(I had been planning to write this post before Steven Landsburg started a whole blogosphere argument about what taxes are for. Honest!)
Functional Finance says you only use taxes if you want to reduce Aggregate Demand to prevent inflation. The Long Run Government Budget Constraint says you use taxes to pay for past, present or future government spending. They sound very different. They aren't.
There's a general principle in economics: first you eat the free lunches; then you look at the hard trade-offs. Functional Finance says "first eat the free lunches". The Long Run Government Budget Constraint says "then look at the hard trade-offs".
Suppose, just suppose, that if you kept on doing what you were planning to do, you never had to worry about inflation. Not now, not in the future, not ever. Because Aggregate Demand was too low now, and was projected to be too low forever. So you are not worried about inflation. Instead you are worried about deflation. And you were a government that could print your own money. What would you do?
You would print money and spend it. Or print money and use it to finance tax cuts. And you would keep on doing it, more and more, until you got to the point where you did start to worry about inflation. You first eat all the free lunches.
That's the underlying kernel of truth in Abba Lerner's Functional Finance (pdf) [see also his book The Economics of Control (pdf)]. And I don't know of any mainstream macroeconomist who would disagree. You use taxes only so you don't have to print money. When you get to the point that Aggregate Demand is high enough, so you start to worry about inflation, you use taxes to finance past, present, or future government expenditure precisely because you don't want to print more money and make inflation higher.
Suppose inflation isn't a problem right now, because Aggregate Demand is currently too low. Does that mean the government should print money and spend it? Not necessarily. Print money yes, but instead of spending it on goods, or on tax cuts, it might be better to use it to buy back some interest-paying government bonds. Because even though inflation isn't a problem right now, it may be a problem some time in the future. So you can buy the money back in future, by re-issuing the bonds (and save on interest in the meantime) without having to raise future taxes or cut future spending.
Here's an easier way to think about it. Print enough money to get Aggregate Demand and inflation where you want it to be. That's the free lunch the government can eat. Any additional government spending must be paid for, sooner or later, with taxes. The present value of taxes, plus the present value of newly-printed money (seigniorage), equals the present value of government spending, plus the existing debt.
Seigniorage revenue belongs in the government budget constraint. The government can pay for part of its spending by printing money. But don't get too excited. It's not that big, on average. If central bank currency is around 5% of annual nominal income, and if nominal income is growing at 5% per year (3% real plus 2% inflation) then 5% x 5% = 0.25% of GDP. (In the right ballpark for Canada — it shows up as the profits the Bank of Canada hands over to the government — but maybe double it for the US). Printing money is a nice little sideline, but we are still going to need taxes.
Let's ask a slightly different question. Why do governments pay interest on their debt? Actually, it sounds like a different question, but it's really the same question. Why finance government deficits with interest-paying debt, when you could use non-interest-paying currency?
The answer is the same: you pay interest on the debt to encourage people to hold it and stop people spending it. If you cut the interest rate on government debt, will people sell it back to the government for money, spend the money, and cause inflation? If not, then Aggregate Demand is too low, and the problem is deflation, not inflation. So there's a free lunch from cutting the interest rate on government debt. And the government should eat that free lunch. And then the Long Run Government Budget Constraint kicks in again.
Now suppose the real rate of interest on government debt is below the real growth rate of the economy. (Or the nominal rate of interest is below the growth rate of nominal GDP — same thing). And suppose it will be like that forever, if you keep on doing what you were planning to do. The government can run a Ponzi scheme forever. It can borrow and spend, then borrow to pay the interest forever, and the debt grows more slowly than the economy, and the debt/GDP ratio declines over time. The Long Run Government Budget Constraint is undefined. The Present Value of taxes can be less than the Present Value of Government spending.
That's another free lunch that needs eating. The economy is dynamically inefficient. The economy wants a Ponzi scheme. And the government should satisfy that demand. Issue debt until the interest rate equals the growth rate. Then the Long Run Government Budget Constraint kicks in again.
Worthwhile Canadian Initiative 
Beautiful. Wonderful. Can you run in some Ottawa riding so we can make you Minister of Finance, Nick? Or how about Governor of the Bank of Canada? Both positions come with a complimentary helicopter.
But the problem is that the mainstream media has been angonizing, handwringing and generally worried itself silly about inflation since 1975. It’s a bogeyman. Every 0.1% increase in inflation is seen as a calamity. A 1% increase is a catastrophe. Anytime the Minister of Finance or the Governor put their hands anywhere near the monetary or fiscal levers and hint about pushing them in the “wrong” direction the media explodes about inflation.
Inflation? It’s not an economic fact so much a collective delusional nightmare.
Have we all forgotten the pain of chronic unemployment? Well, that CSLS paper said we did.
MMT would apply functional finance in terms of sectoral balances to affect demand. The government fiscal balance and the nongovernment (domestic private sector and external) balance sum to zero as an accounting identity. Taxes, saving and net imports constitute demand leakage. Functional finance is used to offset demand leakage in order to keep effective demand sufficient to purchase potential supply and maintain full employment. So if the domestic private sector desires to net save and the country is a net importer (like the US at present), then the fiscal deficit has to offset this demand leakage, or the economy will contract and unemployment rise. This way, the government fiscal balance would respond to shifts in the nongovernment balance as savings desires and the trade balance change, using expenditure to inject nongovernment net financial assets to increase nominal aggregate demand and taxation to withdraw NFA to decrease NAD.
Nick, thanks for the post and continued engagement with MMT.
I’m just going to comment on a few points of your post and provide what I think is an overview of some key MMT points. I’ll try to keep my points as brief as possible.
I’d just like to start off with a disclaimer, that I am only an undergrad, and therefore my views on MMT may be incorrect. If I have made an errors please let me know.
Financed spending versus ‘unfinanced’ spending:
I think a key concept which may be missed in this debate is that MMT doesn’t define the choice between either taxing or ‘printing money’, ‘printing money’ always occurs whenever governments spend. Allow me to explain:
1.MMT define money as a credit-debt relation; money is always financial asset with a matching liability.
2.As Minsky states, all entities can create money, the key is getting your liabilities accepted.
3.Some entities get their liabilities accepted by explicitly stating that they will convert it into something else. For instance, banks allow their money to be convertible into state money.
4.States (defined as a set of institutions which have a monopoly on force over a geographic area) have an easier time in getting their liabilities accepted, they can impose a tax upon the population which can only be extinguished by using their liabilities. Of course the ability to do this depends upon the ability of the state to enforce their taxes.
It follows from this the primary function of taxes is to create demand for government currency; they do not finance government spending. In fact, government spending (or central bank ‘loan’) is logically required first before taxes can be paid. Once a tax has been imposed, spending and taxing become separate operations – governments spend by crediting private sector bank accounts or by issuing a cheque, and tax by debiting private sector bank accounts.
The option then isn’t between financed spending versus ‘unfinanced’ spending, as government spending is never financially constrained.
Furthermore as you have pointed out the other function of taxation is to then reduce aggregate demand.
In fact, the ability for the private sector to pay taxes requires that the government spend (or central bank issues a ‘loan’) first, before taxes can be paid.
I have a few questions regarding this. As I understand it the operation of ‘printing money’ to buy bonds, is essentially changing the composition of financial assets within the private sector, from interesting earning to non-interest earning. MMT is critical of this operation because firstly, it reduces interest income, which reduces demand, and secondly, because apart from lowering the yield curve, it doesn’t do much else.
I don’t understand how the option of issuing bonds in the future is dependent on doing this either, surely the option is always available to government? I also don’t see the how the issuing of bonds is meant to reduce aggregate demand. Wouldn’t the purchasing of the bonds reflect the desired savings of those entities? The government has simply provided a safe form in which that savings make take.
Function of bonds:
Apart from self imposed requirements, MMT states that bonds function to assist central banks in maintaining their target rate. This is how I see it, I don’t believe this is inconsistent with the mainstream view:
1. Central banks have a monopoly on issuing reserves.
2. Central banks can either set the quantity and allow the price to float, or set the price and allow the quantity to float. Central banks target a short-term rate, they therefore allow the quantity to float.
3. From 1 only changes in the central bank’s balance sheet can alter the total number of reserves.
It follows then that the banking system cannot create or destroy reserves, they can only shift them around.
4. Following from 3,
A.if the banking system finds itself deficient in reserves, then there is no way that it can overcome this deficiency, the central bank has the choice of either meeting the demand for reserves and hence maintaining its target rate, or allow the target rate to be pushed up (of course the market will never clear).
B.If the banking system has excess reserves, then the there is no way that it can get rid of these excess reserves, the overnight rate will be pushed down below the target rate.
5. In 4B: The issuing of bonds does two things, firstly, it changes the composition of financial assets in the private sector, from non-interest assets to interest earning. Secondly, allowing the central bank to maintain its target rate – this is why MMT refers to bonds are “interest rate maintenance operations”.
Much the same as taxes, bonds do not function to ‘finance’ government spending. In a system where the government has no financial constraint it doesn’t make any sense to consider bonds as financing operating. The same point re taxes can be made with bonds too, that is, the ability of the private sector to purchase bonds is only possible once the government has spent or the central bank has issued a loan.
As I see it, once the functions of taxes and bonds are understood – that is, once they are no longer defined as financing operations – we can then turn to more important questions such as the appropriate mix of each, as your post alludes to.
I’ll need to re-read this again as it’s getting late and I’m getting tired,
but as far as I hear Warren Mosler keep saying…cash and bonds are simply an asset swap. The interest rates fluctuate and reveal indifference levels in the market. Savers stay savers essentially forever and so the “inflation risk” (aka demand-pull inflation) of bond interest is essentially zero since those savings will more than likely stay in bonds or if anything move to another savings/investment vehicle. The likelihood of those savings to turn around and become consumptive (buying ipods with bond interest woo-hoo!!!) is very, very slim.
So I guess I am confused with your points…again it’s late for me right now, I’m tired, and I could be way off here so chime in and set me straight.
cheers!
In his final para Nick Rowe says “the government should. . . issue debt until the interest rate equals the growth rate.
Well, suppose growth declines to zero because the population ceases to grow, and because technology ceases to advance. Or suppose the economy ceases to grow because we decide to factor in the real environmental costs of our Western lifestyle. Do we take it that the optimum level of govt debt then becomes zero? The reasoning there smells fishy to me.
I’m glad you are engaging these ideas Nick, this openness to ideas is refreshing and encouraging!
Scott Fullwiler addressed the intertemporal budget constraint in detail at the start of this paper: http://www.cfeps.org/pubs/wp-pdf/WP53-Fullwiler.pdf
It is critical to understand that “printing money” is no different from “printing bonds”. Much confusion stems from the belief that one is more inflationary than the other. This belief has been debunked both by a technical understanding of monetary operations as well as from a black box empirical point of view (e.g. the non-effect of quantitative easing).
Also, many government (including the U.S. since 2008) pay interest on money (bank reserves). So earning interest is not a difference between money and bonds.
Finally, the interest that the government pays on its money/debt is set by the government. And there is no economic law that it has to be related to inflation or economic growth. It could be a constant, which would eliminate an artificial source of risk from financial markets.
Tjfxh, [Ralph means to reply to MDM — the name comes below the comment in this blog Ralph — NR] First, don’t worry about being “only an undergrad”. When it comes to something relatively new (or as is the case with MMT, something that is being “re-born”), fully qualified academics are not necessarily better than anyone else. In fact some of them are so brainwashed by the conventional wisdom, that people new to the subject are better. And more fundamentally, there is Jean Paul Satre’s dictum: “man is condemned to freedom”. I.e. you have no option but to think for yourself.
Second, re your claim that “money is always financial asset with a matching liability”, this is not really the case with monetary base. Of course the £20 notes in my wallet say “I promise to pay the bearer on demand the sum of twenty pounds”. But that’s nonsense. Central banks have no intention of honouring their cash liabilities, e.g. with lumps of gold.
Third, you say that “MMT is critical of” printing money to buy bonds because it reduces interest payments which reduces demand. My impression is that it is only Warren Mosler who has made this claim, and even he admits to not being sure of the point.
This demand reducing effect depends on the institutional customs or arrangements in the country concerned. E.g. if it normal practice for such payments to be funded by the central bank with money produced out of thin air, then obviously there is a demand influencing effect. But if it is normal practice for the interest to be funded out of tax, then the demand effect is much less or even zero.
In any case, the whole argument is irrelevant, in that given deficient demand, the government / central bank machine can boost demand any time it wants.
Fourth, you say “I also don’t see the how the issuing of bonds is meant to reduce aggregate demand.” Nick gave the reason, seems to me, when he said “you pay interest on the debt to encourage people to hold it and stop people spending it.” Of course, as you suggest, some people need very little inducement to buy bonds, so there is no effect on demand here. But others do need the inducement.
Fifth, re what you call the “appropriate mix” of cash and bonds, Warren Mosler advocated a “zero bonds” regime in this Huffington article (see 2nd last para).
http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html
I agree with that, but for different reasons. I would say that MMT advocates influencing demand (and inflation) simply by altering the amount of money that the government / central bank machine prints and spends. (That’s the Abba Lerner “money pump”). Given that tool for influencing demand, I don’t see the need for a second tool, i.e. adjusting interest rates.
I will publish a paper on the Munich repec site in the next week or two which gives the whole interest rate adjustment idea good kick in the whatsit. I think the title will be “Monetary and fiscal policy should be merged, which in turn would change the role of central banks.”
BTW: does anyone know of a better link to Abba Lerner’s Functional Finance? I found that link on Ralph’s blog, I think. (I had read the book Functional Finance years ago, but didn’t know that article existed). The article is a little hard to read (I mean it’s blurry — not that it’s … you know what I mean).
Determinant: thanks! But I don’t think I have written anything that economists at the Bank of Canada or Finance would majorly disagree with.
tjfxh: let me re-write what you said using the language of conventional macro:
“The IS curve incorporates the equilibrium condition that desired savings minus investment = the government deficit + net exports. If that equilibrium condition results in too low a level of income (for preventing inflation falling below the 2% target) the Bank of Canada should lower the rate of interest to move down along the IS curve (increasing investment and reducing savings) and/or lowering the real exchange rate (increasing net exports and/or the government should loosen fiscal policy to shift the IS curve right.”
It’s a different way of saying the same thing. The only difference is that maybe MMTers don’t believe interest rates affect desired savings or investment, so want to use fiscal policy. See my last post on reverse engineering.
MDM: “The option then isn’t between financed spending versus ‘unfinanced’ spending, as government spending is never financially constrained.”
Translated, that means the government can finance its spending by printing money (seigniorage). But there’s a limit. The first limit is when inflation gets too high, because there’s only so much 0% interest money people want to hold. That limit is approximately $2 billion per year on average in Canada, for 2% inflation. That’s not much. The second limit is when you hit the seigniorage-maximising inflation rate. I don’t know where that limit is (it depends on the shape of the money demand curve), but Zimbabwe went past it.
“I have a few questions regarding this.”
Standard theory believes that the IS curve is not vertical but slopes down, because a lower (real) interest rate will increase desired investment and/or reduce desired savings via a substitution effect. If you don’t believe this — if you believe that the IS curve is (approximately) vertical (or slopes up), then you get very different results. See my recent post on “reverse engineering MMT”.
People are willing to hold some of their wealth in the form of money that pays little or no interest, because money is a medium of exchange, and it’s really inconvenient to do the shopping with too small an amount of money. But there’s a limit to how much money people are willing to hold. That’s why the money/bond mix matters. Go past that limit, and either issue too much non-interest-paying money, or bonds with too low an interest rate, and people want to spend it, and AD gets too big, and you get inflation.
Mario: “Savers stay savers essentially forever and so the “inflation risk” (aka demand-pull inflation) of bond interest is essentially zero since those savings will more than likely stay in bonds or if anything move to another savings/investment vehicle.”
That’s the key assumption. If you believe the IS curve is vertical, because a lower rate of interest will neither increase desired investment nor reduce desired saving, then there is little rationale for the central bank to set an interest rate above 0%. See my “reverse engineering” post. Mainstream economists do not believe this. They believe the IS curve slopes down.
Ralph: (assume the real growth rate is 0%, and the real interest rate is above 0%) “Do we take it that the optimum level of govt debt then becomes zero?”
No. If r is less that g (forever), there’s a free lunch from issuing debt, so the government should issue it. If r exceeds growth rate, there’s no longer a free lunch. But it might still make sense to pay for lunch, depending on the costs and benefits. E.g. if there’s a real need for high government spending right now (war, for example) but you want to smooth taxes over time to reduce the total distortions, then debt-finance makes sense.
Tschaff: I think that’s the same paper by Scott I have already had a go at reading. (Scott told me about it in comments on Steve Waldmann’s blog). This post, my previous post, and my comments on Steve’s blog, are partly in response.
Max: “It is critical to understand that “printing money” is no different from “printing bonds”. Much confusion stems from the belief that one is more inflationary than the other.”
That’s where we disagree. People will hold some amount of money because it’s a medium of exchange, even when the real rate of return on holding that money is considerably below that of bonds.
All the seigniorage revenue from printing money comes from the interest rate differential between money and bonds. That’s where the Bank of Canada’s profits come from. It issues zero interest currency, and holds interest-paying bonds. The difference is the $2 billion per year. If we ignore that, then any free lunch from issuing money+bonds only happens when the interest rate on bonds is below the growth rate.
“Go past that limit, and either issue too much non-interest-paying money, or bonds with too low an interest rate, and people want to spend it, and AD gets too big, and you get inflation.”
The supply of non-interest-paying money (i.e. paper money) is endogenous. The government has no contol over it. It can control the supply of bank reserves, but in that case it must pay interest if it wants to target a >0% rate.
If the government is bidding up prices with its spending it’s going to cause inflation even with a high interest rate. The high interest may temporarily mask the inflation problem by propping up the exchange rate, but the problem remains.
Max: “If the government is bidding up prices with its spending it’s going to cause inflation even with a high interest rate.”
That, in a nutshell, is a re-statement of my reverse-engineered MMT model in my previous post. MMTers believe that the IS curve is vertical.
Max: “The supply of non-interest-paying money (i.e. paper money) is endogenous. The government has no contol over it.”
That is also the conventional (New Keynesian/Neo-Wicksellian) view. The Bank of Canada sets a nominal rate of interest, and the stock of currency is demand-determined. The LM curve is horizontal. Again, that’s my reverse-engineered MMT model. Horizontal LM, and vertical IS.
” People will hold some amount of money because it’s a medium of exchange, even when the real rate of return on holding that money is considerably below that of bonds.”
That’s a good point — we should think of different demands for different types of assets, rather than one large savings demand.
However, the public is already demanding to hold a stock of MZM equal to its holdings of federal debt.
It’s just mostly outside money, and we allow banks to earn the seignorage income instead of the government.
Banks are allowed to supply households with 7 Trillion in deposits, supposedly because households demand it for transactional (or short term storage) use.
On the other hand the government must not create more money because households are not willing to hold more than a small amount. The government must borrow 7 Trillion — the debt held by the public — at the long term rate, rather than MZM own rate.
I think the seignorage income is huge — enough to retire the entire debt, for the most part. But we hand almost all of this income over to the financial sector.
RSJ: Banks earn money because they provide a useful service–intermediation.
But isn’t there a difference between the economy-wide inflation constraint, and the government budget constraint? Anyone can pay for things with IOUs, there’s nothing unique about governments issuing their own currency. Anyone can borrow. The difference is that a private borrower faces rising interest costs, or an inability to increase their debt past a certain point (or an unwillingness of sellers to accept their IOUs) long before their purchases reach the rising part of the supply curve of the goods they are purchasing. You might in some limited formal way be able to make limited demand for government liabilities look like limited supply of private goods. But they’re really not the same. And MMT claims that (some) governments only face constraints of the second kind, while the conventional view is they face both.
RSJ: (BTW, what’s “MZM”? And did you mean “It’s mostly just inside money”?)
Let me re-state your point in my language:
The government issues currency paying 0% nominal interest, and bonds at i%. That’s the source of its seigniorage revenue from printing currency (minus costs of paper and ink). iM/P is like a “tax” on holding currency. Or, more controversially, it’s the government’s monopoly profits, from its legal or de facto monopoly on note issue.
(Milton Friedman said that the optimal tax on currency is zero, because taxes distort. So the optimal rate of inflation should be minus the real natural rate of interest, to drive i down to 0%. That avoids the wasted shoe-leather costs of people holding a suboptimal stock of currency, and running back and forth between the bond market (or ATM) and the supermarket. But notice that Milton Friedman’s policy recommendation effectively means we are in the ZLB trap permanently. Money and bonds are effectively the same.)
By “taxing” currency in that way, the government creates an incentive for commercial banks to produce currency substitutes (demand deposits etc.) to help people avoid those taxes. But, if the banking system is competitive, the super-normal seigniorage profits of the commercial banks get competed down to zero, either eaten up in operating costs, or by paying interest on demand deposits.
Given that governments generally want a (say) 2% inflation target, and it’s difficult to pay interest on currency, we can’t eliminate that seigniorage tax. We are in the world of the second best. In a second-best world, it’s not a priori clear whether it’s better to allow banks unrestricted rights to help people avoid the tax on currency and the shoe-leather costs, or whether it would be better for the government to tax demand deposits (for example by requiring reserve ratios with no interest on reserves). The 100% required reserve advocates take one extreme position. Canada has taken the opposite extreme position, with no required reserves, and interest on reserves.
“Printing money is a nice little sideline, but we are still going to need taxes.”
Incidentally, in the UK, quantity of notes and coin as a % of GDP has a long-run downwards trend. So the amount of “free lunch” on offer here is gradually vanishing.
MZM = money of zero maturity
“iM/P is like a “tax” on holding currency.”
I think this is the most appropriate way to think of seigniorage. In effect, it’s not a free lunch either, which brings us back to Landsburg’s point about incidence. Somebody has to bear the costs. The real question is who that is going to be.
JW: “The difference is that a private borrower faces rising interest costs, or an inability to increase their debt past a certain point (or an unwillingness of sellers to accept their IOUs) long before their purchases reach the rising part of the supply curve of the goods they are purchasing”
That “rising part of the supply curve” is the flip-side of the falling value of the falling value of the IOU’s issued, and their downward-sloping demand curve. If I start issuing IOUs, they will not usually circulate as a medium of exchange. That’s why there’s no “convenience yield” on Nick Rowe IOUs like there is on Bank of Canada currency IOUs. So I can’t earn seigniorage, and have to pay interest to persuade people to hold a positive stock of my IOUs, otherwise they will fall in value very rapidly as I issue more. Rather like a bus company paying its drivers in bus tickets.
vimothy: thanks on the MZM.
There are two ways to think of seigniorage profits:
1. i(M/P) where M is currency, and i the nominal rate on bonds.
2. dM/P = (dM/M)(M/P) where dM means amount of new currency issued per year.
IIRC, the present value of the two flows of seigniorage is the same.
Nick,
You have talked of the long run budget constraint.
I think the most important point of Macroeconomics can be rephrased in a similar manner: An increase in Government expenditures ΔG = $1 has an effect given by the Keynesian multiplier but the long run multiplier is 0. And given this, is there a way out ? (and of course there is).
Of course, this conjecture depends on a bit of abstraction and really going into high level of detail in deciding which ceteris is paribus, which stocks/flows are exogenous or endogenous etc. Because looked at another way, the multiplier is very strong.
All sorts of explanations have been given ranging from crowding out to inflation etc by the profession…
The Neochartalists’ argument is that the budget constraint is not really a constraint because the so called “sovereign” governments cannot default on their obligations. In fixed exchange rate regimes, it is a constraint since there is a peg to be defended and foreigners’ claims can be very high putting a tight reign on the government’s fiscal stance.
The 1970s I believe was the second most important period in Economics (first is the present shared with 1930s ?) .. the Keynesian demand management failed and economists were left with the task of explaining this failure.
There was one mechanism which I liked which explains the paradox of the multiplier but which I believe is quite incorrect. It was from the London Business School – Ball and Burns. (Have just read an account of this not the original model.). An initial injection of $100 extra of government expenditures increases demand by a huge amount but over time this effect gets nullified. The reason given is that the increased demand increases wages slowly over time and while the higher demand increases imports, higher wages decreases exports. Though I do not believe in this, I thought it is somewhat enlightening.
Coming back to MMT, I believe they have missed addressing the mix between real and monetary phenomenon – focussing all their energy on the fact that governments do not default – with catch phrases such as “debt is not debt” to the point of being dismissive of ideas that there can be constraints from the external world to arguing that imports are “free lunch” (your terminology)!
This is a good example of why macroeconomic models are not covered in texts on microeconomics or financial economics. The macro models simply make no sense. In Micro, we put the quantity of apples on the horizontal axis and the price of apples on the vertical axis, and we get the demand for apples. Then macro comes along and puts the quantity of everything on the horizontal axis and the price of everything on the vertical axis and calls it an AD curve. If people object to this meaningless aggregation then just start piling on math until they walk away. After that, you can start talking about how to “use taxes if you want to reduce Aggregate Demand to prevent inflation”, and by then the micro folks won’t be listening, and you can have a nice friendly discussion with the people who believe as you do, and who actually think they are making sense when they talk about AS/AD, IS/LM, Y=C+I+G, and MV=Py.
NIck: “It’s a different way of saying the same thing. The only difference is that maybe MMTers don’t believe interest rates affect desired savings or investment, so want to use fiscal policy. See my last post on reverse engineering.”
No “maybe” about it. We seem to be are going round and round on this. MMT flatly and emphatically rejects monetary policy and favors fiscal policy. See your last post on reverse engineering. 🙂
MMT combines Godley’s SFC macro modeling and sectoral balance approach with Lerners’s functional finance, among other things, to achieve its aim, full employment with price stability, which is the Fed’s mandate, btw. MMT is recommending substituting fiscal policy for monetary policy. No and’s, if’s, or but’s.
With respect to this discussion, MMT’ers deny that the MMT approach can be reduced to ISLM and recast as a sort of monetarism, as we have already gone thorugh previously. MMT is fiscalism for good reason: The transmission from government expenditure to an increase in nongovernment NFA to increased NAD, and the opposite in the case of taxes, is clear. The transmission of interest rate management is not clear for a variety of reasons that MMT’ers explain. MMT’ers reject the assumption of that interest rates affect I & S in the way presumed, so that the ISLM model is not useful as a policy tool. For MMT the sectoral balance approach and functional finance are policy tools, using fiscal policy.
You also assume that taxation (revenue) funds expenditure. MMT denies this, in that in a fiat system, a monetarily sovereign government that is the monopoly issuer of a nonconvertible floating rate currency funds itself directly with expenditure. No taxes needed for funding. Not now. Not ever.
Expenditure and taxation are separate fiscal operations that do not depend on each other. Expenditure transfers real resources from private to public and increases nongovernment NFA in the exchange. Taxes withdraw net financial assets generated previously by the expenditure that created these assets ex nihilo. That is what “fiat” means. The connection between expenditure and taxation is that the currency that government creates ex nihilo is in effect a tax credit. That’s it. Nongovernment must obtain these credits to satisfy its obligations mandated by government in the form of taxes, fees and fines.
The federal government in the US spends first and then taxes to reduce reserves as needed to control inflationary pressure and issues tsys to drain reserves from the interbank market. Taxation is a fiscal op. Tsy issuance is monetary op. Expenditure adds reserves, taxes subtract reserves, and tsy issuance converts reserves into another asset form without altering NFA. Monetary policy only alters NFA through the amount of interest paid, since interest payments increase nongovernment NFA. So lower rates are deflationary in this respect, and higher rates inflationary, according to MMT.
To understand MMT. it is necessary to recognize that MMT is a “new paradigm,” in that it rejects many assumptions (norms) on which the current economic paradigm rests because, e.g., they do not reflect how the Treasury, cb, and financial sector actually interact — as Scott F. pointed out in another thread, as I recall.
I am happy that you are trying to understand MMT, but I think that without approaching it on its own terms, you are getting confused about what MMT is saying and more importantly at this critical juncture, what MMT is prescribing. ISLM is never going to capture what MMT is saying becuase its transmission is monetary (interest rates) and MMT is fiscal (expenditure and taxation). MMT is shouting out to dump monetary policy and switching to fiscal policy based on SFC macro models, the sectoral balance approach, and functional finance (and some other things, too). MMT sees the issue as lagging demand due to demand leakage stemming from increased saving desire and net imports, which government needs to offset fiscally with a corresponding deficit.
BTW, retiring the debt by increasing reserves to buy up tsys simply puts the reserves drained from the interbank market back into the market. This would mean that the overnight rate would go to zero unless the cb paid interest on excess reserves equal to its target rate, or else set the target rate equal to zero (the MMT recommendation). What you are proposing by transferring tsys to the Fed’s book is the no-bonds recommendation of MMT’ers, which the Fed is now pursuing to some degree. You say that is might be better to buy back bonds now because there might be inflation in the future. The fact is that QE is depriving nongovernment of the added NFA of the interest to be paid and transferring it to the Tsy to reduce the deficit. This is just adding to the demand leakage that is crippling the economy now. If the interest were used to increase the deficit by that amount, this extraction would not lead to demand leakage. Moreover, we can deal with inflation should it arise fiscally, in a targeted fashion, instead using the blunt instrument of interest rates to contract the entire economy and increase the buffer of unemployed as we have been doing under NAIRU.
Nick, the interest on MZM is the MZM Own Rate, which is negative in real terms, and about 2-3% less than FedFunds. IIRC, MZM Own rate has been about -1%. Perhaps -1.6% when adjusted for CPI.
And this does not take into account fees.
And yet households are willing to hold 7 Trillion of it — yet government must pay the bond rate on 7 Trillion of public debt otherwise there would be an explosion of inflation? Really?
Here’s the data
RSJ,
Part of the spread between the Treasury rate and the MZM Own Rate represents the banking (and quasi-banking) industry’s costs, including the cost of capital to the banking industry. The rest (if there is any) must be monopoly profits. If the government starts taking retail deposits, it will also have associated costs, so it certainly won’t be able to reap the entire spread. If you want to argue that it would be efficient to have a government money monopoly instead of inside money, you need to say either (1) why the government’s costs would be significantly lower or (2) why there is monopoly power in the banking industry. I can think of arguments for both of these, but they aren’t trivial questions.
Notes and coins are insignificant.
Just because some small amount of interest is paid does not mean that there is no seignorage.
A more robust definition of seignorage income should be defined as differences in funding costs.
Banks can borrow at negative real rates. There is a limit, due to the limited demand for the public to hold zero maturity assets. Nevertheless that demand is not decreasing as a share of GDP.
Very few people use notes and coins as we move to a cashless society, but this has nothing to say about seignorage income. The seignorage income is still there. It should be measured in terms of spreads on funding costs, not by counting “coins”.
Andy, I think the problems associated with RSJ’s proposal are if anything more serious than that. What advantage does the govt have in terms of the actual process of intermediation, i.e., why should the govt be “better” than the banking system at transforming illiquid assets into liquid liabilities?
Andy,
The banking industry is an oligopoly, and has been from the very beginning, when governments tried to fix the price of deposit rates.
The Law of Large numbers is the best possible example of an increasing returns to scale industry.
I don’t think that the government should necessarily offer retail banking services, but they should tax banks to ensure that their funding costs are at least the fed funds rate. A simple idea would be to tax all bank assets that aren’t CB liabilities at the policy rate, and then give banks tax credits for any interest payments made to creditors that are not supplying bank capital, as defined by bank regulators.
In terms of evidence, you can point to more funds being paid out in the form of bank bonuses to employees than were paid out to shareholders. That, plus compensation in the industry more generally, is prima facie evidence (to me) that their profits are greater than their overall cost of capital.
RSJ, in the UK (as in Canada), the BoE pays interest on reserve balances, so the govt only earns seigniorage on notes and coin.
Nick,
Abba Lerner never wrote a book called “Functional Finance” The Federal Debt paper is the only time in his publications that “Functional Finance” is highlighted. I guess, that the term stuck to his writings.
To get at what the current MMT economists are about, you should probably start at some of the Levy Institute’s working papers, and work backwards to get at the original sources, particularly Working Paper No. 272. Functional Finance and Full Employment: Lessons from Lerner for Today? by. Mathew Forstater http://www.levyinstitute.org/pubs/wp272.pdf The references from that paper should lead you to the relevant Lerner works.
There is a good website on Abba Lerner’s work at http://www.economyprofessor.com/theorists/abbalerner.php and http://www.newschool.edu/nssr/het/profiles/lerner.htm
However, that will only lead you to his life’s work, and not necessarily to the body of knowledge that developed from his ideas.
Functional finance means following this budget procedure if you are a government:
1. Decide the desired level of government expenditure, i.e. the share of society’s real potential output thatis better allocated publicly rather than privately. (G)
2. Given G and the existing level of taxes net of interest and transfer payments, then:
A. If the output gap is too big and inflation is below target, reduce taxes or raise transfer payments.
B. If the output gap is too small and inflation is above target, raise taxes or reduce transfer payments.
3. Repeat in the next period.
The thing about this procedure is that you can follow it without knowing anything about the existing stock of government debt. In particular, it is never the case that you have to set G below the level that would otherwise be desirable because the existing stock of debt is too large.
If you can follow this rule, you are in a functional finance world. If you can’t, you are not.
The argument that Lerner was specifically challenging was that there is an additional constraint on public borrowing beyond the economy-wide inflation constraint, such that if we act too aggressively to reduce the output gap (or raise the inflation rate) in this period, we will be forced to accept a larger output gap (or lower inflation rate) in some future period.
Of course you can redefine long-run budget constraint to mean inflation constraint. But at that point you are not using the phrase the way other people do. And you are not showing that the functional finance and mainstream views are equivalent, you are accepting the functional finance view and rejecting the mainstream view.
Evidence? Just look at the enormous effort – not just academic but in very important policy contexts like the European Growth and Stability Pact – to define acceptable limits to government deficits and debt-GDP ratios. If you agree with that – if you think that the optimal level of today’s deficit is lower when the existing stock of debt is higher – then you are taking the mainstream view. If you think that the optimal level of today’s deficit is the same regardless of the existing debt stock, then you are taking the functional finance view. They are not the same.
JW Mason, What does this rule tell you to do when inflation or the stock of pubic debt becomes very large AND there is an output gap?
“If r is less that g (forever), there’s a free lunch from issuing debt”
I think this free lunch is a lot smaller than a lot of MMTers assume.
True, the government can run perpetual deficits while keeping total debt constant as a proportion of GDP — but only by running smaller and smaller deficits (relative to GDP) over time.
If deficits are constant as a proportion of GDP over time, then the debt is growing faster than the economy b/c it is an accumulation of deficits that are growing as fast as the economy and then additionally paying interest.
This seems like a more significant constraint on deficit spending than MMTers realize, even if their understanding of the economy is accurate.
Derridative has the best pseudonym since Kate Mossad.
JW: suppose there’s a major emergency, so G has to be big this period, but you know it will be smaller next period. If private demand is roughly the same in the 2 periods, your version of FF would mean big taxes this period and small taxes next period. That is generally not optimal. The deadweight costs of distorting taxes will be bigger than if taxes were smoothed. Generally, it’s much better to use bond-finance to handle fluctuations in the amount of G you want. That’s Barro’s tax-smoothing hypothesis. (Not the same as Ricardian Equivalence).
Clonal: Damn! My memory must be going. I’m sure I read a big beige book by Abba Lerner. And I thought the title was Functional Finance!
What does this rule tell you to do when inflation or the stock of pubic debt becomes very large AND there is an output gap?
Those are two separate questions. If the stock of debt gets large, you ignore it and keep doing what you were doing. You always set today’s deficit the same way based in today’s inflation and output, regardless of the existing stock of debt. Lerner was very explicit about this.
If you’re getting conflicting signals from inflation and the output gap, that is a problem. Much (most) of Lerner’s later work was addressed to exactly this question. His view was that this situation would arise if you had excessive levels of monoPoly power in the economy, which isn’t a problem you can solve with macroeconomic tools. In any case, we can say that if this divergence is a persistent problem, we are not in a functional finance world. But that’s still different from there being a long-run government budget constraint, in the way it’s normally understood.
oops, italics were supposed to be the first paragraph only.
[Fixed NR]
Derridative: “If deficits are constant as a proportion of GDP over time, then the debt is growing faster than the economy b/c it is an accumulation of deficits that are growing as fast as the economy and then additionally paying interest.”
That is a very helpful and new (to me) insight. By “deficits” you mean “primary deficits”, yes?
I still can’t quite wrap by head around the math, to get a back of the envelope calculation of how big it is. Care to explain a little more fully, with just a bit more math? (What percentage of GDP can you run a permanent primary deficit as a function of r and g?) Thanks.
I am hoping that this takes care of the italics issue
Damn! Realised that my above comment in response to Derridative doesn’t make sense. Still trying to get my head around the math.
Nick,
There is always a problem when a society (public or private) uses interest bearing debt instruments to finance its spending. See Michael Hudson’s The Mathematical Economics of Compound Rates of Interest: A Four-Thousand Year Overview – http://michael-hudson.com/2004/01/the-mathematical-economics-of-compound-rates-of-interest-a-four-thousand-year-overview-part-i/ and http://michael-hudson.com/2001/04/the-mathematical-economics-of-compound-rates-of-interest-a-four-thousand-year-overview-part-ii/
This is one of the reasons that in the current MMT thinking, the only way to make money work is to have a Zero or negative natural rate of interest. Dis-savings have to be forced by taxation, if savings are held in interest bearing instruments.
“tax banks to ensure that their funding costs are at least the fed funds rate”
there are branch infrastructure, salary, and admin costs that require those spreads
its called retail banking
JW, that is a brilliant concise summation. Thank you.
I would add that popular discussion of the danger of debt assumes an unstable multiple equilibrium situation where if the bond market “predicts” default, then default will occur. We see this playing out in the Euro zone due to the politically fragmented design of the system.
JW Mason, They are related questions in that then govt can either finance its deficit by printing money or by issuing bonds. For “functional finance”, the can opener is the assumption that the govt’s budget constraint does not matter. So it’s no surprise that it doesn’t have any useful suggestions for states of the world in which it does.