selise's blog


Pavlina Tcherneva: ‘Modern Monetary Theory and Mr. Paul Krugman: a way forward’

March 29th, 2011 by selise

[x-posted with kind permission of the author -selise]

By Pavlina Tcherneva

There is nothing more deceptive than an obvious fact.”
— Arthur Conan Doyle (The Adventures of Sherlock Holmes)

The fact that the U.S. government is a monopoly issuer of the U.S. currency is an obvious fact. The fact that an issuer of a currency doesn’t need to borrow its own currency from anyone else in order to spend is also an obvious fact. So is the fact that a sovereign currency nation that issues two government liabilities—government bonds and central bank reserves—can always issue such liabilities and convert one into the other ad infinitum. And yet there is nothing more deceptive than the significance of these obvious facts.

Mr. Krugman in his Friday NYT blog engaged Modern Monetary Theory on these facts and received considerable flack from MMT economists and supporters for misrepresenting MMT’s assertions. Frankly, I was pleased to see Mr. Krugman address our work and was really not surprised by some of his objections. After all, he is making the same arguments we’ve been addressing for the last two decades, since the very early days of MMT. I am surprised, however, that he has relied on hearsay or critics of MMT, rather than our own writings to do them justice. Over those decades we have elucidated our position in great detail in various books, journal articles, blogs and papers (probably the most systematic responses to MMT critiques that are accessible to non-academic audiences can be found on this blog [New Economics Perspectives from UMKC -- selise], Bill Mitchell’s, and Warren Mosler’s). Many more amazing and intellectually curious people have engaged with these ideas, and have started their own blogs (see links on this blog). There are plenty of primary sources on MMT not to mischaracterize it!

But this is an opportunity for dialogue because we are all on the same side here. We are all convinced that poor understanding of the economy leads to bad policy. For MMT, poor understanding of the monetary system leads to especially bad policies. So if we do anything together, Mr. Krugman, let’s build one bridge and let that be a bridge of understanding of what the possibilities are under sovereign currency regimes.

Here I want to make the simple point that it is not sufficient (although it is necessary) to just recognize these obvious facts; indeed we must have a framework for thinking about these facts to move economics and policy forward. Yes, you recognize that we are a sovereign currency nation, but nevertheless conclude in your second piece on MMT that we can (at some point) become insolvent. Your argument looks at bond vigilantes’ behavior to which I will turn in a second.

It is an obvious fact that the U.S. government’s liability is unlike those of the private sector, because only the government pays by using its own liability and there is no limit to which it can issue those. This has been an important point of departure for MMT, but it has been recognized by some of your saltwater colleagues as well. And yet, they have not been able to provide the intellectual leadership to move us forward.

Let’s take Mr. Woodford, for example — a saltwater star economist, who developed the Fiscal Theory of the Price Level (FTPL), which I must admit I have criticized considerably. Problems with FTPL and DSGE models, notwithstanding, Woodford has recognized the obvious fact that sovereign currency nations cannot default on their obligations:

“A subtler question is whether it makes sense to suppose that actual market institutions do not actually impose a constraint … upon governments (whether logically necessary or not), given that we believe that they impose such borrowing limits upon households and firms. The best answer to this question, I believe, is to note that a government that issues debt denominated in its own currency is in a different situation than from that of private borrowers, in that its debt is a promise only to deliver more of its own liabilities. (A Treasury bond is simply a promise to pay dollars at various future dates, but these dollars are simply additional government liabilities, that happen to be non-interest-earning.) There is thus no possible doubt about the government’s technical ability to deliver what it has promised…” (Woodford 2000, p. 32)

Even more surprisingly, Woodford has used this logic to make the point that:

“it is possible for a government to finance transfers to an initial old generation by issuing debt that it then ‘rolls over’ forever, without ever raising taxes” (2000, p. 30).

In other words, programs like Social Security are forever sustainable! Some may wonder why an economist of Mr. Woodford’s standing would make such a claim and yet remain silent at a time when Social Security, the most popular American social safety-net, is under attack by deficit hawks. The reason is because recognizing a simple and obvious fact does not provide the tools for intellectual leadership.

Does the recognition that sovereign governments like the U.S. (he calls these Non-Ricardian Regimes) cannot possibly default on their obligations tell us anything about what fiscal policy should look like? NO, it does not. Does it give guidance on what stabilization policy must look like? Absolutely not. There is nothing in this work of use for economic policy. The reason is that the recognition of this obvious fact has been coupled with a whole series of flawed assumptions, problematic models, and dubious transmission mechanisms, which lead him to conclude that government spending is inherently inflationary.

You too made this logical leap and argued that in normal circumstances when:

“we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation”. (NYT, March 25, 2011)

There is a problem with this claim. As MMT has demonstrated through the use of double-entry book-keeping, in reality, the government always spends by crediting bank accounts, i.e., by creating ‘money’. Yet, considering the inflation data, we’d be hard pressed to make the case that government spending in the postwar era has set unsustainable inflationary processes in motion, much less hyperinflation. Inflation is not a function of too many liabilities in circulation. But both you and Mr. Woodford are assuming that this is the case.

There is another problem with your arguments. You are saying that because government spending has to be financed by the private sector, it can be held hostage by the bond vigilantes. In other words, you argue, the government still needs someone to buy its debt before it can spend. This is not the case as we have explained in detail in our blogs. But even if we assume for a moment that this were the case, how are these bond vigilantes going to finance the government debt? What will they use to buy these bonds? The answer, of course, is reserves. The next logical question would be: how did these reserves get into the hands of the vigilantes in the first place? And since we know that reserves come from one place only – the government – they have to be spent into existence first before they can be used to buy bonds. In other words, government spending is financed through reserve creation by the Fed, not through borrowing from the private sector. We know of course that the Fed cannot force reserves on the banking system (Post Keynesians have made this point for decades, but mainstream economists have come around to understand this too). When the federal government spends, however, be that on military aircraft, Collateralized Debt Obligations, or Social Security, the Fed clears all government spending by crediting the bank accounts of Boeing, Goldman Sachs, or grandma (or anyone else for that matter who gets payments from the government, be they in the form of contracts, bailouts, or income assistance). This is how government spending creates reserves. Bond sales only drain any excess reserves from the system, to allow the Fed to hit its interest rate target, sales which are no longer needed since the Fed started paying interest on reserves (see here).

Now, many saltwater economists use Woodford’s idea that if the government injected bonds into the hands of the population without committing to raising taxes in the future to ‘repay’ these bonds, this bond injection will create net wealth in the hands of the private sector that would produce a wealth effect to stimulate the economy. The logic of this argument is completely upside down. There are two main problems: 1) ‘A bond injection’ does not increase net wealth, because households/investors give up reserves in order to buy Treasuries. Their net wealth position remains unchanged since they lose one asset (reserves) and gain another (a Treasury)—both of which are liabilities and a monopoly of the government. 2) It is a huge leap of faith to argue that more reserves or bond holdings would create a wealth effect. It might, but the transmission mechanism is highly problematic—the banking sector is bursting with reserves as we speak, yet bank lending to consumers and investors continues to be sluggish. The textbook money multiplier is completely wrongheaded and the transmission mechanism from reserves to deposits is fundamentally flawed. Putting aside Milton Friedman’s famous mea culpa and admission that the Central Bank cannot control the money aggregates (Financial Times, June 9, 2003), MMT has always said that it is loans which create deposits, and loan creation is never reserve constrained. Bank lending is based on the credit worthiness of borrowers, bank liquidity preference, capital requirements, regulation, but not on the availability of reserves. Reserves are provided by an accommodating Central Bank after the banking sector has made its loans, which have created the deposits that are subject to reserve requirements.

Note, however, that when a commercial bank makes a loan and creates a deposit, it can get reserves from the Fed (in order to meet its reserve requirement) in two ways: 1) it can borrow them (either at the discount window or through repos, i.e., through temporary OMOs) or 2) it can sell securities outright to the Fed (permanent OMOs) in exchange for reserves. When commercial banks borrow, they acquire an asset (the reserves) and a liability (borrowing from the Fed) so the net wealth position of the private sector does not change! When they sell securities to the Fed to get reserves, they lose one asset (a Treasury security) and gain another (reserves). Again the net wealth position remains unchanged.

Fed direct lending and temporary or permanent OMOs do not change the net financial wealth of the private sector. However, government spending does! When the government spends, private agents get reserves in their bank accounts. The banking sector will then convert these excess reserves into interest bearing assets—Treasuries. Bond sales are only undertaken by the Fed to drain reserves from the banking system and hit its interest rate target. Reserves come first and borrowing comes later. It is government spending that adds net new financial assets to the private sector. If you prefer to use Friedman’s analogy, helicopter drops of money are fiscal operations.

Another saltwater economist seems to get this. That is Mr. Bernanke who knows that the Fed cannot rain reserves unilaterally on the population or that the government cannot technically go broke. But he too has not provided much intellectual leadership even though he has a unique responsibility to do so.

Now, Mr. Krugman, you argue in your blog that “the rapid growth in monetary base since 2007 has taken place because the Fed is trying to rescue the economy, not because it’s trying to finance the government.” This statement is not quite correct because the Fed cannot adequately rescue the economy without financing its government’s purchases, like those of toxic financial assets. Note, the Fed has been lending to the private sector too, but this does not increase the net financial assets (NFA) in the hands of the private sector (a requirement for the saltwater economists’ presumed wealth effect). But according to Bernanke, a wealth effect can be generated, when the Fed finances government spending, (which as MMT’ers have been saying, it always does).

As I have explained in detail elsewhere Bernanke’s recipe for fighting crises and deflationary forces depends on fiscal policy (forthcoming in the Journal of Post Keynesian Economics, Spring 2011). Bernanke clearly recognizes that the Fed cannot increase the holdings of net financial assets (NFA) of the population without the Treasury. Only when monetary policy finances government spending are NFA created into existence. This is what he calls the fiscal components of monetary policy. When the Fed buys toxic financial assets from private banks, it buys worthless (or almost worthless) private sector assets on behalf of the Treasury and replaces them with reserves. Because a private sector asset is also a private sector liability, there is no net wealth created by the private sector as a whole when, for example, one private sector entity issues a CDO and another one buys it. But when the government (or the Fed on behalf of the Treasury) buys the CDO, it provides an asset – a reserve (in exchange for the nonperforming asset), while the issuer of the CDO is no longer liable for his payment. In other words a private sector liability has been extinguished whereas the toxic asset has been replaced by a default risk free asset—the government’s liability. Some private sector entity doesn’t have to pay up anymore, because the Treasury just did. So NFA in the private sector as a whole have indeed increased.

Also, when the government sends everyone a check in the mail (think of the Clinton or Bush Jr. tax cuts), the Fed clears them and creates what Bernanke has called ‘money financed tax cuts’. Bernanke has clearly stated that there is no limit to which the government can finance these.

“Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero… The U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” (Bernanke 2002)

In fact, Bernanke prefers money financed tax cuts to any other type of ‘alternative monetary policy measure’ (see Bernanke 1999). He prefers fiscal policy as a stabilization policy (or to use his vernacular he prefers these types of fiscal components, see here for details). Bernanke has also stated that we are not using taxpayer money to finance these fiscal components, just like we are not using taxpayer money when we lend to banks. The way the government spends or lends is by crediting bank accounts to private agents.

Scott Pelley: “Is that tax money that the Fed is spending?”

Chairman Bernanke: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.”

(60 minutes interview, June 7, 2009)

Why then is the Chairman appearing before Congress arguing that we have a long-term deficit problem and that Social Security and Medicare must be scaled back? Where is the intellectual leadership from this saltwater economist on issues of policy?

Mr. Krugman, you have also made this claim, namely that the government will eventually run into difficulty meeting its long-term obligations. My question is, if the Fed can clear any tax cut check that we get in the mail today, it can certainly clear the social security checks we will get in the future. If the government faced no technical limits to buying toxic financial assets, it clearly can pay for grandma’s social security today and mine in the future. More than that, the government can buy the labor of the unemployed today and put them to work on useful projects. The important question is what can we buy with these checks? MMT has always argued that we have to get past the illusion of financial constraints to start asking the meaningful questions of what the real resource constraints of our economy are and how to employ the idle resources to overcome these constraints in order to provide for the young, poor, unemployed and elderly and to increase the standard of living for all.

There are many economists who still don’t ‘get’ these obvious facts, but a number of saltwater economists do. Yet, ‘getting’ these obvious facts is not enough. We have to, indeed we must, engage in a conversation about the kind of spending we should be financing. Clearly we can finance any kind, but different types of spending will produce different real outcomes. Spending on anything politicians want without limit is absolutely the wrong conclusion to draw from recognizing the obvious fact that sovereign governments do not go bankrupt without self imposed political constraints (e.g., debt limits). Instead, we must ask the question: should the government be buying the junk of the financial sector or should it be buying the productive services of the unemployed? What type of government spending would pose greater risk of inflation than others, when would that happen, and in which sectors?

I’ve already argued that the mainstream cannot offer intellectual leadership on this last question because it assumes inflationary effects from government spending, all evidence to the contrary. MMT can and does fill this intellectual void. We have explained the problems with the traditional view of inflation and have ourselves offered policies for price stability. This work has also been concerned with true inflation beyond full employment and has offered a recipe to address it. We are worried about hyperinflation, and have carefully explained why Zimbabwe and Weimar Germany are extreme and unlikely special cases. From inception, we have been concerned with real economic problems like unemployment, and have argued that we can and must put the unemployed resources to work. We have objected to the inhumane notion economists hold that we can use unemployment to fight inflation and have provided alternatives. We have spelled out the key ingredients of what responsible fiscal policy would look like. We have offered specific policy proposals for addressing this crisis and our long term real economic challenges – policies, such as a payroll tax holiday and the job guarantee. We have argued that Social Security is not broken and that we can always make payments to the retired, but we have been very concerned with what the elderly can buy with these payments. We have always focused on the real productive capacity of the economy and whether it can generate the goods and services that the elderly will need. We have worried about the environment and have suggested specific policies for environmental renewal and sustainability. And on and on and on…..

So Mr. Krugman, let’s get past the obvious fact that sovereign currency nations are not financially constrained in their spending and start thinking about the genuine economic possibilities such systems can provide. Only then can we engage in the dialogue that we so desperately need. As I have argued before if we keep confusing solvency with sustainability, we will remain hostage to dated notions of insolvency, and will never get to ask the meaningful questions of what the government should do and how it should do it? But if we start this dialogue, I am sure that we will find a lot of common ground—and you will see that MMT has very specific proposals to prevent the government from running amuck and spending irresponsibly. We can and indeed we must challenge the current state of economic thinking and propel a new generation of economists forward—economists of the real world, not of the archaic textbooks.

Leave a Reply

Note: Captcha is not required for registered members' comments (register here).