Sunday, 11 March 2012

Sixteen reasons why MMT is right on the fiscal versus monetary policy question.

Note: this post is an updated version of a post I did in February this year called “Twelve reasons why MMT is right on the fiscal versus monetary policy question.” That post is now deleted. The text explaining the first twelve reasons below are is almost identical to that post. The four additional reasons 13-16 are new.


Abba Lerner is often said to be the founding father of Modern Monetary Theory (MMT). He argued that in a recession, government should simply create new money and spend it into the economy (and/or cut taxes) – effectively combining fiscal and monetary policy.

I’ll ASSUME that this “combined” policy is part of MMT (though perhaps some MMTers will disagree). Anyway, the arguments AGAINST implementing fiscal or monetary policy SEPARATELY are thus.

1. Adjusting interest rates is a form of monetary policy, BUT interest rate adjustments are DISTORTIONARY. An interest rate change works only via households or firms which are significantly reliant on variable rate loans: i.e. those reliant on FIXED rate loans or not reliant on loans at all are not affected by an interest rate change. Thus this policy makes no more sense than boosting an economy only via people with black hair, with blondes, red-heads, etc waiting for a trickle-down effect.

Bizarrely, James Bullard, president of the St Louis Fed claimed (p.9) that TAXES ARE DISTORTIONARY! Well it depends which taxes. Sales taxes like VAT or payroll taxes are pretty distortion free. (Incidentally, Krugman demolishes another of James Bullard’s papers here.)

2. QE, another form of monetary policy, has the same defect: it works only via a limited proportion of the population, that is, the rich.

3. The idea that there is a close relationship between interest rates and the ACTUAL availability of credit has been shown to be TOTAL NONSENSE over the last two years. That is, rates are currently at record low levels, but banks are reluctant to lend.

4. Low interest rates can have a DEFLATIONARY effect (pointed out by Warren Mosler). If rates are cut, the central bank will then pay out less by way of interest. That is, less new money will be injected into the private sector.

Minor technical point: this effect depends to some extent on the rules governing the relevant central bank, Treasury, etc. To illustrate, in some countries a rate reduction may NOT automatically reduce the above injection. That is, the reduction may be treated as a reduced budgetary expense for the Treasury, which in turn is expected to collect less tax to compensate. In this case the above deflationary effect would not operate.

5. An interest rate reduction is an inducement to borrow and invest in assets, which tends to cause asset price bubbles. In contrast, a straightforward change in government net spending has less of a “bubble blowing” effect. That is, if the additional net spending is directed at a cross section of the population (not just the wealthy), there will not be a significant asset bubble effect.

6. The optimum price for borrowed money (i.e. the optimum rate of interest) is determined by the same sort of factors that determine the optimum price for concrete, steel or any other commodity: supply and demand. To put that in economics jargon, the rate of interest is optimised when the marginal disutility of forgone consumption by savers equals the marginal utility or marginal benefit from the investments that those savers fund.

If government interferes with this free market rate of interest, then the total amount invested will not be optimum. GDP will not be maximised.

7. Low interest rates allegedly encourage investment. Unfortunately those making investments look at LONG TERM rates, not the fact that the central bank has recently cut rates and will probably raise them again in two years’ time. And that applies both to firms investing in productive capacity and people who borrow with a view to buying houses.

While most people will not buy houses just because interest rates have dropped for a couple of years, there ARE those NINJA mortgage suckers who bought houses on the basis of near zero interests for the first year or two. I.e. there ARE idiots out there. So in that the “low interest rates encourages investment” argument DOES WORK, it works by encouraging idiots to behave irresponsibly!!! Now that’s a ringing endorsement for “low interest rates encourage investment” argument - I don’t think.

Incidentally, the difficulty central banks have in influencing interest rates for corporate bonds or mortgages, this seems to have been born out in the current recession. According to this Jan 2009 Bloomberg article, rates for mortgages and corporate bonds were NOT following the Fed’s low interest rates downwards. In contrast, by May 2011, the Fed’s low interest rates WERE starting to have an effect.

8. The idea that reduced interest rates encourage investment is rendered irrelevant by the fact that in a recession, more investment is exactly what is NOT needed. In recessions (certainly in SHORT recessions) there is more than the usual amount of capital equipment lying idle! Of course it takes TIME to manufacture or create real investments like machinery or factories, and assuming an economy will return to trend growth shortly after a recession, employers need to make sure they are not SHORT of capital equipment after a recession. But employers do not need governments to tell them this. Nor will irrelevant little inducements like 2% changes in interest rates do much to optimise any given employer’s investment strategy.

9. Radcliffe Report on monetary policy in the U.K. published in 1960 concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’.

10. As to the possibility that credit card spending is influenced by changes in a central bank’s base rate, there seems to be no link between those rates and credit card rates. See here.

11. Now for the possibility of using fiscal policy alone: that is implementing the classic Keynsian “borrow and spend” policy. The problem with this policy is crowding out: that is, fact that when government borrows, that tends to raise interest rates, which has a deflationary effect, which negates the whole object of the exercise: imparting stimulus. THE EXACT EXTENT of this crowding out is disputed, but to the extent that it is a problem, the central bank can easily counteract the undesirable effect by cutting interest rates – which it does by creating money and buying up government debt.

BUT HANG ON……… What’s going on here is that the government / central bank machine is implementing the Abba Lerner “create money and spend it into the economy” policy!!!!!!!

Alternatively, to the extent that “borrow and spend” DOES WORK without a crowding out effect, there is another problem: what in God’s name is the point of government borrowing something (i.e. money) when it can create money in infinite amounts any time it likes and at no cost? You ever heard of anything so daft?

12. A novel argument in favour of using monetary policy alone was produced recently by Nick Rowe. This is that fiscal is already doing a huge amount, in the form of taking thousands of micro economic decisions a day - like deciding where to build bridges, to cite Rowe’s example. Thus, allegedly, we cannot impose more burdens on fiscal.

Well the answer to that argument is that the amount of work currently being done by any system has nothing to do with whether it should be given more work to do, or whether the latter work should be allocated to some other system. For example the fact that the military is already spending billions on warships, aircraft and so on has nothing to do with whether the military or the police should be responsible for dealing a riot or natural disaster. If the military are best at the job, they should do it, and be given the necessary funds. If the police are best at the job, they should do it, and get the relevant funds. Period. Full stop. End of argument.

Moreover, having fiscal influence demand is not difficult (contrary to James Bullard’s claims, (p.1). It is not a “burden” on fiscal. Britain has altered its VAT rate twice during the current recession. I’ve heard nothing about excessive bureaucratic costs involved in doing this.

By the way, Bullard makes just about every mistake it is possible to make in his paper. For example he claims government debt is a burden on future generations (p.17). For a demolition of this idea, see here. Bullard also got a drubbing on Warren Mosler’s site recently.

Incidentally, the Fed does have what might be called a “political excuse” for the low interest rate policy it has adopted over the last few years. This is the refusal by Congress to allow enough stimulus. In contrast, the Bank of England and some other central banks have fewer excuses for implementing interest rate reductions and QE.

13. Keynes said, “I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital...will be too great to be offset by any practicable changes in the rate of interest." Keynes’s General Theory – near the end of Ch 12. (h/t to skeptonomist).

14. It is sometimes argued that monetary policy (interest rate adjustments at any rate) can be made quickly, i.e. fiscal changes take longer to implement.

That point is irrelevant. The IMPORTANT question is TOTAL TIME LAG between the decision to implement a policy and the actual effect. I’ve seen eighteen months cited as the relevant figure for interest rate adjustments, whereas the evidence indicates that a significant proportion of the additional cash that wage earners find in their pay packets as a result of a reduction in employees’ contribution to a payroll tax reduction will be spent IMMEDIATELY. For the evidence, see here, here, here and here.

Also, in that fiscal policy consists of expanding the PUBLIC SECTOR, the effect ought to be pretty well IMMEDIATE. That is, if government decides to hire additional people, the effect comes just as quickly as people can be interviewed, and given the means to get on with whatever job they are doing.

15. Borrowing from abroad.

Borrowing is an alternative to raised taxes, and where government borrows, some of the money is inevitably lent by foreigners. But there is a problem there, which is that money flowing into a country from abroad temporarily boosts living standards in the country. And that standard of living boost will be reversed if and when the money is repaid.

Now those standard of living “gyrations”, have nothing to do with solving the basic problem, namely raising employment. The gyrations are an unnecessary and complicating factor. Plus, the temporary boost to living standards poses big temptations for politicians: it enables them to raise living standards while in office, while the mess is left for their successors to sort out.

16. There is disagreement amongst economists as to how effective monetary and fiscal policies are. That little problem can be solved by doing both policies at once. If one policy I much more effective than another, it doesn’t matter: the COMBINATION is guaranteed to have an effect. 


P.S. (10th June 2012). Some research done by G. L. S. Shackle concluded that the connection between interest changes and investment was weak. The entrepreneurs questioned said that estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.

(Hat tip to Macroresiliance.)

P.S. (16th July 2012). Reason No.17. The effect of interest rate adjustments is hindered by foreign currency movements. E.g. a rise in interest rates designed to damp down an overheated economy draws foreign capital into the relevant county, which reduces the desired effect. In contrast, a straight cut in government spending (a la MMT) has the opposite effect, if anything, on internationally mobile capital. That is, given a cut in demand in a particular country, capital will tend to leave the country in search of better opportunities elsewhere.

P.S. (24th July, 2012). There is more evidence on the non-relationship between central bank rates and interest rates charged by credit card operators here:

P.S. (15th Sept 2012). Reason No.18. Using interest rates to regulate an economy exacerbates asset price bubbles. Reason is that when the private sector shifts a significant portion of its spending to asset price purchase from other types of spending there is not necessarily any effect on inflation because the increased inflation stemming from the increased price of the relevant asset(s) will tend to be cancelled out by reduced inflation in other areas. Thus the central bank leaves interest rates unchanged, which in turn makes it easier to borrow and speculate in the relevant asset.

In contrast, if government and central bank ignore interest rates and regulate the economy by creating money and spending it into the economy when required (or raising taxes and “unprinting” money when required), then interest rates would rise in response to borrowing funded asset speculation.

Not that that would bring a total end to asset bubbles, but it would certainly help.



  1. I like the initial description of Abba Lerner's description of MMT. I have often wondered why governments do indeed simply not create new money and then push it out into the real economy. QE doesn't do this.

  2. Farmland investing, To be cynical, the reason why central banks and academic economists don’t favour “creating new money and then push it out into the real economy” is that they think they can do better by splitting stimulus up into its monetary and fiscal components. So we have a credit crunch caused by excessive and irresponsible borrowing, and the authorities try to remedy the situation by cutting interest rates and implementing QE so as to encourage more borrowing!!!!

    They aren’t just wrong: they’re barking mad. Or perhaps that’s too cynical.

  3. Since you are familiar with Mosler, then you know that there is no such thing as "fractional reserve banking", at least in the USA. Loans and deposits are created first, on balance sheets, and each bank's reserves are adjusted up or down approximately a month later, after a 2-week review of previous flows. Then only to hit the Fed's targets. Greenspan exempted all but household savings accounts from reserve requirements. Greenspan also added "sweeps" which borrow checking (demand deposits) for a few hours overnight for clearing.

    You should also know in the most pragmatic sense, government DO NOT borrow to spend. Borrowing is providing investments to savers. In the US, Congress forbids the Treasury from writing an overdraft at the Fed, as other banks can do. This includes when other banks wish to "lend" money to the Govt they can do so by issuing a payment to Tsy with funds they don't have in their reserves. They can borrow that overdraft from the Fed. Congress also forbids the Fed from purchasing T-securities at auctions or directly. Therefore, Treasury must sell Bonds to designated private banks for cash in their accounts, which then turn around and sell Bonds to the Fed, for cash, or to other banks that wish to buy T-securities, including foreign central banks that want T-securities rather than Dollars.

    There's some convoluted assets swaps going on, but basically the Treasury *is* borrowing from the Fed, only indirectly with layers of middlemen and handouts to the banking system and to foreign central banks.

    That's not the same as "borrowing instead of using power to create money". That's corporate welfare to the Rich, to banks and to net savers.

    I believe this was developed as a "workaround" to the US Constitution, which says Treasury can (a) coin money (b) issue bonds aka debt. Without a Constitutional amendment to clarify, if Treasury just started printing money (say, to fund WW One), the govt would have been sued by private banks. Instead, they designed a system within the Fed Res Act so the Govt could "borrow" from it's own big fat Govt Bank, and cut the privileged banks in on the deal.

  4. I’m using “fractional reserve” in the sense that the reserves held by commercial banks are only a small “fraction” of their total assets or liabilities. I’m not using it in the sense that the central bank CONTROLS commercial bank balance sheets by adjusting the amount of reserves.

    The phrases “fractional reserve” and “full reserve” are unsatisfactory in that they give rise to the above sort of ambiguity and misunderstanding. In fact I heard recently that Positive Money is thinking of abandoning the phrase “full reserve” for this reason.

    Re your idea that governments never borrow to spend, as opposed to invest, I have doubts about that. There has been a very steep rise in government borrowing since the recent crisis. I haven’t noticed a vast increase in road, bridge, school or hospital building.


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