A close friend send me some pages from a book she is reading – Ministry of the Future – by author Kim Stanley Robinson, which was published in 2020. It is about an organisation that is chartered with defending the rights of future generations and they pursue various projects accordingly. Its major challenge is climate change, after a “deadly heat wage in India” and the narrative allows the author to entertain very interesting discussions about economics, ecology and society. It is classified as “hard science fiction” because while the work reflects the imagination of the author, he bases the narrative on “scientific accuracy and non-fiction descriptions of history and social science” to bring home the challenges we face with climate etc. The pages I received came from Chapter 73 (pages 365-366), which has a two-page discussion about Modern Monetary Theory (MMT). The author writes in his future scenario that “Enough governments were convinced by MMT to try it. That it influenced so much policy through the late thirties was regarded as a sign either of progress or of desperate fantasy solutions.” While the discussion is interesting, I want to focus on one of the ideas the author presents because they illustrate an important distinction between ‘Keynesian’ and ‘Post Keynesian’ thought on fiscal policy and MMT analysis.
I found the reference to MMT in the book very interesting because it reveals that our academic work is now entering popular fictional narratives and that means the ambit of our ideas is widening and the ideas are now being applied to different agendas.
That signifies progress.
I hope to do a podcast with the author in the coming period.
The following images capture the two-page Chapter 73 on MMT (you can enlarge the files if you are interested).
Lessons that can be drawn
The author writes:
Modern Monetary Theory was in some ways a re-introduction of Keynesian economics into the climate crisis. Its foundational axion was that economy works for humans, not humans for the economy; this implied that full employment should be the policy goal of the government that made and enforced the economic laws …
MMT also reiterated Keynes’s point that governments did not experience debt like individuals did, because governments made money in the first place and could create new money without automatically causing inflation …
MMT recommended robust stimulus spending … to be directed to the effort to decarbonize civilisation and to get in a sustainable balance with the biosphere, humanity’s one and only support system.
I could quibble marginally with this but to no end.
The author continued then:
Critics of MMT … pointed out that Keynes had advocated deficit spending during economic contractions, but also the reverse in times of expansion, governments gathering in enough in taxes to fund things through the next crisis. To ignore this counter-cyclical necessity and regard money as infinitely expandable was a mistake, these critics said, because there was a real relationship between price and value …
It is this notion I want to focus on.
Kim Stanley Robinson’s depiction of this strand of criticism of MMT is sound.
This is exactly what traditional Keynesians, most Post Keynesians, and some of the less extreme New Keynesians (Stiglitz, Krugman, etc) claim.
As background reading to the analysis that follows, this blog post is relevant – The full employment fiscal deficit condition (April 13, 2011).
The idea that fiscal policy has to be balanced over some economic cycle typifies their position and has been labelled a ‘deficit dove’ stance, to separate them from the hard-core ‘hawks’ who never see a role for fiscal deficits.
However, the difference between hard-core ‘sound finance’ and the softer ‘deficit dove’ narrative is not all that clear.
They both essentially believe that government spending is financially constrained and that ultimately governments have to ensure an excess of tax revenue over spending is required to ‘pay back’ the debt built up in past periods, when that condition was not satisfied for one reason or another.
Progressive Keynesians invoke simple narratives that what is good for the homebuyer or a corporation is good for the government – which means that at some times increasing debt through deficits is fine.
So ‘deficit doves’ think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth.
They took this seemingly ‘reasonable’ position to differentiate themselves from Monetarists and others who eschew all fiscal deficits.
Students were taught torturous formulas (debt dynamics, etc) under the presumption that the government faces a financing constraint and told that as long as government adopts fiscal caution things will be fine.
So just as a household or corporation can benefit by increasing their debt levels to expand their wealth or business as long as a sensible return is made that permits the servicing and payback the debt, the government can also increase debt at certain times (during recessions), as long as they keep it under strict control when economic activity improves.
That is the argument. You can see the problem immediately. It presumes an analogy between an entity (household or corporation) which uses the fiat currency and is thus financially constrained in its spending – and an entity (the sovereign government) which is the monopoly issuer of the fiat currency that clearly has no financial constraint.
It presumes that the debt in some way ‘funded’ the government spending and was not used to defend the central bank’s interest rate targets.
It presumes that the sovereign government needs to generate a monetary return (how?) to repay the debt without problems.
First, that is a fictional depiction of how a fiat monetary system works.
Second, it reflects a basic misunderstanding of the purpose of fiscal policy, which the first passage from the Ministry of the Future (above) alludes to – the functionality of government spending and taxes rather than the ‘sound finance’ aspects.
Abba Lerner developed his notion of functional finance as a counter to what he called ‘sound finance’” (which is the precursor of modern mainstream (neo-liberal) thinking).
See the blog post – Functional finance and modern monetary theory (November 1, 2009).
Abba Lerner juxtaposed his “economics of control” policy thinking with the dominant laissez-faire approach that prevailed during the Great Depression.
Sound finance was all about fiscal rules that aimed to balance the fiscal outcome over the course of the economic cycle and only increase the money supply in line with the real rate of output growth; etc.
Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.
He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.
MMT also argues that the idea that you offset past deficits by storing up surpluses (for a ‘rainy day’) is inapplicable in a fiat monetary system.
The currency-issuing government can always spending today irrespective of its fiscal position yesterday.
There is no sensible notion of ‘saving’ that can be applied to a government.
Households save to expand future consumption possibilities because they are financially constrained.
A government that issues its own currency is never constrained in that way and can always purchase whatever is for sale in that currency whenever it likes.
Further, the problem with deficit dove thinking is that it ignores context and thinks fiscal policy is about satisfying certain financial goals rather than functional goals.
Here are some scenarios to illustrate this point.
Scenario 1 – External deficit, Balanced fiscal position over the cycle
The following graph summarises this scenario.
Note the fiscal position is (G – T) and so a positive number is a deficit and a negative number is a surplus.
- External deficit constant at 2 per cent of GDP – which means that much income is being drained from the economy each period and stimulating foreign economies.
- Fiscal position starts off in deficit (perhaps a recession) and then the government imposes austerity and eventually achieves surplus (periods 6 to 8).
- Over the 8-period economic cycle – the fiscal position is balanced at zero – the earlier deficits (periods 1 to 3) are exactly offset by surpluses (periods 6 to 8)
- The private domestic sector moves from a surplus (period 1), to deficit in periods 3 to 8.
Changes in national income over this economic cycle ensure these financial balance relationships are maintained in each period.
The application of the ‘balanced-over-the-cycle’ rule ensures under these conditions that the private domestic sector increasingly spends more than its income (the growing red bars – which are deficits).
With the external sector draining spending from the economy, as the fiscal balance moves into surplus and adds to that spending drain, the only way this economy could keep recording GDP (income) growth would be for the private domestic sector to fill the spending gap by increasing its deficit and indebtedness.
This is an unsustainable dynamic because eventually the balance sheets in the private domestic sector would become so precarious (and be increasingly sensitive to small changes in employment and interest rates, etc) that the households and firms would start to make a spending correction.
The next graph shows what might transpire if the private domestic sector, fearing increasing indebtedness started a ‘saving push’ and were successful over this cycle.
I am assuming the external position is unchanged (just to keep things simple) although in practice imports would probably fall under this scenario.
The dotted bars reflect a successful increase in overall private domestic saving and paying down of debt.
The withdrawal of consumption and investment spending from the economy as a result of this push would push the economy towards, if not into, recession.
And, because the fiscal balance is not exclusively determined by discretionary government policy settings – the reductions in private domestic sector, combined with the on-going external spending drain, would reduce economic activity, which, in turn, would reduce tax revenue and increase government welfare spending (as unemployment rose).
As a result, the dotted green line tells us what the fiscal outcome would be – an outcome that would be forced on government by the private domestic spending and saving decisions and the resulting impacts on economic activity.
Despite the ‘dove’ intention to balance the fiscal position over the cycle, the austerity imposed in periods 2 to 4, would soon be swamped by the automatic stabiliser effect and push the fiscal balance into increase deficit, but with rising unemployment and declining income growth.
A ‘bad’ deficit, in other words.
So context matters.
A broad ‘dove’ stipulation that the fiscal position has to be balanced over the cycle defies context.
A more reasonable (MMT) position is that the fiscal position should float in the face of fluctuations in external and private domestic sector spending and saving realities to ensure desired functional outcomes are achieved.
The general outcome is that with an external deficit and a balanced fiscal position over the cycle, the private domestic sector will end up with a deficit equal to the average external deficit over the same cycle.
There are times where that might be sustainable.
But in general, it won’t be.
Scenario 2 – External surplus, Balanced fiscal position over the cycle
The next graph depicts a very different economy to the previous one shown above.
This economy is recording export surpluses – meaning there is a net injection of spending into the domestic economy from abroad.
Again, we assume the fiscal position is balanced over the cycle – so deficits (periods 1 to 3) as private domestic overall saving is high (and perhaps the economy is in recession or sluggish) and then fiscal surpluses (periods 6 to 8), which reinforce the spending drain coming from the external sector.
As a consequence the private domestic surplus shrinks until the final period, the increasing fiscal drag exceeds the external spending injection, and the private domestic sector income squeeze results in a deficit.
But over the entire cycle – the private domestic sector records a 2 per cent of GDP surplus (and could pay down debt over the cycle) equal to the 2 per cent average external surplus, with the average fiscal balance of zero.
So in this scenario, there is more scope for the government to run fiscal surpluses without undermining total economic activity because there is an external spending injection.
Finally, the next graph shows what might happen if the economy started to experience an export boom in periods 6 to 8, where the external surplus rises from 2 per cent of GDP to 5 per cent over that part of the cycle.
We assume the fiscal strategy and outcome is unaltered. There would have to be adjustments to individual spending and tax parameters to achieve this given the booming export sector and the increasing spending injection that would create.
But with the fiscal authority still successfully maintaining its ‘balanced-over-the-cycle’ fiscal rule, then the impact on the private domestic sector’s financial balances is quite stark.
Even with the fiscal drag in periods 6 to 8, the booming export revenue would create the conditions where private domestic saving could continue to outstrip investment spending and thus the sector could maintain surpluses throughout.
Conclusion
These are simple and stylised examples and there are parts of the story I have left silent to ensure the essential aspects are highlighted.
The purpose of these simple examples is to reinforce the notion that context matters when we are judging the fiscal stance of government.
A blind ‘balanced-over-the-cycle’ fiscal rule is unlikely to be productive in terms of the actual targets that should dominate fiscal policy settings.
In some cases, a fiscal surplus will be fine.
In most cases, a balanced-over-the-cycle approach to fiscal policy is likely to fail (given it is private domestic spending and saving and the external position that significantly influence the final fiscal outcome).
Moreover, the attempts to achieve that fiscal rule are likely to undermine prosperity.
The rejection of that fiscal approach is a major point of departure of MMT from traditional Keynesian and more recent Post Keynesian macro thinking.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.
