Modern Monetary Theory (MMT) leads to the conclusion that a central bank could still increase interest rates even if the US government instructed it to directly purchase treasury debt to facilitate the national governments budget deficit rather than the treasury selling the debt into the private bond market.
Answer: True
The answer is True.
The question hinges on an unstated condition which relates to whether the central bank is offering a support rate on overnight reserves held with it by the private banks.
So what is the explanation?
The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.
So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on "excess" reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).
Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.
If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
So the fundamental principles that arise in a fiat monetary system which are relevant here are as follows.
Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.
Further, the idea that governments would simply get the central bank to "monetise" treasury debt (which is seen orthodox economists as the alternative "financing" method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary unless it is prepared to offer a support rate to the banks for excess reserves held. In the absence of that offer, once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetisation under these circumstances (no support rate). The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.
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Question 5 - Premium question
In Year 1, the economy plunges into recession with nominal GDP growth falling to minus -1.0 per cent. The outstanding public debt is equal to the value of the nominal GDP and the nominal interest rate is equal to 1 per cent (and this is the rate the government pays on all outstanding debt). The inflation rate is stable at 1 per cent per annum. The government's primary budget balance records a deficit equivalent to 1 per cent of GDP and the public debt ratio rises by 3 per cent. In Year 2, the government pushes the primary budget deficit out to 2 per cent of GDP and in doing so stimulates aggregate demand and the economy records a 4 per cent nominal GDP growth rate. All other parameters are unchanged in Year 2. Under these circumstances, the public debt ratio will rise but by an amount less than the rise in the budget deficit because of the real growth in the economy.
The answer is False.
The question relates to the key parameters and relationships that determine the dynamics of the public debt ratio. An understanding of these relationships allows you to debunk statements that are made by those who think fiscal austerity will allow a government to reduce its public debt ratio.
While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.
The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.
Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.
Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.
It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.
The mainstream framework begins with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be "financed" in two ways: (a) by borrowing from the public; and/or (b) by "printing money".
Neither characterisation is operationally necessary in a fiat monetary system.
The basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
However, in the mainstream framework for analysing these so-called "financing" choices the government budget constraint (GBC) is the central organising idea. The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments - Tax receipts must equal (be "financed" by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
However, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
Further, in mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money.
This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite - Deficit spending 101 - Part 1 - Deficit spending 101 - Part 2 - Deficit spending 101 - Part 3.
Anyway, the mainstream claims that if governments increase the money growth rate (they erroneously call this "printing money") the extra spending will cause accelerating inflation because there will be "too much money chasing too few goods"! Of-course, we know that proposition to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result.
So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.
But the mainstream claim that because inflation is inevitable if "printing money" occurs, it is unwise to use this option to "finance" net public spending.
Hence they say as a better (but still poor) solution, governments should use debt issuance to "finance" their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be "paid back".
Neither proposition bears scrutiny - you can read these blogs - Will we really pay higher taxes? and Will we really pay higher interest rates? - for further discussion on these points.
The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to "prove" that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the real GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
The real interest rate is the difference between the nominal interest rate and the inflation rate. Real GDP is the nominal GDP deflated by the inflation rate. So the real GDP growth rate is equal to the Nominal GDP growth minus the inflation rate.
This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to "safe" territory.
Almost all the media commentators that you read on this topic take it for granted that the only way to reduce the public debt ratio is to run primary surpluses.
MMT does not tell us that a currency-issuing government running a deficit can never reduce the debt ratio. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
So the real interest rate in our example is 0 (nominal interest rate = 1 minus inflation rate =1) which then leads to the conclusion that that the proposition presented is false.
A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r - g.
The following Table simulates the two years in question. To make matters simple, assume a public debt ratio at the start of the Year 1 of 100 per cent (so B/Y(-1) = 1) which is equivalent to the statement that "outstanding public debt is equal to the value of the nominal GDP".
Also the nominal interest rate is 1 per cent and the inflation rate is 1 per cent then the current real interest rate (r) is 0 per cent.
If the nominal GDP is growing at -1 per cent and there is an inflation rate of 1 per cent then real GDP is growing (g) at minus 2 per cent.
Under these conditions, the primary budget surplus would have to be equal to 2 per cent of GDP to stabilise the debt ratio (check it for yourself). So, the question suggests the primary budget deficit is actually 1 per cent of GDP we know by computation that the public debt ratio rises by 3 per cent.
The calculation (using the formula in the Table) is:
Change in B/Y = (0 - (-2))*1 + 1 = 3 per cent.
The data in Year 2 is given in the last column in the Table below. Note the public debt ratio has risen to 1.03 because of the rise from last year. You are told that the budget deficit doubles as per cent of GDP (to 2 per cent) and nominal GDP growth shoots up to 4 per cent which means real GDP growth (given the inflation rate) is equal to 3 per cent.
The corresponding calculation for the change in the public debt ratio is:
Change in B/Y = (0 - 3)*1.03 + 2 = -1.1 per cent.
So the growth in the economy is strong enough to reduce the public debt ratio even though the primary budget deficit has doubled.
It is a highly stylised example truncated into a two-period adjustment to demonstrate the point. In the real world, if the budget deficit is a large percentage of GDP then it might take some years to start reducing the public debt ratio as GDP growth ensures.
So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.
Stimulating real growth (that is, in Y) is the most constructive way of reducing the public debt ratio when there is unemployment.
But the best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn't have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.
The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio - which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.