The MMT solvency constraint
It is good to see Paul Krugman prominently discussing “modern monetary theory”, although I don’t think his characterization is quite fair.
I am an MMT dilettante, so I’ll apologize in advance for my own mischaracterizations. But I think the MMT view of stabilization policy can be summed up pretty quickly:
The central macroeconomic policy instrument available to governments is regulating the flow of “net financial assets” to and from the private sector. The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.
A government that borrows in its own currency cannot be insolvent in the same way as private businesses. That is, such a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.
However, the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives (such as, especially, full employment).
The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows. Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.
The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.
Avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilization is slack, as evidenced especially by high unemployment. Avoiding net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed.
However, a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes.
Therefore, a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses. A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes.
I think this is a clever and coherent view of the world. I do not fully subscribe to it — in my next post, I’ll offer point-by-point critiques. But first, let’s see where I think Paul Krugman is a bit off in his characterization:
As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.
I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.
The real question here is why a deficit that would be inconsistent with price stability with “loose money” would be transformed into something sustainable with “tight money”. From an MMT-perspective, it is the flow of net financial assets from public sector to private, relative to the private sector’s willingness to absorb, that matters. Whether those net financial assets take the form of liquid cash or still very liquid Treasury securities is second order. As Krugman himself has pointed out, conventional monetary policy is just a shift in the maturity of government obligations. If the private sector is unwilling to hold the expanding stock of dollar-denominated obligations at prices (in terms of real goods and services) consistent with our definition of price stability, the private sector will be unwilling to hold those obligations whether they are bonds or money.
An obvious objection is that bonds pay yields that might induce private sector agents to hold government paper at current prices (again in terms of real goods and services), while money historically did not. Krugman’s sustainable “tight money, loose fiscal” scenario basically amounts to pointing out that the private sector can be induced to hold more paper if the public sector promises to make large ongoing transfers to holders of its paper. MMT-ers have mixed feelings about using interest payments to increase the willingness of the private sector to hold government paper. Regardless, since most central banks now pay interest on reserves, these payments no longer serve to demarcate “fiscal” obligations of the Treasury and “monetary” obligations of the central bank. Rather than being divided into “fiscal” and “monetary” policy, we end up with “flow” policy and “yield” policy. In order to stabilize the price level and real spending in the face of changes in private sector demand for government paper, the public sector can either modulate supply (by adjusting the size of the deficit / surplus), or modulate demand via the yield (by altering the interest paid on reserves or selling term bonds). As MMT-er Bill Mitchell puts it, “Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.”
MMT-ers view the size of the flow itself — that “6 percent deficit” — as the primary instrument of stabilization policy. By holding the deficit constant in his thought experiment, Krugman deprives MMT of the means by which it would manage demand. MMT-ers do not claim that fiscal policy can ignore private willingness to hold government assets. On the contrary, they take from Wynne Godley’s sectoral balance analysis that fiscal policy should do a jujitsu to accommodate the changing net demand of the private and external sectors. MMT-ers very much agree that it is important not to lose access to the bond market, broadly construed. But they suggest that the government’s power to tax is sufficient to maintain the private sector’s appetite to hold government paper, whether in the form of bonds or of money. Therefore, there is little need to fret about “confidence” and undead theories of government solvency. The government can issue paper — make transfers, deficit spend, whatever — when the private and external sectors are willing to buy, and reduce deficits or even run a surplus when those appetites have been sated.
Anyway, this is long enough. I’ll post critiques of the view I have summarized later.
Much of my understanding of MMT comes from conversations with the excellent Winterspeak. Obviously, any mischaracterizations are my own and any insights due him. I owe Winterspeak a contentious post highlighting our argument about whether it is detestable for wealthy people to maintain large holdings of money and government debt. I say, for the most part, that it is. If you want to read that argument in raw, unhighlighted form, see the comments here. I’ve also learned a lot from the mysterious JKH.
Some writers of note about MMT include Marshall Auerback, Scott Fullwiler, James Galbraith, Bill Mitchell, Warren Mosler, Rob Parenteau, Pavlina R. Tcherneva, Eric Tymoigne, and L. Randall Wray. You can find the writing of several of these authors in Levy Institute’s working paper series and at Economic Perspectives from Kansas City. Some blogs that occasionally offer an MMT perspective include Credit Writedowns, Naked Capitalism, New Deal 2.0, and Pragmatic Capitalism. See also the related links below.
- 27-March-2011, 7:30 p.m. EDT: Fixed misspelling of Marshall Auerback’s name (sorry!). Added lots of MMT resources and related links, many thanks to commenters Sennex and Tom Hickey as well as Winterspeak for some links. One change to the piece itself (pre-acknowledgements): Changed “modulate the yield” to “modulate demand via the yield”
- 27-March-2011, 7:45 p.m. EDT: Changed “effects” to “impact” in Point #1, to avoid repetition of “effective” and “effects”…
- 27-March-2011, 8:45 p.m. EDT: Obsessively removed the “i.e” before “conventional monetary policy”. Also changed “in the present and recent past” to “in the recent past”, just because the latter reads less awkwardly.
Scott, Eric and Randy all write for http://neweconomicperspectives.blogspot.com/ if it helps
Sincerely,
MMT Student (dilettante)
March 27th, 2011 at 5:55 am PDT
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Hmmm … as usual, I really appreciate your thoughts about this. I still refer back to your Rob Parenteau accounting entity article …
I’m curious to see the critiques. I personally think MMT is central to the issue of sector profitability (see Steve Keen). Sector profitability is where the rot is …
Accounting entity economics is never far from the understanding of estimable James Galbraith, Dean Baker, John Hussman, Warren Mosler, Marshal Auerback, etc. but I think it is over- relied upon. People/economic entities cheat … economists are the last to realize that economic agents are crooks and what the crooks want determines economic outcomes. (see China, Weimar, Egypt, Ruben/Citi, etc.)
I hate to break it to ya but all economic agents are crooks which is the ‘why’ of economics in the first place; to put a high gloss on robbery.
Accepted: the US can never be forced into bankruptcy as long as its debts are serviced in currency the US issues (but events can and are forcing the US into effective money- bankruptcy, in the US is already bankrupt from an output standpoint; it’s like a headless dinosaur, it’s too stupid to know it’s dead.)
Within the paperhanging concept the US establishment issues more and more paper ‘valyew’ until it becomes clownishly irrelevant. The critical ambit is the interface of economics and policy (alongside the liquidity/currency traps that are also economic conversation du jour). Economics sez there is no particular reason why the US cannot have an instant multi- quadrillion dollar economy … tomorrow! Politics sez that idea is too idiotic even for Michelle Bachmann.
Given that the liquidity traps lie within the interface between currency and debt. This is where the inflation/deflation arguments come from.
Outside of paperhanging the issue is not the ‘value’ of the paper but that of the goods and services exchanged for it. The goods and services are never examined but promoted as unqualified ‘good things’ (whatever that means). The goods and services side of the transaction is treated differently than the money side. This is a ‘structural dishonesty’ and a fundamental part of modernity (which contains MMT, of course).
In the Undertow wasteland, the goods and services have negative values and represent massively expanding unrecoverable costs. (How much do you earn with your car? How much does the parking lot earn?) This is because the arbitrary ‘values’ attached to goods and services aren’t economic but pop- cultural and determined by marketing/peer pressure/structures rather than return.
What are fifty nuclear reactors worth in Japan today, right now (especially after it emerges that some of the four stricken reactors in Japan have already melted down)? How much is Japan’s industrial ‘product’ worth in the balance weighed by four melted down nuclear reactors? How about all fifty four melting down?
This isn’t idle speculation, it’s an outright inevitability! (See Nicole Foss.) What is modernity and ‘convenience’ worth over a term longer than three months, exactly?
The costs are always shifted: this shifting undermines MMT because what is exchanged and kept account of becomes perceived as worthless like Monopoly money; all sound and fury signifying nothing in particular …
Anyway, more later.
March 27th, 2011 at 8:58 am PDT
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I’ll hold off making more detailed comments, as I’m sure Steve will come up with some interesting critiques, which I’m keen to see. But could you get the spelling of my name right (MARSHALL AUERBACK). The “K” only came because my grandfather’s name was mis-spelled by the immigration officer at Ellis Island, but I’ve become rather partial to it! :)
Agree that Winterspeak is superb on this stuff.
March 27th, 2011 at 11:22 am PDT
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SRW: This seems like a fair summary summary.
The other two legs of the MMT stool (for me) are 1) how reserves actually function within the banking system, and 2) the true mechanisms between private sector balance sheet expansion.
At its core it’s all balance sheet stuff, something that Economics, as a profession, has no concept of.
March 27th, 2011 at 11:40 am PDT
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Steve – an excellent summary of the MMT perspective (at least as I understand it), and I only wish Krugman could open his mind long enough to catch more than a cartoon version of these ideas. You clearly have a very strong grasp of this material, so please do carry through on you next step of constructive criticism, as that is important way to refining these ideas and identifying blind spots or possible challenges to the approach. It is important to remember our mental maps are always just representations of the true terrain, although some maps are more useful than other.
best,
Rob Parenteau
March 27th, 2011 at 12:20 pm PDT
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Steve,
I’m glad you’ve done a post on this!
My take is that the MMTers are pretty paranoid about this point, so as soon as they read the phrase “deficits don’t matter”, they flew straight into attack mode, and in the rush to be “understood”, misunderstood Krugman’s post.
It seemed pretty clear to me that Krugman meant “deficits don’t matter” in terms of the govt’s ability to spend, not that “deficits don’t matter” in terms of the health of the economy, which is how everyone and his dog has interpreted it. How dare he! A strawman! But Krugman was surely thinking of the govt’s budget constraint. Krugman thinks the deficit matters because the govt needs to borrow to spend. But he considers a case in which the govt issues currency instead (because it can’t access capital markets for whatever reason). He thinks that this will cause inflation, because “if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base” (so he’s implicitly ruling out interest on reserves as well).
I don’t think I’ve seen anyone respond to his actual argument, which I take to be the idea that financing with money is more inflationary than financing with bonds. I thought his second post on the subject clarified this—in particular, the bit you excerpt above.
March 27th, 2011 at 12:58 pm PDT
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Dean Baker does MMT: http://www.businessinsider.com/krugman-is-wrong-the-united-states-could-not-end-up-like-greece-2011-3
March 27th, 2011 at 1:45 pm PDT
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For those want to cut to the chase without going through all the comments on Krugman 1 and 2, I have posted links to representative comments there and posts elsewhere at:
http://mikenormaneconomics.blogspot.com/2011/03/paul-krugman-marginalizes-mmt.html
March 27th, 2011 at 3:18 pm PDT
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Nice one Tom
Also, my comment above should read, “Krugman thinks the deficit matters because the govt needs to borrow to net spend”.
March 27th, 2011 at 3:24 pm PDT
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vimothy: “I don’t think I’ve seen anyone respond to his actual argument, which I take to be the idea that financing with money is more inflationary than financing with bonds. I thought his second post on the subject clarified this—in particular, the bit you excerpt above.”
I don’t think that PK needs to bring in the strange case of bond vigilantes refusing to purchase tsys to get to the question of whether currency issuance at full employment would be inflationary under MMT principle. MMT would recommend a fiscal deficit at full employment if domestic or external savings desires warrant. Moreover, Warren Mosler has recommended that the US consolidate the Treasury and Fed in a single agency, let the new Treasury handle settlement and the FDIC take care of regulation, set the overnight rate to zero, and issue no securities longer than three month T-bills. Issues related to this, including hyperinflation, have been debated on several occasions recently at The Center of the Universe, and MMT’ers have argued against there being an inflationary impact.
http://moslereconomics.com/2011/03/18/guest-on-reuters-insider/
http://moslereconomics.com/2011/02/16/mmt-on-marketwatch/
March 27th, 2011 at 4:12 pm PDT
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Tom: But it’s just a thought experiment. Krugman imagines a scenario in which the govt doesn’t issue bonds but instead issues currency to fund its deficit spending. According to MMTers, the govt doesn’t need to issue bonds to spend, so why should the details matter? I think they’re a distraction and you’re missing a good opportunity to engage K / everyone else on the substantive issue in the rush to make sure he’s not misrepresenting you.
March 27th, 2011 at 4:38 pm PDT
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SRW,
I’d be leery of demathematizing the logical structure of balance sheets in dealing with the issue of solvency in the case of government.
MMT acknowledges the importance of the dynamic whereby the government sector creates net financial assets to satisfy demand by the non government sector.
Given the relationship between the two sectors, it is obvious that this requires the creation of a net liability position for the government sector itself, although this is not often recognized very explicitly.
In the case of the private sector, or more generally the non government sector, there are two complementary ideas that underpin the notion of solvency – liquidity and capital. In fact, these two aspects mesh interdependently in the operational dynamics of actual cases of insolvency. Those who go bankrupt typically experience problems related to both the perception of their capital positions and the actual liquidity position they are endowed with in facing that situation.
In relation to MMT, the NFA position created by the government contributes both liquidity and capital strength to the non government sector. NFA generates equity for the non government sector in the form of claims of the highest risk quality. Given this combination, NFA generation by the government therefore adds to the solvency of the non government sector as a whole.
To be clear then, government can manufacture liquidity, capital, and solvency characteristics for non government. This is all embedded in the idea of being a “currency issuer”.
From a balance sheet perspective and from a sectoral balance perspective, it should also be clear therefore that the government itself has the complementary position – negative liquidity, negative capital, and negative solvency.
This of course is a horrifying statement that nobody wants to read or hear. But it is the only logically true statement.
How can this be so?
It is because the government has the strength to “issue itself” into such a financial position, whereby it can transfer its financial position into the non government sector by creating what is essentially a debit position in all of these positive financial characteristics for itself, and still sustain its required operations. The balance sheet stock position it arrives at in doing is quite sufficient, and optimal, thank you very much. It’s a sign of strength, not weakness. That’s just the way it is.
So I wouldn’t be bothered to adjust the interpretation of solvency in the case of government to arrive at a definition that feels good, but in fact doesn’t really fit with the logical structure for the rest of the closed universe from which the very meaning of “net financial assets” is carved out in consistent fashion.
March 27th, 2011 at 5:53 pm PDT
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[…] Interfluidity is on the case. […]
March 27th, 2011 at 10:41 pm PDT
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If I was the USA, my main concern with too much of quantitative easing would be that Saudi Arabia and Qatar decide one day that holding US dollars just doesn’t make much sense anymore. They shrink their oil and gas exports to be just enough to purchase food, clothing and some durable goods. The energy costs skyrocket and everyone is miserable expect those who got the QE III cash.
March 28th, 2011 at 1:09 am PDT
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Prakash, more realistically, the Saudis won’t shun their biggest customer. Hat would be very bad for business. Especially if it caused severe recession in the USA and the Saudis suddenly found themselves on the wrong side of WMD claims….you know, the kind of WMD claims that result in regime toppling. It’s not that far fetched….
March 28th, 2011 at 1:26 am PDT
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So the biggest issue is to take the money control off private hands. Banksters will go.. one way or another. They just don’t realise it yet. The think I like most in this theory is that the government can channel resources to more productive sectors like R&D instead of yachts and noisy cars for narcissistic pseudo-bankers. The problem is if you want it to work, you really need government, not neo-liberal puppets and “revolving door” poodles. But you need it anyway, so..
March 28th, 2011 at 2:00 am PDT
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Vimothy: I don’t think I’ve seen anyone respond to his actual argument, which I take to be the idea that financing with money is more inflationary than financing with bonds
In both of my replies I argued the opposite. Printing money / the Fed buying most/all the bonds & low interest rates (especially longterm ones) lead to low inflation. Examples: WWII US/UK. Japan now. Lots of historical data. Gibson’s Paradox. It’s time to bury J. Horsley Palmer, he died in 1858!
March 28th, 2011 at 4:17 am PDT
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John K,
Are you being serious?
March 28th, 2011 at 6:24 am PDT
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I’m glad to see you tackle this – I should wait for you follow up post, because several elements of your summary sound dubious to me*. Taxation destroys private assets? wtf?
*I don’t mean a poor summary of MMT
March 28th, 2011 at 7:43 am PDT
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JKH: “negative solvency”? Brutal!
March 28th, 2011 at 8:24 am PDT
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JKH, WS: How do you feel about this statement: the present disc value of the govt’s expenditure on goods and services must be less than or equal to its initial wealth plus present disc value of tax receipts net of transfer payments…?
March 28th, 2011 at 9:27 am PDT
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Vimothy,
I’m with you in the sense that you get unbounded increases in debt service growing faster than the debt itself. But–and I’m sure you know this–if the interest rate on the debt is below the growth rate (as it has been on average for the US post WWII) this changes things quite a bit.
March 28th, 2011 at 10:06 am PDT
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Scott: Yes, that satisfies the constraint (and this result features in all the textbooks I’ve seen, e.g. Romer, we get taught it in class, etc–I don’t think neoclassicals are shy about it). I’m trying to understand to what extent you disagree with this conceptualisation of the GBC.
I read Krugman as saying that the budget constraint holds, but that MMTers disagree with it (in principle, not just in practice). Further, being able to issue currency doesn’t help, because (outside of the liquidity trap) it just causes inflation.
March 28th, 2011 at 10:18 am PDT
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Winterspeak: yes – time for strong medicine and gut checks
:)
Vimothy – I was just about to post this before I saw Scott’s comment, but here’s what I wrote anyway:
Scott Fullwiler has written the bible for this sort of calculation with “Interest Rates and Fiscal Sustainability”. I don’t feel qualified to comment at this point, because I still haven’t worked entirely through a subtle but somewhat difficult point (for me) he makes about Ricardian equivalence; he makes the same point (I think) in his post today at Naked Capitalism:
http://www.nakedcapitalism.com/2011/03/scott-fulwiler-paul-krugman%E2%80%94the-conscience-of-a-neo-liberal.html
March 28th, 2011 at 10:24 am PDT
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Vimothy,
The IGBC is valid in as much as it sets the condition for debt service not growing in an unbounded fashion faster than GDP. My core problem with it is the assumption that interest on the debt is set by “markets”; for a sovereign currency issuer, it is or at least at the very worst can be a monetary policy variable. That changes quite a bit the typical dynamics most think of with the IGBC, such as Kotlikoff and the other “fiscal imbalance” folks.
I posted my critique of Krugman to Naked Capitalism today, BTW.
March 28th, 2011 at 10:28 am PDT
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Scott,
So, to clarify, would you say that you,
1, agree in principal with the neoclassical intertemporal govt budget constraint, but,
2, think that the interest rate the govt pays on its debt is a policy variable
(I.e govt is bound by the budget line but can alter its slope/rate at which its lifetime tax revenue is discounted)?
Is this your position as an individual or a general MMT position? (I’m having a hard time imagining Bill Mitchell or Warren Mosler agreeing to 1…)
March 28th, 2011 at 10:46 am PDT
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I agree that the IGBC sets the condition for unbounded increases in debt service. It’s simply math. It’s not a “constraint,” though, per se. Even many neoclassicals argue this (fiscal theory of the price level–though it’s obviously quite controversial).
I don’t think I’ve seen any other MMT’er seriously take on the IGBC on its own terms, which may be why you can’t get a clear answer from the others. I could be wrong, though, but I haven’t seen it myself.
March 28th, 2011 at 11:01 am PDT
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Actually, some of us are having a private email discussion right now, and it seems they’re on board (Randy, Marshall, etc.) given your point 2 AND the additional point that functional finance is Ricardian.
March 28th, 2011 at 11:03 am PDT
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JKH,
Yes, I’m a fan of that paper.
One signal issue seems to be the idea of interest on excess reserve balances. Krugman writes that “if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base”. In other words, T-bills and base are not perfect substitutes, and in order to make them behave like equivalents, you need to give them the same expected return. I’d say he’s actually in agreement with most MMTers here, e.g. Scott in his post at NC: “The reason why reserve balances and T-bills are substitutes right now is because they both earn the same return—reserve balances earn the target rate, that is.”
But here we’re back in the realms of paying the private sector a nominal return to hold govt paper, and the nominal return that the private sector receives on reserves is set by private demand. And since they’re now equivalents the govt should be indifferent between financing with new base or T-bills. So what do we gain?
March 28th, 2011 at 11:16 am PDT
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Sorry, obvious typo is obvious:
“In other words, T-bills and base are not perfect substitutes, and in order to make them behave like equivalents, you need to give them the same expected return.”
Should read,
“In other words, T-bills and base are not perfect substitutes, and in order to make them behave like perfect substitutes, you need to give them the same expected return.”
March 28th, 2011 at 11:19 am PDT
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Scott,
“I agree that the IGBC sets the condition for unbounded increases in debt service. It’s simply math. It’s not a “constraint”.”
Well, in principal the govt can pick an intertemporal bundle outside of the budget line, but if it does so, it does not have the real wealth to discharge its obligations. So the govt’s budget line defines the feasible set of intertemporal consumption bundles (i.e. available future paths of govt expenditure) conditional on the assumption that the govt will pay its debts in real terms.
March 28th, 2011 at 11:27 am PDT
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There is the power to tax and the willingness to do so and I am not sure even a crisis would produce the latter anymore.
March 28th, 2011 at 12:17 pm PDT
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And MMTers of course ignore that political decisions made in the current period create restraints on the political decisions available in future periods. For instance, if you decide to finance current period spending with a bond because people will more easily part from their real goods if you offer them a bond as opposed to cash (0% yield zero maturity bond), you have now made a promise to make transfers in the future, periods of time which may have different circumstances that make those transfers desirable or undesirable. While you could default, inflate away, or tax those obligations each of those actions has political and economic consequences, and effects people’s perception of the future real returns of holding bonds and thus the price they are willing to accept on them in exchange for real goods.
The same could be said of promised future transfer payments such as Medicare or SS. Its true that if we are at full capacity at some point in the future, but existing tax rates are not enough to sterilize new financial flows necessary to pay benefits, we could either raise taxes or cut benefits to bring the net flows in line and thus not create inflation. But what are the odds there will be the political will to do that when the time comes? Do we expect the lobbies in favor of those programs to get weaker over time? Is it ethical to impose onerous taxes on future generations to pay for benefits that are very large in terms of GDP?
Now, it may be that the future, especially the far future, is so unpredictable that we shouldn’t worry about it so much and we will deal with it when we get there. That’s a perfectly respectable way of dealing with public policy, its not necessarily irresponsible. But that can be a dangerous game. Making promises or future transfers in order to get people to act in a certain manner in the present constrains the political options available in the future. If the ways in which you get people to change behavior in the present lead to higher growth and resources to use in the future it may even expand future policy options despite these constraints and be worth the risk. The question then becomes, as SRW has put so many times, if what we are spending our money on really is a good investment or not.
P.S. In the part about bonds I didn’t even get into the issue of how people want different levels of financial balances in different time periods, so money sitting idle in a bank account at one period can be used to bid up real resources in the next for a persons preference for financial assets vs real assets changes between periods (velocity goes up). This would apply even to non-interest bearing “cash”. It is true that the government could sterilize this money by taxing it out of existence, but that’s sure to cause political issues.
March 28th, 2011 at 1:18 pm PDT
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Bah, I still don’t get your weird block quote syntax, and you can’t edit posts here.
[i’ve fixed the blockquote problem in the previous comment. —SRW]
March 28th, 2011 at 1:19 pm PDT
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Let’s disaggregate a bit. The non-financial sector has a finite demand for money, but that demand is already greater than the stock of Federal debt held by the public.
The financial sector also has a demand for reserves that limits seignorage income to that sector.
I would put forth that we are leaving far too much seignorage income in the hands of the financial sector, by letting them supply households with deposits. With this license to mint money, they then fund conservative think tanks such as the Peterson Institute, that tell us that the government needs to live within its means. It’s crazy.
The financial sector adds no value to borrowing short and lending long when the government can borrow short instead. The only value-add of the financial sector is credit analysis, and we should tax away the economic rents earned. As those taxes are paid, we will need to monetize more debt just to keep the base constant. That would be the full amount of seignorage income available to the government, and this amount is roughly equal to the current interest payments on federal debt held by the public.
March 28th, 2011 at 7:09 pm PDT
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Krugman: “But if the U.S. government has lost access to the bond market….”
And I thought countries that lost access to bond markets were those who were losing productive capacity, where industries lay dying, its people unable to work. If the US indeed ever achieves full employment, losing access to bond markets would likely be the furthest thing in the world. Foreigners will even more so look at it as a safe haven. And locals who now have gainful income, and who want to save for the future (where they envision spending in US dollars) will put money into US bonds.
March 28th, 2011 at 9:36 pm PDT
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MarkS,
That is precisely SRW’s point about what MMT postulates.
I have no doubt at all about the US government’s ability to impose taxes and maintain their currency within US boundaries. But outside? Let’s look at the evidence.
They defeated germany and japan, but did not collect reparations.
The US invaded iraq, but did not show the political capacity to impose taxes on the iraqi people. Would they do this with Saudi Arabia or Qatar, especially if they couch their reduction of supply in words of sustainability and environmentalism, I’m not sure.
An unsaid assumption going on here is that every government’s solvency constraint ultimately lies in its political capacity to extract production from enough primary producers thought to be sufficient to sustain modern civilization. Whether this happens via outright taxation or sales of goods is immaterial. To make my point simple, when china sells manufactured goods to saudi arabia and australia in exchange for energy and raw materials respectively, what will be the response of the MMT theorists in the US?
March 29th, 2011 at 12:36 am PDT
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[…] The MMT solvency constraint Steve Waldman. He also provides a huge linkfest if you want more. […]
March 29th, 2011 at 6:00 am PDT
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[…] De M. Waldman: The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows. Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services. […]
March 29th, 2011 at 7:02 am PDT
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[…] The MMT solvency constraint Steve Waldman. He also provides a outrageous linkfest if we wish more. […]
March 29th, 2011 at 7:52 am PDT
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[…] even by very smart people. Paul Krugman doesn’t understand this distinction. It seems that Interfluidity is close to getting it, but he still doesn’t quite get it, because he puts a solvency constraint on governments […]
March 29th, 2011 at 10:08 am PDT
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Branching out from my earlier brutal comment, here is something just plain picky instead:
“The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.”
This may be slightly ambiguous. Because the government manages the size of the NFA position proactively, it is not really possible for nongovernment actors to achieve “net outflows” as such. (A potential exception might be increased taxation flows resulting from automatic stabilizers, but I don’t think that’s intended in your meaning here).
I would interpret your intended meaning more in the sense that individual nongovernment actors attempt (and succeed) in redeeming (currency) and selling (bonds) for current goods and services. That attempt is made against an existing stock (in time) of NFA, managed by the government.
As this non government activity moves to a boil, the velocity of the NFA stock would naturally increase. It is that increase in velocity, relative to a given NFA base, that puts pressure on inflation.
Government can then react to that velocity increase by downsizing NFA in growth (deficit reduction) or absolute (surplus) terms.
March 29th, 2011 at 10:52 am PDT
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SRW wrote about what MMT postulates:
A government’s solvency constraint ultimately lies in its political capacity to levy and enforce the payment of taxes.
It seems to me, at this stage, the U.S. Government is able to levy and enforce taxes.
The important distinction, though, in my opinion, is what percentage of those taxes cover current expenses?
I believe the current budget estimates we spend $1.50 for every dollar of revenue.
When does that become a problem under MMT, when you combine that with the total accimulated debt?
Even if we asume we can never go bankrupt as a nation, it doesn’t mean we are prosperous.
If 10$ of the people own 85% of all financial assets, is that prosperity?
Don Levit
March 29th, 2011 at 11:22 am PDT
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JKH,
“Government can then react to that velocity increase by downsizing NFA in growth (deficit reduction) or absolute (surplus) terms.”
The relevant question is HOW the government would go about achieving a downsizing NFA growth. Decisions made in the present time period create political constraints on what can be done in future time periods. It’s not enough to say it can be done. Its legitimate to ask how, to discuss the difficulties that each “how” presents, and to examine what role “hows” in the present affect available “hows” in the future.
Here is a simple example:
I issue a bond with a positive interest rate at t=0 because I feel I’m not at full employment. At t=1 I’m at full employment and if I A) don’t want to create inflation & B) don’t want to default on promised bond payments then I’m left with C) I have to offset the money created by making my bond payment by destroying it via taxation or some other mechanism. At this future point in time I may decide taxing workers to give bond holders more purchasing power is politically unjust, but there are all sorts of negative consequences to defaulting on “risk free” securities or not sterilizing the new money and letting inflation rise.
It may be that issuing that bond at t=0 will cause an increase in production and make more real resources available in t=1 so that you could allow the money supply to increase without increasing the price of goods. It may also be that the money you spent in t=0 when you issue the bond was a bailout to TBTF financial institutions who used it to pay out bonuses and consume yachts at t=0, in which case there will not be additional real resources in t=1 and inflation will occur if you don’t sterilize new money flows.
March 29th, 2011 at 12:04 pm PDT
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“The relevant question is HOW the government would go about achieving a downsizing NFA growth”
This is Scott’s point about a full employment fiscal policy being Ricardian. Taxes are paid as a proportion of income, and deficit spending is proportional to the output gap — say it takes the form of unemployment insurance.
In that case, when there is an output gap, tax receipts fall and outlays increase. When the economy is back at full output, the reverse occurs.
There is no need to increase tax rates or to cut unemployment benefits. No decision needs to be made as to policy. It happens automatically. There is no need to sterilize anything to avoid inflation.
The budget outcome is endogenous and the debt/GDP ratio will stabilize at some level.
And the point that the MMT’ers make is that the reverse is also true. If the government decides to cut the deficit then it will succeed only temporarily, but longer term it will fail.
As there is a demand for net financial assets, if this nominal savings demand is unmet, then real output will decline, people lose their jobs and start collecting benefits, tax receipts fall and the private sector forces the government to deficit spend not only the original amount demanded, but an additional amount corresponding to the increased savings demands due to increased income uncertainty.
The *only* way to decrease the debt to GDP ratio is to decrease private sector savings demands.
But it is impossible, over the long term, to decrease the debt to GDP ratio by raising taxes or cutting benefits. That may work over the short term, but it fails spectacularly over the long term. The added (nominal) income uncertainty will result in higher equilibrium debt to GDP ratios than would have been obtained via a functional finance policy that served to stabilize nominal incomes and reduce (nominal) income uncertainty.
March 29th, 2011 at 5:15 pm PDT
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It seems to me the biggest difference between MMT and Quasi-monetarism is which mechanism they think is more effective – flow or yield policy. Quasi-monetarists emphasize yield policy far more. Both are trying to control the demand for financial assets, one by changing the cost of holding them and the other by satisfying demand for the marginal holder of those assets.
It seems to me that Congress is not set up to react quickly enough for flow mechanisms to fight recessions. What is the mechanism that MMT has to react to recessions? Conventional fiscal stimulus is too slow and politisized. Income tax cuts would likewise take too long, although perhaps SSA taxes could be set up to react quickly.
March 29th, 2011 at 5:21 pm PDT
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I’m an even greener dlettante, but as I understand it, since the government issues the currency by pressing computer keys and entering numbers on spread sheets, there is no limit whatsoever to creating such currency. Therefore, it cannot become insolvent, so long as any “debts” are denominated in its own currency, which by definition must be accepted in the geographical area in which it is sovereign. If it is indebted in a foreign currency, that is another matter. I don’t see why its solvency would depend on its ability to manage outflows.
To say that the sovereign gov’t “can always create demand for its money…” is simply a truism. Not only “can” it, that is what is always “does.” But the way it is expressed, it is as if the gov’t “needs” to tax when it “needs” money, which it never does. The gov’t neither “has,” nor does not “have” nor “needs” the currency it issues.
It follows that the expression, “A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes,” is incorrect. Taxes and solvency are unrelated items in a fiat currency regimen. The gov’t does not need tax revenues to offset its spending. Rather, uninformed political decisions can certainly hamper the gov’t’s ability to issue currency (to “spend”) by imposing artificial and unnecessary legal constraints, by thinking along the lines of the false analogy with a household economy or a specie-convertible currency.
March 29th, 2011 at 7:35 pm PDT
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Absolutely perfect, RSJ! I’m not even going to try and add anything to it.
March 29th, 2011 at 8:07 pm PDT
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Krugman thinks the MMT position is hyperinflationary and will lose access to the bond market and yet he fully supports QE2, which depreciates the currency, and discourages foreigners from buying US bonds (The future currency loss means they actually incur negative yield from investing in it).
With QE2, only the Fed ends up the natural buyer of bonds, resulting in even more QE, leading to more depreciation, and even less natural buyers. So could Krugman’s toy scenario where the US has lost access to the bond market actually be an extrapolation of today’s policy choices, where there’s endless flooding of reserves into the banking system while government’s cutting fiscal spending?
March 29th, 2011 at 8:20 pm PDT
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Trader’s Crucible has an interesting take, Solvency and Value, Insolvency and Debasement
“Governments in control of their money cannot be insolvent. Insolvency is the inability to pay off one’s debts as they fall due. That’s how Wikipedia defines insolvency.
“But the impossibility of insolvency does not mean the fiat currency will have value. A government might be fully solvent even with a worthless currency. On the other hand, Solvency and currency value do not imply each other.
This distinction between insolvency and debasement is at the heart of MMT. MMT makes a huge distinction between the process of debasement and the act of insolvency – and this distinction has massive practical implications on how governments should act.
“First, it turns out solvency and currency value are confused, even by very smart people. Paul Krugman doesn’t understand this distinction. It seems that Interfluidity is close to getting it, but he still doesn’t quite get it, because he puts a solvency constraint on governments issuing fiat currencies. Read point SRW’s points #5-6 carefully, and then #8, and tell me he understands MMT. Note SRW is a genius. If SRW isn’t getting it, it isn’t his fault, its ours!“
March 29th, 2011 at 8:44 pm PDT
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“In that case, when there is an output gap, tax receipts fall and outlays increase. When the economy is back at full output, the reverse occurs.
There is no need to increase tax rates or to cut unemployment benefits. No decision needs to be made as to policy. It happens automatically. There is no need to sterilize anything to avoid inflation.
The budget outcome is endogenous and the debt/GDP ratio will stabilize at some level. ”
Allow me to summarize the above, and I apologize if this is curt, but you can always correct me:
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At t=0 automatic stabilizers produce exactly enough money to satisfy demand for money at t=0 without incurring any long term obligations that can affect t = 1, 2,…n. Then at t=n we have different demand for money by the private sector, but automatic stabilizers once again set the supply of money exactly right to not cause any inflation of deflation.
—
That sounds fantastic. It also sounds like something nothing like what we have, that is rather politically unworkable, and requires some pretty awesomely designed automatic stabilizers that I’m not sure exist. I mean, its a nice theoretical policy goal, but it doesn’t have much bearing on our situation today.
March 29th, 2011 at 10:53 pm PDT
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[…] The MMT solvency constraint Steve Waldman. He also provides a huge linkfest if you want more. […]
March 29th, 2011 at 11:00 pm PDT
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Tom Hickey,
He gets so close but missed the point. Let’s examine this statement:
“So government bond yields right now are being governed by something other than the risk of insolvency. I’ll say real yields are the price of an option on inflation, but that’s just wild speculation.”
If bond yields are the markets evaluation of future currency value, the rising yields (bond vigilantism) basically indicates rising expected debasement. While the government can ignore these yields, set their own desired yields, or issue currency instead of debt its basically ignoring important market information. Moreover, if people are unwilling to hold government debt because of expected debasement and artificially low yields, they will increasingly use their currency to bid up real resources, demand for the currency will dry up, velocity will sky rocket, etc. When Paul talks about bond purchasers losing confidence he means that their demand for currency and bonds will plummet because of increased debasement concerns.
MMT seems to just keep repeating over the over that solvency is not a concern, like any of us really care about this if it means massive debasement. He even makes this statement, like it actually means something:
“In other words, by removing the fear of insolvency, we can more directly observe the risk of debasement.”
We were already focused on this. We don’t have any new information or insight just by pointing this out. It doesn’t help us set policy. Instead of saying we are worried about insolvency we can say we are worried about debasement. Is the difference so great that its suppose to matter?
All of this wasted ink over a simple facts SRW pointed out months ago:
A) A government spending policy that increases productivity growth will make a nation richer.
B) A government spending policy that decreases productivity growth will make a nation poorer.
C) Whether a spending policy increases or decreases growth is related to other growth opportunities offered by spending by the private sector (the opportunity cost), which tend to vary over time.
That’s it. The real policy question has always been determining what kinds of spending are positive to growth. The recession lowers the opportunity cost, and makes more government spending options NPV positive, but it doesn’t change the fact that waste is waste. A lot of what government spends money on is consumption in nature or incredibly poorly conceived “investment”. When times were good, when everyone thought they were richer, the body politic didn’t mind that government was wasting national resources, because they thought they had resources to spare and they didn’t realize the extent of the waste. Now that things are tight they are starting to take a look around and don’t necessarily like what they see. The opportunity cost of government spending may have come down, but the perceived opportunity cost in the publics mind has gone up, because they no longer believe they have access wealth for the government to squander. They want a commitment that new spending will be done in a responsible manner, but the president and the ruling party can’t or won’t put together credible spending policies and make the case for whatever reason. That’s sad, because there are lots of good projects to be done in this country, but its the real world.
Now, the first objection I’m going to get is, “dave, don’t the repubs/tea party/deficit hawks all rail against the deficit.” The deficit is just an excuse, and it doesn’t really matter to the public at all. The case they are making is that the government doesn’t spend money well, that its not a net positive for the economy, even under today’s circumstances, and therefore increases in spending must be opposed. They have an ideological stance on government spending. If the deficit mattered they would not be pushing tax cuts, but they are because their ideology believes tax cuts increase growth. They are fighting an ideological battle, and they are winning it, mainly because the other side can’t seem to govern or communicate at all. I don’t think MMT is adding much to the communication battle, since its primary accomplishment so far seems to have been to inspire a lot of arguing of whether inflation is really just another kind of default at a time when the public is scared witless over higher food and energy prices.
March 29th, 2011 at 11:45 pm PDT
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No, the point is, the public sector *requires* obligations on the government at t = 0, 1, 2, 3. I think it requires long term obligations as well.
When the change in obligations is too little, you get an output gap that forces the obligations to be incurred, with the added cost of increasing the demand for obligations in the steady state. If the government creates too many obligations, then the nominal boom will drain those away, as each time someone spends or receives nominal income, a portion of that is taxed away.
This is provided that the right fiscal reaction function is used.
For example, Scott has advocated indexing benefit payments as well as tax brackets to the inflation target, not to actual inflation. This means automatic tax hikes and benefit reductions when inflation exceeds the target, to match automatic spending when there is unemployment. The MMT advocate an employer of last resort role for government as well, which I really like.
When talking about MMT, you need to talk about their proposed fiscal reaction functions in order to determine whether it is the right policy or not. It’s not just a question of deficit spending being good or bad.
Yes, this is not what our world is currently like, this is proposal for something different, but I believe something better than trying to manage demand via encouraging private sector asset bubbles.
There are a whole host of problems with using interest rate cuts to stimulate demand, not the least of which are that each time you cut rates, demand increases only if household debt increases, which makes it harder to raise rates. The effects of rate cuts, because of duration issues as well as the asymmetry between increasing capital and liquidating capital, are asymmetric.
That strategy, at the end of the day, is a lot less sustainable — if you care about sustainability — than regulating demand via fiscal adjustments.
For some reason, no one is worried about of running out of nominal interest rate room in the monetary regime, of which its clear that we only have a finite amount, and its also clear that we have been steadily using it up as soon as monetary stabilization was adopted — but they are worried about running out of borrowing capacity. It seems backwards to me. If there is a lesson to be learned from this crisis, it is that monetary stabilization is unsustainable, as we are all at the zero bound now after only 20 years of doing it — and that coming from a high base.
But here I have to diverge from some MMT proponents who favor zero short term rates. I don’t think that is a core part of the MMT paradigm, though, but perhaps others can comment on that.
March 30th, 2011 at 3:05 am PDT
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JKH writes: So I wouldn’t be bothered to adjust the interpretation of solvency in the case of government to arrive at a definition that feels good, but in fact doesn’t really fit with the logical structure for the rest of the closed universe from which the very meaning of “net financial assets” is carved out in consistent fashion.
One could also apply the balance sheet logic to the quality of the relationship between the sovereign and its representation in democratic government thus also closing the political universe to one where claims on government translate into equity claims held by individuals against, ultimately themselves.
And thank you, Mr. Waldman, Mr. Fullwiler and others for your clear thoughts and / or your constructive criticism! Even if all these reactions to Krugman do not lead to an immediate tipping point for MMT in public and professional perception, it certainly has led to some concise, accessible writings that can only be helpful in the long run.
March 30th, 2011 at 3:35 am PDT
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I don’t know about this.
“As there is a demand for net financial assets, if this nominal savings demand is unmet, then real output will decline… The *only* way to decrease the debt to GDP ratio is to decrease private sector savings demands.”
I’m trying to get my head round your mixing of real and nominal quantities here and I can’t make sense of it. Can you explain? You are saying that the real stock of public debt arises out of a series of nominal flows, and therefore, to reduce the real stock of debt, affect the demand for nominal savings net of investment…? If nominal savings net of the flow of nominal investment is higher, real income will be higher as well…?
March 30th, 2011 at 3:59 am PDT
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This was stimulated by Tom Hickey’s post/link, and extends my earlier riff on apocalyptic taxonomy for government solvency.
It also reminds of early days discussion on this blog about government “negative equity” amongst myself, SRW and Winterspeak:
So far, I see most MMT’ers saying something to the effect that a government issuing its own fiat currency can’t be insolvent the way a private sector actor can. I agree with that.
I’ll say in addition that a government isn’t normally solvent the way a private sector actor is.
(There is a special, abnormal case in which the government is solvent in a way that is comparable to a private sector actor, described below.)
Again, there are generally two dimensions along which private sector solvency can be defined – balance sheet and cash flow.
From a balance sheet perspective, government clearly fails the private sector definition, because it typically generates a net liability profile – which is equivalent to negative equity, or negative capital. I noted this in my first comment above.
From a cash flow perspective, a private sector entity is defined to be solvent if it can meet its obligations – i.e. pay off its liabilities. This means obviously that it must be able to pay off its liabilities with the medium of exchange – the same medium that the government issues.
With respect to this cash flow perspective on solvency, the government typically can’t meet the test either. This cash flow test failure flows directly on examination and as logic from the government’s normal net liability balance sheet position:
The government can’t pay off or eliminate a net liability with the medium of exchange. It can’t pay off a net bond liability, for example, because there is no financial asset offset to that net position. This is a fact by construction from what is meant by “net”. Once the netting is done on a consolidated treasury/central bank conceptual platform, there are no more gross financial assets left to satisfy the redemption of such a net liability. Therefore, being unable in particular to draw on the medium of exchange as a financial asset, the government must instead create the medium of exchange as a new liability in order to pay off the bond liability. “Medium of exchange” as used here is a general term that in this case would refer to bank reserves specifically. More generally again, the government can’t pay off any form of net liability, unless it creates another liability by replacement.
Unlike the private sector, the consolidated state entity has no gross financial assets that it can use to extinguish any of its net liabilities – again by definition of its net liability position in aggregate. So it is not possible that there is a medium of exchange left as an asset to pay off those net liabilities. So by the private sector definition, the state is insolvent with respect to the cash flow test.
In general, as noted above, the cash flow perspective on solvency is very much linked to the balance sheet perspective. With respect to the government, its typical balance sheet profile is net liability (NFL), corresponding to the NFA position that it normally delivers to non government as per MMT. The analysis above, relating to the facts about cash flow solvency, flows from the logic of that net liability balance sheet profile.
So by both private sector measures, balance sheet and cash flow, the government is not solvent, based on its typical balance sheet profile. That is to say, it is not solvent in the sense that a private sector actor is solvent, which supplements the more usual MMT take on this issue, which is that the usual notion of private sector insolvency is just not applicable to the government. I agree with that, but I also think that the usual notion of solvency is equally inapplicable.
Now SRW has introduced taxation as the test of government solvency. In that sense, the government can “pay off” its liabilities, not by using the medium of exchange, but by exchanging its own liabilities for liabilities of the private sector – tax liabilities. Thus, we have a liability swap.
But unlike the case of private sector solvency, a liability swap does not leave the private sector actor holding an asset after the government has paid off its liability – it leaves the private sector actor without an asset – since he has used that asset (the medium of exchange) to extinguish his own liability (the tax liability).
So, when the case of cash flow solvency is examined, this new taxation based definition of government solvency is in fact a reversal of the configuration of things, compared to the case of private sector solvency.
This reversal somehow seems consistent with my analysis above of both balance sheet and cash flow solvency as compared for the two sectors. That is to say, the issue of either solvency or insolvency for the government cannot be compared at all to corresponding private sector conceptualizations and definitions – even in directional, logical terms. We are dealing with the other side of the moon here. That is the situation at least in the case of the typical government NFL position, opposite to the NFA position delivered to the non government sector.
But it is nevertheless possible for a government to be solvent in a positive way, and comparable to the private sector case. This is the case where the government has run a cumulative budget surplus, so that it has become a holder of NFA itself, and an issuer of NFL to the private sector. Its own net financial asset position would arise from holdings of private sector financial assets that exceed the liabilities it has issued in the form of reserves, currency, and bonds. It could even hold the medium of exchange in the form of commercial bank deposits. And the equity position it thus generates for itself is a pure balance sheet equity position – not a financial liability – just like a positive household equity position – and inverse to its more normal negative equity position, which is also treated conceptually as a pure balance sheet position. Hence the government balance sheet position is (perversely) NFA – the offset to which is a private sector NFL position. Again, this is the result of a cumulative government surplus.
But we know very well from MMT empirical study that periods of government surpluses typically end up badly.
So a solvent government, in that special case of a cumulative surplus, is a bad idea.
The steadier state for government is what I referred to earlier as negative solvency, because that is what stabilizes the non government sector with some ongoing calibration (via real resource capacity and inflation sensitivity) of incremental solvency transferred to it by government deficits.
Perhaps in the case of government I should have called it inverted solvency instead of negative solvency.
Inverted government solvency is a sign of strength, not weakness.
P.S.
SRW: don’t let that genius thing go to your head
:), :), …
March 30th, 2011 at 6:22 am PDT
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Heh, Vimothy
*You* are the one mixing nominal with real. In a monetary economy in which debt is extinguished with money, debt is a nominal quantity, not a real quantity. It’s not possible to define it in real terms. What would be the “real” stock of money? Say your single real consumption good is wheat.
Suppose your “real” stock of money was 100 billion dollars. Then you tried to spend it. It’s value would depend on how quickly you spent it, right? Would you blame the person who gave you the stock of money for ripping you off? Would you go back to them and demand more money?
No, you couldn’t because he only gave you money, and the prices of goods are determined in the market by the actions of many people, including you, the purchaser. No one can promise to deliver 100 million tons of wheat unless they are actually giving you 100 million tons of wheat. That would be a wheat debt, a real debt.
But government debt is nominal, not real. It cannot be real, it’s logically impossible.
Don’t try to make it into a real quantity, as the government would not be able to pay a such a debt to the private sector — unless the government was a producer of real goods or unless it collected taxes “in-kind”.
But as long as taxes are paid with money and money extinguishes debt, then what the government is delivering to the private sector is stream of money, not goods.
The private sector continues to consume all it produces and no more, regardless of whatever the tax or debt situation happens to be.
If the government taxes 99% of the private sector’s nominal income each year, the private sector would still consume 100% of the real income it produced.
No goods are transferred to the government when the private sector pays taxes, and no goods are transferred from the government to the private sector when government debt is “repaid”. These are purely nominal transfers and do not represent production, sale or purchase of real goods and services.
But what the debt does represent is a promise to deliver a stream of money, which can be used to extinguish other nominal debts. As the private sector incurs nominal debts in order to produce real goods and services, and as the prices obtained for selling those goods and services are uncertain, and therefore your ability to service that debt is uncertain, having access to a risk-free nominal income stream is very valuable to the private sector. It provides a buffer against risk. As JKH said — it represents equity for the private sector as a whole.
March 30th, 2011 at 6:45 am PDT
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“In a monetary economy in which debt is extinguished with money, debt is a nominal quantity, not a real quantity. It’s not possible to define it in real terms.”
Of course it is. What you’ve written here is, in my opinion, nuts. Public debt is a real quantity. The stock of real money balances is a real quantity. Private savings is a real quantity. Income is a real quantity. Government consumption is a real quantity. Private consumption is a real quantity. Investment is a real quantity. Simple accounting tautologies don’t help you understand the behaviour of these variables. That’s why people have been developing economic theory for the last couple of hundred years.
I think this is a highly significant point of departure between you guys and the mainstream. Much more so than anything to do with monetary operations.
When mainstream types talk about “real” variables, they don’t simply mean the physical “thing-in-itself”. Anything and everything with a nominal price can be expressed in real terms—goods, services, assets, stocks, money—anything. The real price of a good is its relative price—its value in terms of an exchange ratio. Say I have a shiny bauble I want to sell, and say that the only other thing available in the economy is clay pipes. If I can buy four clay pipes for one shiny bauble then the real or relative price of the two goods is 4:1. Literally everything available for sale can be expressed in these terms. The fact that the economy is monetary has nothing to do with it.
“Money” has a relative price too. If it did not, it would not be much use. It would not be any use, as far as I can see. The relative or real price of money is its value in exchange for other goods and services. Say that a monetary economy only produces shiny baubles, and that these trade for money at 2:1. Then say that there is some supply shock that raises TFP (or whatever), and now the economy can produce more baubles over the same range of inputs: suddenly the relative price between the two goods has changed. Now it takes four shiny baubles to buy one unit of currency: 4:1.
Inflation and deflation are just words to describe the changing real or relative price of money, because this relative price is so central, because we live in a monetary economy.
To define the real money stock, first define an arbitrary nominal stock of money as M, then divide by the price level, so that the real stock of money balances is M/P. To express the real price of a single unit of the currency, divide one unit of nominal money by the price level, or 1/P. You can do the same for everything else you mentioned—debt, income, savings: anything.
March 30th, 2011 at 8:31 am PDT
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RSJ,
You slightly misinterpreted what I’m saying, but we’ll skip ahead to the meat of the matter, the fiscal stuff.
“This is provided that the right fiscal reaction function is used.”
That’s the heart of governance, figuring out the right fiscal reaction. The stuff you mention, automatically adjusting taxes and benefits to an inflation target, are a good start. We already do this to an extent, we simply do it indirectly through fed yield manipulation. When you start getting down into the details things get messy. For instance, one way you could achieve inflation is to give millionaires a tax break, but is that the best way? Welfare? Who would qualify? How much? Maybe we could have a payroll tax cut or a tax credit for certain kinds of consumption/investment? Deciding what these stabilizers are is the essence of the democratic debate, it has a fundamental affect on the quality of life of different people in our society. And the truth is, not everyone agrees.
Its also very hard to set such mechanisms up and adjust them on the fly, especially considering a great deal of our credit creation is not public, but private, and it changes often. You could change that, you could make them like China where the government orders banks to do XYZ and they do it. It has positives, but it can also mean politicized lending and lots of bad loans. As always, everything is a trade off. And the government is going to have long term direct spending projects of positive social value that is wants to engage in, and that’s going to be outside any automatic flow arrangement but affect it.
I think everyone in a decision making role already figured this stuff out a long time ago, even if only implicitly. They’ve been debating it in Washington for some time. The way the deficit is financed now and the way we tend to create or sterilize money flows under the current framework I can see how people are afraid of wasteful deficit spending. The best way past that is to make the case for productive spending, either directly by government or via transfers via benefits or tax reductions. That case isn’t being made, partly because the people/system governing us really are/is pretty shitty at putting forth productive spending arrangements, and partly because of legitimate differences of opinion on what is productive.
March 30th, 2011 at 9:05 am PDT
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The best thing out of all of the exposure to MMT (thanks PK for extra boost) is getting more people involved in the discussion and education.
The difficulties I see in the debates have been the ever widening scope away from the MMT foundation, into political, economic, trade, taxes and social arenas which distracts from the focused topic of the monetary system. There are even folks that say MMT is just theory because of the legacy name, when in fact it describes the current USA monetary system, MMT should be thought of as the “USA Fiscal and Monetary Theory of Operation”.
All discussion of the USA being insolvent or bankrupt or broke needs to end, this just perpetuates the distractions. When you have the power to issue money to pay for goods and services or pay “debt” denominated in the money then you stand outside of any realm of insolvency and/or bankruptcy.
I believe the biggest key in understanding the MMT system is that it is based on gov’t spending money into existence independent of any requirement to borrow first, or for that matter to borrow at all. This key fact begs the question as to why the US Bond market (short or long term) exists in the first place. The bond market is a vestige of the gold standard days which limited the amount of money issued by the gov’t and forced a “borrow to spend” requirement when the US treasury is in deficit. Today, under the MMT regime, we have an artifice created by a cartel of bankers, the FED, which layers a secretive monetary management structure over the top of the MMT structure. Congress set in law the inability of the UST to overdraft its account at the FED which perpetuates the perception of “borrow to spend” and need for the US Bond market. The US Bond market is used as a “Open Market” vehicle to build the perception that the UST and FED are at arms length, when in fact the UST and FED have an incestuous relationship and meets daily to keep the UST account out of deficit, manage reserve levels and manipulate the market to achieve interest rate targets under the guise of an open market activity. The use of the bond market provides a perpetual flow of income to the banks and primary dealers in fees and spreads – front running to a private buyer or the FED in Open Market Operations including the infamous QE.
The congress also sets an artificial “debt ceiling” which perpetuates political theater and congressional gridlock. Once everyone understands MMT is a “spend money into existence” system, they will see that paying interest on bonds is not necessary and the “debt ceiling” is an oxymoron because there is no borrowing (debt) involved in money creation (issuance).
If we were to apply KISS (Keep It Simple Stupid) principles to the US Fiscal and Monetary system the logical conclusion is to eliminate the FED and US Bond Market. Restore fiscal and monetary control to UST under strict congressional oversight and public scrutiny. Establish a sound money, neutral inflation/deflation policy, limited gov’t, full employment and a tax policy that has built in stabilizer(s).
A straw man proposal, with a bit of QE context, QE III below:
QE I: Bank Back Door Bailout I (BBDB I) – FED buys toxic MBS assets that the private market would not touch at price levels that would keep the banks solvent. The FED did the toxic asset purchase that TARP was supposed to do, but without congressional approval and under the guise of Monetary Policy (QE).
QE II: Wizard of OZ II – Pay no attention to the wizards (BB & Timmy) behind the curtain. Creates continuous distraction and debate while gaming the system.
* enables record deficits by effectively circumventing the law that the UST can’t have an overdraft at the FED
* keeps interest rates low as FED will meet all bond demand (essentially infinite demand)
* effective interest rate on bonds held on FED balance sheet – zero, as FED remits profits back to UST, these profits come from UST paying interest on bonds (and through the fog of deception the FED has the gull to claim that record profits are returned to the UST).
* Provide backdoor gift from the FED/govt to the banks/PD for ‘laundering’ the bonds between UST and FED – front running for the xx basis point spread.
* Provide backdoor gift from the FED/govt to banks by paying 25 basis point Interest on Excess Reserves (IOER)
* QE does nothing to provide liquidity for bank loans – banks loan on the capital base, they can convert bonds and other collateral to loan deposits and access reserve requirements via repo, interbank borrowing and the FED window if necessary. It is not capital or liquidity that prevent banks from loaning money, it is lack of loan demand, tighter lending standards and delevering (either through payback or default) that is occuring.
On the bright side, if folks would understand what is really going on. The more the FED buys bonds and held on the FED balance sheet the less effective interest rate is on the national debt. This could be considered a dry run for eliminating the bond market and FED. This perverse QE activity is validating that fact the gov’t spends independent of the bond market. This is shattering the facade that the US Bond market is an open market process to set interest rates and control gov’t spending. We are seeing that the FED sets the rates through systemic manipulation and gov’t spends unconstrained by either the “bond market” and “virtual” debt cap.
Proposal for QE III — Quick End III: The New Beginning
* End debt based money regime, change from Federal Reserve Notes (FRNs) to US Dollar
* US Dollar spent into existence by the gov’t, issued by the UST
* Shut down the US Bond market – Interest on outstanding bonds paid in US Dollar, as bonds mature the principal paid in US Dollar
* All inter government trust funds, convert bonds to US Dollar. Trust fund managers invest in private market investments and/or State, Muni, etc.
* Convert all reserves to US dollar
* Replace existing FRNs with US Dollars as they flow into the system or UST
* Repeal the FRA 1913 and all subsequent laws – End the FED; absorb operational, economic monitoring, research and statistics into the UST
* End TBTF doctrine – return to competitive free market principles of failure = bankruptcy – No gov’t bailouts.
* Establish a neutral inflation/deflation policy and tax policy to maintain full employment & productive output
* Minimize size of gov’t, constitutionally sound, target balanced fiscal budgets
* Repeal 16th amendment to eliminate corp and personal income taxes, replace with consumption tax and capital gains tax on speculative gains
– consumption tax (e..g fairtax.org) provides built in stabilizer tied to GDP dynamics, when economy heats up, higher taxes and vice versa
– capture capital gain when realized
– No corp or income tax means no special interest tax deductions, credits or loopholes
* End special interest subsidies – restore competitive free market principles
March 30th, 2011 at 1:38 pm PDT
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“This key fact begs the question as to why the US Bond market (short or long term) exists in the first place.”
There is a demand amongst the private sector for risk free debt of a positive yield and maturity in excess of its demand for mere currency (zero duration, zero yield). The US government can increase its spending without creating inflation at t=0 by satisfying that demand. Is it a good idea to do that, debatable. But every politician loves the idea of being able to spend more without causing inflation in the present period. The use of interest bearing debt instruments allows them to do so.
March 30th, 2011 at 2:48 pm PDT
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The “why” might have been more rhetorical, perhaps I should have used a statement “Under MMT, there is no operational reason for the US Bond market, a vestige from the gold standard days”.
Of course there is is demand for a yield on a zero risk instrument, however the question is, should the gov’t be involved in subsidizing that yield return ? Let the investor demand find private market instruments. Having a political motive should not rationalize a US Bond market. Taking away the tool for hiding or delaying inflation, enabling manipulation or corruption of policies for sound money and fiscal responsibility would be a good thing.
March 30th, 2011 at 3:18 pm PDT
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Obsvr-1,
I agree, although I think a certain level bond issuance has some useful purposes. That demand is partly there because people want the bond as a nominal stand in for real capital investment of a public nature. When the government decides to invest in a long term capital project I see see no reason not to allow people to “fund” the project via non-consumption in exchange for bonds. The problem is that there is no separation of government spending in our system. Bonds are issued just as easily to finance banker bailouts as to fund building a bridge. Government debt should only be issued to fund long term capital projects.
March 30th, 2011 at 3:41 pm PDT
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Vimothy,
““Money” has a relative price too. If it did not, it would not be much use. It would not be any use, as far as I can see. The relative or real price of money is its value in exchange for other goods and services. ”
The crux of the debate is that money has a price in terms of debt, and money has a price in terms of goods. When you say that money is a “real” quantity, are you are asserting that only the price of money in terms of goods is important? And likewise, that only the price of debt in terms of goods is important, but not the price of debt in terms of money? Note that the price of debt in terms of money is the *nominal* interest rate.
Only money, and not goods, can extinguish debt in a monetary economy. That’s what makes a monetary economy different. Nominal quantities take on an independent life.
If people anticipate future taxes to be higher, or if they desire to repay debt, then demand for money increases, even if the quantity of goods is unchanged. As people hoard money, prices fall and M/P or the “real” stock of money goes up. But the ability of people to extinguish the debts has not gone up.
If debts *were* real, so that you could extinguish them with goods, then you would not get a glut of goods.
How would you model that? Say you put M/P in the utility function. That wouldn’t capture this. You would need to put M/D into the utility function as well, with the first term relating to a demand for money to purchase goods, but the second term relating to a demand for money to extinguish debts.
And the ratio of these two “real” quantities — M/P/D/P is the ratio of two nominal quantities M/D. It’s the M/D that makes purely nominal quantities important.
March 30th, 2011 at 5:16 pm PDT
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And as a sociological note on the groupthink here — e.g. “you are insane” ;)
What is going on is that economists have, in simple, static models, decided that only the real quantities are important, and this makes it difficult for them to model nominal quantities. So they fudge and pretend that government is borrowing wheat when it is selling bonds, so that the private sector is deprived of the use of the wheat. And that government collects wheat when it taxes, so that tax collection is a transfer of real goods to the government, when in fact it is a nominal transfer. Governments do not collect taxes in goods. Then they continue the fudge and assume that the government stores the wheat in a warehouse somewhere, and pays it to creditors, fulfilling its “real debt”.
Now, I don’t care how you want to model things. But when you venture into the public policy arena, and start asserting that there is a “real” debt, and get the taxes and spending all wrong, then it becomes serious.
You have to get things right. No wheat is transferred to the government when the public buys its debt. It is an exchange of money for paper. The private sector gets to keep and use all of its wheat. It’s a purely nominal adjustment, that has real effects *if* the portfolio of money and bonds was suboptimal.
Similarly, when the government collects taxes, it is not collecting any wheat. The private sector still consumes all its wheat. This is again another nominal adjustment.
Now I don’t care whether you think these nominal adjustments are important or not, or if you want to make up your models in which taxes are paid in kind, and government debts are real. But the policy prescriptions of those models are not applicable to our world, and you shouldn’t use the same words to describe such different operations. If you think that your definition and the actual definition must boil down to the same thing, then that is just lack of insight, it does not mean that they actually boil down to the same thing.
March 30th, 2011 at 5:54 pm PDT
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Ha!
March 30th, 2011 at 5:59 pm PDT
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@dave writes:
Obsvr-1,
I agree, although I think a certain level bond issuance has some useful purposes. That demand is partly there because people want the bond as a nominal stand in for real capital investment of a public nature. When the government decides to invest in a long term capital project I see see no reason not to allow people to “fund” the project via non-consumption in exchange for bonds. The problem is that there is no separation of government spending in our system. Bonds are issued just as easily to finance banker bailouts as to fund building a bridge. Government debt should only be issued to fund long term capital projects.
— Reply
Remember we are in the MMT context, US Bonds do not fund US Gov’t spending either short or long term. Nor do taxes fund spending, US gov’t spends ‘money’ into existence.
It is relevant for state, local or private business to sell bonds for long term projects and likely required.
March 30th, 2011 at 6:06 pm PDT
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Obsvr-1,
The fact that it doesn’t have to doesn’t mean that it shouldn’t. You posed a question as to why government bonds exist, and I provided a reason why issuing bonds might make sense.
March 30th, 2011 at 7:30 pm PDT
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RSJ,
Demand for money varies with the kind of money. If you give money and yield the demand for it increases. Since people’s consumption needs vary over time, they tend to prefer a basket of different kinds of money, some convertible to goods in the present and some with a positive yield convertible in later time periods.
When the government taxes, it destroys people’s money balance. Since they would prefer to hold some money in addition to real goods, this leaves an unfulfilled demand for money. The government can then spend money into existence and get people to turn over real goods to them in exchange for being able to rebuild their money balances. If the level of taxation is roughly equal to the spending the supply of money to goods remains and thus nominal prices remain relatively constant. Adding bond issuance into this picture murkies the time periods a bit, but bonds are just money with different properties then regular currency.
Nominal prices are the mechanism by which people try to make economic decisions. People would like to save all the wheat, medical care, and anything else they would need to retire on. But that’s not practical, so we give them money as a stand in. If you want money to inform and enhance economic decision making, its supply should try to approximate real goods. The same goes for bonds and real capital goods. If nominal and real values are out of whack then people won’t be able to make informed economic decisions. IMO, its much easier for this to occur in the debt sector then the currency sector.
March 30th, 2011 at 7:43 pm PDT
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RSJ,
Also, if you understand my last paragraph, you will understand why it makes a lot more sense to allow bad debt to be modified or defaulted on then to try to avoid doing so by inflating the price of everything.
March 30th, 2011 at 8:09 pm PDT
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Dave,
Yes, in certain models, you can think of taxes as “effectively” being real transfers from the private sector to the government. For example, the government taxes money, uses the proceeds to buy wheat and consumes it. But that that is a theorem, not a definition, and it only holds under very restrictive circumstances — e.g. households were only going to use the funds to eat wheat themselves, and they do without, the government was going to use the funds to spend rather than make a transfer payment, there are no substitution effects, etc.
But that is a theorem, not a definition. And it doesn’t hold in the general case. In the general case, most government spending is for transfers, not consumption of output. You *should* call consumption of output the “real tax”, because that corresponds to real goods that are taken away from the private sector and transferred to the government in exchange for money. Taxation transfers money from households to government. Taxation of money does not correspond to a transfer of real goods. You can consolidate the operation of (tax+purchase+consume) into a single operation that you call “tax”, but that is a bad definition of taxation.
Similarly, you cannot *define* a nominal debt to be a real debt. The own rate of wheat is not the own rate rate of money. Borrowing wheat for 1 year and then repaying with interest is a fundamentally different operation than borrowing money for one year and repaying it with interest. In some cases, they may be equivalent, but you need to prove that, and in general it will not be true.
So use the right definitions.
No one is disputing that people are maximizing utility across time. But that does not allow you to take short-cuts, and define the macro operations in the wrong way, because you think they should be equivalent in ideal cases.
Particularly when the object of study is periods when the ideal case does not hold.
Yes, the enterprise value of firms divided by CPI should, under very simplistic cases, be the market price of capital goods divided by CPI, but it isn’t, so don’t define it to be in your models, or your analysis. Prove the conditions under which it is.
_Prove_ when the effect of a nominal debt is invariant to changes in the price level.
But never define a nominal debt to be a real debt, and never define a nominal transfer to be a real transfer. Keep the definitions honest. The government does not have a real debt, it has a nominal debt. Taxes are not a real transfer, they are a nominal transfer. Government consumption of output is real transfer of goods to the government and nominal transfer to the private sector. The combination of taxation + spending is a real transfer to the government. The combination of taxation + social security payment is an intergenerational *nominal* transfer from the private sector to itself. It may lead to a real transfer and it may not. Prove when it does.
Etc.
Just get things straight, and then use the right definitions as building blocks for your models.
March 30th, 2011 at 8:46 pm PDT
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“As people hoard money, prices fall and M/P or the “real” stock of money goes up. But the ability of people to extinguish the debts has not gone up.”
In fact it has gone down: the relative price of the debt has increased. Whereas before the price level fell, it only cost you ten units of output to extinguish your debt, now it is going to to cost you twenty.
“Only money, and not goods, can extinguish debt in a monetary economy.”
But how do you get the money to extinguish the debt? You take some of the goods you produced, and you swap them for money. If the price level changes, this changes the amount of goods you need to swap in order to buy the same amount of money to pay your debt.
Consider two situations where an agent faces the same nominal debt, say $100. In the first case, it costs the agent 10 units of output to buy $100. In the second case it takes 1000 units of output to buy $100. The nominal value of the debt is the same in both cases, but the real value is quite different.
You can apply the same logic to taxes. Think of the price of taxes in terms of the price of your labour. The real wage is the relative price of your labour income for output, and the real tax rate is the value of your taxes in terms of output.
“If debts *were* real, so that you could extinguish them with goods”
I think you might be missing the point. Its the relative cost of extinguishing them in terms of goods. No goods actually change hands.
“How would you model that? Say you put M/P in the utility function.”
You don’t put money in the utility function. Consumers get utility from consuming–that’s why relative prices matter.
March 30th, 2011 at 9:55 pm PDT
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“You can consolidate the operation of (tax+purchase+consume) into a single operation that you call “tax”, but that is a bad definition of taxation.”
Why? You reduced the ability of the private sector to use real resources so that the government sector can. Just because you do it with money and the intermediary doesn’t chance anything.
“Borrowing wheat for 1 year and then repaying with interest is a fundamentally different operation than borrowing money for one year and repaying it with interest. In some cases, they may be equivalent, but you need to prove that, and in general it will not be true.”
When people borrow and lend money, they are using it as a stand in for real goods. I don’t buy treasury bonds just because I want dollars in the future, I buy treasury bonds because I want dollars in the future as a means of purchasing real goods, and I expect to be able to purchase equivalent or greater real goods at that future point. There is an implicit agreement as to the value of that future cashflow relative to goods.
“But never define a nominal debt to be a real debt, and never define a nominal transfer to be a real transfer. Keep the definitions honest. The government does not have a real debt, it has a nominal debt. Taxes are not a real transfer, they are a nominal transfer. Government consumption of output is real transfer of goods to the government and nominal transfer to the private sector. The combination of taxation + spending is a real transfer to the government. The combination of taxation + social security payment is an intergenerational *nominal* transfer from the private sector to itself. It may lead to a real transfer and it may not. Prove when it does. ”
Fine, but people don’t give a shit about definitions or nominal and real. They aren’t buying bonds because they expect to get a bunch of worthless nominal paper in return. They are making economic plans about their future based on the idea that those nominal flows will retain a predictable purchasing power.
What burden of prove could you possibly want me to show to “prove” that nominal transfers are the equivalent of real transfers. I get SS tax deducted, so I have less to spend on my own consumption, and thus consumer fewer real goods. The beneficiary receives the nominal amount and uses it to purchase real goods, increasing his consumption. Is that not really really obvious? Do you not here old people talking about spending their SS checks. Have you never been to AC the day they come in the mail and see all the retirees at the slot machines? Its the busiest day in the casino.
March 30th, 2011 at 10:23 pm PDT
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“Why? You reduced the ability of the private sector to use real resources so that the government sector can. ”
How?
You’ve only reduced the nominal income of the private sector, not the real resources. They have all the wheat that they had before. Only they will be able to sell it for less dollars, and will buy it for less dollars. So what?
Now, if you assume sticky prices, nominal debts, etc, then this can have real effects. Some wheat may go unsold so it will correspond to unwanted inventory accumulation, etc.
But those effects are what you need to prove in your theorems, and you have no hope of determining those effects if your definitions are all wrong.
“When people borrow and lend money, they are using it as a stand in for real goods. I don’t buy treasury bonds just because I want dollars in the future, I buy treasury bonds because I want dollars in the future as a means of purchasing real goods”
No, you don’t. Or at least, that is not the *only* reason.
You are not considering all the options here.
dollars can be used to
1 purchase present consumption goods
2 purchase present capital goods
3 purchase bonds
4 repay dollar debts (of which tax payments is a special case)
There are 4 separate uses here. 4 separate demands, only one if which is the purchase of present consumption.
Only in highly idealized cases — e.g. zero carrying costs of goods, zero risk, correctly valued asset prices, zero unanticipated inflation, can you collapse these 4 uses into just two uses:
* purchase of capital goods
* purchase of consumption goods
But in the messy world in which we live, there really are 4 separate uses for dollars, not two.
If you anticipate capital prices to fall, then you will sell capital and buy government bonds until you anticipate capital prices to rise.
If you anticipate capital prices to rise, you will sell your bonds and buy capital.
Depending on the carrying cost of wheat, you may have a demand to borrow and buy wheat today if you think it will be more expensive in the future. Now you are borrowing not because you want to time shift consumption, but to perform arbitrage. Yet your borrowing increases the supply for bonds.
Etc.
There is a whole lot of state dependent stuff going on here.
If you want to model it, then you can’t assume that bonds = capital and that money = consumption goods.
Well, you *can* makes those assumptions, but then your models wont be very applicable, right?
So let’s just agree not to take short-cuts with our definitions, and instead let our theorems decide to what degree and under which conditions we can assume that money = consumption goods and bonds = capital goods.
March 30th, 2011 at 11:36 pm PDT
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“As people hoard money, prices fall and M/P or the “real” stock of money goes up. But the ability of people to extinguish the debts has not gone up.”
In fact it has gone down: the relative price of the debt has increased. Whereas before the price level fell, it only cost you ten units of output to extinguish your debt, now it is going to to cost you twenty.
And you will have continuously less goods to extinguish them with. The process is self-reinforcing, absent any stabilizers to counteract. MMT posits, the opposite happens when there is enough money spent into existence to satiate ‘savings demands’. Below full employment, this augments the path of real output (at a stable exchange rate between nominal and real) versus the alternative of not meeting savings demands, thus pushing the economy towards full employment. At any point, deficits beyond the desire to hoard / pay off debt / import and the economy to absorb them as real / employment growth can no longer enhance the real output path but rather cause a decline in the exchange rate from nominal to real (inflation). Maintaining that ‘sweet spot’, actually ‘sweet path’, is what MMT is about, imo.
But how do you get the money to extinguish the debt?
Again, in aggregate, via the deficits that are added to the economy thus maintaining the steepest possible path for real goods while satiating the desire to hoard / pay off debt / import. As long as the interest on government debt is a policy variable, as MMT claims it is, and its rate is kept below the growth rate of the economy, this process is linear and thus manageable with the means of functional finance. It is in this extrapolation where MMT and Krugman et al. part, I believe.
March 31st, 2011 at 5:58 am PDT
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Steve:
Assume:
We accept MMT/”functional finance” as being the way to go — govt spends enough/cuts taxes to purchase avail supply when the private side doesn’t, and reduces spending/increases taxes to reduce demand so it matches supply in hot economies.
Assume: there’s no way the political machine can manage this technocratic feat effectively, much less give confidence of doing so in the future. In the last 30 years, at least, we’ve had a dismal record of this kind of Keynesian obviousness.
Automatic stabilizers are one rather clumsy solution (I say: turn the EITC *way* up, and index it to some measure of unemployment), but is there a way the Fed or a Fed-like entity could do this?
IOW, I want a Fed that directly affects real-economy money *flows* — total spending on real-economy goods and services — not stocks (the money supply), because money stock has a very second-order effect, and a very tentative relationship to money flow. cf current excess reserve balances.
Kind of the antithesis of Friedman.
I can’t imagine what entity could achieve this, given political realities, but for MMT to work, it’s kind of what we’d need…
March 31st, 2011 at 9:07 am PDT
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Very interesting discussion Dave, Vim and RSJ
Much of your talk about real and nominal in regards to debt and savings is where most of the confusion lies IMHO, so please keep it going its quite helpful to see these concepts described more accurately.
Something that was said by Dave I think is quite illuminating and is at the heart of what I have felt is wrong with our system for quite some time. He was talking about the expectations of savers and noting that a big expectation of theirs is to be able to redeem their nominal saving for real goods at a later point in the future. This certainly true but I agree with RSJs response that it is not quite that simple. However, the bulk of savers are conditioned to believe that their monetary system, if it doesnt keep their purchasing power the same over time, is ripping them off via inflation. Punishing them for being frugal. This is an extremely strong and widespread sentiment and I think it deserves a post of its own by someone. I think the roots of that sentiment are wrong. At its core this sentiment is saying, “I could have bought a Toyota Camry but I didnt need one so I put the $25,000 aside and I expect to get the equivalent of that Toyota Camry whenever I choose to liquidate my stock of savings and if I can’t afford the equivalent at the time of my choosing, the system has ripped me off”. This has ALWAYS struck me as a very unrealistic sentiment yet it seems to have infected most everyone. I have yet to find anyone who has said to me that they agree with me, and Ive posted this idea at lots of places.
Here is why I think it is a completely unrealistic expectation of our money system. If at period zero, when you make your choice to forgo consumption the value of that decision is based on your relative buying power at that time, not just your absolute buying power. IOW, the price of the “representative good” you are forgoing in order to nominally save, is based upon two factors 1) the quantity of that good AND the number of people bidding for that good. Both of those variables will change over 20 periods and to expect them to retain a relationship that keeps YOUR buying power constant is …………. ridiculous.
The old “The $US has lost 95% of its purchasing power since 1913” argument is tied in with this I think and I really get tired of hearing that as some sort of argument for why we need to do things some other way and stop punishing savers. Savers are punishing them selves by missing out on opportunities today and waiting for tomorrow. Tomorrow might not even get here.
Steve did a post a while back where he argued in the comments that he thinks savers are to blame for the pickle we are in. Winterspeak took the counter point and I understand, as an MMT acolyte, exactly where Winterspeak is arguing from but I still think I agree with Steve. Savers have very unrealistic expectations and when they amass huge quantities of capital they hold undeserved influence in policy debates.
March 31st, 2011 at 12:42 pm PDT
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Greg,
People have that expectation when it comes to risk free debt. When they hold risky debt, if production in the future isn’t what people thought it would be, then the nominal claim defaults to reflect the real claim. Which is a pretty nice feature, all things considered, it doesn’t allow nominal debt holders to hold future production hostage unless the investments they made in the past made present production possible. Inflation can perform a similar function, but its a lot messier and less focused, and causes all sorts of complications and problems.
The problem is simple, people thought their savings was freeing up resources to invest in real capital which could produce the real goods they want in the future, but they were only saving nominally. When nominal capital is a good stand in for real capital it helps people plan. When nominal capital bears no relation to real capital people get all sorts of false positives about how much capital is out there to back up future nominal claims on production. When the bubble burst and nominal prices started coming back to real prices via the mechanism of default, people decided they needed to rebuild the savings they lost. They do so the only way they can, nominally. But just like they did in the bubble, if that new nominal savings is also not based on real capital investment then its going to have the same outcome.
What must be done is not that complicated. Bad debt must be recognized and written down. That means an end to extent and pretend and a much more aggressive mortgage mod program. Then we need to help people accumulate nominal savings backed by real capital. To the extent the government can spend on high ROI infrastructure projects and issue currency or debt to do so, it should. If more needs to be done and it can’t locate good projects, it should enact a payroll tax holiday or some other measure that puts spending power in the hands of American workers so they can decide how to invest and spend it.
However, one quick and dirty fix that won’t solve anything in the long run is to give people bonds so they think they’ve saved real capital for their futures, but then it turns out the only real capital they saved is spent bullet casing on some Iraqi dirt road and a used yacht a bankster bought with his bailout money.
March 31st, 2011 at 4:02 pm PDT
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“When they hold risky debt, if production in the future isn’t what people thought it would be, then the nominal claim defaults to reflect the real claim.”
You may be 100% correct about the physical return of your invested capital. You baked 100 more breads as a result of buying the oven. Unfortunately, that does not extinguish the debt. Production is not income. You have to also guess how many dollars people are willing to pay for the bread. Producing enough bread is not enough.
That is harder to do than guessing the increase in output as a result of buying the oven, particularly as the amount of money that people are willing to pay for bread is determined in part by the amount of present investment, which is determined in part on the expectations of future prices, etc.
In practice, it is expectations in future nominal returns that cause the problem, not expectation failures of future physical return. And when there is a mass demand failure, so that people cannot pay debts, then this means all capital is liquidated, even if, in physical terms, it is producing as expected. Now the nominal problem has become a real problem.
There could be situations in which the baker buys the oven and somehow fails to produce enough bread. Software development is a risky business — you may not be able to ship the product even as you add manpower to it. Boeing has had trouble shipping planes, etc.
But it doesn’t seem to me that these physical return errors would happen en masse with the business cycle. The real problem is that people more or less *know* what the physical return will be, but they do not know what the nominal return will be. There can be longer term problems with productive capacity declining, and government policy can be to blame, but these aren’t business cycle problems. At best you can say that the wrong policy response to business cycles (e.g. constantly trying to lower the cost of capital) will lead, over the long term, to lower levels of productivity. But there was no unanticipated physical decline in productivity that caused our crisis. It was all nominal.
March 31st, 2011 at 6:06 pm PDT
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And I would add that you can (and should) view a policy of supplying more bonds as socialization of losses, because on the one hand (nominal) default is avoided so physical capital is not scrapped, but on the other hand, there are future tax obligations as well. It is a type of mass restructuring on the nominal side that leaves the physical side unchanged. The fairness issues raised by this suggest a progressive tax policy that does not distinguish between capital income and wage income (another pet peeve of mine), so that everyone has to, in the future, reduce their nominal income to compensate for the Big Bond injection. As long as the debt to GDP ratio remains stable, you should be able to make these bond injections when the public gets confused about nominal returns.
That is the other issue with nominal debt versus real debt. The issue is not that that government will inflate the debt away. There should be a commitment to maintain a known inflation rate. But the mechanisms of maintaining that rate will be increasing taxes, and that includes taxes on those who receive bond interest income. I know several people who view that as a government default event! But it’s not, the point is that that you have two objectives, servicing a nominal debt and maintaining price stability. The combination of these two objectives is not the same as “repaying” a debt in real terms.
March 31st, 2011 at 6:21 pm PDT
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Dave
“People have that expectation when it comes to risk free debt”
Which, in my view, is exactly when they SHOULDNT have that expectation. The closer you get to putting money under your mattress the further you get from having your savings keep up with inflation.
As we understand the premises of MMT we learn that we dont need savings in order to have investment. This makes saving a not particularly rewarding or noble endeavor which I think is a step in the right direction. Lets stop acting like we need people to save, we need people to produce.
March 31st, 2011 at 7:06 pm PDT
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“As we understand the premises of MMT we learn that we dont need savings in order to have investment.”
This is very wrong, in my view. It’s easy to see why, historically, Chartalists were referred to as “nominalists”. You don’t need savings to create money, but this is sadly not the same thing (as we have seen).
March 31st, 2011 at 7:18 pm PDT
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“You may be 100% correct about the physical return of your invested capital. You baked 100 more breads as a result of buying the oven. Unfortunately, that does not extinguish the debt. Production is not income. You have to also guess how many dollars people are willing to pay for the bread. Producing enough bread is not enough.
That is harder to do than guessing the increase in output as a result of buying the oven, particularly as the amount of money that people are willing to pay for bread is determined in part by the amount of present investment, which is determined in part on the expectations of future prices, etc.”
Which is why we shouldn’t always be in such a rush to inflate away problems or play games with the money supply.
—
“In practice, it is expectations in future nominal returns that cause the problem, not expectation failures of future physical return. And when there is a mass demand failure, so that people cannot pay debts, then this means all capital is liquidated, even if, in physical terms, it is producing as expected. Now the nominal problem has become a real problem.”
Except there are real problems. We do have huge tracts of empty cul de sacs. We do have ghost town strip malls. We do have a bunch of scrap metal remains of million dollar tomahawks in some desert somewhere. We do have an outsized FIRE sector that needs to be reduced. There are massive real misallocations of capital. By contrast we know we are massively under invested in tradeables and likely public infrastructure. I can accept that there is a nominal component in conjunction with a real component, but the correct policy solution to that isn’t too plow a bunch of money into real sectors we know to be overproduced in order to prop up nominal values that need to come down just because it makes people consume more in the short term.
—
“But it doesn’t seem to me that these physical return errors would happen en masse with the business cycle. The real problem is that people more or less *know* what the physical return will be, but they do not know what the nominal return will be. ”
People know what current prices and trends are and make projections based on that. Sometimes the price mismatch is nominal, but sometimes it reflects shifting real demand. A software developer may spend years developing a new program only to learn the operating system he developed it for is no longer popular. Boeing develops a new jet only to find people are traveling less because fuel is more expensive. Physical return errors happen all the time, and when a surge of nominal money pours in and creates a bubble they tend to happen en masse. This just happened in the last bubble. I suppose if you only look at it narrowly as housing, you don’t see why its such a big deal. But if you look at it more broadly, if you view it as housing, all its secondary markets affected by housing, and a super bubble that a lot of our biggest economic sectors are in (FIRE, perhaps medical care and higher education), then the real misallocation if vast.
—
“And I would add that you can (and should) view a policy of supplying more bonds as socialization of losses…”
“The fairness issues raised by this suggest a progressive tax policy that does not distinguish between capital income and wage income (another pet peeve of mine), so that everyone has to, in the future, reduce their nominal income to compensate for the Big Bond injection.”
The socializing of losses on private financial interests that were converted into guaranteed treasury bonds at or near par is easily the greatest injustice of the 21st century. The fact that we as citizens will be making payments on that theft for generations in the name of preserving a illusory financial stability is simply outrageous.
—
“But the mechanisms of maintaining that rate will be increasing taxes, and that includes taxes on those who receive bond interest income. I know several people who view that as a government default event! But it’s not, the point is that that you have two objectives, servicing a nominal debt and maintaining price stability. The combination of these two objectives is not the same as “repaying” a debt in real terms.”
Wow, so now when grandma won’t be able to afford to heat her home because her savings get taxed away instead of inflated away. I’m sure she will be grateful!
Why should we all pay for the sins of a few. Its exceedingly obvious that the maximum possible value should be extracted from the perpetrators themselves before asking anything from society. As long as one bonus avoids clawback, as one criminal remains out of jail, as one TBTF bank gets to continue business as usual, you aren’t going to get much sympathy from me over have my savings stolen.
You may, ignorantly, follow up that your taxes are “progressive”. I’ll say two things about progressive taxes:
1) Why should Steve Jobs have to give up his income so Robert Rubin can clip bond coupons. The “rich” aren’t a unit, they are a bunch of individuals. I see no reason to socialize taxes on financial fraud between them.
2) The “rich”, the real rich, don’t pay taxes. They pay lobbyists, accountants, and lawyers, but very little taxes. Usually “progressive” is just a code word for “squeeze all the excess income out of middle and upper middle class people, especially if they are savers”. Throw enough to the poor to keep them dependent and off the streets and transfer to rest to plutocrats.
Greg,
You do need people to save in order to invest most of the time. When people save they don’t utilize real resources, which makes room for the government to spend money on investment without creating inflation.
March 31st, 2011 at 10:26 pm PDT
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Greg,
“We do have huge tracts of empty cul de sacs.”
The producers guessed that they could build the houses and they succeeded in building them. No error on estimating marginal physical product, but a gross error on estimating marginal revenue product.
Again, clarity on understanding the difference between physical and nominal would avoid these types of errors.
“Sometimes the price mismatch is nominal, but sometimes it reflects shifting real demand”
When the inflation rate goes up, the prices of zero coupon bonds fall. Nominal price movements *are* real shifts in demand, as the demand for zero coupon bonds (future consumption) is reduced and the demand for (present) consumption goods increases. That shift from future to present consumption *is* a shift in “real” demand.
March 31st, 2011 at 10:56 pm PDT
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“You baked 100 more breads as a result of buying the oven. Unfortunately, that does not extinguish the debt. Production is not income. You have to also guess how many dollars people are willing to pay for the bread. Producing enough bread is not enough.”
And if you were to observe a price change in this fashion, how would you know it is nominal and not relative?
March 31st, 2011 at 11:04 pm PDT
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RSJ: That’s not what distinguishes the two terms!
March 31st, 2011 at 11:05 pm PDT
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Vimothy, “And if you were to observe a price change in this fashion, how would you know it is nominal and not relative?”
Thank you.
Those empty cul de sacs aren’t just empty because of any nominal problem. Their empty because we overbuilt housing. Sometimes people accidentally build the wrong things, so even when they succeed in building them as planned nobody wants them, or want them a lot less.
People often build the wrong things when they get false nominal signals, like say a big financial bubble caused by creating a bunch of money and credit and flooding it in a few directions (like housing). Thus nominal bubbles end up distorting real production. If you want to fix real production, the solution isn’t to try and prop up nominal values of things that don’t have real value, its to try and channel new money into things that people value in a real sense.
Let me try to sum up:
1) Bubbles have both nominal and real components.
2) If you try to ignore one your going to implement bad policy.
3) The fact that its hard to distinguish between them makes good policy more difficult, but that isn’t an excuse to just default to #2.
My critique of current policy is threefold:
1) Its intent on preventing necessary nominal adjustments. If you want to maintain nominal aggregates you have to try to do so in a way that achieves goal #2 (below), simply plowing money into sectors with real misallocations to prop up nominal values just prolongs the adjustment.
2) There is no effort to address misallocations in the real economy, mainly because doing so would challenge powerful interest groups. Real misallocations are treated as a problem to be addressed by hitting them over the head with money printing.
3) They are, quite obviously, incredibly socially unjust. The idea that workers should be paying interest on t-bonds their whole lives so that crooked bank CEOs can give themselves bonuses from bailout funds is just soul crushing.
April 1st, 2011 at 12:09 am PDT
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IOW, I want a Fed that directly affects real-economy money *flows* — total spending on real-economy goods and services — not stocks (the money supply), because money stock has a very second-order effect, and a very tentative relationship to money flow. cf current excess reserve balances… I can’t imagine what entity could achieve this, given political realities, but for MMT to work, it’s kind of what we’d need…
Steve Roth, that entity goes by “RSJ” :o)
“IOR is horrible. Levy a tax of 4% on any non-monetary base assets held by banks instead, if you want interest rates of 4%. Put the “cost” back in “opportunity cost”. Seriously, making something expensive is not hard to do.”
http://moslereconomics.com/2011/03/24/us-approaching-insolvency-fix-to-be-painful-fisher/comment-page-1/#comment-47862
Here’s whats interesting, the Fed already has the power to make fiscal adjustments since Congress has effectively delegated taxing power to it. The Fed has authority (12 USC 248a) to establish user fees, (“any new services which the Federal Reserve System offers… fees shall be established on the basis of all direct and indirect costs actually incurred…”). And of course, the Fed rebates its net earnings to Tsy (12 USC 289). The “new services” offered could target stocks or flows. If the Fed governors declare that inflation is an indirect cost of a new Fed banking services we’ll call “interest rate maintenance operations (after all, P = MV), then a fee on non-monetary base assets could be imposed and could be adjusted at any time. Tsy could then spend without borrowing or tripping over the debt ceiling (coin seigniorage works but simplest way is for Congress to delete section b. of US Notes statute (31 USC 5005) with its $300 million cap and ban on holding US Notes as reserves). As excess reserves are created, the Fed could anchor Fed Fund Rate by adjusting the IRMO fee.
Because of the earnings rebate, every FFR change would also be a fiscal adjustment. Rate hike, revenue drain; Rate cut, revenue add. Even at zero interest rate, the fee schedule for Fedwire and other bank transactions could be used to adjust fiscal stance. Either way, once US Notes statute is amended, Congress doesn’t have to do anything except cut taxes as the earnings rebates get larger. :o)
April 1st, 2011 at 3:35 am PDT
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Vimothy,
What you are saying doesn’t make sense. I am talking about price changes occurring within historical time. In that case, every nominal price change is relative, because there are bonds. There are no purely nominal price changes that occur in the actual world, which is (what I hope) what we are discussing.
April 1st, 2011 at 4:07 am PDT
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RSJ, Any change in the current market price of the good could represent either 1, a change in the relative price of the good, 2, a change in the relative price of the unit of account, or 3, some combination of 1 and 2. It is not possible to know which of these three it represents from the mere fact of the price change alone.
April 1st, 2011 at 4:41 am PDT
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OK, perhaps there isn’t a real dispute here.
I was discussing the actual economy, in which there is a chain of nominal debts stretching from the start of the economic system up until the present. In that case, every nominal shift in prices that we see is also a relative shift.
But if you are just discussing models, then yes, you can relabel all prices and this is not a real change. But you have to relabel all debts as well, so you will end up needing to relabel all prices at all points in time, going all the way to t = 0 (assuming that there is an overlapping chain of debts connecting each period). There is one degree of freedom in relabeling prices at the start of the economic system. We can assume that if the U.S. didn’t start out with the dollar, but with the peso, then there would be no difference in our subsequent history. But that is prior to people making their consumption and savings plans. Once the system is up and running, any price change that is not retro-active all the way back to t = 0 will alter the optimal consumption plans. It will cause a break, and time will be required to adjust to this break, as some will experience capital losses and others will experience capital gains.
As in practice, no price shift observed in an actual economy can be retroactive, then every nominal price shift is also a relative price shift.
Hope that makes sense.
April 1st, 2011 at 4:48 am PDT
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Let me rephrase
You dont need people putting “nominal” savings into a bank account so that there can be future investment. Banks do not use MY savings when they invest they create whole new deposits out of the borrowers income stream. If no one ever put another dime into banks, banks could still make a loan after they secured collateral and verified an income stream to be able to service the debt.
Yes, if everyone is consuming at maximum capacity at present (never has or is going to happen), there must be someone to forgo some consumption in order for there to be “room” but in that condition there will also be full employment and full use of resources so why would there need to be investment anyway? We are not close to that condition now so it seems silly to posit a future we’ll likely never reach.
Dave;
“Those empty cul de sacs aren’t just empty because of any nominal problem. Their empty because we overbuilt housing. Sometimes people accidentally build the wrong things, so even when they succeed in building them as planned nobody wants them, or want them a lot less.”
There are plenty of people who WANT them. Millions are homeless or living with parents not by choice. There just arent enough people with the income to afford them for what the seller hopes/needs to get for them. Are we overbuilt or underbought?
I agree with most of the other points you make, at least in sentiment. I disagree with the characterization that workers are paying for T Bills. As long as the growth rate of the interest payment on the debt is less than the growth rate of the economy, no one is being squeezed. In addition a lot of workers are receiving debt payments via their retirement plans.
April 1st, 2011 at 5:35 am PDT
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“There are plenty of people who WANT them. Millions are homeless or living with parents not by choice. There just arent enough people with the income to afford them for what the seller hopes/needs to get for them. Are we overbuilt or underbought?”
You might as well say people WANT ferraris, so we are under producing ferraris. The simple truth is that people don’t value housing as they once did, and not just in the nominal sense. Its true that fixing the nominal market would at least allow these things to clear, and reduce the damage to the real market a bit. However, current policy is expressly focused on the market not clearing. It wants to prop up housing by pouring money into it, not recognize bad debts, etc. Then you’ve even got people talking about trying to raise the general price level by leaps and bounds by flooding banks with money as some back ended way of making current nominal prices clear. Its absurd. If you want the nominal market to clear then write down the principal on mortgages so they represent peoples real value of them relative to other goods. Anything else is just some rude goldberg device to fix the mortgage market for the sole benefit of bank CEOs being able to pay themselves bonuses from pretending their mortgages are worth more then they are.
“Yes, if everyone is consuming at maximum capacity at present (never has or is going to happen), there must be someone to forgo some consumption in order for there to be “room” but in that condition there will also be full employment and full use of resources so why would there need to be investment anyway? We are not close to that condition now so it seems silly to posit a future we’ll likely never reach.”
So the 70s never happened? All of those periods of inflation in history never happened? There is a reason crass Keynesian got discredited in the 70s. Inflation in that era was cause by a lot more the mere oil increases.
April 1st, 2011 at 9:01 am PDT
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Dave
People dont value a roof over their heads?
I completely agree with principal writedowns. I’ve never said otherwise but to suggest we dont have the notional demand for housing is wrong I think. Plenty of people need a house period and many want a house of their own. I happen to disagree with the home ownership mania that has gripped our world but the fact is many humans like to own a piece of property with a house on it. The unoccupied house/family that might like a house ratio is not way out of whack. We have had a steady deterioration of incomes and houses have become a luxury item for many unfortunately.
The screw up in the housing market, causing so many balance sheets to implode did not need to have the “real” affects on the rest of ther economy if it had been dealt with properly.
This whole notion that we cant afford things we were affording 3 years ago is insane. Money doesnt disappear. We invented and control money. Our policy decisions are all to blame for our problems, not some invisible hand of economic equilibrium. Its insanity what we are doing toourselves with austerity and forced unemployment.
April 1st, 2011 at 3:18 pm PDT
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“People don’t value a roof over their heads?”
Obviously they don’t value it as much as the inputs that went into it, which means that we are poorer then before as a result of that misallocation of capital.
“The screw up in the housing market, causing so many balance sheets to implode did not need to have the “real” affects on the rest of ther economy if it had been dealt with properly.”
It certainly was going to have some effect because we used a lot real resources to build things people valued less then the original inputs, i.e. we are poorer. There are plenty of policies we could have done to rebuild our wealth, but that doesn’t make the initial loss go away.
“This whole notion that we cant afford things we were affording 3 years ago is insane.”
Why? Our human and physical capital was aligned to produce certain goods. It turns out the economy doesn’t want those goods as badly as it seemed. So now we have to retool to produce a new set of goods. That makes lots of human and physical capital that was set up for the old production patterns less valuable, since it can’t readily produce according to new demand dynamics. If your capital level is lower, you produce less. The solution is to rebuild capital capable of producing the goods people actually want.
April 1st, 2011 at 3:34 pm PDT
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“Obviously they don’t value it as much as the inputs that went into it, which means that we are poorer then before as a result of that misallocation of capital.”
If you believe a capital good that costs $1 today will cost $.90 next year, and if the 1 year rate is 2%, then you will require a rental rate of $.12 in order to buy the (longer term) capital good. Otherwise you buy the shorter term bond, wait 1 year, and then buy the capital good when it is cheaper.
In that case, a marginal capital good will be purchased only if it can be rented for $.12, or a yield of 12%, even though, in principle, the “equilibrium” rate would be be $.02
Capital goods prices would need to fall to $.90 in order to avoid excessively high rental rates for capital from being charged. Until that happens, high rental rates will be charged.
Similarly, if you believe the capital good will be worth $1.10 next year, then you are willing to accept *any* rental rate. All of the above is nominal, not real.
When house prices are rising, people are willing to overpay for an OK consumption experience because they will benefit from appreciation. When house prices are falling, people are only willing to underpay for an OK consumption experience because they will need to absorb the loss.
The signal of lack of demand for housing is just as phony as the exuberance for housing. It is not the “true” signal that would be obtained in an equilibrium in which capital goods (or houses) had a constant price.
But when this happens across the board for all capital goods, every producer is charged with a higher rental rate than the bond rate, including the producers of capital goods. Everyone cuts back on production in order to satisfy that rate. It’s not a matter of too much housing and too few software developers. Impossibly high returns are being demanded of everyone in every industry simultaneously. But even though the (nominal) bond rate can always rise to offset the expected increase in price on the way up, in order to keep the rental rate from falling too low; the bond rate may not be able to fall enough to offset the expected decrease in capital goods prices during the bust, in order to prevent the rental rate from rising too high.
April 2nd, 2011 at 12:17 am PDT
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[…] The MMT solvency constraint – Steve Randy Waldman – “It is good to see Paul Krugman prominently discussing “modern monetary theory”, although I don’t think his characterization is quite fair. I am an MMT dilettante, so I’ll apologize in advance for my own mischaracterizations. But I think the MMT view of stabilization policy can be summed up pretty quickly: …I think this is a clever and coherent view of the world. I do not fully subscribe to it — in my next post, I’ll offer point-by-point critiques. But first, let’s see where I think Paul Krugman is a bit off in his characterization: A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.“ […]
April 2nd, 2011 at 10:00 am PDT
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RSJ,
How can there be no overproduction in housing when it soared above all historical metrics, especially in specific localized areas:
http://bigpicture.typepad.com/comments/images/2007/05/17/starts_permits.png
How can there be no bubble in the FIRE sector when its grown exponentially and we can’t even point to any benefit its produced:
http://yglesias.thinkprogress.org/wp-content/uploads/2010/01/finance.jpg
How can you say the tradeables sector isn’t underdeveloped when your running huge and ever growing trade deficits:
http://blog.reblace.com/wp-content/uploads/2006/11/trade-deficit.jpg
I could go on and on through a lot of sectors. The evidence that we have massive REAL production misallocations is huge. People don’t want tract homes in the desert in Vegas. They are in inconvenient locations and take a massive amount of upkeep to maintain. I’m sorry but that was a malinvestment, and now that people aren’t buying them to flip them it turns out not many people want to live there.
If you can’t get over this I can’t help. If you really think that our current production alignment is perfect and if we all just had a few more pieces of paper the problem would solve itself then that’s what you believe. I’ve provided my evidence as to why I think that’s not the case, it seems convincing to me but I can’t make anyone believe anything.
April 2nd, 2011 at 11:52 am PDT
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But all of these imbalances are driven by a process of nominal arbitrage.
Investment only occurs because the money rate of interest is less than the return from purchasing capital. That differential determines the amount of investment that occurs. You have a sequence of steps that deliver $100 return, and another sequence of steps that delivers $90, which sequence do you take? Does your selection of a sequence depend on the price level?
The trade deficit, finance-sector pay, it’s all being driven by nominal arbitrage.
You can borrow money more cheaply in China, and so real production is transferred there, even though they are not more productive, they are less productive. The government controls the lending rate and sets it at level that encourages a lot of investment. Just as the difference in funding costs, and not productivity, is why the financial sector is earning the highest returns here, and why resources are being pulled into that sector.
It is all driven by nominal returns and nominal income flows. Someone proposes a policy of stabilizing the nominal income flows, and the rational response is yes — that is how you stabilize the resulting “real” investment.
But the *irrational* response is “the real investment produces itself, so there is no need to stabilize the nominal income flows.”
April 2nd, 2011 at 1:51 pm PDT
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Thanks RSJ
That is perhaps as clear as I’ve ever seen it laid out. Everyone is chasing money or nominal because the real will come as a result.
The whole notion Ive seen expressed by some people(Vimothy I believe has said it) that money is a sideshow, is quite odd. Money is THE SHOW. Yes money hides almost as much as it reveals but how does ignoring money improve on that? Without money we have no agreed upon convention of worth. Money is imperfect but it is what we have. Treating money like a commodity, where we impose scarcity to give it value has never worked to create a system where trade can continue and our payment system function as necessary for very long periods of time.
The goal, I should think, is to have a situation where our payment system doesnt get in the way of our production system. Maybe thats clumsily worded but I’m trying to express the idea that balance sheets can get way out of whack while the real economy is just slightly out of whack. It seems as if the last three years of imposed hardship have been completely unnecessary from a real standpoint. Everyone laid off was still able and willing to do their job. They were laid off because someone else either was laid off and stopped buying what they produced or feared being laid off and went into defensive mode. It wasnt because we were making things which no one wanted, it wasnt mass wasting of resources. Yes there was some of this but 3 years of decline, forced cutting of valuable services because some home builders made some poor judgements on the number of people who could afford a new house?
April 2nd, 2011 at 2:39 pm PDT
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Subscribers to MMT believe the federal government cannot go broke.
Of course, that doesn’t mean that its citizens, as a whole, are prosperous.
I am curious if those MMT fans think that Medicare Part D is fully funded. It is funded 75% by general revenues and 25% by participants.
According to the trust fund perspective, it is fully funded.
Don Levit
April 2nd, 2011 at 3:50 pm PDT
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Don
No currency management system guarantees that citizens as a whole are prosperous. There can be, are, and will always be real factors which affect ones standard of living. What MMT does make clear is that we do have the ability to make all financial decisions on our own terms when we are sovereign in our own currency. We never have to worry about funding only real production and distribution within our currency area. We never have to listen to anyone else telling us we are paying a policeman or a teacher too much or letting them retire too early. Those are OUR choices when we have our own currency. We choose the terms under which we want to adjust our standards of living when necessary.
Bond traders in New York, London or Berlin should have ZERO say what the Greek govt pays its workers. Screw them. If Greece had their own currency they wouldnt have to listen to that crap.
April 2nd, 2011 at 11:43 pm PDT
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Greg,
I don’t have time for a full reply, but I want to touch on this.
“It wasnt because we were making things which no one wanted, it wasnt mass wasting of resources. Yes there was some of this but 3 years of decline, forced cutting of valuable services because some home builders made some poor judgements on the number of people who could afford a new house?”
I don’t see the evidence for what seems to clearly be a subjective judgement. It seem obvious to me we are producing plenty of things nobody wants, and not enough many of the things people do need (see my post to RSJ). It also seems obvious there was a vast wasting of resources. I can’t see bankster bonuses, spent bullet casings in the middle east, or track homes in Vegas the nobody wants to live in anymore and only got build to sell to speculators as anything but waste.
Yes, there is directly the housing bubble, but also the entire overextended consumer sector that surrounded it (the marble counter tops, the strip malls, etc). Beyond that the housing market was a sideshow to the bubble that created it, the FIRE bubble. When I look around its not hard to find some pretty huge bubbles in American society. I don’t consider the real portion a tiny part of the problem, I consider it the main problem. Moreover, I see nominal values as largely the causes of these real misallocations of resources, and all of the policy proposals with any political traction propose only to try and maintain real bubbles by jamming nominal dollars down the throats of inefficient markets.
April 3rd, 2011 at 4:48 pm PDT
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Understanding and dismissing MMT requires no more than understanding the kind of people who support it.
Their motivations (free stuff for hippies) are what ruins the idea.
The more interesting discussion is Natural Money. It’s MMT for entrepreneurs.
April 4th, 2011 at 12:21 pm PDT
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Greg, there is no “we” – monetary policy doesn’t exist for YOU, it exists for people who have money.
April 4th, 2011 at 12:23 pm PDT
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Morgan, I took a look at http://www.naturalmoney.org/introduction.html
A complete ban on credit and interest, and a fixed money stock. Are you serious?
April 4th, 2011 at 1:50 pm PDT
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Dave:
“Obviously they don’t value it as much as the inputs that went into it, which means that we are poorer then before as a result of that misallocation of capital.”
Now, how is it you make that claim? We don’t know what the inputs are – we know what the asking price is. I hope we know that debt is not an “input”. The real inputs were wood, concrete, labor, land, copper, etc. Are we out of wood? Are we out of concrete? What about labor? No, what we are out of are debts that can be realized.
It is no wonder we have difficulty with the difference between real and nominal. The nominal is freezing up the economy, while there is no lack of real resources available. We can discuss energy as separate topic, but I believe energy (because it is so hard to store – it is the phantom between a stock and flow) is always a problem that has to be managed.
Retooling is way over-estimated as a problem. The demand that wants to be filled today is not some new demand for which we need new skills and tools. People want medical care, they want decent housing, they want education, they want entertainment, they don’t want to wait in line at the DMW for 2 hours, they would like to eat occasionally.
Yes, we have poor allocations of resources. But unless this creates a supply constraint, it’s as if we spent that time digging holes and refilling them for our daily bread. I certainly don’t condone waste nor the empty homes in the desert – but I do not think we have some social sins which require financial penance (at least not for the public – the banks, OK). We don’t need perfect productive alignment – that is the great thing about a flexible economy.
We underestimate the vast productive capacity of this economy – we completely take it for granted. Having a educated work force that WANTS to work and has some fairly decent productive infrastructure (still) is not a bad place to start. I do not want to hear about the vast waste of tract land built out in the Southwest desert sucking up all of our available resources. Yes, our NOMINAL resources, but not our real resources.
(BTW, trade deficits are a nominal expense but a real benefit.)
April 6th, 2011 at 11:31 pm PDT
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[…] will be a long post. I’ll discuss each of the seven points I outlined in my summary of MMT stabilization policy. Then I’ll offer some general comments. Before you continue, you should understand the point […]
April 7th, 2011 at 8:34 am PDT
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hi,thnak you very much
April 7th, 2011 at 9:45 am PDT
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If the State has the monopoly money on power, there had better be severe constrainsts on such power:
“The nation state as a fundamental unit of man’s organized life has ceased to be the principal creative force: International banks and multinational corporations are acting and planning in terms that are far in advance of the political concepts of the nation-state.”
Brzezinski, Zbigniew, Between Two Ages: America’s Role in the Technetronic Era (New York: Viking Press, 1973), p. 246.
Henry Kissinger reduced the almighty powers of the Federal Reserve to one line: “Who controls money controls the world.”
Former chairman of the Federal Reserve Alan Greenspan, who served for 18+ years in his position, was asked by political talk show host Jim Lehrer: “What should be the proper relationship between a chairman of the Fed and the president of the United States?”
“Well, first of all, the Federal Reserve is an independent agency, and that means basically that there is no other agency of government (including the executive office) which can overrule actions that we take,” Greenspan responded matter-of-factly. “So long as that is in place… then, what the relationships are don’t frankly matter.”
April 9th, 2011 at 9:59 pm PDT
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