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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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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