Tuesday, January 10, 2012

A Critique of Modern Monetary Theory

My friend JP and I have been talking about Modern Monetary Theory
(MMT). You can see more about what its proponents believe here:

Or just google "winterspeak" or "warren mosler" for some MMT proponents.

In some ways, MMT is the weirdest economic model I've ever seen.
Fundamentally, it holds that the government determines net savings and
interest rates based on whether it runs a deficit or surplus, and thus
government deficits directly regulate inflation, unemployment and all
the other things we usually attribute to monetary policy. An ancillary
result is that banks are not constrained by their reserve levels, but
instead by the demand for credit, because they can always just get
reserves from the Fed.

The theory starts by saying that it's impossible to do net saving
unless the government runs a budget deficit, defining net saving as
savings minus investment.  This is functionally a measure of "money
lent to the government"; there's no distinction between money holding
government bonds and reserves because reserves are deposited with the
Fed, and all money that's put into private assets is ultimately
invested. The Fed can then influence the money supply and interest
rates by running  surpluses and deficits – when the government runs a
deficit, it injects money into savings and when it runs a surplus, it
pulls money out of savings.

There are a number of separate issues I have with the resultant set of

Firstly, I'm not sure they quite understand the behavior of interest
rates. In MMT, there's no such thing as "crowding out". When the
MMT-world government runs a deficit, they're injecting more money into
the system which chases interest rates down. In more mainstream
theories, when the government runs a deficit, they're "crowding out"
private capital. In other words, they're injecting more money into the
system, and that money chases the less-elastic supply of things to
buy, which causes inflation unless interest rates go up.

In mainstream economics, a negative supply shock increases inflation
and decreases production because you have more money chasing the lower
amount of supply, so you produce less and spend more on it. Similarly,
a negative demand shock decreases inflation and decreases production
because nobody wants to buy. For example, if velocity suddenly drops
because everyone is worried about whose assets are really worthless
(hello, late 2008) and wants to save cash for the upcoming rainy day,
then spending drops, production drops, and by forcing interest rates
down (and, at the zero bound, inflation expectations up), the
government gets money moving again and restores the economy. This is
Milton Friedman-style monetarism (and, more recently, Scott
Sumner-style market monetarism).

In MMT, however, there is an important assumption. More government
spending injects more cash into the economy, and for that cash to
drive interest rates down instead of up, that cash, on net, needs to
directly chase savings. If the injected cash is instead chasing
private economy goods, some portion of the injected cash will convert
to inflation (exactly how much would be determined by the short-run
aggregate supply curve). This creates a bizarre interest rate
condition – market floating interest rates must go down as inflation
expectations go up, holding Fed action constant.*

This doesn't line up with how investors behave – market floating
interest rates go up as inflation expectations go up (which makes
quite a bit of sense – if your cash is depreciating in real spending
value, you're going to demand a better return on your cash). The only
other possibility is that all the money injected by government
spending goes directly to savings because the private sector doesn't
seek to do anything else with it. That's an unintuitive knife-edge

The fundamental issue here is that MMT looks so closely at the
mechanics of "how banks deal with excess reserves" (selling them, thus
driving down interest rates) that they ignore the much more important
supply and demand sides (eg, prices are going up and there's more
demand for things, so I'll produce more and we won't need more

Secondly, and relatedly, I have issues with how they approach real
resource constraints and spending efficiency.

According to MMT, if there's a demand shock that decreases employment,
the government can just run a large budget deficit to drive down
interest rates.

This, unfortunately, ignores a lot of the effects of government
spending on the real economy.** MMT's prescriptions for dealing with
unemployment (run a large budget deficit) and inflation (run a large
budget surplus) completely disregard the efficiency of said spending
or taxation. MMT harps on this idea that "government deficits don't
matter because all you're going to end up doing is paying them off
with money that you either print or take out of the system." They
ignore the fact that the manner in which the money enters the money
supply affects the amount of real-resource damage you do when you pull
it back out again.

If the government pays people to dig ditches and fill them in again,
in MMT world, you're just injecting cash into the economy and forcing
interest rates down (which should stimulate credit creation). Even if
MMT were right about interest rates, the issues are at least twofold:

1) You're increasing the cost of labor for more productive purposes.
This is less important in recession scenarios but it doesn't just
disappear. This creates a negative supply shock.

2) You've incurred a debt that needs to be reversed with either
inflation or taxation down the road, and inflation and taxation
actually have real economic effects.

If you're going to inflate, interest rates no longer go down. Again,
inflation causes market rates to increase because in order to find a
buyer for your debt, you need to pay them for the inflation they
expect. Even if you grant the MMTers their claim that the short rates
will decrease, you'll increase long rates, which actually makes credit
more expensive. Long rates going up are a good thing when they're the
result of long-term optimism about the rate of economic activity.
They're a bad thing when they're the result of pessimism about the
likelihood of inflation during monetization of debt, because that has
little associated positive economic activity associated with it
outside of what you spent the initial money on.

If you're taxing, you're creating a cocktail of bad effects, also –
you're replacing  future productive activity with unproductive
activity today, exacerbating your long-term productivity issues.
You're creating crappy incentives in the future with high tax rates,
hurting labor supply. There are potentially other effects.***

Thus, the quality of government spending needs to be taken into
consideration. If the government is excellent at making sure its
spending yields a market rate of return (accounting for future
taxation/inflation, crowding out, velocity of money, etc), then these
issues aren't such a big deal – you're taxing a private economy that
can do X with its money in the future (or doing the same damage via
inflation) and doing X or better today, and you're not increasing the
cost of labor for more productive purposes because there aren't that
many more productive purposes. Fine. But if your government looks
anything like the US government, where there is a LOT of pork
spending, economically-inefficient/growth-retarding welfare spending
(sometimes justified on other moral grounds, and sometimes not, but
certainly not justified on an economic return basis), and incremental
spending tends to be much worse than average spending… these are
serious issues which can't be waved away in the mechanics of everyday
bond transactions. Believe me, the people buying bonds aren't.

Relatedly, MMTers end up hyperfocusing on flows and ignore stocks (of
debt, of capital, of anything). There are plenty of situations where
the stock of something affects the price and speed at which it can
flow. Venezuelan debt comes to mind - everyone's so concerned they're
going to default or inflate that increased government spending would
just make the problem worse – they wouldn't be able to sell their
bonds, they'd need to print money and inflation would increase their
interest rates. There's a confidence effect in a government's
willingness and ability to repay that gets ignored in the intense
focus on lending mechanics.

Thirdly, I'm not sure that they even make sense talking about the
mechanics of interest rates, holding the entire real economy constant.
MMTers argue that if the government has a net positive outflow in one
day (deficit), the short rate must be equal to the central bank's
reserve rate because banks have too much reserves and thus deposit it
with the Fed. However, the fact that the Fed can set the discount rate
implicitly gives the Fed power to tweak short rates and get the money
supply and credit creation they want based on market conditions.
Increased government spending doesn't matter in that calculus – the
Fed can just set the discount rate they want.**** No more deficit
control of interest rates.

Fourthly, their loan creation dynamics only make sense in a very, very
technical reading. Banks need to be able to physically give money to
someone for a loan, and for them to do that, they need to get the
money – which means they're pulling it out of their excess reserves or
off the interbank market, and when the Fed is willing to supply
unlimited capital, they can borrow whatever they want to create loans.

But one major role of  Fed discount rates and other monetary
intervention is to set the opportunity cost of lending for banks at an
appropriate level. The Fed can tweak short rates or to get the money
supply and credit creation the Fed wants based on market conditions.
Loan creation isn't a function of some abstract version of credit
demand and the desire of banks to underwrite loans, it's a function of
the credit demand and the desire of banks to underwrite loans at the
interest rate that is the opportunity cost of a bank's funds plus a
spread for risk (and profit).

Finally, as Scott Sumner points out here -
http://www.themoneyillusion.com/?p=10178 – and here -
http://www.themoneyillusion.com/?p=10238 -the MMT theory of credit
creation, in which money supply is endogenous, would make the price
level indeterminate. In the extremely short run, credit creation may
make money supply endogenous, but ultimately, rates will be moved by
the Fed to change the money supply and thus credit creation and the
price level. If money supply is endogenous to credit creation, then
why do countries with more credit per capita not have higher prices
per capita? I understand how the price level works when money supply
is exogenous, but when it's endogenous, it's a much more nebulous
concept. To quote the second article above, "MMTers forgot that the
nominal interest rate is the price of credit, not money. The Fed can't
determine that rate, it reflects the forces of saving supply and
investment demand." (note that this aligns with my first footnote

There are a number of other issues that I either feel unqualified to
talk about*^* or are merely "very common" pieces of MMT rather than
fundamental to the ideology.*^*^* In general, I've tried to wrap my
head around MMT and am having issues. Am I missing something? If I am,
please let me know.


*Note that market floating interest rates are different from the rates
the Fed can use in a response – in both cases, you'd expect the Fed to
respond to high inflation expectations by raising the interest rates
it controls to pull money out of the economy. In MMT-world, that could
mean higher inflation expectations have indeterminate effects on
interest rates, whereas in mainstream-world, higher inflation
expectations lead to higher interest rates.

** Note that MMTers are not alone in making this mistake; many of the
Keynesians do, too. I wrote a post on this here:

***Again, I spend a lot of time on related topics here:

****Even ignoring that – it's possible I'm misunderstanding the
argument because I can't imagine MMTers would miss something that
simple – I'll refer back to the crowding out problem. They implicitly
(and in some cases, explicitly) deny the existence of crowding out,
where the government has a net positive change in outflow because the
private sector buys their bonds and removes its money from the money
supply. If I save more and the government spends more, the effect on
interest rates will depend on a lot of things -  the short-run
aggregate supply curve and resulting elasticity in how much the
private sector spends, the velocity of money and the relative economic
efficiency and velocity of private vs. public spending. It also
depends on how the private sector is allowed to lend against the bonds
they hold, but that's outside my area of expertise.

*^* You may need to integrate "bank expectations of the future path of
interest rates" into their treatment of bank behavior at the zero
interest rate bound, for example, because if I read MMTers correctly,
banks should lend to every positive NPV project that comes along at
the zero bound, but I'll posit that consumers aren't seeing interest
rates quite THAT low, even adjusting for risk. All of that assessment
should be left to someone more qualified to talk about it.

*^*^* One I find particularly obtuse is the "Job Guarantee", which
comes up a lot as an MMT solution to many things (in the program, the
Federal Government would guarantee a job at a fixed wage to the
unemployed). This site here:
http://bilbo.economicoutlook.net/blog/?p=10554 seems to indicate that
a job guarantee would anchor demand-side inflation because people who
had those jobs would have a fixed wage. I find this confusing; we had
demand-side inflation when they had no wages to spend. Why would
giving them wages to spend – fixed or flexible - mitigate demand-side

No comments:

Post a Comment