Sunday, March 18, 2012

Noah Smith asks, "How can debt affect GDP?"


The problem is this: The way Salmon talks about debt, and debt's effect on GDP, seems to reinforce a common quasi-fallacy in pop economics - the idea that debt can create temporary but "fake" or "artificial" growth.
As Paul Krugman is fond of pointing out, the economy is not like a household. A household can temporarily increase its consumption by borrowing money.

But then Prof. Smith starts slipping off the rails.
But how can a nation artificially increase its maximum possible production by borrowing money? A nation's total productive capacity is determined by things like how many workers it has, how good their skills are, how much physical capital it has, what kind of production technologies it has, etc. How can borrowing money increase any of these things?
First error — currency issuers fund themselves directly. According to the MMT analysis of monetary operations, there is no need for a government that issues its own non-convertible floating rate currency to borrow at all. What looks issuance of interest bearing securities looks like borrowing but it is actually not a fiscal operation at all, but rather a monetary one that drains excess reserves so the cb can hit its target rate.  It works simply by adjusting the composition and term of non-government net financial assets without changing the amount.

Second error, and where Prof. Smith goes off the rails. According to MMT-based macro, government injection of net financial assets into non-government through deficits is appropriately used to offset non-government saving, which results in demand leakage and economic contraction if not addressed by the only entity that can offset changes in non-government saving desire — government.

To maintain output at capacity and full employment, thereby optimizing productive resources, government must accomodate changes in non-government saving by adjusting its fiscal balance in offset. Unless the cb either pays IOR or sets the interest rate to zero, then the Treasury needs to issue securities to drain the excess bank reserves injected by deficits. In this way, the federal debt in the US is properly conceived in terms of national savings rather than as public debt that obligates the government as currency issuer in the same way that private debt obligates currency users.

Yes, there is a macro relationship among full employment, price stability and production and productivity such that they constitute a self-augmenting system if kept in balance by maintaining a full employment budget. The sectoral balance approach and functional finance show the way to achieving this.

Interestingly, the congressional mandate to the Fed states that the Fed should use monetary policy to optimize production in order to maximize unemployment and maintain price stability within tolerance. This is based on the loanable funds doctrine underlying the use of interest rates to adjust saving and investment, which doesn't apply under the current monetary system.

The reality is that effective demand must be managed to ensure optimal use of national productive resources. This is accomplished through intelligently designed fiscal policy that look to employment as an indication of the efficiency and effectiveness of an economy's chief resource, its human "capital."

Less than full employment is a signal that effective demand is lagging owing to demand leakage, and the role of economic policy at this point is to inject net financial assets into non-government to offset this leakage. The appropriate size of the deficit is given by the sectoral balance approach, and it is empirically confirmed by the employment rate. The inflation rate shows when demand is exceeding the capacity of the economy to expand to meet it, necessitating adjustment of non-government net financial assets downward.

In this way, economic policy is consistently geared to a full employment budget along with price stability, which ensures optimal use of national resources since it directly addresses idle resources. MMT-based macro also uses an employer of last resort program to create a buffer of employed to mop up residual unemployment and a floor wage that serves as a price anchor against inflation. According to MMT the only "structural" unemployment is frictional, so the "natural rate" of unemployment is in the area of 1-2% rather than 4-6%, or even more as in the "new normal" of 6-8%.

What about the intertemporal government budget constraint (IGBC)? Not to worry. See Scott Fullwiler, Interest Rates and Financial Sustainability (2006).

Read it at Noahpinion

How can debt affect GDP?
by Noah Smith


paul meli said...

Some things are so simple a caveman can do it.

He neglects to ask what happens when all of the money created is accumulated (effectively destroyed) as wealth (savings).

And he neglects to ask what happens when $0.5 Trillion in net exports is drained away annually.

It dosn't occur to him that maybe an economy doesn't function very well on negative money (private debt accumulated by others as wealth).

Why did these guys waste so much on their educations?

College students - the only known consumers that don't want to get their money's worth.

Tom Hickey said...

Noah Smith majored in physics at Stanford, graduating in 2003. He has criticized the economics profession and economic teaching based on this knowledge. I would think that stock-flow consistency, national accounting identities and economic theory and engineering based on this would appeal to him. Maybe an MMT physicist should explain the system dynamics and its math to him.

paul meli said...


It's hard to believe he doesn't get it - I know he's smart. I think over the next several years there will be an awakening among those that are skilled in math and systems. The trouble is there will also be a lot of noise. Young people seem to get it pretty quickly if they are ever going to. They haven't been brainwashed yet.

If I recall form my education (I graduated in 1971) I didn't learn about closed sytems in Physics - I learned it in Thermodynamics 101 in my Junior year.

I don't know if that's still the case.

I also am not sure that citing the 2nd Law of Thermodynamics is going to win many economic arguments because it isn't intuitively analagous if one hasn't been exposed to it. I've tried it several times and so far…crickets.

I knew MMT was the right paradigm when I first read it at Bill Mitchell's blog (thank you Brad DeLong of all people for the link) because he talked in terms of closed systems (actually used the term I believe) and the basis for my understanding was almost instantaneous.

For economics the closed-system properties apply to the monetary economy and makes analysis of money-creation easy. Money acts a lot like electricity or hydraulic fluids and can be modeled similarly, hence the term "circuitists".

Matt Franko said...


"and the basis for my understanding was almost instantaneous."

There you go.


WillORNG said...

In a sense, non-government net saving provides the fiscal/real economic resources "space" for net government spending to balance the national income "sums".