My new article on MMT

I have a new Econlib article, which will appear in two parts. It summarizes the results of my research on MMT.

Note that this sentence in Part 1 has a typo:

“In Singapore, both the interest rate and the exchange rate are endogenous.”

It should have been interest rates and the money supply are endogenous. It might be corrected by the time you read the article.

Thanks to commenter Garrett for pointing that out.


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Understanding MMT

I’ve mostly completed my study of MMT, although I have a few more papers to read. But I feel like I know enough to draw a few conclusions about how MMT relates to the broader field of economics.

When reading the Macroeconomics textbook by Mitchell, Wray and Watts, I was frequently struck by how MMT is almost the exact opposite of Chicago school economics, particularly the monetarist version I studied in the 1970s. On a wide range of issues, MMT is on one end of the spectrum, the Chicago school is on the other end, and the mainstream is somewhere in between.

Here on some examples:

1. Chicago economists believe that the supply and demand model is extremely useful for a wide range of markets, even markets that don’t meet the classical definition of “perfect competition”. Mainstream economists believe the S&D model is quite useful, but worry more about imperfect competition. MMTers are highly skeptical of S&D models, viewing the model as only useful in a very limited number of cases.

2. Chicago school economists believe that free market policies are almost always the best. Mainstream economists believe that free market policies are often optimal. MMTers are highly skeptical of what they call “neoliberalism”, viewing it as almost a religion.

3. Chicago school economists don’t believe there is much value in talking to bankers when trying to understand how monetary policy works. MMTers believe that knowledge of the nuts and bolts of the banking industry is highly important when trying to understand monetary policy.

4.  Chicago school economists believe that the concept of opportunity cost is extremely important, and applies to almost all policy debates.  That’s a bit less true of Keynesians, whereas MMTers assume that in many if not most cases the economy is well below full employment, and there is no opportunity cost to additional government expenditure.

5.  Modern Chicago economists are extremely skeptical of the “Phillips curve” approach to macroeconomics.  Earlier monetarists such as Milton Friedman thought there was a short run tradeoff between inflation and unemployment, but no long run trade-off.  Mainstream economists sort of agree with Friedman, but also argue that there might be some long run trade-off due to hysteresis.  MMTers seem to be most enthusiastic about the claim that boosting aggregate demand can boost employment over the long run, highly skeptical of natural rate models that say that AD doesn’t matter in the long run because money is neutral once inflation expectations adjust.

6.  Chicago school economists tend to favor relying on monetary policy to determine AD, and are highly skeptical of the efficacy of fiscal policy.  Mainstream economist favor of mix of the two, whereas MMTers prefer fiscal policy and are skeptical of the efficacy of monetary policy.

7.  Chicago school economists argue that it is most useful to treat money as exogenous, i.e. under control of the central bank, at least under a fiat money regime.  Mainstream economists treat money as endogenous in short run models with interest rate targeting, and exogenous in long run models trying to explain large changes in the trend rate of inflation.  MMTers treat money as being almost completely endogenous.

8. Chicago school economists believe that changes in interest rates primarily reflect the income and Fisher effects.  Thus falling interest rates are usually an indication that money has been tight in the recent past.  Mainstream economists view interest rates as being heavily influenced by monetary policy (the liquidity effect), but also reflecting the income and Fisher effects, especially in the long run.  MMTers see interest rates as almost entirely reflecting monetary policy, at least under fiat money.  They mostly ignore the income and Fisher effects, and reject models of the “natural rate of interest.”

9.  Chicago school economists see investment being determined by saving rates.  Mainstream economists see investment as being determined by saving rates during normal times, but also worry about a “paradox of thrift” when interest rates are extremely low.  MMTers see the paradox of thrift as being the norm.

10.  Chicago school economists believe high inflation is caused by excessive money growth.  Mainstream economists see high inflation as being caused by a mix of monetary policy and supply shocks.  MMTers see high inflation as mostly reflecting aggregate supply problems.

Because I’m a Chicago school economist, the MMT model doesn’t have much appeal for me.  That’s especially true because their arguments are often confusing and unpersuasive, even to mainstream economists.  In my view, MMT may have some success promoting ideas such as aggressive fiscal stimulus, due to the worldwide trend toward low interest rates.  I doubt, however, that they’ll make much headway in convincing the profession that their theoretical model makes sense, unless they can find a more persuasive way of explaining their ideas.

BTW, I’d say the same about market monetarism.  I expect we’ll have some success convincing the profession that NGDP targeting make sense, but very little success in convincing economists that the monetarist approach to monetary theory has value.  But I’ll keep trying.

PS.  It’s not clear to me that all of the ideas in the textbook I read are MMT beliefs.  Thus there may be some MMTers who are more favorably inclined to free market policies.


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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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Krugman on the effect of increased money growth

Tim Peach directed me to a graph in Paul Krugman’s International Economics textbook (coauthored with Maurice Obstfeld and Marc J. Melitz.) It’s a very elegant display of the long run effect of an acceleration in the money supply growth rate (and roughly describes the US economy from 1963-73):

Here’s how to read these graphs.  Graph A shows the money growth rate increasing, say from 5%/year to 8%/year (a steeper slope to the line).  Graph C shows that the growth rate of the price level also increases due to the quantity theory of money.  Prices take a sudden jump at time=0, which we’ll consider later.

In Graph B you see the nominal interest rate jump up at time=0 due to the Fisher effect—higher inflation leads to higher nominal interest rates.  Because the nominal interest rate is the opportunity cost of holding money, this causes money demand to fall at time=0, or if you prefer it causes velocity to rise.  Going back to graph C, this drop in money demand explains the sudden jump in the price level at time=0.  The bottom line is that when money growth accelerates, prices rise even faster than the money supply, as there’s less demand to hold zero interest money.  Both the growing money supply and falling money demand push prices higher.

And in Graph D we see the exchange rate follow the price level, due to purchasing power parity.  BTW, an increase in the price of euros means the dollar is actually depreciating.

This is roughly what happened during 1963-73, and the analysis is right out of Milton Friedman’s monetarism.  Money growth accelerated, inflation accelerated, nominal interest rates rose, and the dollar depreciated.  The process was less smooth than you see here, because in the real world prices are sticky and hence the price level does not jump discontinuously when money growth accelerates.

This exercise helps us to understand the difference between New Keynesians like Krugman and MMTers.  Both groups tend to agree on policy at zero interest rates, favoring fiscal stimulus and not worrying about crowding out.  Both are skeptical of the efficacy of monetary policy at zero rates (although MMTers are even a bit more skeptical than New Keynesians.)

It is when nominal interest rates are positive that the two schools of thought sharply diverge.  When I try to explain the views of MMTers I get shot down.  But that’s never stopped me before, and so I’ll try again here.  I believe that MMTers would start by claiming that the Fed can’t increase the money supply growth rate, as money is “endogenous”.  If you insisted that they consider what would happen if the Fed persevered in trying to force more reserves into the economy, they’d argue that this would drive rates to zero.  Krugman is arguing that faster money growth raises interest rates in the long run.  This difference helps to explain why Krugman differs from MMTers on the existence of a “money multiplier”.

MMTers would claim that driving interest rates to zero would cause banks to hoard most of the new money, and thus it would not have a multiplier effect.  They’d also suggest that it would have relatively little impact on the price level, as aggregate demand is determined by spending, not the stock of bank reserves.

Both New Keynesians and monetarists argue that the Fisher effect is very important when thinking about the long run effect of a change in the money growth rate.  In contrast, MMTers seem to pretty much ignore the Fisher and income effects, and view interest rates as being set by the central bank via the liquidity effect.  An exogenous increase in the money supply growth rate would lead to lower interest rates, in their view.  Because central banks target interest rates, MMTers assume money is endogenous.  They basically ignore the vast empirical literature on the “superneutrality of money” when the money growth rate changes.

To be a good macroeconomist, you need to hold two models in your head simultaneously.  One is the long run flexible price classical model, such as Krugman illustrates in the graph above.  The other is the short run sticky price model, which has special characteristics at zero interest rates.   Krugman’s a brilliant macroeconomist, and thus is not attracted to MMT models that have no tools for evaluating the long run impact of changing money supply growth rates.



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Three MMT fallacies

I see three statements repeated by Modern Monetary Theory proponents, almost like mantras:

1. Money is endogenous
2. Banks don’t loan out reserves
3. There is no money multiplier

All three of these statements are either false, misleading, or meaningless, depending on how you define terms.

1. Endogeneity: Everyone has their reasons

When economists say a variable is endogenous, they mean it is explained by other variables in the model. Endogeneity is not an intrinsic characteristic of a variable, in the way that an apple is red or water contains hydrogen and oxygen atoms. Rather we find it convenient to regard variables as endogenous for the purposes of a certain analysis. Thus one should never say, “You’re wrong; money is endogenous”, rather you might want to claim that, “For the purpose of your analysis, it is more useful to regard money as endogenous.”

Monetarists often view the monetary base as being determined exogenously by the central bank, that is, at the bank’s discretion. At the same time, they understand that if the central bank is pegging some other variable, say exchange rates or interest rates, then the central bank has no discretion to adjust the money supply independently. They might still believe that changes in the money supply under that regime are very impactful, but there is no policy discretion for the quantity of base money.  Base money is endogenous.

Keynesians often regard the monetary base as being endogenous during a period of interest rate targeting, although with the advent of IOER the central bank can target the base and the interest rate independently. In Singapore, the central bank targets the exchange rate, and regards both interest rates and the monetary base as endogenous.

Things change if the central bank stops pegging interest rates at a constant level and instead targets them at a level that is frequently changed. While in that case the base can still be viewed as endogenous for the period when rates are fixed, it’s equally accurate to argue that the central bank adjusts its target interest rate in such a way as to allow desired changes in the base. Thus a central bank intending to do an expansionary monetary policy might cut the interest rate target in order to increase the monetary base. In that sense, they still do have some control over the money supply.  The money supply can be viewed as exogenous over a period of months.

All of this nuance is lost in MMT descriptions of monetary policy. Interest rates are viewed as exogenous and the base as endogenous. Any alternative approach is viewed as unthinkable.

To an omniscient God, everything in the universe in endogenous. Everyone has their reasons.  Claiming that something is “exogenous” is equivalent to claiming that we don’t fully understand the process by which it is determined. Thus interest rates might look exogenous to one economist, while another sees them as being determined by the central bank’s 2% inflation target. Indeed, the entire “Taylor Rule” literature can be described as an attempt to model interest rates endogenously.

2.  It’s a simultaneous system

When a bank makes a loan, it typically gives the borrower a bank account equal to the value of the loan. If the borrower withdraws the money and spends it on a new house, the seller typically takes the funds and deposits them in another bank. That’s the sense in which MMTers argue that banks don’t loan out reserves; the money often stays within the banking system. The exception would be a case where the borrower withdrew the borrowed funds as cash.

My problem with the MMT analysis is that it often seems too rigid, with claims that the banking system has no way to get rid of reserves that it does not wish to hold. That’s true of the monetary base as a whole (cash plus reserves), which is determined by the Fed.  But it is not true of bank reserves in isolation. There are two ways for banks to expel undesired excess reserves, a microeconomic approach and a macro approach.

The micro approach is to lower the interest rate paid on bank deposits and/or add service charges of various sorts. This encourages the public to hold a larger share of its money as cash and a smaller share as bank deposits. On the other hand, it’s not clear that this process would constitute “lending out reserves”.

The macro approach better describes what economists mean by lending out reserves.  Assume the economy is booming and people are borrowing more from banks.  Continue to assume a fixed quantity of base money.   If the borrowed money comes back to banks as increased deposits, then banks can make even more loans and create even more deposits.  Over time, this will increase the aggregate level of both deposits and loans, putting upward pressure on NGDP.

In the 106 years after the Fed was created at the end of 1913, the currency stock grew by 516-fold, (not 516%, it’s actually 516 times as large.)  NGDP was up 549-fold.  The currency to GDP ratio does move around over time as tax rates and interest rates change, but clearly the demand for currency is at least somewhat related to the nominal size of the economy.  When NGDP grows, currency demand will usually rise. Thus, in aggregate, a banking system that makes lots more loans will gradually lose reserves as NGDP rises, holding the overall monetary base constant.

As is often the case, Paul Krugman expressed this idea more elegantly than I can:

When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes” — it’s a simultaneous system.

Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.

Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.

MMTers have a bad habit of assuming that mainstream economists are clueless, just because we use a different framework.

3.  There are a million money multipliers

Krugman’s explanation also helps us to understand the confusion over money multipliers.  Injecting more money into the economy sets in motion forces that boost the nominal quantity of just about everything, not just bank loans and bank deposits.  An exogenous and permanent doubling of the monetary base will double the nominal value of every single asset class, from one carat collectable diamonds to Tesla common stock to inventories of soybeans to houses in Orange County to rare stamps. And it will also double the monetary aggregates.  That’s because money is neutral in the long run, so doubling the money supply leaves all real values unchanged in the long run.

So the money multiplier for any asset class is merely the nominal stock of that asset dividend by the monetary base.  No serious economist believes the M1 or M2 money multiplier is a constant, and indeed textbooks usually explain it this way:

mm = (1 + C/D)/(C/D + ER/D + RR/D)

It’s one plus the ratio of cash and bank deposits divided by the cash ratio plus the excess reserve ratio plus the required reserve ratio.  Then economists model the money multiplier by describing the factors that cause these three ratios to change over time.  In my view, the money multiplier model is pretty useless, as I don’t view M1 and M2 aggregates as being important.  Your mileage may vary.  But there’s nothing “wrong” with the model; the question is whether it’s useful or not.

The one money multiplier that does matter is NGDP/Base.  Unfortunately, both IOER and the recent zero interest rate episodes have made that multiplier more unstable.  I favor a monetary policy where the NGDP multiplier (aka “velocity”) would be more stable.  No more IOER and fast enough expected NGDP growth to assure positive interest rates.

4.  Beware of “realism” and the fallacy of composition

Sometimes you’ll encounter an economist who is very proud that he or she understands how the financial system works in the “real world”.  And obviously that knowledge can be useful for certain purposes.  But the banker’s eye view often misses what’s most important in macroeconomics, the general equilibrium connections that Krugman alluded to in his “simultaneous system” remark.

If the Fed gave me a check in exchange for an equal quantity of T-bonds, I’d be no richer than before, no more likely to go out and buy a new car.  And if I took that check and deposited it in a bank, that bank might be no more likely to make a business loan.  They could simply buy a bond, or lend the reserves to another bank.  But as everyone tries to get rid of the base money they don’t want, subtle changes begin to occur in a wide range of asset prices, which will eventually push NGDP higher.  If wages are sticky then the extra NGDP will lead more people to go out and buy cars.

Just not me, not the person who first got the new Fed-created money.


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Monetary economics: The three heresies

In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.

In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model.  This leads to a period of crisis, and new models are developed to address the empirical anomalies.  I believe that this has happened in monetary economics.

Consider the following claim, which reflects the views of most mainstream economists, circa 2007:

“A policy of reducing interest rates to very low levels is highly expansionary.  When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”

Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above.  And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.

At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:

1.  MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow.  They recommend that central banks in those countries set interest rates at zero.  Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.

2. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.

3. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.”  Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.

So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other.  How did we end up with such a mess?

The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed.  But why three?  The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.

Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy.  In one sense, MMT can be seen as the most anti-quantity theory model ever developed.  Its tenets are almost the polar opposite of monetarism on a wide range of issues.

A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics.  In these models, the Fisher effect is far more important than the liquidity effect.  Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates.  This eventually led to the NeoFisherian model.

A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects.  This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes.  It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.

Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here.  (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics.  It has caused all sorts of confusion, and gave birth to three very heterodox models.

This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters.  Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.


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