Saturday, April 6, 2019

Modern Monetary Theory

I believe it was Robertson who claimed that what was true in Keynes was not new and what was new in Keynes was not true.   Much the same can be said of Modern Monetary Theory (MMT.)

It is almost certain that a monetary system can be developed where the government creates money to fund its spending and uses its tax system to generally absorb sufficient money so that the price level and inflation vary only a limited amount.   All that is necessary is that what is conventionally described as the budget deficit--government spending less tax revenues--be planned such that only a modest growth rate in the quantity of money occurs. Of course, tax revenues actually depend on economic activity and so the actual growth rate of the quantity of money would vary, but the result would be only modest variations in the growth path of the price level and so the inflation rate. Targeting the growth rate of the quantity of money, much less the growth path of the price level or inflation, by adjusting the tax system on the fly would be nearly impossible and adjusting government spending would also be difficult and likely politically impossible. 

However, the sale of interest bearing bonds to absorb money would allow for what amounts to a very conventional monetary policy.   Excessive monetary growth could be offset by what amounts to open market sales--the sale of what would be newly-issued government bonds under this monetary framework.   If it were necessary to contract the quantity of money to target the price level or inflation (or nominal GDP,) then this would simply require a sale of bonds of greater value than the current budget deficit.   Some advocates of MMT apparently seek to avoid bond finance.   This appears to be a matter of anti-capitalist ideology.   Interest bearing bonds allow investors to earn interest income and investment income entails exploitation of the working class.

None of this is new and simply reflects the "standard" view of the government budget constraint.   Government spending must be funded by either taxes, borrowing, or money creation.    Now, to the degree any advocate of MMT emphasized that government first spends newly created money and then absorbs it by taxes or bond sales, then it a bit silly.  In reality, the flow of government spending over time is matched by the flow of tax revenues, bond sales, and money creation.   Before or after is not really economically significant. 

The "Virginia School" approach to monetary theory almost entirely focuses on the need for a "monetary constitution" governing the creation of money.   However, there have always been hints of "old Chicago" due to James M. Buchanan's influence.    Fundamentally, government spending should be funded by taxes, so that voter/taxpayers can make a sensible decision regarding the allocation of resources between the production of private and public goods.   However, the Buchanan approach to monetary institutions implies that there is usually some budget deficit funded by money creation.   Some part of government spending is funded exactly as proposed by MMT.   While this might make up a substantial portion of  spending for a very frugal government, the usual assumption is that the appropriate rate of government funding by money creation is a small portion of government spending.

For many years, following the lead of "new Chicago," or monetarism, Virginia School thinking assumed a very predictable nominal budget deficit reflecting a fixed growth rate for the quantity of money.   However, the "old Chicago" approach assumed at least the possibility of a variable growth rate of the quantity of money.   These changes would be necessary to offset changes in velocity, (or accommodate changes in the demand to hold money) and so maintain a stable price level.   Interestingly, the Virginia School has little more interest in "bond finance" of budget deficits than MMT.   However, the problem isn't any purported exploitation of workers due to interest income but rather concern that the current generation of voter/taxpayers would be using debt finance to fund current benefits at the expense of future generations of voter/taxpayers.

Of course, the Virginia School advocates changes in public finance and monetary institutions.   MMT claims that not only should the government fund all of its expenditures by money creation, but it also insists that is what really happens. MMT claims that under the monetary and fiscal institutions of the United States today, government spending is funded by newly created money and when taxes are paid, money is destroyed. Their distaste for government bonds may sometimes leave it unsaid, but they also claim that the sale of bonds destroys money too.

There is more than an element of truth to their claim, but in the final analysis, government spending in the U.S. is funded by taxes and borrowing.   So what is the element of truth?    The U.S. Treasury has a deposit account at the Federal Reserve (Fed.)   When the Federal government makes payments, the funds are drawn from its account at the Fed.   Those receiving the payments generally deposit them at a bank (depository institution.)   Funds are transferred from the Treasury's deposit account at the Fed to the bank's depository account at the Fed.    It is apparent that this transaction simply transfers money from the Treasury's account to the bank's account.   However, the Fed does not count the Treasury's deposit account as part of reserves and it does count the deposit accounts the banks keep at the Fed, so whenever the Treasury spends money, "reserves" increase.

The opposite occurs when the Treasury receives receipts of either tax payments or bond sales.   The Treasury deposits the checks or electronic payments it receives in its deposit account at the Fed.   The Fed shifts funds from the deposit accounts of the banks used by the taxpayers or bond investors to the deposit account of the Treasury.   Because the deposit account of the Treasury is not counted,  "reserves" as reported by the Fed decrease.

Reserves makes up a portion of the monetary base, which also includes currency held by the nonbanking public.  The logic above suggests that when the government spends money, the monetary base increases and when taxes are paid or government bonds are sold, the monetary base decreases.   This argument supposedly shows that MMT isn't proposing anything new but rather is simply a recognition of what the U.S. government already does--fund its spending with newly created money.

If the Federal Reserve were to target reserves or the monetary base, then it would have to make offsetting transactions.   Each time the government spent money, the Federal Reserve would need to make an open market sale.   Each time the government received a tax payment or receipts from the sale of bonds, it would need to make an open market purchase.

However, this is really not the most useful way to think about it.   The government receives tax payments frequently and it receives proceeds from the sale of bonds more frequently still.   It also makes payments frequently.   These represent the flow of funds through the Treasury's account at the Fed.   When the Treasury's balance at the Fed changes due to a mismatch between its receipts and expenditures, the Fed's measured reserves change in the opposite direction.    The limit to the increase in the quantity of reserves reported by the Fed due to an increase in government spending not matched by tax revenue or bond sales is the Treasury's existing balance at the Fed.   In other words, unlike other entities, if the Treasury spends the money it holds, this shows up as an increase in the quantity of money reported by the Fed rather than a transfer of money balances.   Economically, the effect would be the same, the result being measured as an increase in the quantity of money rather than a reduction in the demand to hold money by the U.S. Treasury.

As explained above, if the Fed targeted the quantity of reserves or base money, and it continued to measure it without including the Treasury's balance at the Fed, then changes in that balance would result in changes in the quantity of base money.   The Fed would need to offset those changes by open market operations.   If the Treasury reduced its balance at the Fed, the Fed would need to sell securities on the open market.   If the Treasury increased its balance at the Fed, the Fed would need to purchase securities on the open market to leave the quantity of money unchanged. 

While the Fed could invest in private securities, if it follows its traditional policy (pre-2008, anyway,) then the Fed would be trading government bonds in place of the Treasury.   If the Treasury reduced its balance at the Fed and the quantity of money increased and the Fed sells government bonds to reverse that increase, then it is the Fed selling government bonds on the market rather than the Treasury.   Because the Fed is an independent agency of the Federal government, if the balance sheet of the Fed and the Treasury are consolidated, then government spending is being funded by bonds.

It seems to me that it is unnecessary for the Fed to control the quantity of reserves and base money so tightly.   If slight transitory fluctuations in the Treasury's balance at the Fed result in slight transitory variation in the quantity of reserves and base money, it would likely have little or no effect on spending on output, the price level, or inflation.   Interestingly, if the Fed targets the federal funds rate, as it has for many years, then if the changes in reserves due to changes in the Treasury's balance have some impact on interbank lending, then keeping the Federal Funds rate on target would require that the Fed make the offsetting open market operations described above.

When thinking about the flow of government spending, tax receipts, and the sale of government bonds, the impact of fluctuations in the quantity of reserves or base money due to variation in the Treasury's balance at the Fed are trivial.    More importantly, the laws of the United States set up a tax system that generates revenue and the government creates a budget based upon spending that tax money.   Any budget deficit must be funded by bond sales by the Treasury.   There is a limit on the total amount of bonds that the Treasury may sell, a limit that is periodically increased by Congress.    While Congress could change the laws, the fiscal institution existing today is that the Treasury must obtain funds from taxes or sale of bonds before it spends it.   However, it would hardly matter if it were not necessary to first accumulate money in the Treasury account as long as bond sales matched the budget deficit over the budget period.

Does the U.S. government fund any of its expenditure by money creation?    The conventional wisdom among economists is that it does.   The government generally does run a budget deficit, which it funds by selling bonds.   However, some of those bonds are purchased by the government's own central bank, with newly created money.   While it is illegal for the Fed to purchase government bonds directly from the U.S. Treasury, it hardly matters that the bonds must pass through some middleman.   The Treasury sells bonds on the market and the Fed purchases some of them on the market.   Since the Fed is an independent agency of the U.S. government, looking at their consolidated balance sheet shows that when the Fed owns U.S. government bonds, it is the government owing money to itself.   From this perspective, the U.S. government funds itself largely through tax receipts, but also through the sale of bonds to private investors (and other governments) and finally through money creation with a sort of legal fiction that that it is borrowing money from its own central bank.

While there is an important element of truth to this perspective and it reflects the Virginia School approach to the role of money in public finance, it is probably not wise to dismiss all the "legal fictions."   If the Fed was bound to a money supply rule, especially a rule that implied a constant growth rate of the quantity of money and if the government runs a substantial budget deficit all the time, then this approach may be the best way to make sense of the situation.   However, the Fed has never operated according to such a rule. In recent years, it has targeted the inflation rate and its legal mandate is to seek price stability along with maximum sustainable employment.  This mandate has generally resulted in a growing quantity of base money, but a policy of offsetting changes in velocity (or in other words, accommodating changes in the demand to hold money,) to stabilize prices implies that sometimes the quantity of money must decrease.   As a practical matter, while the Fed may typically accumulate more and more government bonds, it may sometime accumulate an unusually large amount to offset a transitory decrease in velocity.   But it would then need to be able to sell those bonds to decrease the quantity of money when velocity rises again to a more normal level.   

Of course, the Great Inflation occurred during a period in which the Fed had the same legal mandate as today.   And 2% inflation is hardly a literal interpretation of stable prices.  Further, there has been serious discussion of raising the target inflation rate without any consideration of changing the Fed's legal mandate.  However, consider a central bank that takes its legal mandate seriously--something more than a suggestion.   Then in a very real sense what is supposedly "fiat money" amounts to type of borrowing. 

This would especially apply to the Virginia School approach of a monetary constitution mandating a stable price level.  Under such a rule, a temporary decrease in velocity would require an increase in the quantity of money.   However, there would be a legal requirement that such money be later withdrawn from circulation when velocity recovers.  The best way to frame this situation is that the extra issue of money represents increased borrowing and when it is later withdrawn, it would be paid back.   If there were an existing national debt made up of outstanding government bonds, then a decrease in velocity would require open market purchases, replacing some of those bonds with money.   The best way to understand that is that interest-bearing debt that is not suitable for use as money is replaced by debt that can be used as money.   When velocity rises again, then the quantity of money must be reduced by open market sales.   But what that means is that interest bearing debt that is not suitable as money replaces debt that is suitable for use as money. 

Debt that can be used as money can be issued in some amount at a zero interest rate.   Interest is hardly ever paid on hand-to-hand currency.  Since "fiat money" is frequently identified with such paper notes, lack of a nominal interest return is sometimes taken to be a defining characteristic of money.   Of course, most money takes deposit form which can pay interest.   That includes the reserve deposits banks hold at the Fed.  They can, and since 2008 have, paid interest.

If the price index to be stabilized was simply the price of gold, then it would be obvious that this would be a gold standard.   The monetary constitution would require changes in the quantity of "fiat money" so that the price of gold is stable.   The issuer must stand ready to withdraw it from circulation if the demand to hold it falls so that its value relative to gold would remain fixed.   If the rule was enforced by requiring that paper money be redeemed with gold, then paper money would plainly be a type of debt instrument.

From this perspective, even with only a weak commitment to an inflation target, the money issued by the Fed can be seen as a type of debt.  Abandoning its inflation target would be a kind of default.   Currency bears no interest but reserves do.   The Fed has a balance sheet that includes both government debt and private debt, particularly mortgage backed securities.  The Fed earns more than than it pays and generates revenue.   It uses some of the revenue to cover its expenses, but transfers most of it to the U.S. Treasury.  From this perspective the U.S. government is not funding part of its deficit by monetary creation.   It is rather that one source of government revenue is profit from its central bank.

Suppose the U.S. balanced its budget and so spent no more than it collects in tax revenue.   The Fed would still earn profits and transfer them to the U.S. Treasury.   If the demand for base money increased, then the Fed could issue more.  It must do so to keep inflation on target.   The Fed would typically earn more profit on its larger balance sheet.   If the demand for base money were to fall, for example, due to financial innovation, the Fed must stand read to shrink its balance sheet.   It would pay part of the money it issued back by selling off some of its assets.  As a result, it would typically make less money for the Treasury.

So, there is an element of truth in the claims of MMT.   It is certainly possible to have a monetary institution where the government creates money when it spends it and destroys money when it collects taxes or sells bonds.   A relatively conventional monetary policy would be possible by selling bonds as needed to keep the quantity of money and the price level and inflation under control.   However, it is not the way the U.S. fiscal and monetary institutions operate now.   If the Fed is truly committed to keeping inflation on target, then it is probably best to see government spending as being funded by taxes or else borrowing.   In other words, the "legal fictions" requiring bond finance of budget deficits reflect a more fundamental reality. 


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