Krugman on MMT

Paul Krugman comments today on Modern Monetary Theory (MMT).  Unfortunately, he gets it wrong.  For example, he says:

Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency.

I wish I could agree with that view — and it’s not a fight I especially want, since the clear and present policy danger is from the deficit peacocks of the right. But for the record, it’s just not right.

The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.

I commented and posted this response to him on his blog:

Paul, you either have an incomplete understanding of MMT or have setup a strawman. MMT does NOT hold that “deficits never matter, as long as you have your own currency.” MMT says that deficits do matter but only if (a) there’s no slack of real resources in the economy and (b) the private sector is choosing to net accumulate debt instead of accumulate net financial assets. In the meantime, however, as long the private sector wants to accumulate net financial assets, deficits are necessary to prevent Aggregate demand from falling.

You apparently prefer to use the interest rate on safe assets as the indicator of whether there’s slack real resources available – hence your emphasis on liquidity trap lingo. MMT emphasizes actual unemployment. If there’s significant unemployment, then there’s slack resources available for the government to purchase and put to use producing incomes for people.

A key insight of MMT is how the real world of banking has changed since the 1970’s when gold and fixed rates were abandoned. In our real world today, reserves do not constrain bank lending and money creation. The fears of inflation based on old equation of exchange theories are unfounded. It’s a shortage of real resources that will drive inflation, not deficits per se.

I’m not the expert on MMT. I’m just a teaching economist with both a lot of teaching and practical applied experience. If you really want to know MMT from the experts, try folks like Bill Mitchell and his Billy Blog, or Randy Wray and company at New Economic Perspectives. For that matter, read Wray’s books or Mitchell’s books.

 

The Misunderstood National Debt

A colleague asked for my thoughts on this article/column by Michael Manning in the State News, the Michigan State student newspaper, so I thought I’d post it for all.

Basically Mr. Manning reaches the right conclusions with a correct, but weak case. In looking at the issue of the size of the U.S. national debt and the panicked concerns many politicians are now expressing about the “urgent need to cut the deficit”, he concludes:

Republicans have decided to use this opportunity to further their party’s political agenda, feeding off of the public’s misunderstanding of national debt.

Although the debt is growing at an alarming rate, it does not mean the end of times or the end of American economic dominance. Public debt largely is misunderstood and used as a tool to scare everyday Americans.

He’s right. The debt is not the end of times nor will it end American economic prosperity (other policies may do that!).  And he’s absolutely right that public debt is largely misunderstood.

But the arguments for why it’s not a crisis and how it’s misunderstood are even stronger than he argues.  Essentially, Manning argues that most all of the debt is owed to “ourselves”, meaning either American citizens, American corporations/banks, or other units of government (Social Security program, The Federal Reserve, etc). That’s all true, but there are bigger reasons why the national debt doesn’t really matter.

He quotes Glenn Beck and then responds:

In the words of Glenn Beck, “China, some day, will want their payment, America. They will demand payment and they will receive their payment.

And if we can’t pay, they will do what any other bank would do, emotionlessly take the collateral that they now own. That will be our oil reserves, our land, our resources, our rare minerals, our coal, whatever it is.”

How much stake do these Chinese bankers actually have in America? They own a mere 7.5 percent, or about $1 trillion dollars of the national debt.

Yes, China only holds a small amount of the debt. But that’s not really why they won’t “repossess the collateral”.  The reason China won’t foreclose on the U.S. more complex. First, Glenn Beck is absolutely ignorant.  There is not “collateral” on government debt.  The only security for the loan is the “full faith of the U.S. government”.  In other words, if the U.S. didn’t want to pay, or if it wanted to payoff with new bonds, or if it wanted to payoff with newly created “money”, that’s their privilege. The lender knows that at the beginning.  There is no international court of claims where one country can foreclose on another for a bad debt.  What happens when a nation defaults on it’s debt?  Basically the lenders (usually banks in other countries) get really upset. They stamp their feet. They call serious meetings. Serious communiques are issued.  Foreign ministers get “concerned”.  Then they re-write the debt and the lenders take a loss. Nothing else.  Because it can’t!  The idea of China “emotionlessly” claiming our “oil reserves, land, our resources,” etc. is absurd.  How does Mr. Beck propose this happens?  China just pulls a couple ships up to Texas, kicks everybody out and tows the state of Texas home to China?  Or maybe China just moves in, digs up our coal and ships it home while everybody in West Virginia stands around? Or does Mr. Beck believe China will invade and forcibly take over (a nation with enough nuclear weapons to make dust of all us many times)?  It’s ludicrous.  I repeat.  The government is NOT like a household, and that means there’s no analogy between holders of US debt and a car loan or mortgage you took from the bank.

But the national debt is more misunderstood than just this false household analogy.  Indeed, it’s even misunderstood by many economists.  The issue has to do with money. The U.S. government, being (1) a sovereign nation that creates it’s own money . that (2) borrows in it’s own currency and (3) has a fiat currency with floating exchange rate, means the government (federal) cannot go broke or ever not be able to pay back bonds and interest when they are due.  This is because the government creates and is the source of the underlying “base money”.  It can always create more money to pay the bonds when due.  Now I know many folks, including many economists who haven’t updated their understanding of the monetary system since the 1971, will say “but, but, but that’s printing money and that creates inflation.”.  No it isn’t. And no it doesn’t.  The government doesn’t pay it’s bills or payoff bonds with “money”.  They send checks drawn on The Federal Reserve Bank.  Those checks are accepted by your local bank when you deposit them. When your local bank gives the check to The Fed, The Fed provides the bank with bank reserves.  Bank reserves are not money.  Bank reserves do not circulate. And, since 1971 at least, bank reserves do not limit or really influence how much money is in circulation.  How much your local bank loans out creates money.  And The Fed creates reserves to match what’s needed. (for a more in-depth explanations, see Bill Mitchell’s blog BillyBlog or the UMKC Economic Perspectives or this blog and search on “MMT”).

Now some, including many economists, claim that creating new bank reserves is inflationary.  But this is based entirely on an outdated theory called the quantity theory of money which hasn’t proven useful, accurate, or valid for over 40 years, largely because it’s based on having a gold standard or fixed exchange rates (both of which Nixon abolished).  Inflation happens when the nominal economy grows too fast and the central bank controls that through interest rates, not quantities of bank reserves or money.  I realize that some of this may sound counter to what folks may find in a lot of econ 101 textbooks, but that’s because the textbooks really haven’t been updated to reflect modern monetary theory or modern central banking operations in the way they work since the end of fixed exchange rates and gold standard.  In economics we have a problem with zombie ideas refusing to die.

Finally, there’s another very important reason the Chinese or anybody else that holds U.S. debt in large amounts don’t have a problem with the size of our debt.  That’s because the “debt” itself, the bonds, really shouldn’t be thought of as “debt”.  Government debt is really more like “paper money that pays interest”.  Again this is sovereign national debt – see above conditions.  If you are a state government or a nation like Greece or Ireland that foolishly gave away control of their currency to some foreign central bank, it’s different.  That debt is really debt.  But national, sovereign, floating exchange rate, government “debt”, the kind the U.S., Japan, Australia, U.K., Canada, and a host of other nations have isn’t really “debt”.  It’s a form of interest-paying risk-free cash.  It’s used by pension funds, banks, and investors as a risk-free asset. Indeed, at one point in the previous decade when Australia was actually paying down it’s debt and not issuing new bonds, the banking community persuaded the government to borrow anyway just so the bonds would exist.

So, Mr. Manning is correct, but he’s even more correct than he argued.  The national debt is misunderstood. And a false crisis is being created in order to push an alternative agenda.

MMT Isn’t All That New

Modern Monetary Theory, MMT, is still considered a heterodox theory and a bit outside the mainstream.  That’s largely because of two factors.  First, graduate economics education in money is largely stuck in quasi-gold standard era stuff from pre-1971.  Milton Friedman and his disciples still dominate, despite the facts.  Empirical evidence and knowledge of how banks & central banks actually work doesn’t support the theories, but we publish the stuff anyway.  Second, central banks actually dominate the research agenda and funding of monetary economics research.  Getting central banks to research and publish MMT stuff is a little like getting big Pharma to publish research on nutrients being superior to drugs.

Anyway, I came across this quote from Thomas Edison from 1928.  He and his good friend Henry Ford knew quite a bit about how to generate real economic wealth and well-being, and, it seems, they understood some basics of MMT, too. (from http://www.michaeljournal.org/appenD.htm)

“That is to say, under the old way, any time we wish to add to the national wealth, we are compelled to add to the national debt.

“Now, that is what Henry Ford wants to prevent. He thinks it is stupid, and so do I, that for the loan of $30 million of their own money, the people of the United States should be compelled to pay $66 million — that is what it amounts to with interest. People who will not turn a shovel full of dirt nor contribute to a pound of material, will collect more money from the United States than will the people who supply the material and do the work.

“That is the terrible thing about interest. In all our great bond issues, the interest is always greater than the principal. All of our great public works cost more than twice the actual cost on that account. But here is the point.

“If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good, makes the bill good also. The difference between the bond and the bill is that the bond lets the money brokers collect twice the amount of the bond and an additional 20 percent, whereas the currency pays nobody but those who contribute directly to Muscle Shoals in some useful way…

“It is absurd to say that our country can issue $30 million in bonds and not $30 million in currency. Both are promises to pay, but one fattens the usurers and the other helps the people. If the currency issued by the Government was no good, then the bonds would be no good either. It is a terrible situation when the Government, to increase the national wealth, must go into debt and submit to ruinous interest charges at the hands of men who control the fictitious value of gold.”

By the way, if you really want to dig in and begin to understand MMT and it’s implications, read Bill Mitchell’s blog at http://bilbo.economicoutlook.net/blog/

 

The U.S. is NOT Bankrupt – It’s Impossible

I’ll try to make this point again: the U.S. government can NOT go bankrupt.  It’s impossible for it to default on U.S. government bonds.  Just like it’s impossible for Japan, Australia, Canada, the U.K., or any of the other nations that: have a non-convertible, floating exchange-rate currency and that borrow funds in their own currency.  I’m far from the only one saying this. I know Bill Mitchell at Billy Blog and the folks at New Economic Perspectives have to be nearing exhaustion from  explain it over-and-over-and-over again.  But this time, let’s try the high apostle and saint of monetary policy, none other than the former 17-year chair of the Federal Reserve, Alan Greenspan (the bold emphasis is mine):

Central banks can issue currency, a noninterest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.

That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy’s expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance.

It was not always thus. For most of the period prior to the early 1930s, obligations of governments in major countries were payable in gold. This meant the whole outstanding debt of government was subject to redemption in a medium, the quantity of which could not be altered at the will of government. Hence, debt issuance and budget deficits were delimited by the potential market response to an inflated economy. It was even possible in such a monetary regime for a government to become insolvent. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate.

There. Any questions?   Lest you think I have played some sort of out-of-context trick with this quote, you can read the whole speech here. BTW, you’ll also find out that, yes, a gold standard is dumb and destructive.

 

Excess Bank Reserves: Theory vs. Reality

In the macro econ textbooks, the mainstream explanation for money creation is the story of fractional reserve banking where reserves limit the amount of loans made.  In the traditional theory, the central bank (The Fed in U.S.) controls the amount of reserves banks have through either reserve reqmts or open-market operations.  Commercial banks are supposedly limited in their ability to make loans until they have sufficient excess reserves to “loan out”.  These new loans are what creates new money (at least the M1 variety of bank-credit money).  A lot rides on this theory.  For example, the theory implies that the Central bank has the power to control the supply of money and loans to the economy as opposed to only controlling short-term interest rates.  The theory doesn’t really fit reality very well.  There’s lots of problems with it.  (follow the posts at Bill Mitchell’s blog http://bilbo.economicoutlook.net).  Among the problems are that, in many countries (and in the US for savings accounts) there is no reserve requirement.  Another is that operationally, banks aren’t limited by reserves.  They make loans, then find out how much reserves they have to borrow.  Not the other way ’round.

But a critical piece of the mainstream theory that underpins monetarist theory is that banks, being profit-maximizers, will always lend out their excess reserves.  Wrong.  Check this out:

“Sovereign Default” is an Oxymoron With Fiat Money

Again, there is no risk – none, zip, nada – of default by the US (or any other currency sovereign nation) on their government bonds.  This does not mean that these governments can run unlimited deficits of unlimited amounts without any consequences.  It means the consequences don’t include default on government bonds.  If the government spending were truly too much, the consequence would be an overstimulated economy where aggregate demand exceeds available real resources. It does mean that the national debt does not ever have to be “paid off”.  It also means that deficits now do not imply “higher taxes in the future”.

Today’s support comes from Bill Mitchell ‘s Billy Blog and  Steven Major of the Financial Times.

In his FT article – ‘True sovereigns’ immune from eurozone contagion – HSBC economist Steven Major opens with the following statement:

There are plenty of doomsayers who think it is only a matter of time before the sovereign risk crisis spreads from the eurozone to other countries, including the US, UK and Japan.

This is not going to happen in my view. That is because the obsession with public debt ratios fails to distinguish between different levels of sovereignty. The US, UK and others can maintain high public debt ratios for longer, especially given the amount of deleveraging being carried out by the private sector.

Not all sovereigns are the same. The US, UK, Japan and Canada are examples of what I call “true sovereigns”. For these countries there is zero default risk. Investors should not worry about credit fundamentals, as they will always receive their coupons and original investment on redemption.

This is so contrary to what is being peddled each day in the financial press that a medal for bravery should be awarded. I just did that Steve(!)

Steven Major chooses to term a government in the former category a “true sovereign” because it:

… can issue freely in its own currency, has full taxing power over the population and ultimately, if required, can create more of its own money. None of this means that true sovereigns can afford to be profligate, far from it, but it does mean there is no externally imposed timetable on fiscal retrenchment.

I am 100 per cent in agreement with this construction.

Debts & Deficit Are Not A Problem (until you reach full employment)

In the current media- and pundit-manufactured hysteria about the government budget deficit and sovereign debt, much has been made of a relatively recent book by Rogoff and Reinhart.  It purports to find patterns of default by surveying 800 years of sovereign defaults.  R&R conclude that somehow, magically, an 80% debt-to-GDP ratio will virtually ensure sovereign default, crisis, pain, suffering, and general mayhem.  I find it interesting that they reach this conclusion by noting that somewhat over half of the crises they study had ratios above that.  Strange that they never test the hypothesis by asking how many times have nations exceeded that threshold and NOT come to grief (Japan the last 20 years anybody?).  I obviously was not impressed with the book or it’s scholarship.  I’ve been meaning to blog about it, but Yeva Nersisyan at New Economic Perspectives says what I’ve been thinking…

In every culture there are a set of myths that are used to bring up future generations. In the US parents tell their children that if they don’t behave the bogeyman will get them. In many other countries it is a “Sack man” who carries naughty children away in a big sack. The myths are numerous and differ from culture to culture but the purpose is to get children to conform to the parental authority. As children trust their parents this is usually fairly easily accomplished. Although we would like to think that once we become adults we are not fed similar half-truths and outright lies, unfortunately it is not the case. One would think that as adults who have the capacity to reason and think critically we could spot those lies and myths. But what to do, if the people whose authority we trust, the so-called scientists and experts in the field are the ones feeding us the myths?
Major crises can be useful in helping people to rethink the way they once thought about the world. During the Great Depression, we abandoned the idea that free markets could work without government intervention. Gradually, as the postwar economy avoided major crises, precisely due to state intervention, people got comfortable thinking that the economy has become inherently stable and that state intervention is no longer necessary. Economists were at the forefront of propagating this myth. We were also led to believe that fiscal policy was neither useful nor necessary. But perhaps the biggest myth that we were all taught is that the government should balance its budget just like a household does, that persistent budget deficits are unsustainable and will lead to stagnant growth and even to sovereign defaults. Thanks to this myth, propagated by professional economists, with nearly 10% of the US labor force unemployed and another 7% underemployed, the public debate is now focused on the false issue of deficits and debt.
A case in point is a recent book by Carmen Reinhart and Kenneth Rogoff, “This Time is Different” that has become a bestseller, making them the ultimate authorities on the issues of debt, default and crises. It has been used by conservatives and progressives alike to argue for lowering government deficits and debt in the midst of the current Great Recession. The media as well as academia have fawned all over this book, to the point where one begs the question whether they have actually taken the pain (it is painful!) to read the book (see here for more on this).

Jim, again here.  I have read the book.  I was greatly unimpressed.  Yes R&R have assembled a huge database (there contribution would be useful if they open-sourced the data files), but their analysis is greatly lacking.  They treat 800 years of history as if there’s never been any change in institutions – kind of strange when banking itself is only a few hundred years old.  Most important, though, is that R&R cannot recognize that the gold standard disappeared some 40 years ago.

The book is mostly on crises driven by government debt. Rogoff and Reinhart claim to have identified 250 sovereign external defaults and 70 defaults on domestic public debt. The problem with their “analysis”, however, is that over the past 800 years (and even over the past two centuries that are the focus of the book), institutions, approaches to monetary and fiscal policy, and exchange rate regimes have changed. For example, before the Great Depression the US was on a Gold Standard, then there was the Bretton Woods regime and finally in the last 40 years the US dollar has been a non-convertible currency. From reading the book it seems that this is not important at all. In reality the monetary regime a country operates on has major implications for government solvency. Aggregating data over different monetary regimes and different countries cannot yield any meaningful conclusions about sovereign debt and crises. It is only useful if the goal is to merely validate one’s preconceived myth about government debt being similar to private debt.

A sovereign government that operates on a non-convertible currency regime spends by issuing its own currency and as it’s the monopoly issuer of that currency, there are no financial constraints on its ability to spend. See here, here and here for more. It doesn’t need to tax or issue bonds to spend. It makes any payments that come due, including interest rate payments on its “debt” and payments of principal by crediting bank accounts meaning that operationally they are not constrained on how much they can spend. Governments operating with a non-convertible fiat currency cannot be forced to default on sovereign debt. They can choose to do so but that’s ultimately a political decision, not an economic/operational one. As far as I can tell Rogoff and Reinhart haven’t identified a single case of government default on domestic-currency denominated debt with a floating exchange rate system.

The need to balance the budget over some time period determined by the movements of celestial objects is a myth. When a country operates on a fiat monetary regime, debt and deficit limits and even bond issues for that matter are self-imposed, i.e. there are no financial constraints inherent in the fiat system that exist under a gold-standard or fixed exchange rate regime. But that superstition is seen as necessary because if everyone realizes that government is not actually financially constrained then it might spend “out of control” taking too large a percent of the nation’s resources. See here for more.

When the Great Depression hit governments didn’t know how to counteract the crisis, to solve the problem of unemployment. Further they were constrained by the Gold Standard (which the U.S. finally abandoned in 1933). Today we know exactly what to do to solve the issue of underutilization of labor resources. But unfortunately we are constrained by myths. I wonder what the economists, who propagate these myths, would say if they were in the ranks of the unemployed. Would they say that Congress should not extend unemployment benefits because it will further contribute to the deficit? Would they say that more stimulus is unsustainable? I suggest we leave them unemployed for a while. They will have more free time to do some Modern Monetary Theory reading and more “economic incentives” (i.e. lack of income to support themselves and their families) to rethink their position. Professional economists are a major impediment on the way to using our economic system for the benefit of us all. And Reinhart and Rogoff are no exception.