Modern Monetary Theory and its Critics

Paul Krugman published today another of his critiques of Modern Monetary Theory (MMT) (aka neochartalism, for those who've known about this macroeconomic paradigm since the 90s and beyond). For an excellent introduction to MMT, I recommend the following article by economist Pavlina Tcherneva. Prof. Tcherneva's take on MMT is by far the most comprehensive (and relatively brief) description of neochartalism available.*

In his post, Prof. Krugman argues that adherents to MMT are wrong in (1) believing that modern, economically sovereign governments (i.e. governments that have the ability to issue fiat money) do not face financial constraints and in (2) thinking that deficits financed by money issue are no more inflationary than deficits financed by bond issue.

In regard to the first objection, I could keep it short and simply quote the great economist Michal Kalecki, who argued that the only constraint facing a monetarily sovereign government consists of the inflationary impact associated with spending and investment initiatives undertaken by the private and public sectors. As Kalecki wrote in his article "The problem of financing economic development", there are:

...no financial limits, in the formal sense, to the volume of investment. The real problem is whether this financing of investment does, or does not, create inflationary pressures. (1955: 25)

However, it might be best if Kalecki's statement were echoed by the words of someone with Prof. Krugman's credentials, that is, another Bank of Sweden Nobel laureate. For this reason, I wish to highlight the following quote from the late economist Bill Vickrey, who claimed that:

"...in the absence of a norm such as a gold clause, there can be no question of the ability of the government to make payments when due, albeit possibly in a currency devalued by inflation." (2000: 13) (my emphasis)

Having now attempted to give credence to MMT's claim regarding the financeability of government spending, and having determined that the sole constraint affecting the public finances of economically sovereign governments is essentially one of inflation, let me now turn to Prof. Krugman's contention that deficits financed by money issue are more inflationary than a deficit financed by bond issue. Here, I believe a quote by one of the leading figures associated with the "circulation approach" to monetary economics would suffice. According to Augusto Graziani,

The technique of financing a deficit does have an effect on prices, but only in an indirect way, and the effect produced is opposite to what the dominant analysis indicates. In fact a deficit financed by issuing government bonds increases the amount of interest payments and therefore the money incomes of savers; the consequence is that money prices are pushed upwards more than if the same deficit were financed by money creation. (2003: 140) (my emphasis)

One of the best explanations I've encountered for why financing government expenditures using money creation need not be inflationary is contained in "Optimal growth using fiscal and monetary policies", a paper authored by Hassan Bougrine and Teppo Rakkolainen and published by the International Economic Policy Institute. According to Bougrine and Rakkolainen, fears of inflation resulting from the government creating too much money in a context of unemployment are unwarranted given that:

...there is no such possibility for an excess supply of money since all the money that is created has been demanded. When workers seek jobs, they are demanding money. When contractors are hired to build a needed school, a hospital or a bridge, they are demanding money for compensation. Therefore the supply of money is always equal to the demand for money. The supply of money cannot exceed the demand for it and inflation is not a monetary phenomenon. In fact, when the government permits unemployment to exist by refusing to hire workers and neglects the infrastructure by not building the needed schools, roads, and so on, it is voluntarily choosing to suppress the demand for money and keep it arbitrarily low. Understanding money is essential because it effectively liberates the government from being subject to an imaginary budget constraint and allows it to actively intervene to fill the gap of under-utilised capacity of society as a whole, i.e., to strive to achieve full employment and high economic growth and development. (2009, p. 16) (my emphasis)

Before concluding, I should probably also address two points made by Prof. Krugman in a previous critique of MMT. The first point has to do with the role of taxation (note: Prof. Krugman disagrees with MMT that the purpose of taxation is to regulate purchasing power) and the second has to do with Prof. Krugman's belief that increases in the amount of base money is inflationary.

In regard to the role of taxation, Prof. Krugman should understand that it isn't only MMT supporters who believe that the most important function of taxation is to regulate purchasing power. Even some economists steeped in the neoclassical tradition believe this is the case. For instance, economist Robert Eisner in The Misunderstood Economy argued that:

[t]axes serve a number of purposes. The most important is to reduce the purchasing power of taxpayers. Resources are then freed from production of the goods and services that they would otherwise buy. It is in this sense, in real terms, that taxes pay for government expenditures. (1994: 196) (my emphasis)

As for Prof. Krugman's claim that expansions in the monetary base (i.e. reserves plus currency) are inherently inflationary, I wish to point out that leading economists at the Bank for International Settlement have been arguing for quite some time now that the growth in excess reserves need not result in additional credit creation, thus eliminating the possibility that inflation will ensue as a result. Take for instance, this quote from a recent paper by economists Claudio Borio and Piti Disyatat discussing how the amount of base money has no impact on bank lending:

Contrary to what is often believed, [banks’ reserves with the central bank] do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments. (Borio and Disyatat, 2011: 30) (original emphasis)

To know more on this last point and, more specifically, on why increases in the amount of base money need not be inflationary, please refer to my previous posts here, here and here. In these posts, I discuss the inapplicability of the traditional money multiplier model taught in most macro textbooks and go over some of the implications associated with the Fed's new policy of paying interest on reserves.

* This sentence was updated to include a link to P. Tcherneva's website on 17/08/2011.

Borio, C. and P. Disyatat (2011), "Global imbalances and the financial crisis: Link or no link", Bank for International Settlement Working papers No. 346, May 2011.

Bougrine, H. and T. Rakkolainen (2009), "Optimal growth using fiscal and monetary policies",
Working Paper 2009-11, IEPI, 2009.

Disyatat, P. (2010), "The bank lending channel revisited", Bank for International Settlement Working papers No. 297, February 2010.

Eisner, R. (1994) The Misunderstood Economy: What counts and how to count it (Boston: HBSP)

Graziani, A. (2003), The Monetary Theory of Production (Cambridge: Cambridge University Press).

Kalecki, M. (1955), "The Problem of Financing Economic Development", Indian Economic Review; reprinted in Essays on Developing Economies (Brighton: Harvester Press), 1972.

Tcherneva, P. (2006), "Chartalism and the tax-driven approach to money", in P. Arestis and M. Sawyer (eds), Handbook of Alternative Monetary Economics, (Northampton, MA: Edward Elgar), pp. 69-86.

Vickrey, B. (2000), "Fifteen fatal fallacies of financial fundamentalism: A disquisition on demand side economics", Working Paper No.1, January 2000. A copy of the paper is available on the website of the Center for Full Employment and Price Stability, http://www.cfeps.org/pubs/