Global | Monetary Policy & Inflation
In Part I of this series I examined a few popular, mainstream critiques of Modern Monetary Theory (MMT) and concluded that they were not particularly persuasive. In particular, I disagreed that there was necessarily a natural conflict between monetary and fiscal authorities – that is, that they are consistently independent of one another. In this instalment, I elaborate on this view with the support of some non-mainstream critiques of MMT. I find that MMT is incompatible with modern complexity and information theory, something that should perhaps be unsurprising as MMT is, in fact, an old, stale, ‘free-lunch’ idea packaged up in a shiny new lunchbox.
What Mainstream Criticism Gets Right About MMT
Among others, former governor of the Reserve Bank of India, Raghuram Rajan, has used the term ‘free-lunch’ when criticizing MMT. He’s right. One reason why MMT has such appeal is that its advocates frequently claim that, under an MMT policy regime, government deficits simply don’t matter as long as they don’t result in a meaningful rise in consumer price inflation. Indeed, MMT goes so far as to say that non-inflationary deficits are good in that they provide the private sector with a source of savings.
Rajan and others are right to be sceptical of these claims. The entire science of economics is based on the principle that resources are necessarily scarce. The more the public sector claims these resources, the fewer remain for the private. In most modern democracies, the balance between the public and private sector is a matter of fiscal policy. However, whether public or private, all spending in excess of current income needs to be financed at the prevailing rate of interest, or the funds will not be available. This is basic Macroeconomics 101.
Or is it? Consider the role central banks play in the above. They do not get involved, at least not directly, in fiscal policy or the deficits thereby created. Nor do they get involved directly in private sector debt decisions. But involved they are, in a more subtle way.
Central banks set the ‘price’ of deficits. Or debt. They do this as part of carrying out their mandates, which in most modern economies include maintaining economic stability, defined variously. Their primary conventional policy instrument is the short-term interest rate. This they either raise or lower to maintain what they believe is a stable and sustainable balance between the supply of savings and demand for borrowing in an economy.
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In Part I of this series I examined a few popular, mainstream critiques of Modern Monetary Theory (MMT) and concluded that they were not particularly persuasive. In particular, I disagreed that there was necessarily a natural conflict between monetary and fiscal authorities – that is, that they are consistently independent of one another. In this instalment, I elaborate on this view with the support of some non-mainstream critiques of MMT. I find that MMT is incompatible with modern complexity and information theory, something that should perhaps be unsurprising as MMT is, in fact, an old, stale, ‘free-lunch’ idea packaged up in a shiny new lunchbox.
What Mainstream Criticism Gets Right About MMT
Among others, former governor of the Reserve Bank of India, Raghuram Rajan, has used the term ‘free-lunch’ when criticizing MMT. He’s right. One reason why MMT has such appeal is that its advocates frequently claim that, under an MMT policy regime, government deficits simply don’t matter as long as they don’t result in a meaningful rise in consumer price inflation. Indeed, MMT goes so far as to say that non-inflationary deficits are good in that they provide the private sector with a source of savings.
Rajan and others are right to be sceptical of these claims. The entire science of economics is based on the principle that resources are necessarily scarce. The more the public sector claims these resources, the fewer remain for the private. In most modern democracies, the balance between the public and private sector is a matter of fiscal policy. However, whether public or private, all spending in excess of current income needs to be financed at the prevailing rate of interest, or the funds will not be available. This is basic Macroeconomics 101.
Or is it? Consider the role central banks play in the above. They do not get involved, at least not directly, in fiscal policy or the deficits thereby created. Nor do they get involved directly in private sector debt decisions. But involved they are, in a more subtle way.
Central banks set the ‘price’ of deficits. Or debt. They do this as part of carrying out their mandates, which in most modern economies include maintaining economic stability, defined variously. Their primary conventional policy instrument is the short-term interest rate. This they either raise or lower to maintain what they believe is a stable and sustainable balance between the supply of savings and demand for borrowing in an economy.
What the Mainstream Gets Wrong
In recent years, due to a combination of weak growth and low measured consumer price inflation, several central banks have lowered rates all the way to zero, or even negative. While there is as yet little evidence that this has promoted a return to sustainable economic growth, it has certainly enabled governments to provide an increasing range of direct financial assistance of various kinds to households and businesses. It has also supported financial asset prices, which in general are higher relative to underlying incomes than ever before in recorded economic history.
Some sceptical observers refer to this state of affairs as ‘the everything bubble’. That is, central banks have contributed to asset inflation just about everywhere. Economic growth may have been disappointing in recent years, but this hasn’t prevented huge bull markets in bonds, stocks, prime property, fine art, classic cars, etc.
Another effect of these aggressive reflationary policies, however indirect, has been to encourage fiscal authorities to run unusually large deficits. With the cost of government borrowing essentially zero, so the thinking goes, it makes sense to run up large debts. The term ‘free-lunch’ is sometimes used here, too. In other words, through their actions, central banks have been implementing policies which amount to de facto MMT.
Just this week, this de facto MMT policy came an important step closer to de jure with the US Federal Reserve considering making it official policy only to raise interest rates once both their inflation and employment targets are met. This implies that, going forward, the Fed will be targeting nominal GDP, the central goal of MMT advocates. Meanwhile, the US Congress is working on fresh legislation to provide yet more fiscal stimulus to the economy through various forms of direct income transfers to the general public, taking advantage of what the Fed is clearly indicating to be a prolonged low interest rate environment.
Call it whatever you like, but this policy mix is indistinguishable from MMT. The economic mainstream may claim otherwise, suggesting that this set of extraordinary fiscal and monetary policies is only temporary and therefore that, at some unknown point in the future, some sort of ‘normalisation’ will occur. When have we heard that before? Since 2008, many prominent mainstream economists have regularly said it. So, before that mainstream critiques MMT, they need first to take a look in the mirror and recall who has been in the macroeconomic policy driver’s seat in recent years.
Alternative MMT Critiques
There are also prominent MMT critics from outside the economic mainstream. Indeed, some of these are among the more prominent critics of the mainstream itself. These include modern advocates of so-called ‘free banking’, a venerable school of economic thought originating in the 18th century in response to changes in English banking law, including the creation of the Bank of England. Modern free-banking proponents include Kevin Dowd, George Selgin and Lawrence White, among others.
For those unfamiliar with the concept of free banking, it holds that the creation of money and credit are ultimately more stable and sustainable, and therefore supportive of economic growth generally, when they are subject to the same incentives that apply to other industries. In other words, it extends the basic concepts of free-market capitalism to the banking sector. Importantly, this implies that there should ideally be no ‘lender of last resort’. Rather, banks that get into trouble, for whatever reason, should be subject to market forces and, if they are unable to dispose of their assets in a crisis, they should be subject to the same set of bankruptcy laws that apply to other economic actors.
Free bankers don’t claim that such a system would eliminate banking crises. After all, any normal industry will find itself in crisis from time to time, for whatever reason. The world is an imperfect place subject to exogenous shocks. However, free bankers hold that if banks are fully subject to the consequences of the risks they take, separately or collectively, they will manage their risks more prudently than if they perceive there is some sort of implied bailout in the economic regulatory structure, such as that administered with some regularity in recent years by various central banks.
Although the MMT crowd claims that their ideas are new, it is when we compare their ideas to those of free banking that we clearly hear the echo of a classic 19th-century economic policy debate: that between the British Banking and Currency schools. The former held that it was best to leave banks to compete in a mostly free market, absent any central controls on money or credit growth. The latter believed that it was only through the centralisation of money creation – in the form of the Bank of England – that price stability could be maintained and crises avoided.
Occupying the middle ground in this debate was Walter Bagehot, erstwhile editor in chief of the venerable Economist magazine. While philosophically a member of the Banking School, Bagehot was writing at a time when the Currency School held the upper hand in terms of actual policy. Hence Bagehot’s famous dictum that, when acting as lender of last resort, the Bank of England should, ‘Lend freely, at penalty rates of interest, against good collateral.’ This was, in his view, the best way to avoid moral hazard infecting and destabilising the system.
Well that was then, and this is now. Since at least 2008, central banks have, during crisis periods indeed lent freely. But as the years have rolled by, what were once penalty rates of interest are now zero or negative, and the collateral basket has expanded to include mortgages of dubious value and risky corporate securities, in some cases even those lacking an investment-grade rating. This is precisely the sort of policy regime Bagehot warned against.
Although it might seem odd, modern free banking and MMT proponents are both highly critical of the public-private mix of money and credit creation. More radical members of both schools also perceive the implied moral hazard as providing fertile ground for corporate cronyism. However, their proposed solutions to what they both agree is a highly flawed system are radically different: MMT proposes a complete nationalisation of money and public sector credit creation; free banking a privatisation.
Resolving the Debate Through Complexity and Information Theory
Modern economies are complex systems. Indeed, they are so complex that they defy any attempt to model them in their entirety, in real time. Modern complexity and information theory provide a framework, however, for understanding their dynamics.
The philosopher George Gilder, in his book Knowledge and Power (2013), applies the principles of modern information theory to economics. As he writes, ‘Capitalism is not primarily an incentive system but an information system.’ The single most important form of information, he argues, is prices, and the numerator of all prices is, of course, units of money.
As goods can only be valued subjectively, that is, by their benefits to a specific user at a specific place and time, real-time prices become the only way in which goods can be efficiently allocated. When it comes to inventories of consumer goods, this is already complex enough. When it comes to capital goods, especially those that do not yet exist except on a drawing board, it is so complex it boggles the mind and would crash any computer to model. This is complexity theory in action and the most complex actors of all are the entrepreneurs who bear the ultimate risks of trying to divine the future.
This insight has profound implications. If information flows efficiently, an economy can function efficiently. But if the information is somehow distorted, the economy suffers. Within the financial sector, the ‘price’ of money is the interest rate, either explicit or imputed by discounting. So, the more that economic officials attempt to control money and credit creation, the more they will distort price signals throughout the financial sector. Resources will be misallocated, potential growth and productivity will decline, the system will become unstable, and crises will become increasingly common.
Indeed, the above summarises much of the past decade, as economy policy has drifted relentlessly towards de facto MMT. MMT therefore seeks to extend further and to formalise what is already a huge distortion of natural price signals, the lifeblood of a modern, complex, information-based economy.
To put it more crudely, MMT advocates a form of central economic planning, which, through money creation and the implied debasement thereof, will crowd out private capital in the event that the private sector seeks, for whatever reason, to increase its savings rate. The government is going to decide what the nominal private savings rate should be, based on what it believes the nominal growth rate should be, based on what it thinks the potential growth rate should be, based on what it thinks the real potential growth rate should be. If that isn’t already the nth degree of central economic planning, what is?
MMT advocates further claim that they can do this without destabilising the economy by keeping an eye on consumer price inflation, but that is akin to trying to steer an economy while looking through the rear-view mirror. It won’t work, for reasons strikingly similar to why socialism has failed everywhere it has been tried.
Indeed, it is worth pointing out that Karl Marx, the man who gave ‘capitalism’ the name, was a keen observer of the Banking vs Currency School debate and one who advocated, in his famous Communist Manifesto, for the ‘Centralisation of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly.’
MMT, while purporting to be ‘new’, therefore has surprisingly deep intellectual roots. It is but the latest, trendiest variant of a surprisingly broad tradition in economic thought that has, from time to time, served governments on both the right and the left: The Free-Lunch School. It may be in a shiny new box, but it is old and stale just the same.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)