A couple of years ago, as I was trying to understand how money worked, I stumbled upon MMT (Modern Monetary Theory). It felt like an elegant and consistent way to think about the world, and as an open-minded guy who accepts that macroeconomics can sometimes be counter-intuitive, I wasn’t too bothered by the fact that it contradicted most of the common wisdom that was out there.
Still, I sought out criticisms of MMT (just in case I was missing something) but was comforted by the fact that the ones I found either did not understand MMT or were flawed and easily rebutted by MMT proponents. A lot of those who took the time to attack MMT seemed to come from an unorthodox background themselves, such the Austrian school. Maybe because the mainstream simply thought the flaws were so obvious they didn’t think they were worth addressing?
MMT’s problems are very hard to spot when you look at the world from the MMT perspective, so it took me a while to really wrap my head around them. It also made it very difficult to communicate with Warren Mosler (the more reasonable leader of the MMT movement) and we eventually had to agree to disagree when we discussed the subject in his blog’s comment section. I told him I’d have a separate post ready in “1 to 2 weeks“. That was 6 months ago :-)
In my opinion, the deepest flaw in MMT is its lack of understanding of how interest rates work. Here are a few quotes of Warren Mosler (some of which are from conversations I had with him in his blog‘s comment section, some of which aren’t):
“It’s still all a sign that monetary policy is shooting blanks” (from here)
“When the fed pays interest it adds income and net financial assets. And it got permission to do it from congress.” (from here)
“Another central bank may have it backwards as lower rates turn out to be deflationary and slow things down via interest income channels?” (from here)
“I have no fear whatsoever of the Fed causing inflation. In fact, theory and evidence tells me their tools more likely work in reverse, due to the interest income channels. That’s because when they lower rates, they are working to remove net interest income from the private sector, and when they buy US Treasury securities (aka QE/ quantitative easing) they remove even more interest income from the economy. Remember that $79 billion in QE portfolio profits the Fed turned over to the Treasury last year? Those dollars would have otherwise remained in the economy.” (from It must be impossible for the Fed to create inflation)
So according to MMT, the central banks have very little control on inflation (“shooting blanks”). Or worse, they have it backward: they should raise rates if they want to prop up inflation since that generates income for the economy (“interest income channels”). Pushing this logic further, MMT concludes that the central banks should get out of the way altogether, and let fiscal policymakers take care of inflation:
“I’d leave rates at 0 permanently and adjust taxes accordingly” (from here)
So why did MMT go so wrong? In my opinion, the MMT guys look at the world as a public/private sector dichotomy: anything that doesn’t create “net financial assets” in the private sector basically doesn’t do anything. Since monetary open market operations are essentially an exchange of one financial asset for another (a deposit vs. a repo for the same amount), MMT concludes that it can’t possibly have any effect. Only fiscal operations which truly alter the balance of financial assets in the private sector can push the rate of inflation one way or the other. Of course, MMT proponents love to point out over and over that the stock of “net financial assets” held by the private (and external) sectors is equal to the public debt, “to the penny” (I think that might be why Brad Delong deemed MMT a tautology)
In this subsection of the post, we’re going to go over how a central bank can control the price level of the currency it issues, without altering the balance of “net financial assets” in the private sector or requiring assistance from the fiscal side. In fact, I don’t even need to assume that there is any government spending, taxes, etc.
Start from a world of bartering, and assume a central bank pops out of the ground and announces it will be issuing a new electronic currency, the DOBaroo, to facilitate transactions. The mechanics are as follows:
- Everyday the central bank will post a rate at which it will lend DOBaroos overnight
- Anyone can borrow as many DOBaroos as they want provided they post a generous amount of collateral (could be government bonds if they exist, but could also be real assets such as a house, a business, etc. It doesn’t really matter as long as the loan-to-value ratio is sufficiently low to make credit a non-issue)
- The payment system enables the initial borrower of funds to transfer his DOBaroos to a third party: the saver
- Savers receive the overnight rate of interest posted by the central bank (we’ll assume it’s equal to the rate paid by the borrowers, so the central bank pays and receives exactly the same amount of interest, i.e. no impact on private “net financial assets”)
- The central bank announces that it will altruistically set the rate of interest such as to achieve a certain target for the price-level. For simplicity, we’ll assume 2% CPI inflation
The fundamental question is: can the central bank thwart any inflationary pressure and remain on target? The answer is yes, by setting the overnight nominal rate of interest sufficiently high. Even if inflation expectations were out of control at say, 200%, the central bank could post a nominal interest rate of 500%, so that, if you chose to save for a year, you end up with 6x as many DOBaroos as you started with but they’ll be worth 3x as little: in other words you doubled your real capital (100% real return). Unless return on capital in your economy is that high, holding DOBaroos was a more attractive proposition over that period than holding real capital, and therefore rational agents will do it, preventing the uncontrolled inflation from even being expected in the first place, or the need for the ultra-high nominal rates in the example.
Conversely, the central bank can always set a nominal rate sufficiently low (possibly negative) to prop up the rate of inflation when below target.
We’ve simplified a few things to keep things tractable, but none of the corners we’ve cut invalidate the validity of this theory in the real world. The DOBaroo example is almost verbatim from this theory section, and a more “real world”-like currency construction can be found here. The DOBaroo name is a reference to MMT’s flagship example: the UMKC Buckaroo.
Interest Income Channels
Finally, let’s go over the dreaded “interest income channels” argument whereby savers are encouraged to save even more when interest rates are low in order to maintain a certain level of future consumption, thereby pushing down aggregate demand. This argument leads Warren Mosler (and a few others) to conclude that lower rates are deflationary.
First of all, Warren’s got the causation backward. The saver isn’t saving more because real interest rates are low: real interest rates are low because the saver wants to save more. Is Warren saying that the demand for saving goes up as real return goes down? Ask yourself this: if real return on your savings was -100%, i.e. whatever you save gets vaporized after a year: how much would you save? Personally, I’d consume everything I’ve got as fast as I could.. I might even borrow to consume some more → There always exists real rate of return at which the savings market is in equilibrium.
In any case, the government should not attempt to distort/control real return on capital any more than the price of apples. Real rates are the the price mechanism by which we mutually agree to exchange our consumption through time and we use that price signal to decide how much of our output we produce for investment vs how much we produce for immediate consumption. If we all want to consume tomorrow but not today, real interest rates will be very low (at least in the short term, everything else remaining equal). That’s especially true if tomorrow we’ll all be old and there won’t be many young people to cater to our needs (high demand, low supply → high price of future consumption → low real return). Conversely, if we all want to consume today rather than tomorrow, then real interest rates will be high.
Central banks generally set nominal interest rates wherever they need to be to keep the real overnight return on money in line with the real risk-free overnight return on capital. Like the Higgs Boson, the latter is not observable but it’s still an important concept. A central bank can wiggle its target rate a bit higher or lower than theoretical target, especially if the market is questioning its credibility (as we’ve seen in the DOBaroo’s extreme example), but by and large, the rates a central bank sets are being imposed on it by its mandate and the market conditions.
Contrary to what MMT claims, interest rates can be used to regulate the price level, regardless of whether central bank operations affect the level of “net financial assets” in the private sector. So if monetary policy does the job, should we use fiscal policy for that purpose? In future posts, we’ll see that the answer is No. As we continue to pull on that thread, the entire fabric of the theory will fall apart. In the mean time, I welcome all comments with constructive counter-arguments.