Ralph Musgrave - Ralphanomics

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

File:Abba Lerner.jpgAbba 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.

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.

And there is much argument as to just how much influence central banks have on long term rates. For example, there is one estimate here (3rd last para) to the effect that a 1% change in short term rates brings a change in long term rates of around 0.025: a total and utter irrelevance!

And if that is not bad enough, it seems that in as far as central banks can influence long term rates, they can only influence them slowly – over a two year period. See here. Again, that is utterly hopeless. For the purposes of regulating aggregate demand, one needs as quick an effect as possible.

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.

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.

And finally, the above should not be taken as a criticism of the low interest and QE policies pursued by the Fed over the last two years or so. Given the refusal by Congress to implement enough stimulus, the Fed has little option but to employ interest rate reductions and QE. In contrast, the Bank of England and some other central banks have fewer excuses for implementing interest rate reductions and QE.

Ralph Musgrave - Ralphanomics

Author: Ralph Musgrave - Ralphanomics

I wrote a book on unemployment recently with James Galbraith, and others. Galbraith is one of Obama's economic advisers. I love the different cultures that exist in this world. I took an interest in them long before the daft word 'multiculturalism' was widely used. I want to see these cultures preserved. I want to see Tibet staying Tibetan, and Britain staying British.

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