Why MMT is deeply flawed, part 1: the DOBaroo

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)

The Natural Rate of Interest is Zero

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)

The DOBaroo

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.

Conclusion

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.

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26 thoughts on “Why MMT is deeply flawed, part 1: the DOBaroo

  1. Nathan Becker (@netbacker)

    You start by ignoring the fundamentals and try to prove MMT is wrong? How cool is that?
    In fact, I don’t even need to assume that there is any government spending, taxes, etc.
    The very basis of MMT is that it is based on state money, the power of the govt to enforce taxes and hence their view that Taxes drive money. This is what makes fiat issuing government to remain solvent. With unlimited capacity to create new money, the natural rate of interest is indeed 0. Taxes and bonds drains excess money from the system, hence controlling inflation.

    Reply
    1. DOB Post author

      Nathan,

      The fact that taxes are necessary for a fiat currency to have value isn’t an absolute “fundamental”, it’s an MMT(/Chartalist) conclusion. I don’t ignore it, I reject it.

      The simplified system I laid out in the post (the “DOBaroo”)–which more closely resembles the operational workings of modern monetary systems than the MMT “Buckaroo”–shows how a fiat currency can have value, without requiring government spending/taxes.

      Reply
      1. Nathan Becker (@netbacker)

        You are mixing reality with conceptual thinking. *Today* in the US, with its fiat currency, taxes is what drives the currency. There’s no other reason to use the US dollars otherwise. That’s also true in Japan, Australia, UK and other monetarily sovereign nations. Can you show me a real world example where there’s something similar to fiat currency that has value and with wide acceptance that can exist standalone?

        Secondly, in the modern world, there is no way to get rid of governments. The idea that someday there will be a one world government is a myth. The would will continue to be made up of nations, each of which is defined by its borders, laws and its currency. Lose control of any one of them, and the validity of that nation is lost.

        So what you are doing here is just a mind exercise that serves no purpose in the real world. Anyone can start with an assumption that ignores real world situations and build a model to disprove reality. Reminds me of a quote — ” This may work in practice comrade, but does it work in theory?”

        MMT describes how it works in practice, even though it has theory at the end of its name.
        If you need a primer see this http://bilbo.economicoutlook.net/blog/?p=1075

        Reply
        1. DOB Post author

          *Today* in the US, with its fiat currency, taxes is what drives the currency. There’s no other reason to use the US dollars otherwise.

          Of course there are other reasons. You need a currency to transact in a manner that’s more efficient than barter. The dollar is the standard currency used in the U.S. in part because taxes are paid in dollar, also because of legal tender laws and just because historically the people has agreed to use it. None of this gives the dollar its value, its just why we use it rather than another medium of exchange.

          Can you show me a real world example where there’s something similar to fiat currency that has value and with wide acceptance that can exist standalone?

          Nope, but neither can you show me a fiat currency which isn’t issued and managed by a central bank which targets interest rates or something related, so this neither proves nor disproves anything.

          Secondly, in the modern world, there is no way to get rid of governments. The idea that someday there will be a one world government is a myth. The would will continue to be made up of nations, each of which is defined by its borders, laws and its currency. Lose control of any one of them, and the validity of that nation is lost.

          I mostly agree, although this is very vague and completely unrelated to the matter at hand.

          Note that I didn’t say we shouldn’t have taxes or government. I didn’t even say that taxes and government spending have no effect on the price-level: they do. When the government spend, just like when I spend, the government contributes to aggregate demand. The government just happens to be bigger than me.

          All I said was that taxes and spending weren’t necessary means to control the price-level: the central bank can always offset any fiscal policy effect on aggregate demand/the price level.

          So what you are doing here is just a mind exercise that serves no purpose in the real world.

          The purpose is to show that monetary policy (performed by central banks which very much exist in real world) actually matters. It can’t just be assumed away and declared impotent the way MMT does. This isn’t controversial at all btw: everyone except for MMT agrees on that.

          ”This may work in practice comrade, but does it work in theory?”

          I hope you’re not insinuating that I’m a communist given that you’re the one quoting Bill Mitchell and defending MMT, while I’m defending ultra-free market monetarist ideas.. :)

          Reply
  2. Nihat

    “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.”

    Okay, you start by suggesting the CB can do something. Then you give an example with numbers. But those numbers appear to show that the CB did nothing of the sort. I thought the point of the exercise was to thwart inflation, but your example takes the expected and actual (after CB does its trick) inflation rates to be equal. What did the CB do achieve really?

    Reply
    1. DOB Post author

      That’s the idea of a credible threat:

      If person A holds a gun to person B’s head, and B does what A wants, then A doesn’t have to shoot. That doesn’t mean that a bullet wouldn’t have flown out of the gun had A pulled the trigger..

      The gun is the ability to set nominal rates as high as needed. If the markets understand the CB can do that, it won’t have to. But it could..

      (I understand gun analogies are probably not in best taste these days, but I couldn’t come up with anything clearer)

      In theory, the CB doesn’t have to be as extreme as in my example: setting nominal rate = inflation target + risk-adjusted natural overnight real rate should pretty much keeps the currency stable (or course the latter quantity is a moving target). The CB should only deviate from that if expected inflation drifts from target (i.e. either the market is questioning the will of the CB, or the CB mis-assessed the natural real rate which isn’t observable).

      Reply
  3. Max

    The concept of a “net financial asset” is problematic. Every financial asset is some institution’s liability (whether it’s convertible into something else or not). This includes treasury bonds and currency, which are the debt of the government and the central bank respectively.

    Monetarists tend to make the same mistake as MMTers, by wanting to treat money like a commodity rather than a debt. (Example: http://www.themoneyillusion.com/?p=13294 )

    I think taxes drive money in the sense that they explain why people in country X use money X and people in country Y use money Y. It’s convenient to use the same money that the government uses. But this has nothing to do with why money has value. It has value because it’s the debt of a trusted bank (could be a private bank).

    Reply
    1. DOB Post author

      Agree with all. Some market monetarists (including Sumner) tend to focus more on quantity than interest rates which leads them to conclude that increases in the quantity of money at the zero bound by buying safe assets achieves something. I very much disagree with him on that.

      Reply
  4. warren mosler

    not that the rest makes any sense either,
    but why would anyone sell anything for dob?
    at best you rely on an infinite regression?
    try it in a room full of people- offer a new currency with an interest rate and see if anyone cares.
    then try telling them there’s an exit tax to get out of that room payable in dob, and your guy at the exit has a gun to enforce the tax, and note the instant value of the dob.

    or, alternatively, make the dob convertible into some real good or service, directly or indireclty. that’s works too.
    but i suggest you need something.

    the dollar is a simple public monopoly, and the rest follows.

    Reply
    1. DOB Post author

      not that the rest makes any sense either,

      Thanks for looking at this with an open mind. MMT was my first intro to thinking about money, and even when thinking from within that framework, I converged to the paradigm above–which ends up being roughly equivalent to “the mainstream” (just a different way to explain it). I wasn’t reading all that much outside of MMT world at that time, so it would be an incredible coincidence for me to end up on something that’s both wrong and the mainstream.

      but why would anyone sell anything for dob?

      I’m going to read your question as “where is the ultimate demand for DOBaroos coming from?” since I assume an answer involving turning around and transacting with someone else won’t satisfy you. The answer is: because they expect the DOBaroo to yield sufficiently (in real terms) to preserve its value in the marketplace. They correctly expect that because the central bank has credibly committed to raise nominal interest rates sufficiently high above inflation expectations (if they ever were to rise) to push the price-level back on target.

      I’m not denying that the classroom/household example works nicely with MMT-style currencies, but that doesn’t make it the correct way to think about the real world. In the real world, the governments have specifically delegated power to set interest rates at which they fund themselves to central banks. This is precisely to protect the price-level from fiscal policy impacts.

      If they shut down central banks and told them to “just set” interest rates at zero (that’s what you’re advocating), MMT would be the correct way to think about money. But that just isn’t the institutional setup in the real world as of now–and it shouldn’t be, but that’s the subject of an entirely different post. The only goal in this post is to recognize that monetary policy does affect the price level, not to argue its superiority over fiscal policy.

      or, alternatively, make the dob convertible into some real good or service, directly or indireclty. that’s works too.

      No need to make the currency convertible in anything, as seen in the example. Please let me know specifically what you think will happen (and why) in the real world if a currency were to be setup the way I described, so I can understand what fundamental assertion you’re rejecting.

      Reply
    2. Max

      “or, alternatively, make the dob convertible into some real good or service, directly or indireclty. that’s works too.”

      That’s how it always works, but current convertibility isn’t required – the theoretical possibility of convertibility is enough. The U.S. dollar isn’t convertible into anything, but there’s nothing stopping the Fed from offering convertibility. If it really had to, it could.

      The shocking conclusion is that “fiat” money isn’t something invented by Richard Nixon in 1971. We were using fiat money all along! Sometimes convertible, sometimes not.

      Reply
      1. DOB Post author

        Max,

        I strongly disagree: convertibility into real assets is never required. The central bank mostly owns short term collateralized loans (repos) and government bonds, both of which are nominal assets that are almost by always valued close to par. Convertibility in those assets can’t possibly help the currency retain value since they’re naturally tied to the value of the currency.

        The way to support the value of your currency that is to set real return on the unit of account in line with real return on capital (after adjusting for risk and term premia).

        Reply
  5. Nihat

    DOB, you conclude your post:

    Contrary to what MMT claims, interest rates can be used to regulate the price level, regardless […]. 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.

    According to MMT, isn’t the job of fiscal policy provisioning the government for public purpose, and the price level maintenance a constraint on that policy? From the rest of your post, it is clear that you are not saying, because the CB and monetary policy can effectively regulate price level, our fiscal policy can be more liberal and public purpose more expansive. But the way you phrased your conclusion begs the question.

    Reply
    1. DOB Post author

      According to MMT, isn’t the job of fiscal policy provisioning the government for public purpose, and the price level maintenance a constraint on that policy?

      If fiscal policy is the management of government spending and taxation, then according to MMT, it fully controls inflation and yes, some element of it must be constrained by the inflation target.

      I agree that fiscal policy impacts the price level (so does just about 100% of the mainstream, including the neo-classicals and the neo-Keynesians). I disagree that fiscal policy should be used to willfully control the price level. But that wasn’t explicitly argued in this post, I’m saving that for later. On that the neo-Keynesians (of which MMT are a descendant of) disagree, and the neo-classicals / market monetarists agree.

      Reply
  6. Anders

    DOB,

    What I think your “Econs”-style DOBaroo example demonstrates is that higher CB rates _can_ have a demand-deflating effect at an extreme – ie as deployed against inflation running at over 10%. (But we knew this already from real-world examples of very sharp interest rate hikes, such as the early 1980s or the UK in the early 1990s; these presumably worked mainly via the interest expense / debt deflation channel though.)

    But I don’t think you demonstrate the potency of interest rate policy for everyday – less extreme – inflation management. Using your analogy, if central bank rates were like a gas pedal, it should be possible to show some lagged impact of rates on inflation, using a model normalising for the ‘gradient’ represented by economic conditions. AFAIK, no central bank has managed to do this: they all treat the directional impact of rates on spending as a stylised fact.

    Looking at microfoundations, I think you focus on opportunity cost in a way which doesn’t tie to how the interest income channel works in the real-world. If you work at an I-bank, I imagine you are rather a net creditor household than a net debtor. Do you really feel that small increases of a point or so in interest rates prompt you to curb your discretionary spending? I have no rapport with this (speaking as another such household). And as firms use discount rates that are much higher than their WACCs, I don’t find it plausible that firms’ investment plans are curbed by a small increase in rates. Finally, if we are being sucked into a Japanese vortex of ZIRP, where a swathe of retirees and near-retirees see their incomes highly exposed to interest rates, I think interest income becomes an increasingly relevant, and tricky, effect to model.

    My own view is that the mainstream attachment to inflation and interest rates is largely premised on historical effects relating to the behaviour of borrowers with floating rate (often mortgage) debt. Many of these effects are being attenuated over time: housing as an ‘ATM’ looks broke for a generation, whilst increasing willingness by borrowers (with exceptions) to fix interest rates long term (incl via bonds) weakens the interest expense channel further.

    In short, interest rates are surely a very blunt instrument. Given the recent emergence of institutional frameworks (such as the UK’s Office of Budgetary Responsibility) which could easily de-politicise the fiscal stance per se, surely the right answer is to use fiscal policy to manage inflation. Interest rates could then be treated as exogenous, as per MMT.

    Reply
    1. DOB Post author

      Hi Anders,

      What I think your “Econs”-style DOBaroo example [..]

      What does “Econs”-style mean? Couldn’t find anything on Google..

      (But we knew this already from real-world examples of very sharp interest rate hikes [..]

      Oh yes, I’m not claiming any originality here. This is something everyone knows, except for the MMT-ers who reject it.

      But I don’t think you demonstrate the potency of interest rate policy for everyday – less extreme – inflation management.

      See comments below, but just because you view your own demand function as inelastic doesn’t mean the aggregate demand function is. Small moves work just the same way as large moves, except less obvious in an example..

      Using your analogy, if central bank rates were like a gas pedal, ..

      I assume you’re talking about the analogy that Warren deleted on his site? I will repost it here for the record..

      ..it should be possible to show some lagged impact of rates on inflation, using a model normalising for the ‘gradient’ represented by economic conditions. AFAIK, no central bank has managed to do this: they all treat the directional impact of rates on spending as a stylised fact.

      I’m no econometrics expert, but I don’t think it’s that easy.

      First of all, it’s the difference between the natural nominal rate (defined as natural real rate + inflation target) and the targeted nominal rate that should be an input to inflation, and we’re out of luck there because the natural real rate is completely unobservable (I can’t imagine any economic conditions that could be used as a proxy).

      Second the impact wouldn’t be lagged, it would be led: the minute the central bank announces how it goes about its business, the market has all the information it needs to set forward rates, which factor into the term rates that borrowers and investors face when making decisions. It’s only when the central bank committee surprises the market and disagrees with implied expectations that there is a lagged impact.

      All in all, it’s an incredibly complex equilibrium so I think it’s going to be very hard to establish causality by looking at the data: imho, we’re stuck with the stylized facts. Also see: Goodhart’s_law

      If you work at an I-bank, I imagine you are rather a net creditor household than a net debtor. Do you really feel that small increases of a point or so in interest rates prompt you to curb your discretionary spending? I have no rapport with this (speaking as another such household).

      I don’t think the low elasticity of i-banker demand functions is particularly relevant to the economy :) When the price of gas moves up from $3/gal to $3.25/gal, you or I probably don’t drive any more or less than we otherwise would, but that price move is sufficient to absorb pretty massive supply shortfall (some data on elasticity of gas demand). Likewise, a 100bp move in rates probably doesn’t make us do much, but in the aggregate, it makes a whole lot of people to a whole lot of things..

      And as firms use discount rates that are much higher than their WACCs, I don’t find it plausible that firms’ investment plans are curbed by a small increase in rates.

      When you say discount rates, are you talking about return on equity hurdles? Those are of course higher than the yield on nominal bonds. Generally, I think it’s fair to assume that if a firm can source funds at lower yields, everything else being equal, they expect more profits (since they face a lower interest cost) and are more likely to make the investment. Disagree?

      Finally, if we are being sucked into a Japanese vortex of ZIRP, where a swathe of retirees and near-retirees see their incomes highly exposed to interest rates, I think interest income becomes an increasingly relevant, and tricky, effect to model.

      If a retiree has any interest rate risk (as in, his future consumption depends on the path of interest rates), he’s doing something wrong: as the name indicate, the idea of fixed income is that you can get certainty over your future income at the time you purchase the asset. The fact that the 1970s retirees got better deals than the 2010 retirees in terms of real yield does not contradict the effectiveness of monetary policy.

      My own view is that the mainstream attachment to inflation and interest rates is largely premised on historical effects relating to the behaviour of borrowers with floating rate (often mortgage) debt.

      The only country I know of where mortgages are mostly floating rates is the UK. The mainstream in the US still agrees that monetary policy works.

      In short, interest rates are surely a very blunt instrument. Given the recent emergence of institutional frameworks (such as the UK’s Office of Budgetary Responsibility) which could easily de-politicise the fiscal stance per se, surely the right answer is to use fiscal policy to manage inflation. Interest rates could then be treated as exogenous, as per MMT.

      Interest Rates are the perfect and most natural tool for managing inflation. A full explanation of why using fiscal policy is so wrong tool is beyond the scope of this comment, but a here are couple of pointers before a I get around to writing a more articulated post:

      1) If real interest rates are prevented from reaching their equilibrium levels (by using fiscal to push one way and monetary the other), there would be a huge distortion on investments and capital flows. Read this comment and subsequent responses here [NB: my ideas might have shifted a bit since writing these comments]

      2) Using fiscal policy to regulate inflation would cause wild swings in the taxpayer’s equity = public assets (government investments) – public liabilities (governmental bonds). Would you want to immigrate in a country with a low taxpayer equity? Everything else equal, that country will tax you more and provide you less public service than a country with near-zero taxpayer equity.

      Reply
  7. Anders

    DOB,

    I’m intrigued by your MMT ‘journey’. I have covered similar ground since 2010 with similar motivations to you, but I haven’t made the break with MMT that you have. I have, though – relatively recently – concluded for myself that a key prerequisite for MMT is that one needs to be happy for inflation to be managed by fiscal, rather than monetary policy: if you don’t accept this (and without this bit being accepted by the authorities), MMT gets nowhere. The centrality of this tenet isn’t one you see MMTers articulate.

    Note that getting comfortable that fiscal policy could do the job at least as well as monetary policy doesn’t require one to believe that monetary policy is diametrically flawed. Whilst Warren often makes this – stronger – claim of perversity, I prefer his weaker claim of futility, exemplified in his ‘kid with a fake steering wheel’ analogy…

    I look forward to hearing your conclusions on fiscal policy as a demand management tool. One particular question I’m interested in is how we gauge whether any given budget surplus should be embraced as removing excessive aggregate demand, or feared as encouraging the private sector into a credit binge (as I believe Godley cautioned in the late 1990s); I don’t find MMT coherent on this point.

    Finally, I think you are unfair on MMT when you say ‘anything that doesn’t create “net financial assets” in the private sector basically doesn’t do anything’. Things that don’t create NFA have been acknowledged and discussed as ‘horizontal’ transactions in the wider Post-K tradition for years, along with private sector credit and inside money.

    Reply
    1. DOB Post author

      Note that getting comfortable that fiscal policy could do the job at least as well as monetary policy doesn’t require one to believe that monetary policy is diametrically flawed.

      Agreed: you could conclude that fiscal is the right tool even if you conceded that monetary works.

      One particular question I’m interested in is how we gauge whether any given budget surplus should be embraced as removing excessive aggregate demand, or feared as encouraging the private sector into a credit binge

      Haven’t thought through this completely but I think that the only private credit formation I would rather not see is that which is influenced by regulations and fiscal incentives (more so than overall level of deficit/interest rates). For instance, the last credit bubble came because the banking regulator told banks they were free to lever up to stupid ratios as long as the assets were stamped AAA. Then you’ve got all GSEs and interest deductions…

      Finally, I think you are unfair on MMT when you say ‘anything that doesn’t create “net financial assets” in the private sector basically doesn’t do anything’.

      Warren Mosler was my entry point to MMT and I’ve never heard him push back on this, but maybe other parts of the MMT world are smarter on horizontal transactions?

      Reply
  8. DOB Post author

    Warren Mosler deleted my latest response to this thread of his blog.

    Am reposting here for the record:

    @WARREN MOSLER,

    that central bank asset is only relevant if the currency is specifically convertible.

    It’s sufficient to know that at some point in the redemption of the entire money supply the central bank will sell its lone barrel of oil to know that the entire money supply can’t be worth less than the barrel of oil, which means the expected inflation rate can’t be infinite, which means nominal rate can be made arbitrarily higher than expected inflation, which means real yield of the currency can be made arbitrarily higher than real yield on real capital, which means the price-level of the currency can be supported by interest rates.

    central bank research can’t find any meaningful correlation between interest rates and inflation in the direction assumed.

    Of course they won’t: if you were driving a car on a hilly road trying to maintain constant speed, would you find a correlation between the position of the gas pedal and the speed of the car?

    If anything you might start pressing the pedal hardest when the car is under target speed. Would you then conclude than pressing the gas pedal slows down the car??

    That’s standard Goodhart’s law, and I’m pretty sure central bank staffers know that and aren’t looking for this kind of correlation.

    Reply
  9. Anders

    DOB

    You maintain that AD responds in a predictable way to base rates, for various levels of base rates; I disagree. Since, as you point out, an empirical approach doesn’t endorse the efficacy of monetary policy, I think it’s appropriate to examine potential transmission mechanisms from changes in rates to AD. I see two main mechanisms, which, when explored in the round, have the potential to conflict with each other. This illustrates that the effectiveness of monetary policy as an inflation management tool is at least compromised.

    (1) The first potential monetary transmission mechanism is that agents might be prompted to deploy their disposable income differently. This is an opportunity cost argument. Based on an agent’s utility functions, an increase in the rate of return on financial assets or liabilities could make an agent forego a given item of discretionary spending to increase her net lending (or decrease her net borrowing).

    (2) The other potential monetary transmission mechanism is that agents’ disposable income may be altered: (a) those borrowers exposed to floating rate loans may find their debt servicing costs increased, and (b) those lenders who derive a meaningful portion of their income from floating rate financial assets (as opposed to fixed income) may find their income increased.

    Your analytical framework seems to focus on the former and to disregard the latter.

    Focussing on # 1, I am dubious that small changes in rates actually enter into real-life utility functions (my reference to “econs” – a behavioural economics term for homo economicus – was intended to convey this scepticism). When I said “discount rates”, I meant the rate at which discretionary projects are evaluated on an NPV basis. My career at a large US corporate, an i-bank and now private equity leaves me convinced that CFOs simply don’t alter their capex spend based on the change of a point or two on base rates. IRR / NPV calculations are just not that fine or granular; any theoretical effect that a small change in rates might have would be fully outweighed by wider commercial considerations. What applies in relatively sophisticated firms applies all the more to households; my point about my own utility function being quite unresponsive to the changing opportunity cost of buying a new car vs putting the money in the bank is that if even I am relatively insensitive to base rate movements, then most households must be even more so.

    Turning to # 2a (floating rate borrowers), here I believe there is a robust transmission mechanism (in the traditional direction). Admittedly, in the UK, the BoE holds most residential mortgagors by the cahunas. But in the US, so many borrowers manage to avoid exposure to floating rate debt, either by terming out their mortgages or by issuing bonds rather than bank loans, that this channel is weakened.

    Looking at # 2b (floating-rate ‘rentiers’), you seem to reject the idea that many households have a meaningful portion of floating rate interest income; but data for the US (including that cited by SoberLook at http://soberlook.com/2012/08/feds-zero-rate-policy-carries.html) suggests that this is a potent channel. Sure, one can argue the marginal propensity to consume of rentier households will be lower, but even so, the channel should look meaningful enough to give one pause before hiking rates. My point about Japan was that the longer rates stay low, and the shorter the average duration of government bonds, the more important we should expect bank balances to become relative to other financial assets; so this effect will only grow over time. (Japan is I think what gives Mosler most conviction that the interest income channel is robust; household bank balances in Japan are huge.)

    Your two objections to using fiscal policy to manage inflation are interesting. I agree entirely with your first point, that fiscal and monetary policy shouldn’t pull in different directions, but I don’t see it as an objection: under MMT, one would stop actively using monetary policy, and would subordinate the question of the right level for base rates to the objectives of the fiscal stance and debt management. Perhaps I don’t follow entirely your second point about taxpayer equity, but I have the following concerns with it:
    (i) “taxpayer equity” is a bizarre concept which seems to apply a household or business paradigm to the state. I don’t think anyone actually considers such a thing in practice, whether potential immigrant, taxpayer, politician or bond investor. I’m not sure why it should matter. A bond investor trying to assess Greece’s creditworthiness might look at government “investments” that could be disposed of, but I don’t think anyone does this for a state with monetary sovereignty such as the US or UK. As for people other than bond investors, what matters is surely the real productive capacity of the economy; this ought to move steadily upwards under any inflation-fighting regime.
    (ii) I don’t see any reason that fiscal stance being the main inflation tool should lead to any greater fluctuations in net debt than at present. Under MMT, politicians agree on what the government should buy (and indeed own) and where the tax burden should fall, and in the context of this, the macroprudential authority recommends flexing tax rates or thresholds to influence demand.
    (iii) under MMT, the implementation of the job guarantee can provide a further price anchor decreasing the need for changes in tax rates (note that this is the least palatable aspect of MMT in the eyes of eg Cullen Roche, but it isn’t to my mind an essential part of the MMT package).

    There is a third objection to using fiscal policy as an inflation-managing tool, which you haven’t mentioned: namely, that fiscal policy is inappropriate because politicians can’t be trusted to take away the proverbial punchbowl when the economy is reaching full capacity. I don’t buy this objection either. First, the use of an independent body to recommend a fiscal stance _irrespective of how that stance is made up (in terms of the actual configuration of spending and taxation)_ should remove the temptation for politicians to run too large a deficit for the inflationary risks of the economy.

    Second, the mainstream seems to want to put monetary policy on a pedestal, with an independent central bank, pretending that it is somehow above politics. But, once you look beyond the private sector as an amorphous mass (or a representative agent), you have to concede that significant rate movements inevitably transfer disposable income between net borrowers and net lenders (the letter comprising not just banks, but also households with large bank balances). The distribution of national (disposable) income across an economy is the stuff of politics. The idea that monetary policy is apolitical is just untenable.

    The reason I mentioned this particular prerequisite for MMT, on which we seem to agree, (namely, that one needs to be happy for inflation to be managed by fiscal instead of monetary policy), is that even if one thinks monetary policy can be potent under some circumstances, this doesn’t fatally weaken MMT, provided that fiscal policy can be shown to be effective. So the question of whether or not MMT is “deeply flawed”, in this context, turns on the relative effectiveness of fiscal vs monetary policy. Unlike monetary policy, fiscal policy is able to use transmission mechanisms all of which point in the same direction, so as to speak: by augmenting or decreasing disposable income. And also unlike monetary policy, fiscal policy is by definition consistent with the political / distributive objectives of the government.

    This leaves MMT’s insights – notably, the ‘functional finance’ approach of Abba Lerner – fully intact.

    Best wishes

    Reply
  10. Anders

    DOB – a couple of other points. An old paper from 2003, below, does a better job than me of explaining why monetary policy is a blunt instrument at best for managing inflation – and this was before the learning experience of QE outside Japan: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=382401

    Separately, in response to your specific point (this may now be superfluous after my post above):

    “[a gas price increase from $3 to $3.25] is sufficient to absorb pretty massive supply shortfall… Likewise, a 100bp move in rates probably doesn’t make us do much, but in the aggregate, it makes a whole lot of people to a whole lot of things”

    This isn’t a good analogy. People spend a lot of their income on gas, purchase it regularly, and are used to looking at how much it costs. To the extent the last X% of one’s gas purchases are discretionary, the price of the good itself is an easy variable to process when determining how much of the discretionary purchase to make. Base rates are not a straightforward variable for people or firms to process – which is why I maintain that unless base rates are moved massively, small changes will simply be disregarded.

    Reply
  11. Anders

    DOB – not wanting to bombard you, but your comment suggested you might not know of that many MMTers other than Mosler. So in case you hadn’t seen it, there is a decent post from Scott Fullwiler below covering the ambiguities of monetary policy . It contains links to various interesting pieces including a joint paper by Godley and Lavoie from 2007 arguing for a certain configuration of fiscal and monetary policy.

    http://neweconomicperspectives.org/2013/01/functional-finance-and-the-debt-ratio-part-iv.html

    Reply
  12. DOB Post author

    Hi Anders,

    Happy new year.

    I’d like to delay the discussion on pluses-and-minuses of fiscal policy until I’ve had a chance to write a proper post on this, but agree with you political independence isn’t the main issues as a central-bank like independent body could be created.

    Let me know focus on your other statements which revolve around the redistribution of wealth in the private sector as a function of interest changes and how that might impact AD/the price-level.

    When interest rates (including but not limited to the base rate) move in a way that doesn’t follow the forwards, wealth is transferred between agents in the economy depending on what interest rate risk they hold.

    Further, wealth is transferred between the govt and the private sector due to all the interest rate risk embedded in treasury debt. And also, (expected) wealth is transferred between the govt and the private sector due to any expected change in future taxes as a result of the curve move (note that the impacted taxpayers don’t have to be the same guys who hold the debt, so there can be a ton of redistribution there too).

    Even if you compute all the wealth changes, you can’t even multiply those by marginal propensity to consume in order to get the change in AD because MPC is also likely a function of rates. So needless to say, that calculation requires much more data and effort than I can provide.

    Let me instead take refuge in some mathematics:

    We’ve agreed that extreme rate changes in interest rates can drive the price-level one way or the other in extreme ways. (quoting you: “DOBaroo example demonstrates is that higher CB rates _can_ have a demand-deflating effect at an extreme”)
    Can we further agree that the effect of rates on the price-level is continuous (that is: you cannot cause a huge jump in the price-level by moving the rate by some arbitrarily small amount)?
    Now, let me concede two things that don’t affect my conclusion:
    1) The sensitivity of the price-level to rates might be low (that’s essentially what you’re saying when you mention that a few %-age points might not affect your consumption patterns)
    2) Even thought I don’t believe it’s the case, I don’t have a solid proof for why it couldn’t (locally) move in the “wrong” direction (that is higher rates leading to more AD)
    Despite all this, I can invoke the intermediate value theorem to say that: monetary policy can achieve any price-level with some rate somewhere in between the extreme rates of the example. That means it works, even in “normal” scenarios and despite all the “income effects”.

    I’ll try to come up with some proof/conditions why the direction works out, even locally.

    Regarding your comments on CFOs: I wasn’t in banking-proper but I’ve met a few CFOs. Can’t say they ever walked me through their decision making process for extending their business. Let me venture a guess though: I’m imagining some sort of earnings projection, and some implied IRR based on the earnings and the amount of equity they put in day-1. If they “like” the IRR, they go with it. Am I close? The primary impact of rates isn’t going to be in the IRR-threshold, it’s going to be directly in the earnings: if, for instance, the profit before interest of the venture if $5/year at the interest cost on the debt issued is $4/year, then lowering rates from 4% to 3% would double the future earnings which presumably can make the difference between yay or nay.

    Reply
  13. Anders

    DOB – happy new year to you too.

    I would agree it seems unlikely that a small change in rates could move AD very far, although even if the function might be continuous, I do think it may be indeterminate in some regions, based on other variables such as govt debt/GDP (one of the links I sent postulates a simple relationship where the greater the debt/GDP, the more robust the income effects – so that an increase in rates can be contractionary at low debt/GDP or expansionary at high debt/GDP). And even if one postulates that the AD function of base rates is not indeterminate, the sensitivity of AD to movements in rates of c. 1-2% or less looks very low indeed. Since, as you you seem to agree, empirical research can’t provide much support for central banks, it looks like delusion for the CB to aim to fine-tune AD via small movements in rates. I find myself very taken with Mosler’s metaphor of a kid with a toy steering wheel in the back seat.

    On the topic of CFOs and discretionary spending, your sketch suggests that a company will perform a fully net IRR, using a fully-baked post-tax calculation, including the extra interest cost on the debt required to fund the specific capital outlay. In practice, firms of various sizes seem to look at returns (ROIC or payback period) based on operating numbers (EBITDA and capex) versus a hurdle rate which serves as a proxy for the ongoing capital charge. So my first substantive point is that this analysis won’t tend to pick up small changes in rates: I have seen hurdle rates of up to 35% used today in Western economies, which clearly exceed post-tax cost of debt and equity by a long way, and aren’t adjusted for everyday changes in rates. It would take a sharp increase of base rates of, say, 5% points, to make companies re-work their hurdle rates – but this is well outside the range of normal loosening/tightening by central banks.

    My second point on discretionary capex is that performance vs hurdle is used to rank projects, rather than give an answer yea or nay. There is no reason that the value of hurdle-compliant projects should be the same as the value of discretionary cash flow (after any debt repayment, covenants and/or dividend commitments), and in practice they will always be different. This means that the very highly-ranked projects will tend to get authorised, whilst the lower-ranked projects won’t; for the middle cases, where the cut-off lies will depend more on things like a soft target for a cash balance with a view to possible M&A in future, for example, or commercial considerations. The latter, which might lead to projects being approved or rejected contrary to their return characteristics, could include targets for market share or quality. And many projects, such as a new IT system which improves management reporting / information, will have no quantifiable payback at all.

    It’s common now to refer to ‘sentiment’ as the principal vector of monetary policy, but without robust transmission mechanisms to household and corporate sector discretionary spending, monetary policy is looking increasingly toothless. Interestingly, a recent piece by McCulley and Pozsar argues that monetary policy is entering a phase of being a mere enabler for fiscal policy as the private sector is in a secular deleveraging phase. I would go further and see a primacy for fiscal policy also when the private sector is leveraging, but I applaud their acknowledgement of the inability of monetary policy to reinflate the economy.

    http://www.interdependence.org/wp-content/uploads/2013/01/Helicopter_Money_Final1.pdf

    Best wishes
    Anders

    Reply
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