The Vices of the Modern Monetary Theory

A few months back, I wrote about a virtue of the MMT; namely, the way it focuses on sectoral balances. I think that this view is both interesting and useful for the contrarian investor. However, I do have some misgivings with the convictions of the typical Modern Monetary theorist. Here, I discuss some of the problems with the MMT frame of mind.

 

For those that don’t keep a keen eye on the financial blog space, I should mention that there have been a few heated debates about the MMT lately. To name just a couple: Keynesianism (Krugman) Vs MMT & Austrian Economics (Bob Murphy) Vs MMT. Rather than repeating or refuting whatever was said in these debates, I thought I’d highlight a few issues that I have a problem with.

 

‘The US Government cannot default’:

 

Some advocates of the Modern Monetary Theory say that certain governments cannot default (in our modern fiat currency system). Stand-alone monetary systems (like the US one) – they say – imply that the government cannot default. They argue that there will always be a central bank to buy the government debt, and hence they can never default on their debt.

 

I have no problem with the premise; that is, that a Government has its central bank to buy its bonds. However, I have misgivings with the supposed implication. The reason is quite simple: Default on government debt is characterized by an inability to pay as well as a lack of willingness to pay.

 

Regardless of whether the US government has a potential buyer of new bonds or not, they might not want to pay. To say that – for example – the US will never default (insofar as the current fiat currency system persists), is to say that under all circumstances the US government will choose the printing press over outright default/restructuring. In January of this year, Robert Prechter highlighted something interesting related to this (video below). He mentioned that the US government is highly dependent on its short-term debt, and that – conceivably – the long-term debt could be given up in order to ‘save’ the shorter-term debt. In other words, rather than completely ‘breaking the government debt market’ by printing, the government could choose to let the long-end go in order to salvage the short-end. [start the video at around 15:45].

 

 

Click here to find out more about Robert Prechter & Elliott Wave International.

 

Cheerleading for ‘Net Savings’:

 

Advocates of the Modern Monetary Theory tend to use the notion of ‘private sector savings’ to push their policy prescriptions. They rightly say that the private sector’s ‘net savings’ (S-I) must equal the government sector balance plus the foreign sector balance (see here for the explanation). They then say that if you advocate the private sector improving its ‘net savings’ then you must also advocate a concomitant increase in the government’s deficit.

 

The above is entirely true as far as it goes. That is, insofar as we take ‘net savings’ to be (S-I) and a desirable thing if positive, the above holds. However, this is somewhat misleading. ‘Net savings’ as is described here, is not ‘net abstinence from consumption’. Rather it is the dollar amount saved in excess of the dollar amount spent on investment. However, ‘net savings’ in this sense is not necessarily what people conceive of when they hear the term ‘net savings’, and it is not necessarily a desirable thing.

 

A pertinent example of this kind of peculiar labeling can be seen in Stephanie Kelton’s recent article on ‘What happens when the Government tightens its belt?‘. She uses crystal clear diagrams and accounting tautologies to demonstrate that the government sector and the private sector cannot both credit each other at the same time (on a netted-out basis). But her presumption is that this refutes Obama’s recent statement that:

 

[S]mall businesses and families are tightening their belts. Their government should, too.

 

After having outlined the accounting tautologies about the private, government and foreign sectors, she expresses her misgivings with the above statement by saying:

 

Wrong! When we tighten our belts, it means that we are trying to build up our savings. We do this by spending less. But spending drives our economy. Sales create jobs. So unless Obama has a secret plan to reverse three decades of current account deficits, the Government needs to loosen its belt when we tighten ours. If it doesn’t, then millions of us will lose our shirts.

 

First of all, let me say that I’m not a fan of Obama (or even government per se). Nevertheless, I’ll defend him as I think he’s been wrongly accused. As a matter of pedantry, I should mention that ‘Small businesses and families’ do not necessarily constitute ‘the private sector’. Moreover, although I think that Stephanie is on the right track when she says, “When we tighten our belts, it means that we are trying to build up our savings”, she is merely defining her way into her own solution: We are not necessarily trying to build up our ‘net savings’ as defined by S-I! Instead, we are trying to build up the stock of wealth that we acquire by abstaining from consumption. We are not trying to increase the degree to which we credit the other sectors (or, in other words, the degree to which we save dollars in excess of the degree to which we spend them on investment!). And even if we were trying that, it doesn’t automatically mean that we should fix the results so that we succeed. In other words, that doesn’t automatically mean that governments should increase their deficits. That would only be the case if recessions were an inherently unlovely and evil thing. Only if the premise ‘recessions should be avoided at all costs’ were universally valid, would this be a correct line of reasoning.

 

We Probably Need a Recession:

 

As I mentioned the other day, the whole problem that brings on a recession is that entrepreneurs engage in activities suitable for a richer and/or more abstinent society. The Austrian business cycle theory describes this process with extreme clarity. In fact, I find it hard to believe that some people take the time to understand it, and manage to subsequently reject it.

 

The problem lies within the structure of our monetary system. As Carroll Quigley described in Tragedy & Hope: A History of the World in Our Time (available at the greshams-law.com book store):

 

This unique character in the American economy rests on the fact that the utilization of resources follows flow lines in the economy that are not everywhere reflected by corresponding flow lines of claims on wealth (that is, money). In general, in our economy the lines of flow of claims on wealth are such that they provide a very large volume of savings and a rather large volume of investment, even when no one really wants new productive capacity …

 

The reason why we can have recessions (i.e. revelations of ‘clusters of errors’), is that entrepreneurs – all at once – realize that they are wasting resources (that is, they are using relatively more valuable resources for the production of relatively less valuable resources). Recessions constitute a re-alignment of the structure of production to meet reality. That is, they are the means by which the diverging patterns between wealth itself and ‘claims on wealth’ can be corrected. In this way, they should be embraced rather than feared.

 

All this being said, I do not advocate any particular circumstance (recession or whatever else), all I advocate is the universally valid truth that people own themselves and their own stuff. This truth should not be ignored (which it is when government is called in to do anything other than protect private property rights).

 

Conclusion:

 

I certainly admire many of the insights of the MMTers, however I believe that some have strayed off track in a few of their value judgments. I have no bone to pick with their accounting tautologies as such, rather only the way in which they associate such identities with common concepts (such as ‘net savings’).

 

[For a more thorough refutation of Chartalism, see Pater Tenebrarum’s excellent article here.]

See here for our collection of rare historical economic data.

Posted Jun 6, 2011
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  • http://greenecon.blogspot.com Mitch Green

    I appreciate your reasoned approach to this critique. While I accept MMT, and defend it as the need arises, I can see that you have thought it through and raised some interesting points. I agree with your first point – that governments can default if they choose. I think that most MMT people would accept that as well, which is why they go to great strides to make the point in policy debates that default in a sovereign currency is entirely optional. As for value judgments, I will go on the record and say that governments should refrain from voluntary defaults. I think the consequences of such action are disastrous, but others may disagree. This is a point for further debate.

    I don’t accept, however, the creative destruction argument here. Sure, it is possible for recessions to create the space for an entrepreneurial realignment of resources. But I think it is much more likely that instead you will see a tendency towards further concentration of interests, as deflating assets are acquired by megacorps and you will settle into a rent-seeking mode of production. The defining factor here is the extension and availability of credit during a contraction. As Schumpeter stressed, it is the banker that stands between the entrepreneur and commercial realization. During a balance sheet recession, it is hard to imagine that credit would be extended to such risky activity.

    • http://greshams-law.com Sir Thomas Gresham

      Mitch,

      Thanks for the well thought-out comment.

      Yes, I understand that lots of advocates of the MMT put in the qualifier ‘unless they want to’ on the end. The first section is really for those who disregard that qualifier or think that this qualifier is a 0 probability thing (i.e. that willingness to pay is always guaranteed in a democracy). But looking at your comment and the ones below, I appreciate that I over-estimated the size of this group of people.

      But just to hammer the point home: The matter of investing in any government debt should take heed of the fact that default is about ability and willingness to pay. In democratic societies, I would hazard to guess that all government defaults are as much about willingness as they are about ability to pay. (That is, in democratic societies, the government scarcely ever reaches a scenario where they owe in excess of what they could pay if they really really wanted to pay.)

      I have misgivings with the strategy of compartmentalising the currency issuer into a separate category of those who can always pay (unless they don’t want to). I would suggest that every democratic sovereign has this property to one degree or the other.

      With regards to your second point, I have to say that I really don’t know what would happen. But I really can’t advocate anything that denies the notion that each individual owns himself and the property that he legitimately acquired. So, maybe you’re right about the concentration of interests, I just can’t accept that this ‘trumps’ private property rights. (For how am I to advocate a denial of private property rights if I presuppose those rights in that very argument?).

  • wh10

    Regarding your first point, here is the founder of MMT saying the US should be downgraded based on willingness to pay several months ago: http://moslereconomics.com/2011/03/25/the-ratings-agencies-should-downgrade-the-us-government/

    MMTers certainly recognize the political constraints on govt spending. Perhaps you misinterpret their position because they place so much emphasis on the absence of an operational constraint for govt spending.

    • http://greshams-law.com Sir Thomas Gresham

      Thanks wh10.

      Indeed, maybe I overestimated the group of people who think along the lines of:

      [Govt. (like US) can print] ^ [always will print to avoid default] => [Govt never defaults.]

      I certainly understood that the likes of Warren Mosler would understand that willingness counts. My critique was really aimed at those who contemptuously scoffed at the prospect of owning CDSs on US Govt. debt etc. I was just trying to say that nothing in life is so obvious, particularly with respect to financial matters about the future!

  • http://www.DollarMonopoly.com Craig Austin

    Mainstream economists, like this author, fail to understand that government debt is simply the currency user’s savings as a matter of accounting. It’s a digital resource – a digital account corresponding to all the savings of currency users’ in banknotes, deposits, and treasuries. Mainstream economists are using the wrong models, drawing the wrong conclusions, and giving the wrong advice because they misunderstand monetary operations. For example,the objective should never be to balance the budget as a currency issuer, it’s to optimize it. Fiscal optimization requires maximizing deficits to operate constraints at full capacity and maximize the production of goods and services. Exceeding constraints, such as production capacity, causes inflation and price instability. Government as the currency issuer can maintain optimal deficits indefinitely, either through public spending or cutting taxes depending on your politics, because government debt is a digital resource, a digital account of currency users savings. Government is fully capable of operating those real constraints at full capacity and chooses not to when constraining the deficit. For those of you interested I’ve outlined a laymen’s explanation here – http//www.DollarMonopoly.com The Kansas City school of economists, like Stephanie, are the only ones who understand how the monetary system actually works. You need to follow the money – assets/liabilities – within monetary operations to fully understand the role of a currency issuer. The point is the root of our current economic problems are more operational than ideological – proper monetary management and a properly structured banking system.

    • http://greshams-law.com Sir Thomas Gresham

      Ouch… I’m mainstream lol?

      I’m really not sure what meaning you apply to the term ‘digital resource’… so you’re right in a way, ‘mainstream’ people like me are failing to understand what you’re talking about. Anyway, as I don’t have an intuition with respect to that phrase I can hardly answer meaningfully.

      You need to follow the money – assets/liabilities – within monetary operations to fully understand the role of a currency issuer.

      This is what we try to do here.

  • http://www.DollarMonopoly.com Craig Austin

    BTW the Austrians have it wrong. The underlying cause of the boom/bust cycle is the poor structure of our banking system. Our banking sector needs to be structured for transparency, accountability, and stability to remove systemic risk. Letting private banks sell off their loans introduces a moral hazard. So to quickly summarize Warren Mosler proposals that are spot on we should require the following from banks 1) loans remain on balance sheets 2) no off-shore lending 3) no credit default insurance 4) no proprietary trading 5) real asset collateral The currency issuer is the monopoly producer, lender, and price setter of money. The issuer can provide private banks as much money to lend as they could ever need. The function of private banks is credit analyses, lending and taking deposits. Nothing more. Nothing less. When a banking system is designed correctly the systemic risk and boom/bust cycle will be eliminated.

    • http://greshams-law.com Sir Thomas Gresham

      What do you think ‘the Austrians’ say? For they are enormously critical of the structure of the banking system, after all… Just check the mises.org site once in a while and you’ll see plenty of material criticising the structure of fractional-reserve banking systems as well as central banks. In particular, as you say, they loath the lack of:

      transparency, accountability, and stability

      If you’re against moral hazard then how can you say:

      The currency issuer is the monopoly producer, lender, and price setter of money. The issuer can provide private banks as much money to lend as they could ever need.

  • Adam2

    Your critique boils down to Creative Destruction. While I agree with the premise of Creative Destruction to weed out bad investments and the sort, I disagree that it needs to be during a recession. That can happen during prosperous times as well in fact it usually does without major problems using Bankruptcy Law and the sort.

    • http://greshams-law.com Sir Thomas Gresham

      Right, just to be sure, I don’t advocate inducing a recession or whatever else:

      All this being said, I do not advocate any particular circumstance (recession or whatever else), all I advocate is the universally valid truth that people own themselves and their own stuff.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Your honest and civic engagement with MMT is most appreciated and duly noted. My brief responses to your 3 points would be the following, again, in the spirit of open discussion:

    1. As others have already noted, this is a red herring and misreading. The MMT position is that a currency issuer under flexible exchange rates can never be forced into default; it can certainly choose to as Japan did early in WWII when it decided to stop paying debt owed to its enemies.

    2 and 3 essentially go together. While I’m sympathetic to a lot of Schumpeterian analysis, I think in the current environment the “we need a recession” argument is completely misguided. What we need is to severely downsize the financial sector; we absolutely should have let the losers there fail. Also, many borrowed way too much. But allowing a recession (particularly a big one, even a depression) puts most of the pain on the innocent–people who CAN pay their mortgage until they lose their jobs, for instance. That makes no sense, economically or morally.

    The MMT view is this: It was entirely possible to not bailout the financial system and then cut taxes sufficiently on the private sector early on to (a) keep the economy from crashing and even stabilize it overall, (b) downsize the financial sector severely and ruthlessly prosecute law-breakers, and (c) due to the tax cuts that lead to (a), allow those in the pvt sector that can pay their debts to survive, while others who can’t in a stabilized economy would be in trouble. There’s a good deal of creative destruction in there, but it keeps the innocent by and large from being “destroyed” as they are now (and would be to an even larger degree in the full-blown “creative destruction” scenario).

    Best,
    Scott

    • http://greshams-law.com Sir Thomas Gresham

      Very interesting, thanks for your response Scott.

      1. As others have already noted, this is a red herring and misreading. The MMT position is that a currency issuer under flexible exchange rates can never be forced into default; it can certainly choose to as Japan did early in WWII when it decided to stop paying debt owed to its enemies.

      Ok, fair enough. The MMT position does include the condition that currency issuers can default if they want to. I just wanted to outline that the ‘if they want to’ condition isn’t a preposterous and out-of-this-world proposition (hence the Prechter video).

      My only misgiving with the above would be with the use of the word ‘forced’. For, are we saying that the likes of Greece etc. can be ‘forced’? My contention is that in a democracy we never get to that stage, as in, we never get to see if the assets of the governments can meet the debt: – as the unwillingness of the citizens and the government comes to bear way before that point.

      The US – being a ‘currency issuer’ – could always pay off its debt in confetti-dollars, if they still are the issuer of the currency. It seems to me that it’s not obvious that being a currency issuer can be a constant in this equation. That is to say, the if is a big one. So, if it is a big if, then would we call a US default (to keep its currency issuer status) a matter of choice? Or a matter of being ‘forced’?

      2 and 3 essentially go together. While I’m sympathetic to a lot of Schumpeterian analysis, I think in the current environment the “we need a recession” argument is completely misguided. What we need is to severely downsize the financial sector; we absolutely should have let the losers there fail. Also, many borrowed way too much. But allowing a recession (particularly a big one, even a depression) puts most of the pain on the innocent–people who CAN pay their mortgage until they lose their jobs, for instance. That makes no sense, economically or morally.

      My hunch really is to agree, and a lot of what you say would be my best guess. But, although I sympathise with downsizing the financial sector etc, I can’t – so to speak – impose my judgements of what is fair or not upon others. I’m not saying that we should induce a recession (or not), but rather that a recession would probably come to pass if we let the market do its work. I have to say that any personal convictions about who is innocent and who is not just don’t matter – it’s the market that decides this. As in, in a really simple sense, profits are bestowed upon those people who are engaged in productive work in a capitalistic economy (not upon who I think is doing a good thing). Again, I have to disagree with respect to economics and morality. Economically, we’re burning capital insofar as we let losers win and let winners lose (in the financial sector and out). Morally, with the help of Kant and his intellectual descendants, I find it contradictory to accept the notion that private property rights should be violated.

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  • Merijn Knibbe

    ‘We are not necessarily trying to build up our ‘net savings’ as defined by S-I! Instead, we are trying to build up the stock of wealth that we acquire by abstaining from consumption’. No, we’re not trying this. But when we save money and spend it on bonds or shares this is just an asset swap. The wealth of society does not increase. Prices of these assets may increase but (housing market) when too much money is chasing to few houses this does not necessarily lead to an increase in quality of these houses. That’s the reason why national accountants do not classify asset swaps (including the purchase of existing houses) as investments. On a macro level the distribution of assets changes – but the total amount of assets doesn’t. The concept of investing in the sense of the national accounts (and that’s the I in your formula) is a macro concept. More bridges and houses and whatever do add to the national stock of capital. And don’t tell me that whenever a government builds a bridge this is (as in you link to Pater Tenebrarum) this is just taking away resources from productive purposes. Thee is of course the problem of the allocation of these investments – but why do you think that, after WW II, about the first thing governments did was repairing bridges? This was done to increase the scale of the market and to lower transaction costs, i.e. transport costs in this case. Business was jubilant about this, like households which could by cheaper food again. Thanks to the government and government investments. Tenebrarum also cites Mises on choice, a concept of choice which is thoroughly, totally and completely refuted by modern consumer studies. Preferences are (a) vague and (b) not transitive and if you think otherwise, like Mises, you will end up selling nothing and going bankrupt. Read the literature about the brain interpreter, please, http://en.wikipedia.org/wiki/Left_brain_interpreter Anyway – government spending does add to the flow of money as it is monetary spending, like it or not. And we duly measure and estimate this. Its a fact of life. And decreasing spending by the govenrment is not automatically compensated by increased spending of the private sector, please check the national accounts of Greece and Spain and Ireland and Estonia and Latvia and Lithuania.