N.G.Mankiw’s criticisms of Modern Monetary Theory.

Mankiw, who is a Harvard Economist, recently published a work criticising MMT entitled “A Skeptic’s Guide to Modern Monetary Theory”.

His first criticism is that MMT advocates are not too clear on exactly what it is they are trying to say. While I have supported MMT for several years, I think that’s a fair enough criticism. As he says, advocates of a new idea often come in the form of a group of academics, while MMT advocates are a much more diverse lot (of which I am perhaps typical). That diversity almost inevitably leads to a less clear message than where just one or two academics advocate an idea. Mankiw is generous enough to say that that diversity is not necessarily a flaw.

Mankiw’s first main error comes in the last para of his second page, where he claims there’s a problem with the MMT claim that governments and central banks can  simply create and spend money (and/or cut taxes) up to the point where inflation becomes excessive. The alleged problem is that that new money ends up as bank reserves and that central banks have to pay interest on money. 

Well the obvious flaw in there is that interest on reserves is not inevitable: in fact it’s a very recent development for central banks. Moreover, many MMTers specifically advocate a permanent zero rate of interest policy. (That’s a permanent, or at least more or less permanent zero rate on government and central bank liabilities, which includes reserves. In contrast, the rate of interest on mortgages, pay day loans etc will of course always be well above zero.)


Mankiw’s second criticism.

His second criticism (top of his p.3) is that the latter increase in reserves will increase bank lending, which in turn will further exacerbate inflation.

Well Mankiw apparently hasn’t noticed that quantitative easing resulted in an astronomic and unprecedented increase in reserves, but the effect on bank lending was decidedly muted. And that is not entirely surprising: as J.K.Galbraith famously put it, “Firms invest when they can make money, not when interest rates are low.” I.e. it’s customers coming thru the door that induces firms to borrow and invest.

Of course QE is not exactly the same as cutting interest rates, but it’s near enough the same. Central banks cut interest rates by creating money and buying up government debt. QE is simply a continuation of that “buy up” process when interest rates are near zero and the “buy up” may not actually influence interest rates. 

And another flaw in Mankiw’s above second criticism is that if there is indeed a feed-back mechanism of the type he proposes (i.e. more reserves means more lending, which raises demand), then the solution is simply to go for less of a “reserve increase” (i.e. a smaller deficit) than would otherwise be the case!

Feed-back mechanisms are all over the place in our daily lives. E.g. getting drunk may cause you to behave in an even more irresponsible way and drink even more. Solution: don’t drink so much that the latter feed-back mechanism kicks in!! 



The third criticism.

Mankiw’s third criticism (also at the top of his p.3) is: “Third, the increase in inflation reduces the real quantity of money demanded. This fall in real money balances, in turn, reduces the real resources that the government can claim via money creation.”

Well the simple answer to that is that if there is excess inflation, there is no need for government to “claim more resources via money creation” (i.e. raise public spending)! Indeed there is no need for it to “claim more resources” in any other way!



Conclusion.

I don’t think MMTers need to seriously re-consider their ideas in the light of Mankiw’s criticisms.

Richard Murphy and Colin Hines’s way of funding the Green New Deal.

Murphy & Hines have just published their ideas on this subject in a work entitled “Funding the Green New Deal”.

I’m all for the GND, but Murphy & Hines’s (M&H) way of funding it leaves a bit to be desired. Basically they claim that funds can be nicked from other types of investment: in particular they advocate changing the rules for ISAs and pension funds so that a proportion of the savings currently going to the latter two are diverted to bonds to fund the GND, and certainly that’s possible.

Problem though, is that would starve the banks, firms etc which rely on ISAs and pension funds for money for investment, which would push up interest rates. And that in turn would benefit creditors / the rich while hitting borrowers, e.g. those with mortgages.

That wouldn’t be the end of the world given that in the 1990s UK mortgagors were paying nearly three times the rate of interest they pay nowadays, and strange to relate, the sky did not fall in in the 1990s. But M&H ought to be more open  about that interest raising effect.

The above “rate of interest raising” effect does not actually have anything specifically to do with ISAs or pension funds or any of the many other possible ways of diverting funds to the GND. To illustrate, if government just offered bonds to fund the GND at whatever rate attracted lenders in sufficient quantities, the inevitable effect would be a rise in interest rates and attract funds away from other types of investment.

Put another way, if government decides to borrow and spend an extra £Xbn a year, and assuming the economy is already at capacity (which it more or less is in the case of the UK in 2019), that extra spending is not permissible unless some form of spending cut is implemented so as to balance the extra spending. That cut can be brought about by a rise in interest rates or a rise in tax, for example.

And frankly it does not make a huge difference which one is chosen: if the interest rate rise option is chosen, then in effect it’s mortgagors and other borrowers who are induced to spend less. And mortgagors are pretty much the same collection of individuals as taxpayers, though clearly not exactly the same collection of individuals.

And finally, if the distribution of after tax income is what government thinks is optimum before implementing the GND, then funding the GND via borrowing will disturb that optimum set up (e.g. because mortgagors are worse off). Thus government will have to adjust tax on so called “unearned income” (on the rich) and subsidies for mortgages (if there are any) etc etc. 

Be simpler fund the GND via tax, and in a way to maintains what government thinks is the optimum distribution of after tax income, don’t you think?

Why the IMF was so hesitant about stimulus during the recent recession.

As others have noted, the IMF was positively schizophrenic on the subject of stimulus during the recession that started in 2007/8. In one breath they backed stimulus, while in the next, they warned of the dangers of the alleged increased debt that governments incur when they implement stimulus.

The first obvious flaw in the latter “debt” point is that to a large extent, governments just didn't incur more debt when they implemented stimulus! To be more exact, in the first instance they incurred more debt, but then their central banks did large amounts of QE: i.e. they printed money and bought back that debt.

Thus in effect what many governments did (assisted by their central banks) was simply print money and spend it (and/or cut taxes).

Yet strange to relate, the recently retired chief IMF economist, Olivier Blanchard claims here that low interest rates facilitate fiscal stimulus. His actual words: “…..low interest rates increase the room to use fiscal policy.” (See p.4). (Article title: “Interview with Olivier Blanchard”, published by Goldman Sachs).

To repeat, the going rate of interest has absolutely no bearing on the ease with which government can implement fiscal stimulus because (to repeat) governments and central banks between them can fund fiscal stimulus by simply printing money!!!!!

Keynes pointed out in the early 1930s that stimulus can be funded simply by printing money. You’d think his message would have got thru by now, wouldn’t you?

As Claude Hillinger put it in his paper entitled “The Crisis and Beyond: Thinking Outside the Box”:

“An aspect of the crisis discussions that has irritated me the most is the implicit, or explicit claim that there is no alternative to governmental borrowing to finance the deficits incurred for stabilization purposes. It baffles me how such nonsense can be so universally accepted. Of course, there is a much better alternative: to finance the deficits with fresh money.”

Some popular misconceptions about the debt and deficit.

Scott Wolla and Kaitlyn Frerking, two St Louis Fed authors, try to enlighten us on the deficit and debt. They make some valid points, but also a few mistakes, which I’ll deal with in the paragraphs below. Their article is entitled “Making Sense of the National Debt”.

The first mistake, which appears in the first two paragraphs, is the idea that government, can increase everyone’s consumption by borrowing, just like a household can temporarily bring about a increase in its consumption by borrowing to go on a world cruise or buy an expensive new car, and do that via borrowing. The authors say:

We live in a world of scarcity—which means that our wants exceed the resources required to fulfill them. For many of us, a household budget constrains how many goods and services we can buy. But, what if we want to consume more goods and services than our budget allows? We can borrow against future income to fulfill our wants now. This type of spending—when your spending exceeds your income—is called deficit spending. The downside of borrowing money, of course, is that you must“ repay it with interest, so you will have less money to buy goods and services in the future. Governments face the same dilemma. They too can run a deficit, or borrow against future income, to fulfill more of their citizens' wants now.”

Unfortunately the world of macroeconomics (e.g. the world of government and the economy as a whole) is very different from microeconomics (which is concerned with individual products, households, firms, etc).

Assuming the economy is at capacity, if government spending is $X more than income, excess inflation will ensue unless there’s an $X CUT in spending elsewhere. Unfortunately borrowing $X won't cut spending all that much. In fact it might not cut it at all. Reason is that it’s the rich who lend to government, and the rich don’t change their weekly spending much in reaction to a change in their stock of cash. In fact, given that they won’t lend to government unless they think they’ll make a profit in the long term, they may actually spend that profit before it crystalizes, i.e. raise their weekly spending!!

Thus in the later “borrow and spend” scenario, government and/or central bank has to find some way of supressing demand to balance the increase in demand coming from the “borrow and spend” exercise. Most commonly the central bank, as soon as it spots the above deficit will raise interest rates. Or it may wait till the above mentioned excess demand and inflation actually materialises before raising interest rates. But the exact timing is not of importance to the basic point being made here.

Thus it just isn't possible, in the words of the St Louis Fed article, for government to arrange for the country as a whole to   “consume more goods and services than our budget allows”. For example, in the case of the above interest rate rise, that will dissuade people from buying new or bigger houses, which of course amounts to consuming FEWER goods.


 Borrowing from abroad.

Having said all that, there is one slight reservation that should be made, which is that if a government borrows from abroad rather than from its own citizens, that will enable the relevant country to consume more than it produces for a while. E.g. if China supplies the US with goods, while the US abstains from paying cash on the nail, and borrows from China instead, that will give the US a temporary increase in living standards.

But only a minority of most countries national debt is funded from abroad, so that point is of limited relevance.


Interest on the debt is an opportunity cost?

The authors’ second error is in the passage starting “However, this does not mean that debt is without cost. It is important to understand that debt has an opportunity cost.”

In fact interest on the debt is simply a transfer from one lot of people to another: it’s a transfer from taxpayers (who fund the interest) to holders of government debt. Now why would that have any influence on government’s ability to “finance other projects”?

Clearly the money grabbed off taxpayers is an opportunity cost in the sense that it then becomes more difficult to grab yet more money off those taxpayers. On the other hand, debt holders are better off in that they’ve received the money grabbed of taxpayers, so it is then easier to milk those relatively well off people. All in all, I suggest there is not much of an “opportunity cost” there.

Put another way if government grabbed $Xbn a year off males and gave the money to females (or vice versa), GDP would remain much the same, and hence government’s ability to “finance other projects” would remain much the same.


Growth in the debt is unsustainable.

Next, the St Louis Fed authors trott out a common concern about the debt, namely that if it’s growing faster than GDP in real terms, that is clearly not sustainable in the very long term, which (allegedly) is a problem.

Well now an accelerating car is an “unsustainable” system: it cannot  go on accelerating indefinitely. That’s first because of speed limits on roads, and second, there’s a physical limit to the speed of any car (determined by its engine size and other factors.)

So are accelerating cars a problem? Well clearly not, because there are (to repeat) natural limits to the speed of a car.

And much the same applies to the debt. That is, while the amount of debt that the private sector wants to hold my rise steadily over a period of years or even decades, there must be some sort of limit that the average household wants to hold (either directly or via pension funds and similar).

To illustrate, if someone on average wages discovered they had ten million dollars of government debt, would they just carry on accumulating it, or would they cash it in at the earliest possible opportunity and go on a bit of a spending spree? I think I know the answer to that.

Conclusion: there are natural limits to the amount of debt the private sector will want to hold.

 
Default.

Under the heading “Debt Risks”, the St Louis Fed  authors then worry about the possibility of a government defaulting on its debt when the debt gets sufficiently large and the private sector starts to doubt government’s intention to repay its debt, with the result that debt holders then start demanding a much higher rate of interest for holding debt.

Well the solution to that problem is easy. If interest demand does rise significantly, government can just tell debt holders to get lost when their existing debt matures. In effect, that equals QE.

Of course that would result in former debt holders having a larger stock of cash than previously, which might result in excess inflation (although the actual effect of QE in recent years does not seem to have been inflationary). But if excess inflation does loom, all government has to do is raise taxes. That will produce a deflationary effect to counter the above mentioned inflationary effect.

Nothing difficult in principle there.

Yet another feeble defence of private money printing.

I set out the flaws in many of the excuses proffered for letting private banks create money here recently. (Article title: “Silly excuses for letting private banks print money”)
 
 Another attempt to defend the existing bank system (i.e. allow private money creation) appeared in the Financial Times recently authored by Isabella Kaminiska. To be exact, she tries to argue that Stablecoin comes to the same as full reserve banking, a system under which private money creation is banned. (Article title: “Stablecoins as a euphemism for full-reserve banking.”)

Well Stablecoin (i.e. a central bank issued crypto currency tied to the £ or some other stable unit) is certainly similar to an element of FR. To be exact, under FR, depositors can keep their money in the latter form of totally safe, central bank guaranteed money, or they can choose to have their money loaned on to mortgagors etc, in which case depositors carry relevant risks themselves.

Unfortunately, as Kaminiska makes clear, Stablecoin does not necessarily involve a total abolition of private money creation. Stablecoin thus has similarities to one element of FR, but certainly does not equal FR. 

As for her  final three paras, they are nonsense.Her third last para says, “Love them or hate them, banks -- especially when unconstrained by the need to keep investments liquid -- offer a highly efficient economic service that the government or the central bank cannot emulate. That service is entirely connected to their ability to lend first and fund later, notably by finding appropriate liabilities to match against assets on a so-called “matched book” basis. This allows them to sidestep the economically costly requirement of having to acquire large sums of liquid cash float on an intraday basis to bridge any exchange.”

Well now, the idea that “government or central bank” cannot lend without first attracting funds to lend is a bit of a joke: unless I’m much mistaken the Fed produced around a trillion dollars from nowhere at the height of the recent recession and loaned it to sundry banks.

I suggest Kaminska’s ideas on full reserve can be dismissed until she gets her act together.

A large deficit is OK if it’s spent on investment?

 

Olivier Blanchard (former chief economist at the IMF) made a submission to the US House of Representatives  Committee on the Budget recently. He claimed, “First, deficits, running at more than 5 percent of GDP, are large. Unless they are used to finance an ambitious and credible public investment plan, they should be decreased.”

Well unless I’m much mistaken, the size of the deficit determins the amount of stimulus an economy gets, regardless of whether the deficit is caused by extra capital or current spending. So if a country goes for an excessively large deficit and tries to justify that on the grounds that the deficit arises from extra capital spending, it will find itself with excess demand and excess inflation. 

And what adds strength to the latter point is that there is actually no sharp dividing line between capital and current spending. To illustrate, does something designed to last one year count as capital or current spending? Or should the dividing line be six months or two years or what?

Of course that is not to suggest that a substantial increase in public investment might not be desirable. But the idea that it can be funded via public borrowing is very questionable. At least, if a big increase in public investment is funded via borrowing, that will push up interest rates which will cut private investment, presumably not the effect that those who back more public investment would want.

In short, the world of macroeconomics is very different to the world of microeconomics. That is, borrowing to invest can make sense for a microeconomic entity, e.g. a firm or household. Unfortunately the same does not apply in the world of macroeconomics: a big increase in public investment has to be funded via extra tax, unless we want the extra public investment to be matched by a cut in private investment.  

JFK was an MMTer..!

Seems according to this document* (Appendix A, Note 1) that Kennedy thought the only limit to the size of the deficit and debt was inflation. To be exact, the conversation between Kennedy and James Tobin went as follows.

Kennedy:  “Is there any economic limit to the deficit? I know of course about the political limits. People say you can’t increase the national debt too fast or too much. We’re always answering that the debt isn’t growing relative to national income. But is there any economic limit on the size of the debt in relation to national income? There isn’t, is there? That’s just a political answer, isn’t it? Well, what is the limit?”

Tobin then says (describing the exchange of views) “I said the only limit is really inflation. He grabbed at that.”

Kennedy then says, “That’s right, isn’t it? The deficit can be any size, the debt can be any size, provided they don’t cause inflation. Everything else is just talk.”

The only criticism I’d make of Kenndy’s summary of the debt and deficit there (and indeed, this is a criticism of MMT as well) is that there is actually another limit to the size of the debt, which is that if the deficit is larger than is needed to bring full employment, with a consequent excessive debt piling up in consequence, government and central bank will be forced to raise interest rates unnecessarily so as to damp down the excess demand that stems from the private sector finding itself in possession of more government debt than it wants, and trying to spend away that excess.

Incidentally, those holding government debt cannot of course spend their debt directly on consumer goods or whatever, but they can wait till their particular tranche of debt reaches maturity and then spend the dollars they get at that point rather than reinvest the dollars in more debt.

And finally, I am indebted to “Matthew B” (a Bloomberg journalist) who dug up  and publicised the above points about Kennedy.

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 *Council of Economic AdvisersOral History Interview –JFK#1,08/1/1964