More on MMT and the mainstream

ICYMI, Simon Wren-Lewis wrote a post wondering what MMT contributes to macroeconomics that isn’t either false or already well-known. I answered with a post arguing that MMT is really a philosophical theory about the purpose of currency and the role of the state.

Wren-Lewis acknowledged my argument but remains unconvinced by the theory of currency. Nick Rowe wrote me a detailed reply, arguing against that theory. It gave me a lot to think about, though I’ll save a reply to his reply for a later post.

I should thank both of them. Rowe engaged me in a detailed and informative discussion. Wren-Lewis paid me the compliment of saying that my post plus discussions allowed him to pick which parts of MMT he does and doesn’t agree with, which is all I’m really after. I think we might be getting somewhere.

I’d like to continue the dialogue a bit more, so I hope at least one of them reads this at some point.

MMT and IS-LM

Rowe suggests the relevant bit of MMT for policy is substantially reducible to IS-LM analysis with a flat LM curve and a vertical IS curve (Rowe points out that this reduces to an even more basic ‘Keynesian Cross’ analysis). Wren-Lewis admits that some MMTers propose something more complicated than this – more an IS curve of unknown shape.

Strictly speaking, of course, we can’t reduce MMT to any sort of IS-LM. MMT, like Post-Keynesian economics in general, rejects IS-LM analysis altogether as simply not applicable to the real world.

But I don’t want to quibble about that now. Maybe Rowe’s point could be restated as follows:

IS-LM with a flat LM curve and a vertical IS curve captures as much of the MMT position as can be represented within standard macroeconomics.

I want to dispute that claim.

The Flat LM Curve

The “flat LM curve” part I definitely agree with. As Rowe points out, this just represents the operational reality of a floating fx system with no actual reserve constraints on banks. Mitchell and Wray’s MMT textbook explicitly states that if we were to use IS-LM, we should have a flat LM curve:

The fact that the money supply is endogenously determined means that the LM will be horizontal at the policy interest rate.

So far, Rowe is right.

Next, as he notes, New Keynesian macro generally accepts this revision to classic IS-LM. Thus Rowe draws the “New Keynesian or Neo-Wicksellian version” of IS-LM as follows:

This is a picture of an economy in recession. The current equilibrium is at (Y0, r0). But ‘full employment’ output (or output at the ‘natural rate’ of unemployment) is Yn. The ‘natural’ rate of interest, given the current level of spending, is rn. In terms of a policy response, you can have a fiscal expansion to push the IS curve outwards until rn rises to the level of r0, or you can have monetary policy lowering the interest rate (currently r0) until it falls to rn. (Inflation expectations are left out for simplicity.)

We should pause here to remind ourselves that one main policy disagreement between MMTers and New Keynesians is that the latter believe, and the former do not, that monetary policy on its own can bring the economy to a ‘full employment’ level of output. For New Keynesians this is true except in the special case where rn<0. For MMTers it isn’t true at all.

Wren-Lewis asks: “What about a world where monetary policy did successfully control demand and inflation, which is the world I’m writing about?” The MMT reply would be that such a world doesn’t exist. But why not?

The Vertical IS Curve?

To get to this MMT conclusion, Rowe proposes a vertical IS curve. If the IS curve is vertical, then raising and lowering rates quite obviously can have no effect on output, and so the world in which monetary policy controls demand and inflation doesn’t exist:

But I disagree with this reading of MMT.

The key point for MMT is not that aggregate spending is unresponsive to changes in the interest rates, so that the IS curve is vertical. Rather, the point is that monetary policy has fiscal effects, and these undermine the intended effects of monetary policy.

Monetary Policy is Fiscal (whether it wants to be or not)

Here is how Warren Mosler puts it:

The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers. The economy, however, is a large net saver, as government is an equally large net payer of interest on its outstanding debt. Therefore, rate cuts directly reduce government spending and the economy’s private sector’s net interest income.

The first bit suggests that the propensity to spend of borrowers and savers might be such as to have an IS curve with something other than a negative slope. But Mosler doesn’t follow that up. Instead, he points out that monetary policy has fiscal results: cutting rates reduces interest payments from the government to the private sector. Raising rates increases such payments.

This isn’t an MMT point as such. It’s just a recognition of the interest-income effect. But MMT, which is particularly focussed on existing institutions and operations, takes fairly seriously the size of the interest-income effect in a context where the government is very big and a net payer of interest.

My point here is just that this idea can be represented in the New Keynesian version of the IS-LM diagram. There is no need for any vertical IS curve.

MMT in IS-LM

In the New Keynesian version of IS-LM analysis, monetary policy is represented as upward or downward shifts of the LM curve, as the central bank adjusts rates. Meanwhile, fiscal policy is represented with leftward or rightward shifts of the IS curve.

To see Mosler’s point, imagine that the central bank lowers rates during a recession. Here is the key: In the first instance, the result of that will be an decrease in total government spending, since interest payments on government debt are reduced without any other adjustments in spending. Multiplier effects follow. This shifts the IS curve leftwards, so that the end result can be a fall in output. It depends in part on how far the IS curve shifts. But MMT, again, takes seriously the institutional features that make the interest-income effect likely to be big. Thus in the diagram below, the lowering of rates, combined with the interest-income effect, provokes a move from (Y0, r0) to (Y1, r1):

IS-LM MMT

These effects occur only in the first instance, as I highlighted above. In the above example, the government can take the low rates as an opportunity to cut taxes or increase other spending, thus countering the negative interest-income effect. On the other hand, it might not do so. That’s a matter of fiscal policy.

The Moral

The moral is that the effect of monetary policy hangs entirely on the response of fiscal policy. Monetary policy on its own can’t control demand and inflation because it never operates on its own. Interest adjustments always have fiscal effects, and where the government is a large net payer of interest, these will be big enough to matter a lot.

Importantly, lowering the rate when the government is committed to fiscal austerity is likely to reduce aggregate demand, not raise it.

Given our current institutional framework, that’s the world we’re in. And it is the world that MMT is writing about.

To be clear: I don’t think IS-LM is the right way to express this point. But if you insist on forcing MMT into an IS-LM framework, there’s no need to make the IS curve a different shape from what it is in the standard New Keynesian version.

It’s not about the shape of the curves. It’s about the way they mooooove.

 

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30 thoughts on “More on MMT and the mainstream

  1. NeilW

    Mainstream economists just can’t get their head around the dynamics of the system- a consequence of the mathematical language they choose to express their concepts in. Their view is over simplified, over-abstracted and overly static.

    And most damaging from a system stability point of view it is about constantly pushing ever more private sector borrowing from banks to offset ever more savings – which is a dynamically unstable structure. As 2008 demonstrated in droves.

    The framing here is interesting. Mainstream trying to suggest there is nothing in MMT they don’t already describe.

    A more appropriate view is whether there is anything in mainstream that isn’t more simply and better expressed via MMT

    Reply
    1. axdouglas Post author

      That last question is pretty good. Building a static model and then trying force dynamics in by jiggling the curves around isn’t ideal in my view.

      Reply
    1. axdouglas Post author

      I thought so until recently. But that only makes sense if you exclude interest payments on gov debt from G.

      Reply
      1. axdouglas Post author

        Conceptually, I don’t see the rationale for taking interest payments out of G (and working them somehow into the I(r)). Is it that they’re non-discretionary? But then should the auto-stabilizers also be taken out of G?

      2. Nick Rowe

        Using standard National Income accounting conventions, G refers to government purchases of newly-produced final goods and services, so G excludes interest payments on government debt. Interest payments are a transfer payment, which is a negative tax, so appear in “T” with a minus sign.

        But, it is up to us how we most usefully define the IS curve (i.e. what we hold constant when we draw it). And it is perfectly standard, for example, to hold the tax rate t constant, rather than total taxes T constant, when you draw the IS curve. So there is nothing logically wrong with holding the tax-transfer *system* constant when we draw the IS curve. And the general rule with drawing curves is that if the thing on the axis (r in this case) is what caused the change, it’s a movement along the curve rather than a shift in the curve.

      3. axdouglas Post author

        Thanks, I see (I meant G as shorthand for G-T – as it is in some textbooks – but either way your point stands).

        So then yes, you could represent Warren’s view with an upward-sloping curve and the degree to which it slopes up determined by the relative size of the government as a net payer of interest.

        You and SWL both asked why, if this is right, central banks managed to control inflation in the 70s/80s using textbook policy. But couldn’t one answer be that having to pay higher rates provokes governments to find savings, and they generally find enough to more than compensate for the interest-income effect?

      4. Nick Rowe

        Alex: Yep.

        Let’s take an empirical example. Canada in the mid to late 1990’s tightened fiscal policy a lot (because the debt/GDP ratio was growing too quickly, not because Aggregate Demand was too high). But the Bank of Canada loosened monetary policy, so there was no big recession, and inflation stayed close to the Bank’s 2% target.

        Unfortunately, it’s not as clean an example as I would like, because Canada is a very open economy, so the exchange rate matters as much (maybe more)than the interest rate.

        But there’s still a general point here: if the IS curve sloped the “wrong” way, then central banks have been moving interest rates the wrong way too, which would make it very puzzling that they have been able to control inflation even to the extent they have. (It’s like a driver who thinks the steering wheel is hooked up the wrong way around; it would be very puzzling if that driver managed to stay on the road at all.)

        I have also used the same argument against the Neo-Fisherians, who also (though for very different reasons) think central banks need to raise interest rates to increase inflation.

        More generally, MMT reminds me so much of 1960’s British Keynesianism, Radcliffe Report, and what we used to call “elasticity pessimism”. Raising interest rates would never work to bring down inflation, and would only cause inflation to go up.

      5. axdouglas Post author

        But it’s not so much the Canadian government deciding to tighten fiscal policy as the private sector deciding to reduce its net saving position. And if that’s a matter of ‘animal spirits’, you can see why lowering the rate a bit won’t be enough to reverse it.

      6. Nick Rowe

        It would be a bit of a fluke though, if private sector animal spirits just happened to change by exactly the right amount to offset the big tightening of fiscal policy.

        And it’s an even bigger fluke that 25 years ago the Bank of Canada said it would target 2% inflation, and average inflation has been almost exactly 2% ever since. Either the BoC can control inflation, or else it has been very lucky.

      7. axdouglas Post author

        It’s not a fluke if fiscal deficits are non-discretionary and determined by private savings desires as MMT suggests.

        Then the decision of the private sector to reduce its net saving position drives the government towards surplus. The government then scores political points by claiming this as a victory of ‘fiscal responsibility’. Meanwhile, the central bank ascribes it all to its masterful handling of the interest rate. In fact it was the animal spirits all along with others taking credit for it.

        The MMT theory of the price level is that it’s just a function of what prices the state pays when it spends and what collateral it demands when it lends. In that sense the inflation rate is a function of fiscal as well as monetary policy.

        But it’s just textbook monopoly pricing with the state as the single supplier of currency. Money only enters through state spending/lending, so if the state pays 2% more each year for the same stuff, while the CB demands 2% more collateral for the same loans, then you get 2% inflation. Meanwhile the monetary policy committee does a rain dance with the rates and takes credit for the weather. 🙂

      8. Mike Otsuka

        But the state doesn’t target 2% inflation in its purchases. The only inflation-targeting by the state is via the CB and rates. It’s not just in Canada but also in the US and the UK that inflation has been much closer to 2% since CB targeting was introduced.

      9. axdouglas Post author

        That’s true, but wage and other contracts are made on the expectation of 2% inflation. And in the government’s case, the expectation is self-realising.

      10. Mike Otsuka

        “So then yes, you could represent Warren’s view with an upward-sloping curve…”

        In which case the monetary policy committee rain dance is actually drought-inducing, but this is overwhelmed by the fact that people expect it to create rain.

      11. axdouglas Post author

        The rain dance on its own doesn’t do one thing or another. What matters is what the state decides to spend and what prices it decides to pay.

      12. axdouglas Post author

        For a concrete example: suppose the CB raises rates and this has the textbook effect of making people save more and spend less.

        Less spending means less tax revenue for the state, which is now paying higher interest on its bonds. If it keeps buying the same stuff, it drives up the average price level, since it’s paying the same wages for most labour and paying higher rent to bondholders.

        Or suppose it reacts by trying to close the deficit gap by cutting back and hiring less labour. Now it drives wages down towards the rate of unemployment benefits (or sometimes even less), which offsets the higher rent paid to bondholders and could be deflationary.

        It all depends on what the fiscal policy is.

      13. Mike Otsuka

        “Less spending means less tax revenue for the state…”

        Less spending also implies less demand for goods, which lowers their prices. So the rain dance causes rain. This rain might either be intensified or counteracted, depending on the sort of fiscal policy the state pursues in reaction to the decrease in revenue consequent upon the decrease in spending.

      14. axdouglas Post author

        True, but that can only give you a once-off price-adjustment. To get inflation/deflation you need fiscal policy to continue the direction of adjustment.

      15. axdouglas Post author

        And this is assuming the rate adjustment has textbook effects. And there’s no reason to assume that: higher rates give more spending power to bondholders.

      16. Mike Otsuka

        “To get inflation/deflation you need fiscal policy to continue the direction of adjustment.”

        Surely it depends on how great the adjustment is, and to what extent, if any, fiscal policy counteracts the intended inflationary or deflationary effect of the change in the rate.

        In any event, if, as you did in an earlier comment, one assumes textbook effects, then I don’t think there remains a disagreement with New Keynesians, who would accept that fiscal policy can have inflationary or deflationary effects which can magnify or frustrate the desired effects of monetary policy.

      17. axdouglas Post author

        There are inflationary /deflationary forces all through the economy: wage bargains, markup pricing, long-term contracts, forwards trading, supply shocks, and, yes, monetary policy. Working through that tangle to see what wins out would be a hell of a job.

        Luckily, it’s unnecessary, since the state currency monoply has total control and defeats all of those influences as it likes.

        New Keynesians might know that deep down, but they don’t say it. Instead they make it sound as though monetary policy has some direct mechanical effect on prices / output that doesn’t have to pass through fiscal policy.

        So right now all they’re doing is confusing people.

        And these models are one big mass of confusion. The I(r) function might be positive, but certainly not for the reason they give based on diminishing marginal returns on capital. Because Robinson and Sraffa are still right that that makes no conceptual sense.

  2. warren b mosler

    CB’s didn’t manage to control inflation in the 70’s/80’s, which was caused by the oil shock (not excess demand). In fact their high rate policies prolonged the inflation. What broke the inflation was Carter’s dereg of nat gas in 1978 which led to massive fuel substitution by public utilities, with opec cutting production by some 15 million bpd to try to keep price over 30, but it wasn’t enough and oil prices collapsed to about $10/barrel. And note how long inflation lingered, as Volcker only very gradually brought rates down, releasing that source of inflationary pressure.

    Reply
      1. TofuNFiatRGood4U

        Hi Mr Mosler,

        (Right off the bat I want to express my Huge Admiration for you and am just trying to resolve an intellectual conflict.)

        There was an interesting discussion on mikenormaneconomics concerning an alternate scenario as to why the oil price declined in the 80s an 90s.

        In the comments for this posting, Dan Lynch provides a link to a paper arguing that the 1976 Doha agreement, and that a delay in Saudi production response lead to the 2nd oil shock:

        http://mikenormaneconomics.blogspot.com.au/2016/02/bruce-bartlett-and-james-galbraith.html

        My comment at the end has a link to a .gov site detailing natural gas price history for the period in question apparently contradicting your claim.

        On reflection, this does not mean your argument is wrong: relative oil/natgas prices, the expectation of future supply reliability, and then over capitalization in the oil sector in the early 80s can be argued for the causes of the 15 million bpd excess (so your could say you are summarizing the complexities of the situation). I do think the assertions re: Doha are a twist to the story.

        Also, Bill Mitchell has written (in a response to Matt Franko) that inflation in the 70s was not strictly about oil (see the response to my query):

        http://bilbo.economicoutlook.net/blog/?p=33307#comment-44326

        (“It is simply incorrect and a denial of the historical facts to blame OPEC for the inflation prior to late 1973.”)

        I’m not saying you are substantially wrong, only that the situation appears nuanced, and if you have any additional thoughts on this I would appreciate them.

  3. Ralph Musgrave

    Well we can expect senior members of any profession (e.g. SW-L) to be not entirely happy when a group of outsiders (MMTers) claim to know better than those “seniors”. Worse still, a significant proportion of MMTers are not professional economists and don’t even have any impressive economics qualifications. In fact many come from a business background (e.g. Warren Mosler, me, Neil Wilson).

    Anyway, one area where I think MMTers know better than the professionals is this. SW-L is still to some extent stuck with the traditional view that national debt is comparable to a household debt: something to be paid off as soon as possible. I may be doing him an injustice, but I’m almost certain he expressed the view in one of his blog posts that the time to pay down national debt is when the economy is booming or at full employment.

    The standard MMT response to that idea is that it’s almost right, but not quite. The standard MMT view (if I’ve got it right) is this. National debt is a private sector asset: a paper asset. And the more of that form of asset there is in private sector hands, the higher will private sector spending be, all else equal: when people come by a very large chunck of “paper assets”, e.g. when they win a lottery, their spending rises doesn’t it?

    Thus if the total amount of paper asset in private sector hands rises as a result of government running a deficit to deal with a recession rises, then ALL ELSE EQUAL, it’s not unreasonable to expect that that stock of assets will be too large (and hence induce too much spending) after the recession. Thus the debt will have to be paid down.

    However, things will NOT NECESSARILY BE EQUAL. That is, the stock of paper assets that the private sector wants MAY RISE. In that case, it is futile to try to pay off the debt: doing so will stimply spark off another recession. Thus the idea expressed by SW-L that it’s desirable to pay off the debt after a recession is not necessarily right.

    The above MMT view is entirely consistent with the famous phrase uttered by Keynes: “Look after unemployment, and the budget will look after itself”.

    Reply
  4. axdouglas Post author

    There are inflationary /deflationary forces all through the economy: wage bargains, markup pricing, long-term contracts, forwards trading, supply shocks, and, yes, monetary policy. Working through that tangle to see what wins out would be a hell of a job.

    Luckily, it’s unnecessary, since the state currency monoply has total control and defeats all of those influences as it likes.

    New Keynesians might know that deep down, but they don’t say it. Instead they make it sound as though monetary policy has some direct mechanical effect on prices / output that doesn’t have to pass through fiscal policy.

    So right now all they’re doing is confusing people.

    And these models are one big mass of confusion. The I(r) function might be positive, but certainly not for the reason they give based on diminishing marginal returns on capital. Because Robinson and Sraffa are still right that that makes no conceptual sense.

    Reply
  5. James Charles

    “Monetary policy on its own can’t control demand and inflation because it never operates on its own.”

    ” I asked what mechanism in the real world the Fed has available to raise money supply above money demand (something that you said above is necessary if inflation is to occur). Money supply can rise if the Fed buys assets or if loans are made from available reserves. To my way of thinking, neither of these can occur without the full and conscious participation of the other side of the transaction. Hence, the supply of money cannot be increased in the absence of demand.
    Yet you say (above) that inflation only occurs when money supply is in excess of money demand. You have defended this with analogies, but not with real-world examples of the underlying process. I am a huge fan of using analogies to get the essential idea across; however, unless these mirror something that is going on in the real world (and in a very real and tangible sense), then recommending policies based on such stories is dangerous to say the least.
    I hope you don’t think I’m being rude, but I think this is a key question and one that I have never found a monetarist able to answer: how is it in the real world that the central bank raises money supply above money demand? Can you please tell me this and in the context of actual Federal reserve policy tools?
    This is not a trivial question. The entire monetarist superstructure rests on it. If the answer is that in reality this cannot happen, then I’m not sure how the rest of the monetarist analysis survives.”
    http://www.forbes.com/sites/johntharvey/2011/05/14/money-growth-does-not-cause-inflation/4/#6e38191ef9f8

    Reply
    1. axdouglas Post author

      James, I’m not sure who you are arguing with. I don’t see where I “say (above) that inflation only occurs when money supply is in excess of money demand”. Certainly I don’t think it occurs when the central bank ‘raises’ money supply above money demand. Can you clarify?

      Reply

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