Sunday, June 17, 2012

The Deficit We Should Worry About

Since not long after President Obama took office, Republicans have been making a big fuss about the federal deficit--something they don't typically do when a Republican is president and/or when military spending is the focus of attention. Then it's the Democrats who make a fuss about the federal deficit.

What's distinctive about the deficit fuss this time around is that it's linked to the 2008 economic crash and our subsequent economic troubles--as if, in hard times, it's important for all of us to tighten our belts and the federal government isn't doing its share of this. Usually this line of thinking is bolstered by an analogy to household budgets, which need to be balanced on pain of producing long-term hardship.

Not long ago a friend of mine, Steven Stark, very nicely explained the problems with this analogy. In a nutshell (and oversimplifying matters a bit), the argument is this: The federal government is fundamentally unlike a household (or a state govermnent, for whom the household analogy works better), because the federal government is a creator of currency. It creates the currency that it spends--and the currency isn't backed by gold in Fort Knox or anything like that. Not anymore.

Households get their economic resources from elsewhere, and if their expenses exceed their income they need to borrow economic resources from someone to whom they then owe money. But as a creator of its own currency, the federal government doesn't "owe" in anything like the way that we owe. And the way that the US government creates currency is through deficit spending. To put it another way, the federal government creates dollars by spending dollars--or, to be more precise, by spending more dollars than it takes in through taxation.

Deficit spending, in a nutshell, is a means for the federal government to pump money into the economy and thereby stimulate economic activity. The federal government puts money into the economy through federal spending and takes it out through taxation. When the economy is sluggish, the government peps it up by paying contractors to build roads or paying researchers to make new discoveries without asking someone else (the taxpayer) to foot the bill--that is, the government peps up the economy by putting more money into the economy than it takes out. In other words, through deficit spending. When the economy is overproducing relative to demand, the government can slow the economy down and so avoid runaway inflation by taking money out again--through taxing more than its spends.

If all of this is right, then the idea that the government needs to rein in deficit spending in tight economic times is precisely the wrong idea--and dangerously wrong. When the problem isn't runaway inflation but a cycle of shrinking consumer demand leading to business downsizing, leading to greater unemployment, leading to shrinking consumer demand, leading to even more downsizing, what we've got is a feedback loop that only deficit spending will break--only some combination of increased spending or tax cuts. To follow the household analogy here--to do as households do, and "save money" in tight economic times--is to guarantee, in effect, that our economic problems get worse rather than better.

That's the argument--rooted essentially in the economic insights of Keynes. If we're going to make progress in handling our economic woes wisely, we need to take arguments like this very seriously. We don't want to base policy on false analogies just because they seem like common sense on the surface. If we do, we're in danger of magnifying our woes rather than treating them.

But with all that said, I think there is something that conservatives on this issue get right. Because it isn't quite right to say that the federal government, unlike households (and state governments, etc.), create the currency they spend (in fact, create by spending) rather than getting its economic resources from elsewhere. Or maybe it's better to say that, while this is correct as far as it goes, it is misleading. No one lives on currency. We all live off of what currency buys. And the things that currency buys come from the planet--from the soil, and the oceans, and the mines we dig into the mountains, and the wells we dig in deserts and gulfs.

When we increase the amount of currency in circulation, we buy more things--more goods and services, more food and fuel. Businesses are stimulated to make more of the things we buy. Currency is a fabrication that governments can create by fiat, but the natural resources of the planet are not something we can similarly create by willing them into existence. The human economy depends on the economy of the natural environment. And the economy of the natural environment, upon which all of human civilization depends--does work a lot like a household budget.

The human economy is a subsystem within the broader planetary systems of nature. And the human economy is sustainable in the long run only if it extracts resources from global geo-ecological systems at a  rate equal to or less than the rate at which those resources renew themselves; and only if it dumps waste at a rate less than or equal to the rate at which the planet can assimilate those wastes.

Now fortunately, resources do renew themselves. And fortunately, our waste is assimilated, at least when our waste is some other creature's resource. But when the global human economy exceeds these environmental renewal and assimilation rates, humanity is engaged in the equivalent of massive deficit spending. We do that for long enough, and eventually we'll go bankrupt. That is, we won't be able to meet our needs anymore, and the global economy will collapse catastrophically.

Insofar as federal deficit spending stimulates economic growth, and insofar as economic growth means greater consumption of resources and waste production, federal deficit spending can contribute to ecological deficit spending--at least when the size of the global economy has already hit the limits set by renewal and assimilation rates. And there is reason to think that we are at or beyond those limits now.

The absurd character of our political system is such that those who are most clamoring for federal deficit reduction are precisely those who show no special concern for environmental protection, who think environmental concerns are overblown, who are global warming deniers, etc. But if there is a reason to be concerned about the federal deficit, it is because that deficit is correlated with an ecological one.

But this is not to say that we should oppose, on environmental grounds, any federal-level deficit spending. Not all federal deficit spending is created equal. Deficit spending is targeted: The government spends money on specific things. And some of things that one might spend money are things that help to reduce the ecological deficit. Development of our public transportation infrastructure. Research and development of more fuel efficient vehicles. Development of our capacity to harness solar energy. Environmental cleanup efforts.

Some forms of deficit spending qualify as invenstment spending--and while not every investment pays off (Solindra), the more we invest in enhancing our capacity to live within our ecological means, the better off we'll be. Some investment spending (education) isn't directly related to fighting the ecological deficit--but it is utterly essential for our capacity as a society to effectively mitigate environmental problems we confront.

In short, what we should care about isn't the federal deficit, but the ecological one. And while some kinds of deficit spending might contribute to the ecological deficit, other kinds might help mitigate it. If we want to crawl out of our current economic woes, the federal government needs to spend at a deficit. The trick is to know how to do that without selling out our children and grandchildren, without leaving them a world on the brink of ecological collapse. What we need now is targeted deficit spending that prioritizes environmental capital, that invests in our ecological wealth, and that positions us to more effectively confront the challenges ahead.

Comment: Today is Father's Day, and while this might not seem like a Father's Day post, in fact it is. My father, in his last years, devoted his life to educating the public about environmental sustainability issues, and was active in spearheading the development of "geoethics," a dimension of geology (his field) devoted to considering the ethical and social implications of insights gleaned from the earth sciences.


  1. Thanks Eric- I think this debt issue is the most important issue of the election. Once people understand it, they won't fall for the biggest stick the conservatives have to beat down progress and later turn around and pass budgets that give more money to the rich.

    Part of the occupy narrative is an enormous reframing of who should get what in a society- whether finance is socially useful, etc. But another part is this technical issue of what the federal deficit is, why we don't really ever pay it back, why it is the supremely valuable tool that none of the euro countries have right now, etc.

  2. Eric

    There may be a danger here of shrugging off one dogma (fiscal deficits are always bad) only to run straight into the arms of another (fiscal deficits don't matter). While it's true the household analogy doesn't hold, this doesn't imply that deficits don't matter. Rather it may be that deficits matter for rather different reasons. Were this not the case, then we would surely choose to live with no taxation at all, governments could simply run unfunded deficits and all would be well.

    There are many reasons why governments around the world choose to fund their deficits through debt. These include the observation that government spending typically lacks downward flexibility, impacts upon money supply, interest rates, price signals, exchange rates and the balance of payments, investor confidence, inflation, crowding out etc

    Don't get me wrong, I'm a Keynesian through and through when it comes to recessions, and am puzzled by the success of the deficit-phobic lobbies. But, there is a world of difference between calling for stimulus in times of downturns, with an aim to balance budgets over the course of a normal business cycle, and the emerging claim that deficits need not be thought of in terms of debt.

    More interesting to me is the second claim in this piece, that we might inspire to green growth (getting the economy going again through fiscal stimulus, but favouring green initiatives to achieve this growth). There are those who suggest green growth is a contradiction, and that so long as we are stuck in the paradigm of trying to grow our way out of our problems, the solutions will elude us. Not sure what you think of this.


    1. Bernard,

      I agree in substance with your comments here. I don't think we should dogmatically hold that fiscal deficits don't matter, and I hope I didn't convey that impression. Much hinges on the state of the economy--and, as I indicated, the targets of the deficit spending.

      As to your second point, I tend to agree, actually, that a paradigm of economic growth ultimately has to give way to a new economic paradigm (something like what Herman Daly has been trying to articulate in his career, perhaps), given that, overall, economic growth DOES correlate with growth in consumption rates and waste production rates. (even if growth in certain sectors might not) Endless growth is unsustainable in a world of limited resources.

      The question is how we transition a society that has been defined by a culture of growth for such a long time. Large-scale cultural changes are needed--in terms of personal values, collective priorities, business culture, etc., etc.

      Increasing our investment in green technologies and green infrastructure strikes me as one crucial step in any meaningful transition. To the extent that we take the untapped human potential--that is, the unemployment--created by an economic downturn and direct it towards the development of our ability to use resources more efficiently per capita, and create less waste per capita, we are moving in the right direction WHILE putting people back to work. We are stimulating the economy by stimulating the kind of activity necessary for reducing consumption rates.

      But I agree completely that this is not ENOUGH. If we want sustainable civilizations, we need to fundamentally change the culture of consumption--by which I mean the culture in which people seek happiness to a large measure in and through the market of consumer goods. And we need to rein in the global population.

      If we put people back to work in ways that have a chance of helping us reduce our per capita global footprint, but the people who are back at work now can afford to buy more and so return to their old patterns of consumption, we are accomplishing two things at cross-purposes with each other--increasing per capita consumption by giving more people the resources to consume, while helping to develop the infrastructure and technology required to somewhat blunt the impact of "consumption-addicts."

      Fewer people, and more people whose values enable them to find satisfaction with less, are utterly essential. Neither of these goal will be at all easy to achieve, and we may very well fail. In which case, of course, our consumption rates and overpopulation will be reined for us...but with much greater global pain.

    2. Hi Eric

      I agree, and would go further by suggesting the problem is deeper even than that. I don't think we value growth because of all the pretty shiny things it buys us. I think we value growth because it allows as many people as possible the dignity of a working life and a chance to support themselves and their loved ones. When the economy falters, we may find fleeting hardship in the rationing of our coffee fixes, but it's the brutality of deepening poverty that moves us to demand more logging, drilling and driving.

      Although we might hope the circuit breaker is green growth, I think there's good reason to be highly cynical about this. And if that's right, the first discussion is going to be about redistributing what we currently make, but down this way at least, as soon as The Greens veer in this direction, someone calls them socialists and their support just plummets. Tricky.


  3. Bernard-

    Let me second Eric and defend this view of economics, called MMT economics. It is a well-worked out analysis, not some one-off matter of intuition. The limit for the currency issuer is inflation. When we face deflation, as now (combined with high unemployment and depressed conditions), higher currency printing and spending by the state is called for, but when inflation is the problem, the state would have to spend less and tax more.

    An important point is that over the business cycle, the currency issuer may still need to run net deficits (as the US has done) to provide the currency for general economic growth, population growth, and trade deficits (all given the inflation constraint). So the intutive notion that while some Keynesian spending is OK in down times, the government's budget needs to balance for some reason over the full cycle.. is also incorrect. The debt does not pile up for someone else to repay. We have been carrying debt since the nation's founding, and no one pays it back. The existing stock is minimized by further economic growth as well as managed inflation.

    The point of all this is to furnish a prosperous economy where employment is high and finance serves a socially constructive role. What the employed people do is another matter, and it is a question of public policy whether they pillage the environment or restore it. I think the sustainability proposition in general is that we can in large part maintain our life styles in the West at dramatically lower environmental harm with pro-environmental policies like high carbon taxes and other specific regulations. These are intrinsically public goods problems that have to recognized and solved at the collective level. Indeed one can hope that religion plays a positive role here(!), being heavily concerned with collective action and social norms.

    I think it would be helpful for progressives to separate good economics from sustainability issues, lest we get captured by the conservative narrative that all economic growth has to happen via off-loaded externalities, and accede to their program of "the worse, the better!", thinking that economic depression is positive for the environment.

  4. Hi Burk

    I'd love to talk economics with you, but I'm not sure this is the appropriate forum. I think have a fair understanding of MMT. On the one hand it appears to do add nothing new, the accounting identities it highlights are fundamental to any economic model, and were certainly front and centre when I did my economics degree back in the eighies.

    I accept there has been an intellectual fashion not to even speak of 'unfunded' deficits, following the stagflation of the seventies, and I would agree that was an overreaction. All levers should be in the mix.

    Nevetheless, I sense an enthusiasm in some quarters for non-debt deficit growth that, I'm yet to be convinced of. Too many reasons to discuss here, much as I'd like to. The environmental one, though, is interesting. There was some evidence that pre-recession specific resource bottlenecks were squeezing prices (oil and food) and it may well be that inflation pressures will accumulate very quickly in a way that wasn't true say in the post war environment. When the resource constraint is labour, inflation picks up as we near full employment, but I wonder if that relationship hasn't fundamentally changed.

    I don't buy your point that we should consider sustainability as a separate issue, as good sustainability policies in the first instance are going to seek to ration rather than exploit overtaxed resource bases, and in this sense will in the short term be anti-growth (which is why both sides of the political divide find it easier just to pretend it's a problem that can be solved by a few well placed wind farms).

    I have no answer to this tension, but I do think that's where the real economic debate lies, not in funding mechanisms but in natural resource stocks (and somehow managing a slow down whilst addressing the plight of the dispossessed, how the hell do we do that?)


  5. Bernard-

    No degree in economics here, I have just been following various crank economists!

    I'd agree that empirically, economic growth is not intrisically environmentally friendly. By raising employment, bringing more labor and productivity on line, it allows all consumers to do more of what they want, which is usually to consume more, not to mention having more children, etc. It is the story of Hobbes.

    Nevertheless, I really am not interested in counselling austerity for the sake of the environment, even if long-term, the environment is far and away the most important policy issue. I think we have enough consciousness and reason at this point to attack that problem frontally on its own terms, directing consumption in sustainable ways. One part of the overall narrative from the last few decades that has to change is to conviction that markets can do no harm and are maximally efficient, good, etc. We can do better that that, even if half the political system is dedicated to reducing our capacity for collective action and even collective thought.

    Serious sustainability policy may indeed be anti-growth, in the sense of growth built on coal and tar sands. But it need not be anti-employment or anti-worker, given good macroeconomic management, which also affects the economic justice / equality aspects of economic policy- a third aspect. And per the Stern report, it doesn't have to be anti-growth overall.

    Anyhow, I'd be interested in your views of MMT, since it is somewhat distinct from, say, Paul Krugman's views, and offers what I (naively) take to be a better model of what is going on. For instance, he seems to agree with the fiscal-balance-over-the-business-cycle theme. There are also differences in the understanding of banking, especially the roles of reserves and the origin of the money multiplier. They also were out front in calling the euro system unworkable. Krugman has been trending towards the MMT positions, while dismissing their work. These are perhaps esoteric issues, but at the same time politically pertinent. On the whole, just getting back to a classical Keynesian understanding would be a huge step forward, for the US at any rate.

    On your resource questions, to me it seems essential to put higher prices on things like carbon, water, and pollution. We can use economics to solve these problems. The way we treat water is a scandal. These are all regressive taxes, so more positive fiscal policy and redistributive policy would be needed to make it all work, in an ideal world, as I wave my magic wand...

  6. Hi Burk

    How long have you got? I'm no expert on monetary systems, but from a distance the Krugman/MMT spat looks a little like two plumbers called in to fix a leak who end up arguing about the molecular characteristics of water. As you say, broadly speaking their policy fixes at the moment are not worlds apart, and I'm with them in believing this is no time for austerity measures.

    The difference appears to lie with beliefs about the circumstances under which inflationary pressure arises. My view on this is heavily influenced by the NZ experience in the early eighties. After a decade of inflation pushing into the high teens, an over-confident finance minister decreed he would simply get rid of inflation by making it illegal. The price freeze was never going to last, in time transaction and policing costs, plus resource misallocation, was going to do for it. What happened when it came off (after about 18 months I think) is inflation shot straight back up, for no other reason than people expected it to. Sometimes inflation just happens because people think it will.

    Worst of all, the failure of this control was the opportunity the right needed to claim that no controls ever work, and upon coming to power they implemented a scorched earth policy, the children and grandchildren of which now suffer in my our classrooms.

    If you look at the textboks, there are any number of theorists who will swear they understand the root cause of inflation (money supply, downward rigidity in prices, demand pull, cost push, expectations...) and I suspect they're all a little bit right, sometimes.

    There is, I believe, good empirical evidence that sometimes expansion of the money supply triggers inflation, even when the economy is not approaching full employment. There's also evidence that bottle necks can trigger inflation well before full employment kicks in. So, my central concern with MMT is the danger of an inflationary cycle well before the full emplyment level. You're still running deficits, much of the spending is locked in, and rightly or not people blame the unfunded deficits. Which cuts off that avenue. A tax raise is going to choke off the nascent growth completely you're forced to borrow, but lenders, having seen the enthusiasm with which the deficit spending was undertaken, are reluctant to lend... Is that not a small step away from a currency crisis?

    I know the right use inflation-fear as a monster in the cupboard, that will emerge and eat anybody who doesn't endorse their version of the slave economy, but I'm yet to be convinced the MMT approach couldn't trigger this sort of crisis. The US has probably got more wiggle room here than a small economy like ours, but I do think expectations play a much larger role than the theory allows for.

    Interested in your thoughts on this. I may well be misrepresenting the position.


  7. Bernard-

    Sorry to subject Eric et al. to this, but it is absolutely fascinating. I agree that one's view of inflation is critical in all this. I think one contribution by the MMT folks to this debate is a clear exposition of how banking and fiat money work. They do not seem to have quite as clear an exposition about how inflation works, and I have been trying to come up with some reading on the issue.

    I'd take a mostly monetarist approach, actually, where the government controls inflation by the two arms of policy- direct spending and money creation, and interest rate policy, restricting banks from issuing money secondarily. While banks are not reserve limited, (by MMT), they are capital limited, which works out quite similarly in the end.

    Additionally, I guess that regular people can drive inflation by shifting their saving/spending balance, (or, in extremis, the productivity of the whole economy might collapse, also generating inflation), but that tends not to change as readily as bank behavior, nor can it be sustained for long periods of time, as savings get drawn down.

    So I guess I would take a somewhat less mystical approach to inflation than you seem to, and think our Federal reserve has plenty of knowledge and tools to deal with inflation, were that an issue. Money doesn't grow behind fig leaves.

    One particular question I would have is how resource prices lead to inflation. Naively, I would think that if the price of, say, oil goes up substantially, this would displace some other consumption and in net terms, we would not see inflation at all. Indeed, by shipping more money out of the economy overseas, inflation might decline in this setting. But if the Fed were to counteract the contractionary effect of that resource price increase by loosening monetary policy, then we might get both inflation and stagnation, before the economy works around the resource constraint. Does this make any sense to you?

    Anyhow, the current situation, given price and wage rigidity, seems more like effective deflation than any kind of inflation. Real interest rates are negative. The Fed has all the credibility in the world, and the ECB, far too much! So it seems that we have a long way to go before hitting any inflation to worry about.

    It is a topic involving many unknowns and great abstraction, much like religion, I dare say!

  8. ## Bernards last comment doesn't appear.. so I am entering it:

    Hi Burk

    I agree that there's no obvious inflation pressure at the moment, and further agree with Paul Krugman that in general a looser inflation target would make sense anyway. There's probably opportunity therefore to do some unfunded deficit spending without any immediate risk. The MMT Krugman disagreement as I read it is that Krugman thinks there's very little potential to run this beyond the present circumstances, and inflation pressures will arrive early, whereas the MMT folk seem to believe there's very little inflation risk further down the track.

    I don't know enough about the Fed's operating history to comment really, but down here the central bank has found it s most effective levers are those that impact on the real rather than monetary economy, so for instance raising interest rates attracted capital inflows, kept the exchange rate up, kept import prices down, or using tight monetary conditions to suppress investment and consumption spending, keeping unemployment up and wage claims down, and talking and acting tough until eventually people stopped expecting inflation to return. (I used to teach the son of the chap who headed our central bank during the eighties, so talking to him was interesting).

    In terms of spiking oil prices, if it's a significant enough rise, then that's a cost that contributes to almost every output in the economy, and in the first instance those that have the ability are going to pass the cost on. If this occurs as the economy is growing (so the deficit spending is starting to kick in) and confidence is rising, the chances of pass-on costs are higher, as are the chances of other sectors trying to claw back their drop in real income. If this happens in an environment where MMT policies are being observed, and there is a general belief the expanding money supply is itself driving the inflationary cycle, then price expectations are ratcheted up. A lot of prices are set in advance (rentals for instance, wage negotiations, a lot of contracting) and the higher expectations inform this price setting, and you're away.

    Possibly you're also going to see an effect where the expanded momentary base means it's easier for people to get credit, the theory going that in times of tight credit banks ration by risk profile, but when conditions ease, the temptation is to lend more broadly. This credit may then allow people to accommodate the price rises, also adding impetus to the upward spiral.

    At this point a watchful central bank is going to step in, using whatever levers they have to dampen the cycle. But if their levers involve depressing economic activity, the initial expansion has become self defeating, and if the levers include pulling money out of circulation by selling debt instruments, then the net effect is that the deficit has been debt financed after all.

    As I say, there's a difference between considering the appropriateness of what you folk call quantitive easing in current conditions, and the broader question of whether MMT provides a longer term alternative to the management of business cycles. I think at the extreme end there's the claim that printing money is never of itself inflationary, and I don't know enough about what that claim is based upon to judge it.


  9. Bernard-

    I'd agree that MMT is weak on a realistic model of inflation. They sort of theologically say that there is no inflation before one gets to full employment, which is both vaguely specified and not correct. On the other hand, they do have a significant critique of the NAIRU, saying it is a very squishy concept, changing with time, ideologically loaded, and not any kind of solid guide to policy. They also have the interesting idea that fighting inflation, when it does occur, doesn't necessarily have to happen on the backs of workers via unemployment, if one has a backstop program of universal job guarantees at a living if minimal wage.

    Anyhow, I'd be interested in your model of how expectations can drive inflation. Do banks lend into an inflationary spiral, funding employer's grants of wage increases? Does the government spend more, perhaps by indexing salaries to inflation, in a self-fulfilling cycle? It seems that if there is a conscious actor in the mix, these behaviors can be stanched through policy- by someone spending or lending less. But it does take some discipline. I guess you outlined this model in your last note, and I do agree with it.

    The question is what can we reasonably expect as an equilibrium level? Is 8% unemployment going to be the price of so-called "prosperity" and super-low inflation? Or was the case of the 50's attainable again, when we experienced extended unemployment more in the 4% range, with low inflation? The differences may seem small, but they have momentous effects on the capital-labor power balance. I think overall, the MMT school believes the equilibrium can be substantially lower, because contemporary policy is very heavily weighted to inflation fears and anti-labor policies, with the ultimate outcome we see in the crisis.

    On the specific question you posed about printing money and inflation, I think the MMT people fully engage with inflation risks in those terms. Their fixation on accounting balances takes in a need for taxation to make room for government consumption, dangers of excess government spending, need to account for balances of trade, etc.. But they do make two interesting points. In the context of quantitative easing, printing money to sit idly in bank reserves when banks are neither reserve-limited nor lending due to market conditions or risk perceptions is just not inflationary, other than via its effect on long rates. That surely reflects reality.

    Secondly, they posit that debt financing of a sovereign government's deficits has little effect on inflation and could be dispensed with. Such debt is bought with money used for savings anyhow, and whether it goes into legal tender notes or debt paper notes makes very little difference, the market for each being quite liquid. It is a holdover from the gold era and the mindset of financing constraints, which don't exist anymore. Only in rather extreme situations (like world war II), does debt sale really pull money out of active circulation.

    Thanks for being receptive.. one can only hope that they Europeans get their act together.

  10. Hi Burk

    I won't pretend to have all the answers on this. I think the question of what does and doesn't drive inflation, and particularly the vexed role of the banking system and money supply, remains an open one. The MMT debate is almost certainly useful in encouraging new perspectives on that.

    The challenge for any inflationary theory is twofold. The first is that it needs to account for the mechanisms that account for actual pricing decisions being made at the petrol pump or the seven eleven. So, while it's tempting to argue that a certain action won't have inflationary consequences unless, say, monetary policy accommodates the new price setting behaviours, a mechanism for the way this kicks in and stops the haulage firm pushing up their rates needs to be involved. One argument that used to be put, I don't know how it's viewed currently, is that the velocity of circulation is volatile, and responsive to behaviours beyond the control of central banks, and that in effect once inflationary expectations take hold, they can't be easily constrained by monetary policy (except to the extent that this policy can dampen aggregate demand, confidence and expectations).

    The other challenge is to account for the observed real world relationships. The establishment view is that we have many historical cases of printing money apparently leading to a collapse of confidence in the currency. I'm not sure how the MMT approach explains this relationship, but you've got me interested to look further into this.

    The points that are made regarding the effect of bond sales on money supply initially strike me as counter intuitive, but this may well be because they run counter to the way I was taught to think about this. Certainly they represent the point where this approach departs most clearly from the orthodoxy. Let me consider that, and do some more reading. Maybe I'll come back to you on it if I feel I have anything useful to say..

    Anyway, all very interesting, and great to have a chance to discuss it.


  11. Hi Burk

    I've tried to find some stuff on the MMT approach to inflation, but it's hard to pin this down, different people seem to be making markedly different claims in the name of the movement. If you fnd a good source, let me know.

    The orthodoxy is that money supply and inflation are tightly linked (evidenced by things like the entire nineteenth century being inflation free) and that inflation can occur even when we're well away from full capacity(so, the seventies). Also, that inflation is potentially disastrous (as seen both in currency collapses, and the social pain of various attempts to bring inflation under control in the eighties).

    The most interesting claim from MMT seems to hinge around the idea that funded and unfunded deficits have a similar effect on money supply, and therefore, if you are going to spend in recession, why borrow?

    This seems to me to be, at least loosely speaking, testable. If we look at the seventies, we have a wide array of fiscal and monetary reponses to both the onset of and battling with inflation. Presumably patterns that were at least suggestive of this relationship might emerge. Not sure if there is a strong core of econometric activity in the MMT world, but their claim is an extraordinary one, and ultimatley will need compeling evidence to back it.

    An interesting implication, if one accepts the premise that money supply relates to inflation, is that MMT may actually end up being an argument for debt financing, in that this imposes the discipline (through servicing, refinancing and public accounting) required to stop monetary overheating, whereas without these constraints, Government spending and taxation are both slow ships to turn, with tremendously little downward/upward flexibility. That's a deliberately perverse take on it, but not entirely without merit.


  12. Hi, Bernard-

    My guru for MMT is Australian economist Bill Mitchell. He writes a daily blog which is incredibly verbose and self-aggrandizing, but also a bit humorous and, once one sifts through it all, rather compelling. I'd agree that his view of optimal inflation is mostly non-existent, just that he has tolerance for more than is currently customary- that current policy settings are seen as overly tight in a persistent, unconscious, and anti-labor way.

    I don't think anyone is pro-hyperinflation. And no developed economy with anyone sentient at the controls is in danger of hyperinflation. Certainly we were not in the 70's in the US. (And they would posit that the costs of battling it are overblown, certainly compared to the current bout of deflation.) MMT folks are aware of past debacles, which is why the accounting identities are so important. If trade deficits, overall growth, and private savings continually drain dollars from circulation, there is room for government deficits (or looser bank lending). If not, there is not. The mechanism of the Weimar example is still a bit murky, (to me, at least), whether the government itself was at fault, or its privately run central bank, which was a loose cannon until it was reformed and a new currency set up. As an aside, it is ironic that Germany today is essentially putting Greece in a similar reparations bind that it was put in after WWI, being refused both trade and growth as means of repayment.

    All that said, one's view of inflation has strong ideological / class components as well. Capital and savers like low inflation, workers and debtors like higher inflation. The costs of (non-hyper) inflation are relatively modest efficiency costs. A favorite motto of the MMT folks is that you can fit alot of Harberger triangles in an Okun gap, the Okun gap being the enormous losses from unemployment.

    I think there is broad agreement in modern macro that consistent low inflation in the ~2% range is ideal. I had a remarkable quote from David Hume on a recent blog, indeed, praising the utility of low, constant inflation as a spur to economic activity, calling savings and other money stores into activity. The 19th century regime was punctuated by very severe depressions. Certainly elastic money carries its own risks, and we are talking about tweeking and optimizing, not about going back to a gold standard.

    The MMT folks are sympathetic (I think) to a recent idea called nominal GDP targeting, where the central bank would target, in essence, inflation plus GDP growth, say at 5%. So if growth is low, at 1%, then the inflation target would be on the high end, at 4%, while the reverse would be the case if the economy were booming. This would make central bank policy a bit more dynamically useful, especially since over here they have an employment mandate, nominally.

    ... cont ...

  13. I was intrigued by your micro-view on inflation, that detailed behaviors of price-setting need to be accounted for. I'm more interested in macro, which Keynes showed was a distinct field, accounting for counter-intuitive effects, fallacies of composition, etc. But it all does have to hang together in the end. If the gas station raises its prices to cover costs, it does not raise anyone's wages. The money goes off to pay the higher resource cost, presumably in foreign lands. If wages don't rise, then overall, prices can't go up, even if they go up in one sector.

    Perhaps another mechanism is economic contraction. If a resource shock reduces real productivity and production, then the stable money supply becomes inflationary over a smaller real base. Another is that consumers dig into their savings to fund unusual resource shocks, or take out extra consumer loans, bringing more money into circulation. I think we both see it as a complicated situation. I think there must be more room for rigorous modelling in the field.

    Lastly on the unfunded deficits question. I am not aware of any place where non-funding is practiced. So it is a somewhat theoretical idea. But seems compelling to me at least, given the fiat currency world we are in. Looking at Japan, I am not sure what the discipline really does for you. Japan has debt at 2X GDP, and are doing fine, with a super-saving public, printing a bit of extra money to cover the debt interest. You are just engaging in an annuity program for the rich. Which is not the kind of discipline we need most.

    The whole model of having "the market" and the bond vigilates enforce discipline on a fiat-issuing government is sort of non-functional. It provides an illusion of private market discipline, and a stick for political conservatives, which they wield with glee, but pay no attention to when they are in office. The ratings agencies have downgraded Japan and the US, to very little end. The real rates on such bonds will always be rock-bottom, assuming political stability. In the non-debt, non-funded case, one would still have public accounting, and the inflation and unemployment rates would be the prime metrics, rather than the interest rate or the absurd debt load, debt bomb, etc...

    In extremis, in a high inflation environment, the government would face the choice between turning the screws on private money creation by the banks (via the interest rate) or on itself via its net spending. That seems a proper position of a democratic government, and the MMT folks incidentally support merging the central bank with the treasury to make a consolidated, democratically accountable, authority.

  14. Hi Burk

    The thing of course is that we seek to avoid the government having to turn the screws in this way, because of the immeasurable social damage of such adjustments. Hence, to back MMT, one first would want to establish that it is not, as the mainstream theory suggests, inherently inflationary.

    Now, because there was a degree of unfunded deficit priming used through the seventies around the world, the laboratory to test this proposition does to some extent exist. The onus is on the new theorists to do this testing.

    Without such empirical backing, you end up with something akin to religion. Here is something we really want to believe is true, it's just so hopeful. It has charismatic proponents and a fervent following, and a set of tautologies (the standard accounting equations of the circular flow) as its intellectual foundation. It even has a morality play for a narrative (the right wing conspiracy of pain). Yet, when questioned on its mechanisms, particularly regarding its central claim on inflation, there's a certain degree of hand waving going on. And, crucially, it's first instinct is not to seek out methods of empirical testing. This all sounds, well eerily familiar.

    This is not to say it can't be right, but isn't the appropriate sequence hypothesis (which we have) then clear explanation of causal mechanisms (still developing) then testing of the hypothesis against possible data (which I'm not aware of) then acceptance? It seems to me open minded scepticism is the correct first response.


  15. Bernard-

    Your critique is quite keen. One thing to say is that while most folks in MMT are left-inflected, in itself it is just a model for understanding the macro system, and could be used to run a low-inflation regime as well as a high-inflation regime. Being aware of the relevant stocks, flows, and dynamics seems useful in any case, insofar as the theory is correct. And it has been quite successful in accounting for the European pickle, (lack of fiat currency, imbalanced trade flows), and many aspects of the current crisis elsewhere, at least in the narrative way I understand it, which mostly doesn't differ much from standard Keynesian accounts.

    What does it say about the 70's? I have asked that question myself and have gotten little answer on Bill's blog. My own view is that you are quite right about the excess spending in the 70's, started in the guns & butter age of the Vietnam war. First the government spends with abandon, and pressures the Fed to keep interest rates low, and then tries to impose price controls, not to mention printing up those "Whip Inflation Now" buttons. It was insane. Then we got continued excess accommodation from the Fed through the oil crisis, and while unemployment wasn't too bad, (by current standards), inflation kept creeping up until Volcker pulled the plug. (US unemployment series.)

    I think the problem that MMT has with all this is that we didn't quite have to keep fighting inflation quite so hard in the ensuing decades, and we certainly don't need to be fighting the last war right now, with even more austerity. Personally, I am still searching for an effective model of all this, and find MMT a very useful critique/guide, while following Krugman and others as well.

    Perhaps I don't understand the nature of empirical testing in economics. My impression is that various theorists try to come up with compelling narratives, and the most convincing one (to knowledgeable parties) wins. One problem is that models that economists use these days to perform putatively empirical research (equilibrium, rational expectations) are themselves seriously compromised, so I don't think there is a fully neutral framework to do empirical testing with, nor controlled conditions to do it on. That is what is so frustrating in cycles of economic scholarship. First Keynes wins the day on one set of conditions, then Friedman wins the narrative for a while, based on one critical empirical event, and it seems to cycle on and on. Real empiricism seems very hard to pin down.

  16. Hi Burk

    I agree. Economics is so deeply political by its very nature that econometrics often takes a back seat to what are little more than cargo cults. And absolutely, usually one key event is proffered as incontestable proof. It's madness.

    However, many careful economists would agree with this sorry description. As my professor told us in our last class, 'don't ever accept a theory if you can't find the data to back it up. The first thing to do is to measure.' So, I would hopefully claim, beneath the public, ego-driven stoushes, there is some careful scholarship going on. The challenge for MMT is to move down the scholarship line, rather than the cult one. And that's going to take some key figures eschewing celebrity status and doing the hard graft.

    The fascinating thing about the 70's is that the stagflation was an international phenomenon, and yet had very different characteristics from country to country, in terms of start and end points, and peaks. And that makes it as close as we get to a laboratory in economics. So, although you don't get the tight repeatable testing of science, you do get to broadly test claims. The mainstream tenets, as I understand them, take much support from the relationship between monetary policy and price level during that decade. It's highly controversial, with left and right having their favourite spin on it, but it's at this level of analysis that MMT will need to establish itself.

    Neo-keynesians also call for less obsession with inflation, and also warned against the currency union in Europe (Krugman published on this, I think). The difference is that they claim the MMT model of inflation is both fanciful and dangerous. I don't know if this true, but I do believe a close look at historical data could help us resolve the difference.


  17. Bernard-

    The Levy Institute is a mostly MMT/Keynesian group that publishes ongoing on these issues. Here is an example of some of their theorizing / modelling on inflation.

    A little empirical work on inflation targeting in Brazil, though to what end, I am not sure.

    To back up a little, the point of MMT is not that inflation is good, but that unemployment is bad. And particularly that the reigning Phillips curve / NAIRU tradeoff between unemployment and inflation has some problematic aspects.

    First is that the setting has tended to be excessively tight over the last couple of decades (a matter of some dispute). Second is that it ignores other sources of inflation and instability, as the financial crisis / debt boom / housing inflation / shadow banking era demonstrated. Third, that there may be targeted ways to mitigate unemployment (via a job guarantee) without using the macro-gun and without disturbing inflation significantly. Fourth, that the central bank, typically run by bankers, is perhaps not as democratically accountable or publically interested as it should be, in the interests of the majority of the population and the economy at large.

    All the issues the MMT folks have, about the debt, about accounting inequalities, about the nature of banking, etc. are meant to be accurate theories about how things work that clear away some prior ideology and allow conscious policy choices about how to run the macro system, hopefully with an orientation to maximizing employment. I agree that they would benefit from empirical cases. One is Argentina, which dropped its currency peg and defaulted in 2002, and has been doing quite well since. As has Iceland since its debacle. But as you say, this is solidly within a Keynesian framework (of a functional finance, or other modern nature).

    I take it all with quite a grain of salt and as a spur to further investigation. The question of not funding a government deficit.. I know of no national examples for empirical work, though perhaps there are some.. it is a difficult search. But smaller scale examples abound. One example is the points awarded at a bowling alley. These are not matched by borrowing points on a bowling bond market. They are just made de novo by the operator of the alley, can be redeemed perhaps for some prizes, and are destroyed .. as patrons walk out the door, without the legal ability to tranfer them to others. Other token systems for baby sitting, household chores, etc.. follow the same model. They don't need to be funded, but are themselves the fiat tokens of value.

    The problem is surely just one of temptation- that if we really understood the power of the fiat system, and unbound ourselves from the rather empty and misused discipline of bond markets, then we would go hog wild and be unable to govern ourselves. But the democratic unpalatability of inflation is quite apparent around the world, so my take on it is that we should be allowed to govern ourselves in this as on all those other far more momentous issues, with proper accountability and transparency.

  18. Steven Stark tried to post something on this discussion thread but for some reason was unable to do it (and his efforts haven't appeared in my span filter). So I'm posting this for him. Here's his comment:

    Great post from Eric. Great exchange between Bernard and Burk. I just have a few, very general and scatter-shot, comments:

    Keeping the economy purposefully weak because of inflation fears is like denying a patient life-giving medicines because we are afraid she'll jump up out of bed, fall down and scrape her knees.

    We are not Weimar - we don't have another country disrupting our production capacity while demanding reparations in currency we cannot really control.

    The paper economy should serve the real economy, not the other way around. Let's not pour milk down the drain to preserve prices while people are thirsty. We need real production, real investments in science, education, health, infrastructure, etc. That's the key for the success of the next generation.

    If the debt seems high, it's simply because the economy is too top-heavy - but I don't worry about the paper debt too much......obviously! ;)

    Yes, we need more consumption - one person's consumption is another's income. It's not the consumption that is the issue, it is WHAT we consume that is the issue. Perhaps the most important one of all. Obviously this is the main thrust of Eric's post, and Burk writes along these lines in his comments.

    You all are so right that 70's stagflation is what casts its shadow. I am not super knowledgable on it - it's tough. My understanding is that it was a combination of lots of spending in the Vietnam war era and the supply side commodities shocks of the early 70's. Couple that with stronger unions that could actually fight for higher wages - which caused inflation but kept the working classes from accepting the full brunt of the supply shocks (for those who kept their jobs anyway) - and you get some fairly serious inflation. But once again, I need to study this more for sure!

    My main two reasons for finding MMT compelling are 1. its description of how the money system works, which even many of the critics seem to accept as a contribution and 2. the realization that public enemy number one is unemployment. We simply should not allow it, especially long-term. It's a waste of real resources and an extreme hardship on the social fabric of our society. It is a primary driver of economic inequality.

  19. Oh- Bernard's last comment seem to be missing from the page, so I will add it.


    Hi Steven

    Thanks for those thoughts. The reason I am initially suspicious of MMT is that I can't get my head round what it's theory of inflation is. Insomuch as its advocates believe we have made an unhealthy obsession of inflation targets, I agree wholeheartedly. Ditto the need for employment opportunities, the danger of ill thought out currency unions, the moral blackmail of financial markets etc.

    But, one can reach all these conclusions via current orthodoxies. People like Stiglitz and Krugman, Nobel prize winners both, have been publicly making these points for some time. MMT stands out as something more than a Keynesian hitch hiker by asserting the ability to move away from debt financing of deficits without triggering a currency crisis. That, as I've said, is an extraordinary claim, and clearly it would be delightful if it turns out to be true. If it turns out to be wrong however, the policy prescriptions will cause the dispossessed even more pain and suffering, so getting it right is hugely important.

    With regards to the true deficit, our borrowing from future generations via resource depletion, we are less in agreement. To target growth, in the current environment, is to endorse abuse of the ecosystem, or so I believe. And it's worth remembering that it's the most vulnerable who are hit hardest by climate change, water shortages etc. The third world is going to pay the price for the first world's obsession with consumption, and that should make us mad as hell.


  20. Bernard-

    Let me take a step back from my claim, after learning a bit more about it. While the government doesn't have to issue bonds to fund its spending, it does issue bonds as a monetary operation to implement its interest rate policy, according to the MMT model.

    Currently, the government (US) spends a trillion dollars net into the economy yearly, and what happens? The balance is so strongly towards saving (deleveraging) that people buy up bonds at essentially zero interest. If those bonds were not issued, they would invest in other forms (commodities, real estate, stocks, etc.) or just hold dollars. Such a policy might be better for the real estate market, though not so great for commodities. At any rate, it wouldn't have much impact on consumer spending, since the market has already spoken in any case... it wants zero interest, low risk savings.

    In contrast, if the Fed/Treasury wanted to defend a 5% policy interest rate, then it would have to "flood the zone", as it were, issuing so much debt that savers would be sated enough to bid rates up to that level. Of course, just announcing such a target would do half the work, as banks raise their rates as well, etc. This would pull vast amounts of money out of couches all over the land. But its anti-inflation effect would probably come more from the bank channel of lower lending, than from soaking up people's savings.

    So, in the MMT model, there is a role for government debt, just not to fund spending, but to implement monetary policy. Which is eventually going to be related to government net spending, in a time-delayed way, and depending on other aggregate conditions, like trade balances, savings propensities, etc. That hopefully makes a more realistic model from your perspective.

  21. Hi Burk

    It does make it far more realistic, and indeed makes it far more akin to the standard model. If we believe money supply and inflation are linked, and we accept inflation can be triggered well before full employment, and we consider that issuing debt is a way of reducing that pressure, then the stance would appear to be that quantitative easing is entirely appropriate in conditions where there is no credible inflationary threat.

    Where such a threat does exist, it may well be that deficits will need to be backed by borrowing. The difference then is a predictive one, about how quickly conditions will become inflationary if we adopt a policy of unfunded stimulus. As I read it, MMT proponents are picking a much more sluggish price response to this sort of growth.

    Getting these predictions right matters because the goal is steady sustainable growth, primarily because of the stability this offers workers. The disaster scenario is getting this prediction so wrong that we end up in a series of surge and brake events, with each deflationary episode causing more destruction.

    Hence, the inflation model is crucial (and for a small open economy like my own, the trade model). My only partially developed view on this is that none of the major schools have a compelling inflation narrative. Rather dogmas have taken hold and then, following a shock, have faded from view to be replaced by a new one.

    Like MMT exponents, I think the right wing inflationary model (the original sin model, unless we all sit on our hands and think pure thoughts it's going to escape and consume us all) is the most damaging on record, and if they can push on from this intial challenge to establish a robust alternative that could be game changing.


  22. Bernard-

    Sluggish indeed. The Federal reserve's rounds of quantitative easing have done nothing significant, despite huge rises in the "money supply". That seems to be because the money has lain inert as reserves in banks whose lending is neither reserve constrained, nor encouraged by the reserves or any other market conditions right now. Perhaps Keynesians make this point too, but it is spending into the real economy that generates demand, economic activity, and perhaps inflation, not the money supply per se, at least by formal definitions. The velocity of this particular supply of money has been zero.

    I sense you have a deep fear of inflation. But how about a healthy fear of deflation? Perhaps Keynes led the way to recognizing that deflation was a special condition that has more damaging consequences and is more difficult to control than inflation, though each can be managed, given enough insight. And one can make the case that despite the minimal inflation we see, we are in a deflationary environment, masked by nominal rigidity in wages and other components. Krugman had a blog on this..

    I think the service of MMT in all this is to show that we have a good deal more freedom than we have been boxed into believing, providing a wider perspective. The government "funding" issue is an example. It is good to recognize that while there is an ultimate tradeoff between money creation, inflation, and the interest rate, it is poor policy to make up arbitrary 1:1 funding rules when the macroeconomic situation may demand more flexible and active management. ... All presupposing that we live in a rational world with reasonable people at the controls.

    As far as the inflation narrative, I'd agree that no one has perfect modelling and knowledge. But on the other hand, the Fed is recognized to have plenty of tools and dedication for the task, wherever inflation might arise from, and however we can agree to define and measure it. The main problem seems to be establishing what is optimal in terms of inflation and in other parameters like government vs private spending, saving vs consumption and investment, labor vs capital, acceptable unemployment etc. Which end up being political and class questions (I dare say philosophical!) as much as anything else.