. For this to happen, the central bank and the Treasury have to make financial transactions. Banks know that they will always get the reserves from other banks or the central bank. The central bank cannot refuse to lend reserves to banks because if it refuses, the overnight rates move higher and what the central bank has promised the markets will be questioned.

    Most central banks will refuse to accept this openly thinking there is some stigma attached to it, whereas in reality there shouldn’t be actually! It cannot be otherwise.

    The other thing is the belief that if interest rates are higher, borrowing will be less. This is completely false. Borrowers worry less about interest rates and more on the return. If I have an art exporting company, and need to borrow money to ship, I am indifferent to whether the loan rate is 5% or 8% – I am worried if it will sell. Bank lending is always demand led. The “supply of money” is actually a misnomer. Demand creates supply and not the other way round. There can never be an excess of money.

  13. Ramanan, thanks for your reply.

    There are no minimum reserve requirements for exchange settlement account holders with the RBA.

    Capital adequacy requirements have replaced reserve requirements in regulating the banking system in Australia. These requirements effectively mean banks are required to hold a portion of their assets in the form of highly liquid assets such as Commonwealth government bonds, semi-government bonds and cash balances at the RBA. As the RBA only pays the cash rate target minus 25bps on balances held, banks tend only to keep a minimum balance for the purposes of settling their daily transactions.

    But none of this means that banks do not have to source funds or deposits in order to continue their lending activites. If a bank were to make loans continously without sourcing funds, they could find their reserve account diminishing as the people they loan to make use of the funds. They would have to sell liquid assets to settle their transactions, and could end up in breach of their capital adequacy requirements.

    All participants in the market including the RBA are well aware of this process, I don’t think anyone is refusing to accept this reality.

    Now to get to the situation in the US of the Federal Reserve and the excess reserves (the Fed does impose minimum reserve requirements). US banks have effectively exchanged their less liquid and possibly impaired assets (mortgage backed securites) for cash balances.

    Here lies the potential for inflation. If lending opportunities start to occur in the US economy (I am not saying I necessarily think they will at any time soon), these reserves are available for lending at a current opportunity cost of 0.25%. I am definitely not saying that I think inflation is a sure thing, but I think it is quite possible. I’d like to hear your thoughts, what do you think?

  14. Gamma,

    Further, reserves vs. capital causes a lot of confusion. Some fraction of the reserves appear in the left hand side of banks’ balance sheets because of their sales of high-quality assets such as Treasuries to the Fed. It is just a replacement of one asset with another. Another fraction of reserves appear because of purchases of various securities by the Fed from firms who do not have an account at the Fed. This increases reserves and deposits in the banking system by an equal amount. The remaining fraction of reserves appear because of the alphabet soup of lending operations by the Fed. Again, this increases deposits and reserves by an equal amount. Remember deposits are bank liabilities.

    Just like banks are not reserves constrained, they are not capital constrained either. They make sure that they satisfy capital adequacy requirements by setting the loan rates such that they keep accumulating enough retained earnings and hand out good dividends to shareholders. Except in this crisis when capital “evaporated” – causing supply side issues. The US Treasury could simply have announced that Basel 2 is irrelavant for the next 5 years instead of causing so much drama with TARP.

    A good rule of thumb is: lending is demand-led

  15. Gamma,

    Yes, I know that there are no reserve requirements in Australia. So is the case with Canada, NZ and the UK. But again, bank lending is demand determined. You may think that it is an adamant stand but that is the way it is. Now – I have oversimplified this. However, you have to analyze the housing boom properly. “Demand-led” comes with an assumption that banks have been doing their creditworthiness checks correctly. Also, because of securitization, they just lend without checking anything! The markets thought that they are self-correcting and allowed all this and there was no regulation! Blaming low interest rates on the housing bubble is like blaming the invention of fire, in case of a fire.

    We are told so frequently that low interest rates create inflation that it has become a self-eveident statement. However, consider this: you have talked about banks’ costs – how about producers’ costs ? When interest rates are high, producers do not borrow less, instead raise prices because they want to pocket some amount of profits proportional to their sales. Higher rates lead to higher costs.

    I can go on and on, but you can check various blog posts and Bill has patiently written about almost all the aspects of the crisis. This is the only place where you will find the correct and ultra-detailed explanation of the crisis.

  16. Gamma – “They would have to sell liquid assets to settle their transactions, and could end up in breach of their capital adequacy requirements.”

    This is close to what occurred in the crisis. Except that the system shut down due to fears of liquidity – inability to trust a counterparty to maintain cash flow – regulators were NOT looking at capital adequacy requirements anyway.

    An insolvent bank – if allowed to remain a going concern by regulators – can loan and loan and loan to its heart’s content. This is Washington Mutual did – it was clearly insolvent but remained in business. Bank runs occur post insolvency – the bank operates until they are either shut down by regulators (somewhat orderly) or the market/public puts them out of business (no one will purchase a loan from them – NOT withdraw their deposits). Remember an insolvent bank, once known as such to the public will be unable to sell its assets to any other financial institution – the bank will stop lending because whatever capital remains will be at even higher risk (as well as legal ramifications or being strung up on a lamppost) – hence out of business. Hopefully regulators intervene before the market figures it out.

    Post crisis, reserves were increased to provide system liquidity/counterparty settlement capacity – they did little for solvency (added a little income and changed the risk profile a bit).

    Capital requirements are relevant to the extent that regulators review them and then do something. Investors in banks would like nothing better than to operate without any capital – infinite leverage.

    So capital position does not affect loan capability in absence of regulation – reserves can always be purchased at a cost (currently at a negative cost) – if the loan expected return exceeds the cost of reserves. Regulators want to see investors having something at stake to moderate risk. This assumes that insolvent banks will be closed and investors lose their capital. Don’t know if that is what we are going to see going forward (except for small banks in the US).

  17. Gamma,

    price is the result of real demand versus real supply. Surely demand can increase as well as supply drop and then you get price increase. But it can happen with as well as without excess reserves, with as well as without banks having enough capital, with as well as without many other things in financial system. How would you make a case then that _excess_ reserves are so critical to price increases, i.e. inflation? You argue about currency in circulation and yes, there is correlation. But any book on correlation will tell you that it does not mean causation.

    And the same process applies to deposits vs lending. Yes, there is correlation (because of balance sheet), but any bank can choose to attract deposits before it can lend (and these are typically called retail banks) or to lend and then match that lending with deposits (and lets call these wholesale banks though this one is a bit tricky. Northern Rock in the UK was clearly of this type). So deposits and lending are correlated but direction of causality is pretty much a business decision.

  18. Ramanan, thanks that’s an interesting perspective, although I can’t say I agree with everything you have said. I would agree that bank lending is demand-driven, although with some qualifications. Some particular types of borrowers (eg owner-occupier home buyers) are very sensitive to the cost of borrowing.

  19. Sergie, why do you only consider the supply / demand dynamics of goods and services and not those of money as well?

    I don’t claim to know with certainty what causes price inflation in all instances, but I am open to the possibility that the supply and demand for money could have an influence.

    There are so many examples where the aggregate supply / demand idea fails to adequately explain what has actually occured in real economies.

    For example in Zimbabwe, I understand Bill’s argument is that the inflation can be attributed to a contraction in output, without a corresponding decrease in demand.

    However the country exhibited huge unemployment at the time (which in the MMT theory is an indication of a LACK of demand). Obviously demand for discretionary goods and services would have been greatly reduced, while demand for essentials is unchanged.

    Ultimately the resulting inflation was far in excess of the decline in output. From 1999 to 2009 real GDP declined between 5% and 15% per year, while inflation was in the region of hundeds of percent per year, and in 2009 thousands of percent per month. The collapse in output alone, simply does not explain the level of price inflation.

    This is not to say that the Zim economy would not have been in dire straights if the hyperinflation did not occur. But is there any evidence that the massive increase in the money supply actually did anything to improve the situation?

  20. Gamma,

    The mainstream story is that the central bank prints money and the banks lend this out through a multiplier process. The government spends by taxing and borrows by issuing debt. The status of the government is thus reduced to that of a household. Since the government spending is supposed to have been financed, this is alright to some extent but it needs to be disciplined. Anything above 3% deficit is bad because there is some monetization and leads to inflation because the central bank reserves increase. Needless to say this is far from the truth! Its like a story some student hardly prepared for an exam would write.

    Mainstream economics also gets the non-fiscal issues incorrectly. When there is a supply shortage, central banking manipulation can hardly achieve anything! There is a huge increase in the prices of vegetables in India these days. Of course not comparable to Zimbabwe but some prices have doubled in no time. Thankfully, I haven’t seen any press report blaming it on the fiscal deficit. There are a few exceptions though – blaming it on the central bank liquidity. Everyone studies Mankiw! The explanation seems to be that the Agriculture Minister has a conflict of interest and he is doing some price manipulation. It has also led to some speculation and a lot of hoarding of many food items like sugar. Can a fiscal contraction or increase in central bank rates target do anything ? Obviously not!

    Its also amazing that the US Fed is said to have started “printing money” more than a year back and no inflation has happened yet. So they – Mankiws – have an explanation – the Fed pays interest of 25bps on reserves so it has just delayed it!

    Essentially what I am trying to say is that whats said here is not that just tinkering with deficits will solve all the world’s problems – there are so many non-fiscal things to be done as well and the present governments do not do it simply because the economic advisors with PhDs from Ivy League schools have no idea of how the world works. The government – because it is not revenue constrained – has so many options in front of itself such as making sure that there is never a supply shortage. The fact that the government is not revenue constrained is not so easy to understand and you can check various posts in this blog to understand that.

  21. Hi Ramanan
    I can see the producer side of the argument. What about the consumer side , doesn’t low interest rates entice consumers to take out loans for say purchases of houses or other consumables. Last year in Australia we had generous fiscal and monetary policies that encourgaed lots of young buyers towards home ownership. Some reports show that house prices have jumped in the 10 – 17% range in some areas, a sharp turnaorund from 2008 when prices actually fell. What is your view on that governments need to use both fiscal and monetary policies to suck out excess liquidity incase the government overspends or over stimulates, but in real life fiscal policies are populist, become entrenched and governments react too slowly to change them or dont change till election time. By then the damage is already done.


  22. Sergei, I agree that fiat money has a neglible cost of production. But it most definitely has a price and value (which can change over time).

    Don’t you think it’s possible that money itself might have a supply / demand dynamic that might come into play from time to time? For example, if your income rises you can choose to spend or save this additional money. The aggregate effect of how much money people want to save or spend could well have an effect on prices.

  23. Ramanan, I think there is a bit of inflation fear creeping back into the markets. I’m certainly not hoping for it, but that is my feeling, so keep you eye on breakeven inflation rates.

  24. Gamma,

    if I suddenly discover a source of fiat money in my basement then I will definitely try to spend it. If I win a lottery it is a one-off and not income. My income is dependent on other things (e.g. my contribution to the value added in the economy in a given period – read goods produced and sold by me) rather than some aggregate measure of supply of money in the economy. Value of my income comes from the things it can buy me rather than nominal size of monthly deposit in the bank.

    However, continuing with your supply/demand. You claim that high supply and low demand lead to inflation, i.e. “value” of money drops. Is it value of money as “store of wealth”? There is no value of money in the fiat money. We are not in the gold standard and it is by definition not possible to store wealth in the fiat money system. So what is that dynamic that you refer to?

  25. Gamma,

    “I think there is a bit of inflation fear creeping back into the markets” because everybody tells you the same. It is very difficult to be an outlier.

    ps. I think I am commenting too often and it is against the spirit of this blog to send one line comments. No more from me unless I have to say something really useful 🙂

  26. Dear All

    The value of the currency is dependent on what you can purchase with it in real terms. The problem at present is that governments, even though they are running against the neo-liberal tide to some extent, still have not put in a coherent nominal anchor.

    That is one of the functions of a Job Guarantee – because the government would ultimately be setting the value of the currency in this way. We know it can always purchase anything that is for sale in the currency of issue. However, if it competes in the market with other purchasers for goods and services at market prices then it runs the risk of pushing those prices up – unless it has a nominal anchor.

    By definition there is zero private demand for the unemployed and thus if the government offers it a job at a fixed price it immediately sets the nominal anchor in place. It can buy as much of these labour services as are available at that price and this disciplines the inflationary process. In the extreme case of a serious generalised inflation the government can easily redistribute labour from the inflating sector to the fixed price sector to curtail the price spiral.

    The current strategy is to redistribute that labour from the inflating sector to the unemployment scrap heap.

    Anyway, inflation is always a risk of pushing the economy towards high pressure – so it is better to have a nominal anchor in place to set the currency value.

    best wishes

  27. bill,

    I’m not quite sure what you mean by a nominal anchor, and also how the government can redistribute labour from an inflating sector to the fixed price sector.

    Have you written previously about this, or would you care to elaborate?

  28. Gamma,

    With a Buffer Stock Employment Model the government becomes an employer of last resort buying up unused labour at a nominal / fixed price below the federal minimum wage. Anchors anyone ?

  29. Another minor point on Zimbabwe. The collapse in supply goes beyond simply the unemployed – the lack of infrastructure, poor education, fragile trade relationships, external foreign debt, instability and insecurity all make for a situation where shocks cannot be easily absorbed.

    Where you have a country with a strong infrastructure and higher material output capacity (the Western world, Japan, much of Asia, South America), the economic shift from manufacturing to services allows a job guarantee great flexibility. Services do not generate cost shock pressures as easily – competition is high, consumers have more choices, there is a larger labour : capital ratio.

    So, with a job guarantee in a services-oriented economy, the wage component of inflation (which is all anyone cares about, that is why they exclude energy and food from the US CPI) is less fixed to external cost pressures, demand for labor doesn’t rise as quickly as raw material/intermediate goods during a cost shock. Non-cost shock wage pressures would be generated from market demand for particular services, where the government has better ability to shift supply.

    An example of this might be physicians, where government funding for medical schools or publicly-provided health care can be shifted to keep supply and demand more balanced. Where there are real material constraints (substantially controlled by private interests), the government has less control except as to the quantity of real resources purchased through government spending.

  30. pebird, so how would the job guarantee work in your example for physicians? How would the government induce doctors to move from the private system to the public fixed price system? Is this what you are suggesting?

  31. Gamma,

    “how would the job guarantee work in your example for physicians? How would the government induce doctors to move from the private system to the public fixed price system? ”

    Bill has never included physicians as a part of the Jobs Guarantee. If you bothered to read anything you would know this.

  32. Forgive me if I sound really ignorant (I’m a second year undergrad whose knowledge of macroeconomics stems mainly from reading Mankiw’s Macroeconomics textbook), but is there any particular reason why aggregate demand AND money supply growth can’t both be responsible for inflation?

    From my (poor) understanding, the contraction in demand that we’ve seen would lead to deflationary pressures, which could in theory, be counteracted by an expansion in the money supply.

    It’s slightly ironic that most of the lecturers at my university are self-confessed ‘post-Keynesians’ but use Mankiw’s textbook in their courses. Though we did do a bit on endogenous money supply,

  33. Shafiq,

    You do not sound ignorant. You sound like someone who is not convinced by what Mankiws text is teling you. Wanting to expand your knowledge is a good thing.

    With respect to your question.

    It’s not a matter of aggregate demand AND money supply growth not being responsible for inflation it’s more a point of inflation not being an inevitable consequence of them above everything else.

    The dynamics of inflation are far too complex (intractable) for us mere mortals to completely grasp / understand.

    That the Mankiws of this world think that such complex relationships can be explained using the age old quantity theory of money is laughable simply because it cannot explain which way the causation runs.

  34. Alan,

    Thanks for replying.

    The quantity theory did seem a bit too simple for my liking, but for the exam, I regurgitated everything anyway – you gotta do what you gotta do to pass your exams!

  35. “In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.

    “The second “and more important job”:

    “… is to control the quantity of money that is made available to the economy, called the money supply.”

    Mankiw leaves out the Fed’s mandate to hold down unemployment. Bernanke omitted that, too, in his testimony in his last reappointment hearing.

  36. This is an excellent piece, and it’s all *entirely* clear. I think the history of private creation of money, and today’s “shadow banking system”, is proof enough that the central bank cannot control the money supply.

    But perhaps *the government can*. It can control it through regulation, by prohibiting the creation of money-like substances, by shutting down banks which attempt to create too much money. This was the original purpose of the Office of the Comptroller of the Currency!

    It would be a fair point to discuss this. I personally suspect that an unresolved demand for money would invariably lead to some private money creation no matter how well regulated it was (quantity supplied is always demand driven, in nearly every market including money). But regulation might reduce private demand by deterring use of private money.. Agree?

    But anyway, your MMT point seems to be that the central bank *can* control the price of money (interest rates). Can it even do that? Does it have that much pricing power/? If so, why? It controls three main rates: the rate paid to banks on loans to the Federal Reserve, the very similar rate paid to banks on loans to the Treasury, and the rate at which the Federal Reserve loans money to banks.

    It can always drive down the rate at the “discount window”, but if the interbank rate drops below the discount window rate, how can it possibly drive rates up? Thinking out loud here: by raising T-bill rates so that banks will prefer to hold T-bills rather than lend to each other? In other words, in order to drive rates up, the government has to pay money to private investors?

  37. I would like to note regarding inflation that a number of South American countries lived fairly comfortable with continuing, steady, fairly high inflation rates. It doesn’t cause accelerating inflation, apparently. It’s just something you adjust to. It’s not clear, empirically, that there’ s any reason that a stable positive inflation rate economy is meaningfully different from a “steady money” economy. (A deflationary economy is in trouble as long as debts are nominal, but even if they aren’t it may suffer from rational hoarding. I can see no comparable problems with a steady inflationary economy, as long as everything ends up inflation-adjusted, except that the accounting gets more complicated.)

  38. pb wrote:
    “What is your view on that governments need to use both fiscal and monetary policies to suck out excess liquidity incase the government overspends or over stimulates, but in real life fiscal policies are populist, become entrenched and governments react too slowly to change them or dont change till election time. By then the damage is already done.”

    In real life, unfortunately, monetary policies are often *ANTI-*populist, driving wealth into the hands of lenders and driving average people into debt — they *also* become entrenched and governments react too slowly to change them or don’t change them until election time! We just witnessed that with the Crash of 2008!

    If we have the choice between two policies with the same political problems, one of which is populist and benefits the people, and the other of which isn’t and doesn’t…. hmmm.

    Of course, fiscal policy can also be anti-populist, and I present the Bush tax cuts and subsidies to agribiz as examples one and two.

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