Tuesday, April 16, 2019

Peter Bofinger — Modern monetary theory: the dose makes the poison

This article explains the ISLM view of MMT in some detail without being overly wonkish for general accessibility. While it is sympathetic to MMT, it is still wrong, but instructively so. Assumptions die hard.

Notice the assumptions about the effect of changes in "money supply" based on money supply being settlement balances in the payments system ("bank reserves balances", abbreviated as "rb").

The effect of such changes in conventional economics is based upon assuming that changes in the amount of rb in the payments system (base money) are determinative of changes in the amount of "money" available for spending in the economy that affects "purchasing power" and therefore price level (inflation).  This assumes a "money multiplier" that controls bank lending through the amount of bank reserves. The notion of the money multiplier has been debunked, but many conventional economists have not yet picked up on this.

The concept of "crowding out" of investment assumes that government borrowing competes with private sector borrowing for investment. This assumes a fixed amount of "loanable funds" available for borrowing. This, too, has been debunked. In the first place, loans create deposits rather than deposits being necessary to extend credit. Secondly, government spending adds the precise amount that government injects into the economy after netting for taxes, which withdraw "money" from the economy (reduce deposits). The balance of the funds injected get transferred in the payments system from government liabilities of zero maturity (rb) to government liabilities of non-zero maturity (government securities usually lumped together as "bonds"). This drains the fiscal deficit from the payments system (monetary base) into government securities.

Conventional economics assumes that issuance of government securities "neutralizes" the purchasing power of the net government injection from deficit spending, that is assumed to be otherwise potentially inflationary. But government securities do not prevent spending other their basis since they are highly negotiable and also prime collateral. So there is essentially no difference between issuing government securities to drain the monetary base and not doing so, other than the interest. It is done operationally in order to facilitate the central bank hitting its target rate when setting the interest rate and not setting to zero, or not paying interest on reserves. In short, issuance of government securities does not neutralize deficit spending as conventional economists assume it does.

Conventional economists have monetary and fiscal operations and their effects wrong, so their analysis is without basis. But it is interesting to see how their analysis goes and this article may be useful in doing so.

Hopefully, one of the MMT economists will pick up on this article and "fisk" it point by point.

Social Europe
Modern monetary theory: the dose makes the poison
Peter Bofinger | professor of economics at Würzburg University and a former member of the German Council of Economic Experts.

1 comment:

Ralph Musgrave said...

Not a bad article. As the author rightly says, a country which funds public spending via government debt which is then almost immediate bought back by the central bank with freshly created base money is basically implementing MMT.

That policy, assuming no interest is paid on reserves equals another MMT idea, namely the permanent zero interest rate idea. So the question arises as to why the latter makes sense, a point the author does not address. I suggest the answer to that question is thus.

If government and central bank create and spend so much base money into the economy that they then have to borrow back some of that money at interest so as to curb inflation, that is clearly a self-contradiction. I.e. what’s the point in imparting excess stimulus, only to then have to negate some of that stimulus via government borrowing?

As for the idea that public investment justifies government borrowing (at interest) that’s nonsense. As every taxi driver who wants a new taxi knows, if he has enough spare cash to buy the taxi, there is no point in borrowing. I.e. the justification for borrowing is shortage of cash, not the fact of making an investment. But governments are never short of cash in that they can grab near limitless amounts of it from taxpayers, or simply print the stuff.

Conclusion: the MMT permanent zero interest rate idea is correct, though I wouldn’t rule out the occasional use of interest rate hikes in an emergency. Milton Friedman advocated much the same. See his para starting “Under the proposal…” here: