That doesn’t mean what you think it means

Over the past month, I’ve been trying to pin down exactly what’s wrong with Modern Monetary Theory. Or perhaps a less presumptuous way of putting it is that I’ve been trying to figure out what mainstream economists believe is wrong with MMT.

Here I’ll list 6 MMT ideas. I’ll first explain the kernel of truth in each claim.  Then I’ll explain the mistaken way that MMTers interpret these claims.  Finally, I’ll explain how and why these claims don’t mean what MMTers think they mean. I’ve taken this approach because I believe that MMT is based on a series of basic misunderstandings:

1.  Banks don’t loan out reserves.

2. There is no money multiplier.

3. Money is endogenous.

4. Interest rates are an exogenous monetary policy instrument.

5. Investment is not very responsive to interest rates.

6. In a closed economy, net saving equals the budget deficit.

1. Banks don’t loan out reserves.

It’s true that most bank loans are executed by crediting the borrower with a new bank account, and thus the reserves usually don’t immediately leave the banking system.  BTW, for any given monetary base, the only way that reserves can leave the banking system is as currency notes.

From this mostly valid claim, MMTers wrongly conclude that an injection of new reserves into the banking system does not boost bank lending.

As I explain in this post, the injection of new base money by the Fed (initially as bank reserves) sets in motion a series of price and quantity changes that has the effect of boosting bank lending.

2.  There is no money multiplier.

It’s true that the money multiplier is not a constant, a point well understood by mainstream economists.

From this valid claim, MMTers wrongly conclude that a permanent and exogenous injection of new base money by the Fed does not have an expansionary effect on the monetary aggregates.

As I explained in this recent post, the injection of new base money has a multiplier effect on all nominal variables in the economy.

3.  Money is endogenous.

When there is no interest paid on bank reserves, it’s true that pegging rates makes the money supply is endogenous, which means it cannot be changed at the discretion of a central bank.

From this valid claim, MMTers wrongly conclude that under an interest rate targeting regime the central bank cannot adjust the money supply to control inflation.

In fact, even under interest rate targeting, central banks can and do adjust the money supply to target inflation, as during the period from 1983 to 2007.  To adjust the money supply appropriately they must frequently adjust the interest rate target, but they are quite willing to do so as required to stabilize inflation.  They didn’t target the money supply during 1983-2007, but they used OMOs to adjust the monetary base as required to control inflation.

4. Interest rates are an exogenous monetary policy instrument.

On a day-to-day basis, it’s true that central banks can and do target short-term interest rates.

From this valid claim, MMTers wrongly conclude that changes in short-term interest rates reflect changes in monetary policy.

In fact, over any meaningful period of time, short-term interest rates are mostly endogenous, determined by factors such as the income and Fisher effects.  The Fed merely follows along to prevent an economic disaster.  As an analogy, at any given moment in time the path of a bus going over a mountain range is determined by the driver’s handling of the steering wheel, but over any meaningful span of time the path of the bus is determined by the layout of the road, combined with the bus driver’s desire not to go over the edge of a cliff.  In this analogy, the twisting road is like the fluctuating natural rate of interest.  As I pointed out in this recent post, MMTers don’t understand that if the central bank targets inflation then interest rates become endogenous, and positive IS shocks cause higher interest rates.

5. Investment is not very responsive to interest rates.

It is true that a decline in interest rates does not usually do much to boost investment, and vice versa.

From this valid claim, MMTers wrongly conclude that a decline in interest rates induced by an expansionary monetary policy does little to boost investment.  I.e. they conclude that monetary policy has little impact on aggregate demand.

This is reasoning from a price change.  Most declines in interest rates are due to the income and/or Fisher effects, not easy money.  Those sorts of declines are not expansionary.  A fall in output or inflation reduces the natural rate of interest, in which case the central bank must cut the target interest rate even faster to stimulate investment.  Because MMTers mostly ignore the income and Fisher effects, and view the natural interest rate as being zero, they miss the fact that most changes in interest rates do not reflect shifts in monetary policy.

6. In a closed economy, net saving equals the budget deficit.

The MMTers define private net saving as the budget deficit plus the current account surplus.  Thus it’s true (by definition) that net saving equals the budget deficit in a closed economy.

From this valid claim, MMTers wrong conclude that if the public wishes to engage in more net saving, the government needs to run a larger budget deficit.

Actually, the central bank should respond to this scenario with a more expansionary monetary policy, which will push the public’s desire to net save back into equilibrium with the budget deficit at full employment.  Conversely, when there is an exogenous change in the budget deficit, the Fed needs to adjust policy so that net savings moves appropriately, without impacting the Fed’s targets.  The Fed did this fairly well in response to the sharp reduction in the budget deficit during 2013, and again in response to the sharp increase in the deficit during 2016-18.

These MMT errors are all interrelated.  Because MMTers misinterpret the supposed “endogeneity” of money and the supposed “exogeniety” of interest rates, they get monetary policy wrong, greatly underestimating its potency (at least when interest rates are positive).  This leads them to miss the importance of monetary offset, and that leads them to greatly overrate the importance of fiscal policy.

At a deeper level, MMTers seem to draw invalid causal implications from a series of accounting relationships.  Those accounting identities don’t mean what MMTers think they mean.

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