The right policy mix and why MMT got it backwards.

I recently wrote a post on MMT but stayed clear of Job Guaranty and other policy prescriptions. Instead, I focused on MMT key contributions to our understanding of the economy. Here, I want to follow-up with my thoughts on the appropriate policy mix to achieve full employment. Specifically, I will advocate for vesting central banks with fiscal policy tools.

First, let me recap the key insights MMT brings to our understanding of the economy:

  • The economy does not self-correct to full employment, not even in the long-run.
  • Banks cannot be ignored for the purpose of studying the economy.
  • A sovereign currency issuer cannot default on its domestic debt because it can always print money.

So far so good. The problems begin when we start talking about inflation and asset bubbles. With respect to inflation, MMT and mainstream econ agree that inflation is the single most important constraint to both fiscal and monetary policy. The problem is that neither MMT nor the mainstream has an all-encompassing theory of the price level that can explain inflation across different countries and different points in time. With respect to asset bubbles, market exuberance is not seen as a policy constraint. MMT attributes bubbles to irrationality (e.g., Minsky’s stability breeds instability). The mainstream view on asset prices boils down to “markets are always right”.

We can no longer sweep these problems under the rug, especially not when we are attempting a major policy rethink as advocated by MMT. We must understand inflation and asset bubbles if we are to ever design full-employment policies that are consistent with price and financial stability.

In my view, the monetary base may prevent interest rates from converging with income-growth expectations in the economy, thereby giving rise to economic fluctuations, changes in the price level as well as asset booms and busts. I outline this view in a series of posts (for a more detailed discussion, please refer to this post: Alternative view of the business cycle — Part III).

According to this framework, the economy bootstraps, whereby incomes must be anticipated ex-ante to be generated ex-post (Chart 1).

Chart 1

Aggregate demand is determined ex-ante based on income expectations for the current period plus desired borrowings less desired savings. Banks finance this demand by creating money. As agents spend the newly-created money, the economy generates nominal incomes. In other words, bank-financed demand creates its own nominal supply with prices, output and employment (as well as the money supply at the end of the period) being the unknown residuals.

In this model, banks are special because they are market-makers in money markets. Since banks can create money eh-nihilo, they can finance short-term borrowers even if there are no short-term savers, thereby enabling the economy to bootstrap. On the flipside, banks can accommodate long-term savers, who want to hold money, even if there are no long-term borrowers on the other side.

On the other hand, there is no market-maker in capital markets. For every borrower, there must be a willing saver, and for every saver, there must be a willing borrower. I think of capital markets as the markets for duration. Duration is a widely-used term in finance that measures the change in the value of an asset or liability with a change in interest rates. Money has zero duration because its nominal value does not change with interest rates. A long-term loan at a fixed rate of interest has duration because its value is inversely related to interest rates. Duration allows borrowers and savers to lock expected returns. Borrowers want lock a borrowing rate below their income-growth expectations. Savers want to lock a rate of return above their income-growth expectations. The supply of duration by borrowers and the demand for duration by savers give rise to capital markets.

The second box on Chart 1 drives the business cycle. Consistent with Keynes’ insight from the General Theory, a disequilibrium in desired borrowings and savings causes fluctuations in nominal incomes that enforce the ex-post identity between actual borrowings and savings. An excess of desired borrowings adds directly to aggregate demand, driving the upward leg of the cycle. Under the assumption of upwardly-sloping aggregate supply curve, excess demand means higher prices (i.e., inflation) and rising employment. A shortage of desired borrowings subtracts from aggregate demand, driving the contraction and resulting in lower prices (i.e., deflation) and falling employment.

According to the proposed framework, desired borrowings equal desired savings when risk-free interest rate in capital markets equal the average income-growth expectations in the economy as of the respective term. Interest rates with terms beyond the current period may differ from income-growth expectations because savers with negative income-growth expectations do not participate in capital markets but chose to hold money, giving rise to asset money demand.

Asset money demand substracts from the demand for duration in capital markets, causing interest rates to rise above income-growth expectations. Under the assumption that commercial banks perfectly duration-match [1], only the central bank can substract from the supply of duration by issuing the monetary base in exchange for bonds with duration. As a result, the monetary base works as an offset to asset money demand. If the monetary base equals asset money demand, the economy is in a steady state. To the extent that the monetary base differs from asset money demand, interest rates diverge from income-growth expectations, giving rise to the business cycle.

This model has a number of policy implications. First and foremost is whether asset money demand is denominated in the domestic currency. If this is the case, central banks are in position to manage the business cycle (e.g., advanced economies). However, if domestic agents prefer foreign reserves (or gold), the central bank is not in position to meet asset money demand because it can not issue foreign currency. Business conditions are dictated by foreign capital flows, and the economy suffers from a positively-sloped Phillips Curve (e.g., emerging and developing economies). Even the US went through such period. In the aftermath of the gold exit by the Nixon Administration, domestic agents continued to prefer gold as the reserve of choice, giving rise to the stagflation of the 1970s. Only after Chairman Volker proved the Fed commitment to price stability, did the US dollar re-gain its standing as a global reserve currency.

The key to reserve-currency status is central bank independence and commitment to price stability. The problem is that while price stability does indicate a steady state, it does not necessarily mean full employment because of the bootstrapping problem I referred to earlier. Accordingly, central banks in advanced economies have defined price stability as low and stable inflation, the thought being that low inflation is an acceptable trade-off for high employment. In practice, central banks achieve their inflation target with a slight-to-moderate oversupply of reserves. This causes interest rates in capital markets to fall slightly below income-growth expectations. The resulting excess of desired borrowings bootstraps the economy to higher employment and gives rise to low and steady inflation.

However, the business cycle is not eliminated. Keeping interest rates below income-growth expectations inflates asset prices. This gives rise to bubbles and overinvestment and ultimately, leads to an asset bust. That’s when the central bank can pull another ace up its sleeve. It can expand the monetary base by more than the increase in asset money demand. As a result, interest rates decline by more than income-growth expectations. This restarts the cycle of excess private borrowings. Recessions are shallow and are quickly followed by renewed growth.

In the long-term, though, reliance on private debt to bootstrap the economy means that private leverage rises continuously. Private agents never have an opportunity to de-lever due to aggressive central bank response to recessions. The rising burden of private debt prevents income-growth expectations from fully recovering during expansions. This means that the long-term trend in income-growth expectations and, by extension, interest rates is downward, putting the central bank on a collision course with the zero lower bound (ZLB).

Once income-growth expectations hit zero in the aftermath of the inevitable investment bust, all that the central bank can do is dramatically expand the monetary base. This caps interest rates at zero and prevents income-growth expectations from going negative. Depression is averted, but the central bank can no longer bootstrap the economy toward higher employment because interest rates cannot go negative due to the existence of paper cash. As a result, the economy settles in a state of permanently high unemployment.

That’s where fiscal policy comes-in. Fiscal deficits can bootstrap the economy toward higher employment, even at ZLB, but only if such deficits are money-financed. If such deficits are financed in the domestic capital markets through bond issuance, resources are simply diverted from the private to the public sector. In other words, there is 100% crowding-out. That’s because capital markets match willing borrowers with willing savers. On the positive side, this also means that bond-financed fiscal deficits are never inflationary and are always sustainable. It is simply a matter of allocating existing resources from private to public use. The same allocation would have been achieved had these resources been paid-for with taxes. With respect to inflation, the only difference between tax-financed and bond-financed government spending is that taxes re-allocate resources involuntary while government debt re-allocates resources voluntary.

Fiscal-deficits can be money-financed in one of two ways. The Treasury can fund the deficit with one-month bills (for practical purposes, such bills have zero duration and can be considered money). Alternatively, the central bank can monetize the deficit by purchasing government bonds. In either case, there is not a willing private saver who forgoes consumption or investment to accommodate the use of resources by the government. This means that money-financed fiscal deficits result in 0% crowding-out. The underlying government spending is immediately incremental to private activity and as such, bootstraps the economy toward higher employment. That’s exactly why QE was so effective in the US despite ZLB. The Fed effectively monetized the fiscal deficits, and it was those monetized fiscal deficits that powered the recovery. On the flip side, money-financed fiscal deficits are always inflationary precisely because they do not crowd-out private activity. If there are idle resources, the inflationary impact will be low, but if there are few idle resources, the inflationary impact will be high.

MMT calls for fiscal dominance, whereby full-employment policies, such as Job Guaranty, are financed with money issuance. MMT relies on higher taxes or ex-ante review of spending priorities to ensure that inflation is kept in check. In other words, fiscal policy takes the lead in managing inflation and employment with the central bank playing only a supporting role.

According to the proposed model, money-financed deficits can bootstrap the economy to full employment, so MMT is correct in that respect. The problem is that money-financed deficits are always inflationary. To address this concern, MMT could change its position with respect to bond-financed deficits. Once the economy reaches full employment, fiscal deficits should be bond-financed. My bigger concern is that fiscal policy is controlled by the political branches of government that lack the statutory commitment to price stability. Delegating the central bank to second fiddle jeopardizes the very reason MMT policies are feasible in advanced economies. It is not beyond the scope of reason to expect domestic agents to switch to a different store of value for their asset money demand, unwinding Volker’s hard-won victory over inflation. No one, not even MMT, wants a return of a positively-sloped Phillips Curve, which is precisely the risk that comes with fiscal dominance!

Instead, I call for central-bank dominance, whereby the central bank is vested with fiscal policy tools to ensure full employment. With respect to price stability, central banks have a powerful took kit, namely interest-rate targeting and balance-sheet management. Where central banks fall short is their full-employment mandate. Reliance on private debt to bootstrap the economy gives rise to asset bubbles and ultimately, puts the central bank on collisions course with ZLB. If the central bank has control over counter-cyclical fiscal spending programs, it can chose to monetize the respective deficits, thereby bootstrapping the economy without affecting capital markets and creating bubbles. As an added bonus, the central bank will no longer be constrained by ZLB.

Political control over government spending has always been the norm. On paper, this is intended to ensure that the costs and benefits of public spending are allocated in a democratic and fair manner. In practice, this is rarely the case because the political process is fraught with existing power structures, corruption and special interests, but I digress. A counter-cyclical fiscal program that does not afford its administrator with discretion over the allocation of costs and benefits could be safely delegated to technocrats at the central bank. For example, one-time tax refunds, unemployment benefits, temporary consumption and investment tax credits and why not, basic income. It’s all about handing-out central bank checks without the central bank having preferential control over who gets a check.

This, of course, must be accompanied with a strong full-employment mandate that explicitly defines the full-employment target. I would say that full employment means 0% long-term unemployment rate. If you’ve been looking for a job for at least 6 months, you ought to be able to find one.

Central bank dominance raises the possibility of a steady state at full employment without inflation or asset bubbles — that seems like a utopic dream. I believe it is possible, and unlike MMT, I believe the key to that world belongs with the central bank.

[1] Banks duration-match in order to hedge interest rate risk.



Thoughts on money and the economy. Follow @HPublius

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store