Big Guns Shooting Holes in the Sky

The New Keynesian monetary mainstream has brought out the big guns. Paul Krugman, Kenneth Rogoff, and Larry Summers have come out to shoot down the rising star known as “MMT,” which stands for Modern Monetary Theory. For a while, it was academically convenient to withhold paying any public attention that could foster competition in the field. Like other non-mainstream ideas in economics, MMT was simply ignored by our star mainstream economists, who are always ready and keen to lend their wisdom and advice for public action. Now that MMT has reached the public debate through arousing interest among powerful public voices, fostering political debate about available policy options, protecting the mainstream monopoly of opinion has prompted them to take aim at MMT.

The key issues in the battle of ideas between Paul Krugman (New Keynesian monetary mainstream of the IS/LM variety) and Stephanie Kelton (MMT) are out there for everyone to see (see Krugman, Feb. 12th; Kelton, Feb. 21st; Krugman, Feb. 25th; and Kelton, Mar. 4th). It is noteworthy that the two do not seem to be all too far apart regarding their preferred policy agenda. At its core, the controversy really concerns monetary theory – including the question of what kind of money and monetary economy any relevant monetary theory should theorize about. Regarding this particular battle, I will only add that Keynes, in his response to John Hicks’ (1937) IS/LM model interpretation of The General Theory, addressed the very point that Krugman and Kelton strongly disagree on.

In terms of the IS/LM model that Paul Krugman is so very fond of, increased government spending means increased government borrowing pushing against an upward-sloping LM curve that generates a rising interest rate, and hence “crowding out” of private borrowing and spending.

Remember here that the LM curve’s upward slope stems from the assumption of a given money supply apparently controlled by the central bank (Keynes preferred the notion “pool of liquidity” as provided by the banking system). When Hicks highlighted this outcome in his seminal 1937 article, Keynes responded:

From my point of view it is important to insist that my remark is to the effect that an increase in the inducement to invest need not raise the rate of interest. I should agree that, unless the monetary policy is appropriate, it is quite likely to. In this respect I consider that the difference between myself and the classicals lies in the fact that they regard the rate of interest as a non-monetary phenomenon, so that an increase in the inducement to invest would raise the rate of interest irrespective of monetary policy, — though they might concede that monetary policy was capable of producing a temporary evaporating effect. (Keynes 1937, Collected Writings, vol. 14, p. 80)

In contrast to the [neo-]“classicals,” Keynes regarded “the” rate of interest (i.e., the whole complex of interest rates featuring risk, term, and liquidity premiums) as a purely monetary phenomenon. According to his liquidity (preference) theory of the rate of interest, interest rates reflect a portfolio equilibrium, a (momentary) balance between those that need to be convinced (rewarded) to give up any liquidity they may have together with the willingness of the banking system to meet any pressures for more liquidity as generated in growing economies (thereby enlarging the pool of liquidity available to appease the nonbanks’ preference for liquidity at any time).

The point emphasized by MMT is that modern money, unlike commodity monies such as gold that the mainstream traditionally has in mind, is ultimately a creature of the state, a token that owes its value to the fact that the state requires its subjects to pay taxes in terms of the very token that is a creature of the state. It is a matter of pure logic to accept that for these subjects to be able to pay their taxes in terms of said monetary tokens, the state has to first issue its money.

While featuring the state, this point also highlights the logic of capitalism: the “money-first principle.” For without money (liquidity, really), not much will happen in a capitalist economy. In a monetary production economy, for anyone to order the production of anything, you need to get your hands on money first (which may of course feature many forms of credit, including shadowy ones). It takes money – obtained from the financial system where it is made – to spend, produce, or acquire assets. This point was at the heart of the “finance motive” debate following the publication of The General Theory, a debate that allowed Keynes to drive home the vital insight that “loanable funds theory” was fatally flawed. In preindustrial agrarian economies, the saved corn provides the seed (the investment) that yields next season’s harvest. By contrast, in capitalism, economic activity in monetary production economies is not drawing on some preexisting pool of saving or loanable funds, but on the pool of liquidity as provided by the financial system.

Stephanie Kelton emphasizes that a state in control of its own sovereign monetary tokens can be thought of as spending these tokens into existence. Increased government spending then pushes liquidity into the system – while bond issuance is the means and monetary policy tool used to mop up liquidity from the system. In other words, bonds are issued to control interest rates – but not to collect any saving or loanable funds from some imaginary loanable funds market used to “finance” government spending, as Mr. Krugman would have it. And it makes no material difference here if, as a practical matter, the tokens are not generally spent into existence but are born when the central bank buys (“monetizes”) any assets. The government may issue bonds to fill up its account balances at the central bank or banks before it spends from it, while the central bank manages the liquidity it provides the system so as to maintain its desired target rate of interest. The point is, as Keynes emphasized in his response to Hicks, that at issue is deciding the “appropriate” monetary policy – rather than any invisible hand market mechanism ruling in some imaginary loanable funds market.

One can be brief on Kenneth Rogoff. It appears Mr. Rogoff felt a strong enough urge to declare that MMT was nonsense – but didn’t really have anything of substance to say on MMT, or didn’t care to even try to do so. His foremost concern in his op-ed “Modern Monetary Nonsense” appears to be that MMT would result in excessive public debt, mount an attack on central bank independence, and ultimately end in hyperinflation. It is not the first time that Kenneth Rogoff has issued such scares.

For anyone willing to take their cue from Kenneth Rogoff, just remember here that this particular mainstream greatness was a key leader in the debate raging in the aftermath of the last big crisis about whether western governments were facing bankruptcy and should therefore better embrace austerity before it was too late. At the time, Kenneth Rogoff came up with the magical number of 90 percent for the public debt ratio as the critical threshold that would see growth crumble and debt disasters unfold. Too bad not everyone realized quickly enough that his magical number was based on flawed arithmetic. Take a look at what happened over in Europe when, under German leadership, countries collectively embarked on a mindless austerity crusade. Their efforts were so successful that the European Central Bank (ECB) is today still keeping interest rates in negative territory while the economy continues struggling to recover from the public finance insanities inflicted on it.

Kenneth Rogoff had further great ideas. I still remember when I first came across Mr. Rogoff’s famous call for “conservative” central bankers as a graduate student at Cambridge U.K. in the early 1990s. This was in the context of the debate about central bank independence, made fashionable by ideas like Mr. Rogoff’s. It was conventional wisdom among mainstream experts that the Bundesbank was the model of a conservative central bank. As it happened, the Bundesbank came to bequeath its sound money conservative wisdom to the ECB when the euro was launched in 1999, and it still plays the role of the guardian of monetary conservatism in European monetary affairs until today. Incidentally, it took until 2015 for the ECB to finally embark on QE. Not everyone is still convinced today that central bank conservatism might offer any free lunch.

Academics sometimes seem to have great trouble observing what central banks are actually doing. In fact, there appear to be long and variable lags in mainstream monetary economics between fashionable academic modeling exercises and actual central banking practices on this planet. If you need any further evidence, check out modern macro text books (including Paul Krugman’s). They are still full of banks that collect loanable funds in the form of deposits to be lent on as loans while multiplying some money base helicoptered upon them by the central bank. If some mainstream theorists seem upset about the appearance of the word “modern” in MMT, could it be that they are subconsciously aware that much of mainstream monetary economics is awkwardly pre-historic? Even the Bundesbank, of all central banks, has by now openly declared that mainstream textbook fictions about banking and money creation were nothing but stale monetary nonsense.

But at least in one respect the mainstream has caught up with central banking reality: variables representing some money supply have disappeared from the monetary policy literature and given way to interest rate rules like the famous “Taylor rule,” describing how a central bank should set its policy interest rate to keep the economy in non-inflationary, full resource utilization equilibrium. While Taylor rules are generally understood as guideposts for sound monetary policies, central bankers are still understood as chasing some invisible Wicksellian “natural rate” that the imaginary loanable funds market is supposedly grinding out as the system’s intertemporal anchor.

In contrast to Messrs. Krugman and Summers, who are on the liberal side of the New Keynesian mainstream spectrum, Messrs. Rogoff and Taylor represent the conservative side of the mainstream money crowd. Rogoff’s preferences for “conservative” central bankers and central bank “independence” have survived until today and are shared by many liberals. John Taylor has prominently attacked the Greenspan Fed for keeping its interest rate too low (i.e., below “the” Taylor rate) for too long before the crisis. And he also attacked the Bernanke Fed when it embarked on QE, declaring (together with a group of conservative compatriots) that this would debase the (gold?) dollar and put the U.S. on the Weimar path. With some amusement we could all witness last year that not even monetary nonsense of this magnificent caliber would prevent John Taylor from getting an interview with the president for a job that he is quite obviously not qualified for (and I will refrain here from turning this observation into a pun about the president).

Let’s turn then to Larry Summers. Larry Summers is not only a well-known mainstream Keynesian monetary economist. He also played prominent official roles: at the World Bank, at the U.S. Treasury under President Clinton (highly instrumental in liberalizing finance both nationally and internationally), and the National Economic Council for President Obama. At one point he was also a candidate as Federal Reserve chair. It is said of him that he is usually the smartest person sitting at the table. Reading his Washington Post op-ed made me wonder what kind of people Mr. Summers tends to share a table with. In his contribution to the debate, he took an embarrassingly shallow shot at MMT, referring to it as a set of “new ideas [that] are being oversimplified and exaggerated by fringe economists who hold them out as offering the proverbial free lunch.”

Most of what he says is completely beside the point, because MMT does not deny that there are real resource constraints that any government, even a left-wing one advised by fringe economists, has to acknowledge. In fact, the whole point about MMT is to get government to focus on the real policy options available and not get distracted by allegedly missing money or missing loanable funds or any such mainstream money lunacies.

What is most remarkable is that Larry Summers almost seems to refuse to talk about the U.S. and the relevance of MMT in the land of the dollar. Instead, he refers to emerging markets that have allegedly undertaken MMT experiments. And he also refers to European countries that have allegedly done so too: “The Mitterrand government in France in 1981 and the Schröder government in Germany in 1998 began with MMT-type approaches to policy and were forced to reverse course.”

It is true, the French government did make a critical macro policy U-turn in the early 1980s. In the early 1980s, West Germany chose to pair tight money with fiscal austerity, burying any remnants of Keynesianism that may have existed in the country before. Mitterrand’s France made the consequential decision to accept Bundesbank diktat. In intricate ways, this French decision prepared the ground for the euro’s launch in 1999. The immediate consequence of France’s U-turn of the early 1980s was what Americans pitifully refer to as “eurosclerosis”: unemployment got stuck at high levels. Hence, public debt levels increased too, driven by unemployment and crazy-high interest rates.

The U.S. approach was quite different. The U.S. combined tight money (“Volcker shock”) with Reagan’s fiscal expansion caused by drastic cuts in marginal tax rates coupled with huge increases in military spending. This policy-mix certainly failed to deliver on wild promises of the Laffer-curve “voodoo economics” kind, but at least it avoided stagnation and “yankeesclerosis.” Mr. Summers declared he doesn’t think much of voodoo economics; and neither do I. But he does not explain what he liked so much about the French macro policies at the time (and after), saving France, apparently, from MMT.

Larry Summers’ remarks about Germany’s macro policy shift in 1998 are even more puzzling. I still lived in Germany at the time and I was unaware of any MMT experimentation or even discussion thereof. What I saw was permanent austerity combined with, starting around 1996, wage repression. We all know where Germany’s “sound money” choices have gotten Europe in the meantime. In the beginning, Germany only turned itself into the “sick man of the euro.” Later on, the relentless German drive for über-competitiveness wrecked the Eurozone. Germany continues to run huge current account surpluses as well as budget surpluses until this day. And Mr. Trump is congratulating Mrs. Merkel on her unparalleled macro policy successes almost daily. It appears Larry Summers also likes the policies that Germany adopted after, apparently, reversing course away from MMT in 1998.

Essentially, Mr. Summers is setting up an MMT strawman in his Washington Post op-ed: anything he ever saw (or thought he saw) and didn’t like, gets defined as MMT. The shots he takes, supposedly at MMT, are nothing but hot air. He repeatedly warns of “voodoo economics” and “monetary nonsense” in referring to MMT. It turns out Mr. Summers is a closet admirer of “sound money” à la Buba. Beware what you wish for.

Let me show my hand then. I am not an MMT follower, but an MMT sympathizer. I am foremost a Keynes scholar; you may consider me a traditional Cambridge Keynesian if you like. I sympathize with MMT for two reasons. First, MMT offers a logically coherent theory of money and a framework based on observations about money and monetary economies on this planet. (If you consider the mainstream neoclassical theoretical framework consistent, you are either ignoring the “loanable funds fallacy”—see here and here—or you should at least admit that your preferred theory is not about money and monetary economies on this planet.) Second, I appreciate MMT’s refreshing impact on policy debates. MMT seems to help liberate us from the box (or: monkey house) in which neoliberalism, with the help of our great mainstream monetary thinkers, has trapped us.

There is a peculiar contrast in U.S. politics. Republicans talk a lot about public debt but when in power make it clear that they could not care less. For three times in a row, Republican (Reagan-Bush 1, Bush 2, and now Trump) policy choices have blown gigantic holes through public finances. Somehow the U.S. did not experience hyperinflation and the U.S. dollar is still king. Democrats, on the other hand—similar to Germanized Europe in this respect—have been trained (by whom?) to focus on balancing the budget above all else and forgetting about their real policy priorities. Because somehow the money isn’t there or the needed loanable funds are in short supply on just those occasions. That’s terrific nonsense of course, and MMT provides a welcome wakeup call – even if our mainstream New Keynesian friends don’t seem to like that so much.

It feels weird to explain to neoclassicals—who really only ever do “real analysis” and at best treat money as a mostly “neutral” add-on—that it is the real resource constraints that matter in making our political choices. Of course, there is no free lunch in an economy that cannot mobilize any more real resources. But don’t try to fool anyone by declaring that a lack of money or loanable funds would prevent the U.S. from going for a “Green New Deal.”

I commend Paul McCulley’s call for open-mindedness in this controversy. In contrast to Blackrock’s “garbage” talking Larry Fink, former Pimco Fed watcher Paul McCulley understands money and central banking. And I also recommend reading Conor Sen’s reminder of how well the promises of mainstream monetary economics – instrumentalized to peddle neoliberalism – have worked out for the few while the many got fleeced. If you want to get the usual monetary nonsense, you know where to go. If you think it may be time to think afresh, check out MMT with an open mind.

In a sober moment, with an open mind and mindful of the standards of intellectual honesty and academic integrity (perhaps after chatting with Brad DeLong), I even venture the thought that Larry Summers might come to look back at his Washington Post op-ed of March 5, 2019 with embarrassment.