Saturday, July 16, 2011

Modern Monetary Theory

I need to step back, for a minute, from the current debt ceiling argument, and say a bit about MMT - Modern Monetary Theory. I am a new student of this subject and have read quite broadly in it for the last six weeks. A significant part of my "economic worldview" has changed as a result. The way I thought some things worked turned out to be wrong. Not everything, but quite a lot.

Turns out deficits are not so awful. The US has had them for about 200 of her 230 year history.We have had six depressions: 1819, 1837, 1857, 1873, 1893, and 1929. Each one followed a period of serious deficit reduction and budget surplus. How could this be? Turns out net government flows must equal net private flows (including the trade balance) in the national accounts. If the government sector is in surplus, the private sector will be in deficit: the sum of private saving and the trade balance must be negative. When government runs a surplus, and you are importing more than you are exporting, you have private credit expansion (negative private savings) which eventually blows everything up. On the other hand government deficits allow the private sector to save, even with a negative trade balance. This is not opinion, or political philosophy. This is fact by virtue of accounting identity.

Take a look at the following chart showing sectoral balances for the US from 1950 to the present. The data above the x axis is uses of funds. What is below the line are the sources of funds. Sources and uses, as always, must equal; so the area above the line is a perfect reflection of what is below the line. Government sector consists of government spending less taxes (G - T). Foreign sector equals exports minus imports (X - M). Private sector equals private savings minus business investment (S - I). Notice how up until the mid-1990s', the pattern was government deficits supporting private savings, with the trade balance (here called Capital Account) moving from positive (below the line as a source) to negative (above the line as a use).

Notice also that the Clinton surplus was only made possible by a private borrowing binge, interrupted briefly in the early Bush years, then blowing out until the Crisis, when the Private sector retrenched aggressively and Government deficits mushroomed. If we want and expect the private sector to keep shoring up their personal balance sheets, and we forecast a 2-3% ongoing trade deficit, we must, therefore, expect and welcome Government deficits in the range of 5-7% of GDP:

Understanding the absolute interconnectedness of government and private flows changes a great deal. The whole conservative, supply-side argument that private investment is superior to public spending, that government spending cannot create jobs, and that demand is not the issue, it's government regulation and interference - all of this, for me, becomes recognized as nonsense. In the Sector Financial Balances, what matters are Sources of Demand/Income and  Uses of Demand/Income. The Sources are: government spending (G), Exports (X) and Private Investment (I); the Uses are Taxes (T), Imports (I), and Private Savings (S). Sources must and always do equal Uses. I (Private Investment) is not better than G (Government Spending). And as in the past, we will almost always have, and need to have, government deficits.

But 10-12% deficits will surely kill us, everyone says.

First, the level is so high (more than double what could be considered normal), because private households have been slammed. As personal balance sheets are repaired, the deficits can come down. And doesn't this analysis almost scream at us to undertake a significant mortgage mod program, that would repair private balance sheets?

So let's say we get S down to 3-4%, and X-M stays about 3% negative, then we need 6-7% GDP deficits, or $800 billion plus. My God, people will cry, we will go broke!! We will drown in inflation!! The Chinese will dump all their Treasury bonds and we'll be up a creek!! We will saddle our kids with debt they cannot ever repay!!

And here's where we have to open our minds and let in new thinking. I will not try to explain the background support for the following statements, which all come from MMT, but will direct you to the same sources I have been studying:

     * The US, which has its own fiat currency (since 1971 not tied to the gold standard) cannot ever go broke. Our Central Bank, the Federal Reserve, creates money by fiat, whenever it wants to, essentially "by keystroke". We will never run out of money.
     * There is a relation between money and inflation, shown in the formula MV = PQ, where M is the monetary base, V is the velocity, or turnover of that money, P is the price level, and Q is the output of the economy. If the money supply is increased, and money turnover stays the same, then either Prices or Economic output must go up. When the economy is operating at full employment, and money supply is increased, you will have price rises, hence inflation risk. With high unemployment and huge excess/underutilized capacity, output will go up, not prices.
     * So could we have a Weimar hyperinflation (or Zimbabwe)? Hugely unlikely. In Weimar Germany, the Ruhr industrial basin had shut down, while the government kept printing money to pay the onerous war reparations - not a scenario much like our own. Nevertheless, when economic capacity utilization moves up, the Fed must always be wary of the inflation risk.
     *We had a bout of serious inflation in the 70s'. But that was due to the overheated economy (Vietnam) and the oil embargo supply shock, not government deficits.
     * There is no legislative or market constraint (other than inflation calculations) affecting the Fed's ability to issue currency/create new money. During the Crisis, with no legislative approval required or sought, the Fed created $2.5 trillion of new money to support the mortgage market, provide liquidity funding to primary dealers and foreign banks, to buy toxic assets from Bear and Lehman, to support the non-mortgage ABS market in a public-private partnership (TALF - Term Asset-Backed Lending Facility). Almost nobody even knew about this. It came out into public view with an FOIA court discovery order. Lots and lots of new money: zero inflation pressure. Take a look at the 10 year Treasury market.
     *So we can't go broke. And inflation is something to watch, but not an unmanageable problem. How about the Chinese - what if they decide to dump their US dollars and Treasuries? If they get tired of holding dollars and want to sell their $2 trillion of bonds, we will be the likely or possible buyer. Remember, the dollar is the reserve currency. So when they sell, they still get dollars, only this time, without an interest coupon. And if they then want to shift into another currency, which one will they pick? If they really don't like holding dollars in the future, they will slow down their export machine and not sell more to us than we sell to them. Given the critical nature of their export sector for their economy, how likely is this? Not very likely, in my book.
     * How about our kids? They'll be in the same boat we grew up in: 3 - 7% deficits, funded mostly by bond sales, with interest payments staying reasonably consistent with historical trends as a % of GDP.
     * What about the "entitlement crisis", and all the unfunded liabilities that will surely destroy our kids and grandkids? There is an often overlooked central economic law: long term trends that can't be sustained, won't. All these 50 - 100 year forecasts are simply nuts. We don't do anything in a straight line, or forever. We figured it out. And so will our kids!

Here are some MMT references:

Understanding the Modern Monetary System (Pragmatic Capitalism)
New Economic Perspectives
billy blog (Bill Mitchell, Australia)

MMT will be a continuing reference point for me as we go forward to review policy alternatives for the US.

No comments:

Post a Comment