MMT: Modern Monetary Theory or Mad Macro Tosh?

John Maynard Keynes’ General Theory of Employment, Interest and Money came about as a direct response to the economic conditions of the Great Depression which he attributed to deficient demand. His work, and that of his followers, demonstrated that cyclical variations could be dampened by greater government intervention to smooth out movements in the economic cycle. But by the late-1970s, the world was growing weary of recessions, high inflation and rising unemployment and was looking for alternative policy options to the statist economic model that had produced them. Thus was the free market economic revolution born. Fast forward thirty years to the fallout from the crash of 2008 and questions have increasingly been raised about the role of free market economics in producing the biggest economic slump in 80 years and the perception that economic and social inequality has widened.

One of the candidates for a new economic theory for the 21^st century is Modern Monetary Theory (MMT) which has been around for a while but is now attracting a huge amount of attention in the US. As might be expected, the pendulum has swung completely, with the latest policy theory attempting to move from the fringes to the mainstream espousing a much bigger role for government. It has increasingly been adopted by those on the left of the political spectrum as a policy which could justify a big increase in government spending. The likes of Alexandria Ocasio-Cortez, the high-profile US politician who is making a name for herself in the Democratic Party, has argued that her proposed expansionary fiscal agenda can be justified by MMT in which a rising deficit does not impose major constraints on the US economy.

MMT’s big thing: The lack of a government budget constraint

So what exactly is MMT? It starts from the premise that the government is the sovereign supplier of money. Consequently, there is no such thing as a government budget constraint because governments can finance their deficits by creating additional liquidity at zero cost when the economy is running below full employment. Even when the economy is operating above full employment, although there are some inflationary consequences, the budget constraint is still not regarded as an issue.

In conventional economics, the intertemporal budget constraint implies that if a government has some existing debt, it must run surpluses in the future so that it can ultimately pay off that debt. In formal terms, current debt outstanding is equal to the discounted present value of future primary surpluses. MMT gets around this problem by arguing that since the government is the sovereign supplier of money, it will always be able to generate the liquidity to cover any debt obligations. This implies that a sovereign government that issues debt in its own currency can never go bust. There is nothing controversial in that proposition per se – indeed, it is one of the arguments I have long used to refute rating agencies’ concerns about UK fiscal solvency. However, there are some major reservations.

MMT makes a big thing about the government’s monopoly in monetary creation. But governments need not be the sole supplier of money, as the recent Bitcoin debate has illustrated. It just happens to be the most convenient form. Second, all students of economic history are aware of past experience when unlimited monetary creation resulted in hyperinflation. This in turn gives economic agents an incentive to find alternative forms of money that will maintain their value. Third, whilst it is true that governments will always be able to repay their local currency debt, it does not justify continually expanding the deficit without limit. In what can be thought of as the “when you’re in a hole, stop digging” theory, governments have to be aware of the extent to which there will always be willing buyers of debt. If one government expands its deficit without limit but another is more prudent, bond investors will always favour the more prudent debt issuer. 

It claims to offser insights that standard Keynesian analysis has missed 

Indeed, the more closely we look at MMT the more we realise that some of its key underpinnings do not stand up to scrutiny. One of the claims made by its proponents is that it offers new insights that standard Keynesian analysis has missed. This is an overstatement. MMT appears to claim that Keynesian analysis failed to recognise that governments could finance themselves by issuing money and that budget surpluses reduce private sector holdings of high-powered money (that which is issued by the monetary authority). Both of these claims are false as both can be inferred from standard Keynesian ISLM models. There is also nothing new in the claim that if the private sector wants to save more (less) than it invests, government must run a deficit (surplus). Again, this is standard national income identity stuff.

MMT claims to differ from standard Keynesian analysis in that it “does not rely on increasing aggregate demand in order to reach full employment; it disconnects full employment from economic growth[1].” It does so by engaging in “targeted spending that is designed to improve the structure of the labor market by developing a pool of employable labor while at the same time ensuring continuous employment of those ready and willing to work.” Critics such as Thomas Palley[2] point out that there are no theoretical underpinnings as how this might work which makes it hard to validate the intellectual argument. My reading of this approach is that it merely represents a choice by government as to how to use the resources at its disposal (which MMT proponents argue are unlimited).

But its treatment of inflation is hazy

What is new is the claim that it is possible to create higher employment without generating inflation. But MMT lacks a well-defined inflation process which makes it difficult to validate this claim. Labour markets operate on the basis of the supply-demand principle and if there are labour shortages in key areas there will be higher wage inflation, particularly where there are structural impediments such a high concentration of trade union membership. Some MMT proponents do not accept that this Phillips curve-type world exists but offer no alternative inflation-generation model. There are some who do allow for such a process but they then cannot therefore escape the fact that they have introduced a trade-off between wage inflation and unemployment, even in today’s flatter Phillips curve world. 

It seems to me that much of the analysis relies on the assumption that a wise government planner will be able to determine in advance where bottlenecks in the economy will arise and that offsetting action can be taken. But since I am not convinced that macroeconomists fully understand the inflation creation process (here) I rather suspect this may be a forlorn hope. 

Desperate times call for desperate measures by desperate governments 

I have long been an advocate of using fiscal policy as a tool of demand management, so an attempt to identify a coherent policy that ascribes a role for government should not be dismissed. I am just not convinced that MMT lives up to (m)any of the claims which are made for it. Palley argues that “it is a policy polemic for depressed times. A policy polemic that promises full employment and price stability at little cost will always garner some attention … such a policy polemic will be especially attractive in depressed times.” It is widely dismissed as being neither modern nor a theory. There again George H. W. Bush initially dismissed Ronald Reagan’s supply-side policies as “Voodoo Economics” before he signed up to them as Reagan’s running mate. Just because it is flawed may not prevent governments desperate for alternative policy measures from trying it out.

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[1] Tymoigne, L. and L. R. Wray (2014) ‘Modern Money Theory 101: A Reply to Critics’ Levy Economics Institute Working Paper 778

[2] Palley, T. (2014) ‘The critics of modern money theory (MMT) are right’ IMK Working Paper 132

Not the beginning of the end but the end of the beginning

It is fair to say that after another tumultuous week in Brexit-land, we have only succeeded in ending up where we originally expected. The Withdrawal Agreement was heavily rejected on Tuesday for a second time; MPs indicated on Wednesday that they did not wish to leave the EU without a deal in place and parliament yesterday instructed the prime minister to request a three month delay to the Article 50 deadline. It is no exaggeration to say that the eyes of the world were on Westminster and not necessarily for positive reasons.

But we are by no means out of the woods. It has been clear for a while that the UK’s best option was to seek an extension of the Article 50 deadline but having got to that point I am less sure about what happens next. The UK now has to formally request an extension and it is by no means certain that it will get what it wants. Until recently, my assumption was that the EU would grant three months as a matter of course merely to prevent the worst case outcomes from impacting on the EU economy. But the mood music across the continent appears to have changed.

What will happen if the Withdrawal Agreement is resurrected for a third time?

The Commission’s view is that the UK must be able to show “a credible justification for a possible extension and its duration.” The UK thus plans to seek an extension for the purpose of implementing the necessary domestic legislation, which it cannot now do before 29 March because it has wasted so much time in trying to pass the Withdrawal Agreement. But as it currently stands the UK has not decided the terms on which it wishes to leave the EU, so it is hard to argue that it is in a position to implement any legislation. Therefore, it now seems likely that the UK will drag the corpse of the twice-rejected Withdrawal Agreement before parliament once again in a bid to give Theresa May a little bit of cover when she makes her case to EU leaders next week.

This is a very risky strategy. If parliament does ratify the deal, there is a very high likelihood that the EU27 will agree to Theresa May’s request. But if it does not it is a whole different ball game. So what are the chances that dissenting MPs will swallow their pride and vote it through? There appears to be a dawning realisation amongst the Brexit-ultras that the EU is in no mood for reopening negotiations and that if they reject the Withdrawal Agreement yet again, they may well reduce their chances of getting any Brexit at all. The DUP also appear to be biddable. Much appears to depend on whether the rebels buy the latest arguments from the Attorney General that the UK could unilaterally break away from the Irish backstop under the terms of the Vienna convention.

In simple terms, Article 62 of the Vienna convention says that if there has been "a fundamental change of circumstances" following the conclusion of a treaty "which was not foreseen by the parties", then the countries involved would be allowed to withdraw from the treaty. But since the current arrangement says that the backstop will come into place if no solution to the Irish border can be found, it is hard to argue that it would be unforeseen. Moreover, since the Attorney General argued only on Tuesday that there continue to be no grounds for the UK to unilaterally exit the backstop, and since nothing has changed in the interim, this does rather sound like a desperate ploy. But since rationality has very little to do with the Brexit debate, it might just be enough to convince those who want to be convinced, and thus enable the Withdrawal Agreement to be ratified.

And what if it is rejected?

But if it is rejected once again, MPs will have sent the prime minister “naked into the conference chamber” (to quote Nye Bevan). She will not have any cards left to play and the EU will be in a position to call the shots. Do not be surprised under those circumstances if the EU offers a much longer extension (e.g. until the end of 2020) with conditions attached that the prime minister is unable to accept (e.g. participation in the European elections). You can imagine what the Conservative Party reaction would be to such a proposal. Remember that almost one-third of MPs yesterday voted against an extension of Article 50 (i.e. for a hard Brexit), and of those who did support the extension many will have held their nose in voting for a short postponement. They are far less likely to accept one which runs (say) to end-2021.

This will put MPs in the position of having to choose between a no-deal Brexit and a long delay. But there is always a chance that Theresa May could put the Withdrawal Agreement up for a fourth attempt. Incidentally, if the margin of defeat follows an arithmetic progression, the sequence runs 230 (January), 149 (Tuesday), 68 (next week), -13 (fourth attempt). So it could pass on the fourth attempt after all. I thus do not buy the view that if the EU turns down May’s proposal next week that a hard Brexit will emerge by default.

A whole new dimension of Brexit issues

But we should not overlook the fact that the Brexit debate is about to enter a new dimension. In the short-term, the UK is about to throw itself on the mercy of the EU. But EU politicians, as opposed to the Council and Commission, are likely to take a much harder line on an extension. Attitudes are hardening amongst EU governments which fear that Brexit could be a distraction in their fight against populist politics in their own countries during the election campaign. There are also concerns that if the UK were to extend its EU membership beyond mid-year, but refuse to take part in parliamentary elections in May, the legitimacy of the parliament would be called into question which would give ammunition to the many populists across the continent. Make no mistake, the EU is rapidly running out of patience.

Even if the UK does ratify the Withdrawal Agreement and leaves the EU by mid-year, thus entering the transition period that runs to end-2020, a whole new set of problems will emerge. The UK will have to negotiate what sort of future relationship it wants with the EU. The shenanigans over the course of recent months, with those responsible for negotiating with the EU voting against the agreements they reached when they returned home[1], is not exactly going to fill the EU with confidence that the UK is a trustworthy partner.

It is also a fair bet that Theresa May will resign if she can negotiate the UK’s exit by mid-year. After all, why put herself through the stress of dealing with her divided and unthankful party? It will be left to another prime minister to deal with the longer-term arrangements, which could change the complexion of negotiations, but it is unlikely they will be any more successful than Theresa May in squaring the circle of domestic and international requirements. The initial stage of leaving the EU will not, in the words of Winston Churchill, be the beginning of the end but merely the end of the beginning.

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[1] The classic example is former Brexit Secretary Dominic Raab who was responsible for negotiating the Withdrawal Agreement between the UK and EU but who has twice voted against it in parliament. His successor Stephen Barclay this week made the case for  extending the Article 50 deadline beyond March and then voted against it.

Brexit Through the Looking Glass

This morning in the office we were kicking around song titles to describe the current Brexit situation. As one old enough to remember the glory days of punk, my contributions were "Should I Stay or Should I Go" by The Clash (released in 1982) and "Anarchy in the UK" by The Sex Pistols (1977). Such is the shambolic state of the Brexit debate that we are beyond the five stages of grief (denial, anger, bargaining, depression and acceptance) and have reverted to outright ridicule.  

It is hard to know where to start but the bulk of the blame for the disastrous sequence of events over the past two years has to be laid squarely at the feet of Theresa May. I have no doubt she is a fundamentally decent woman who believes in delivering the best she can for her country, but as a prime minister she is useless. There is no shame in that. Some people are just not cut out to lead and she is one. But it has got to the stage where she is an outright liability to her party and country. She repeatedly makes promises she cannot keep and continues to bluff her way through, even though she has the weakest possible hand of cards. 

The litany of errors is long: By treating the non-binding referendum result as if it were a winner-takes-all event, May alienated Remain voters and large parts of her own party. Triggering Article 50 without a plan of what the government hoped to achieve was a huge strategic mistake. And the ill-judged election call weakened her domestic authority. Add to that her failure to judge the intentions of the EU, let alone the Brexit ultras in her own party, and the last two years have seen a steady erosion of May’s authority to the point that she makes a lame duck look secure.

The only reason she remains in 10 Downing Street is that the alternatives are either worse or simply don’t want the job under current circumstances. But as The Times noted this morning in an editorial, "Mrs May's attempt at brinkmanship has failed. Without trust and authority it is hard to see what she has to offer, having been trounced twice. The Conservative Party may now decide that only a new leader can find a path to an adequate Brexit." Following parliament’s efforts to prevent May from keeping no deal on the agenda this evening, with her own cabinet colleagues voting against her, her authority is weaker than any prime minister I can recall.

In fairness to the PM, when you are being undermined at every turn by so-called colleagues such as Jacob Rees-Mogg, David Davis and Boris Johnson, a difficult job becomes impossible. The Conservative Party generally is a mess. The pro-Brexit ideologues in the European Research Group have effectively split the party in two with their continued denial of the economic realities facing a post-Brexit UK. There will be no healing so long as they remain in the party. One of the great puzzles of modern British politics is how Theresa May remains so relatively popular (amongst Tories she is second only to – wait for it – Boris Johnson). The answer is she is opposed by Jeremy Corbyn whose dissatisfaction ratings are the highest of any opposition leader in 40 years. Labour has shown no leadership on Brexit and the 48.1% who voted Remain in 2016 believe themselves to be completely disenfranchised by the main political parties.

The great irony of the UK’s current position is that it has spent decades trying to undermine the EU’s drive towards ever-closer union, whilst Brexiteers celebrated winning their “independence” in 2016, only to now have to throw itself on the mercy of the EU to grant an extension of the Article 50 deadline. The sheer, utter, spectacular incompetence of the UK political class in allowing itself to be put in this position defies words.

Having handed the negotiating power back to the EU, what is likely to happen now? Other EU leaders have expressed the view that the UK needs a good reason to be granted an extension, and incompetence in dealing with its own MPs is unlikely to be good enough. And whilst Theresa May has expressed a preference for an extension that is both limited and one-off in nature, the EU is unlikely to give much weight to her wishes. Why should it? It’s not as if she can deliver on what she has promised. Moreover, DExEU has already suggested that the UK is not prepared for a no-deal Brexit in March and there is no reason to suppose it will be any better prepared in (say) three months’ time.

There is thus a strong possibility that if the EU does grant an extension, it will come with conditions attached – one of which may be that it has to run to end-2020. This will not go down well with MPs, many of whom will decry that the UK is being held prisoner by the EU. They may then be forced to make a choice between leaving without any deal and accepting that the only way that Brexit can be delivered at all is by accepting a prolonged delay.

This will raise the risk of a no-deal Brexit which is exactly what most economists have warned against for at least three years. Under these circumstances, I would not be at all surprised if the Withdrawal Agreement that has twice been rejected by parliament by two of the largest margins in the last 100 years will once again find its way back onto the table (and that is indeed being widely trailed on this evening's TV news programmes). Theresa May used to say that no deal is better than a bad deal. Judging by her desperation to get this deal over the line, she now seems to think that the opposite is true.

We should be in no doubt that the political shambles which has emerged over the past two years is the result of a lack of planning, organisation and leadership. Whatever people thought they voted for in 2016, it surely wasn’t this. My favourite quote to describe the Brexit omnishambles comes from fictional spin doctor Malcolm Tucker from the BBC satire The Thick of It who, when faced with political accusations, fired back with the memorable line “How dare you come and lay this at my door! How dare you blame me for this! Which is the result of a political class, which has given up on morality and simply pursues popularity at all costs.” What was political satire in 2012 is the political reality of 2019.

Monetary policy: What's the alternative?

The news last week that the ECB will commit to keeping interest rates on hold for the remainder of this year and provide additional liquidity in the form of targeted longer-term refinancing operations (TLTROs) is an illustration of the central bank’s concern about the economic slowdown. But it also reflects the continued reliance on monetary policy to support the economy in the absence of any other options.

That the euro zone economy has lost momentum is not in doubt. But this to a large extent reflects a number of exogenous factors, such as the Chinese slowdown, which is at least partly the result of the trade dispute with the US. ECB President Draghi indicated as much in his prepared statement, telling the assembled journalists that the loss of economic momentum was primarily due to “the slowdown in external demand” and that “the risks surrounding the euro area growth outlook are still tilted to the downside, on account of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” Responding to this slowdown by committing to keep rates unchanged makes some sense. But what is less obvious to me is why, when factors beyond the control of the ECB are responsible for the loss of economic momentum, is the ECB prepared to activate monetary measures designed to target the domestic economy, particularly TLTROs which operate at one remove? Moreover, why wait until September to initiate them?

In the ECB’s words, TLTROs “provide financing to credit institutions … at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy.” And whilst it is true that in recent months the rate of loan growth to the euro zone private sector has slowed (chart), the most notable loss of momentum has been in corporate sector loans which is likely to be a consequence of global business conditions. Increasing liquidity supply is all very well, but there are serious questions as to whether demand for additional cheap credit exists. Indeed, unlike 2008-09 when the credit crunch was actively holding back economic recovery, today we are awash with liquidity. But the euro zone’s problem is magnified by the growing split between northern and southern states. For example, borrowing costs for Italian banks have risen since last summer as concerns grow regarding the government’s fiscal stance. The TLTROs are thus of more benefit to southern Europe than the north.

Draghi’s comments also repeated the long-standing message that “structural reforms in euro area countries need to be substantially stepped up to increase resilience, reduce structural unemployment and boost euro area productivity and growth potential.” This is a message which has been part of the ECB’s communications strategy since the days of Wim Duisenberg and in fairness has been heeded by the likes of Germany. But Italy’s growth performance remains by a considerable margin the worst in the G20 and recent efforts in France to broach the subject of reform were met with a wave of public protests which caused the government to back down. But the fact that the euro zone’s potential growth limit today stands at 1.5% compared to 2% at the start of monetary union does illustrate the necessity to heed Draghi’s call.

But the biggest failing across large parts of the industrialised world in recent years has been the unwillingness to use fiscal policy as a tool of economic management, which has thrown the burden of adjustment onto monetary policy. Draghi did point out that fiscal policy across EMU is mildly expansionary but “countries where government debt is high need to continue rebuilding fiscal buffers.” Whilst accepting that excessively high levels of debt have economic costs, notably the fact that they represent claims on future resources, Italy has consistently run a primary surplus over the last 20 years of around 1.5% of GDP. Requiring additional fiscal tightening in Italy is only going to prove counterproductive. The extent of fiscal tightening across many European countries is captured by the decline in cyclically-adjusted government spending (here, see Table 6A) which in Germany has fallen by 10 percentage points of potential GDP since the mid-1990s whilst in Ireland it is down by 15 percentage points (and nearly 40 points since mid-2010).

A lax monetary policy cannot offset a fiscal tightening of that magnitude. For one thing, monetary policy operates in an indirect route in which the benefits may get lost in the transmission process (e.g. if there is limited demand for credit). Moreover, a long period of low interest rates is likely to have adverse side effects. Our future incomes as represented by pension savings require us being able to generate a decent rate of return on the income we set aside to provide for tomorrow. The ECB’s policy of holding the short end of the yield curve deep in negative territory, whilst buying up to one-third of the euro zone debt stock, has resulted in German maturities up to nine years falling into negative territory. Following last week’s announcement by the ECB, even the nine-year segment fell below the line whilst the benchmark 10-year Bund yield at one point hit just 0.05%.

That is not going to help our future incomes. Nor does it help banks, which rely on a positively sloped yield curve in positive territory to generate income. With the ECB deposit rate at -0.4%, banks have no incentive to hold excess liquidity at the central bank. Even the BIS has pointed out that profitability is a crucial area of banking resilience since this determines the extent to which they can recover from losses resulting from economic shocks. Although much progress has been made to weather-proof bank balance sheets thanks to legislation implemented in the last decade, profitability – particularly in Europe – remains well below pre-2008 levels. With European bank price-to-book ratios still well below unity, this indicates that investors are not very optimistic with regard to a recovery in profits.

It is hard to avoid the conclusion that central banks, particularly the ECB, continue to operate a lax monetary policy because there are no other policy options. But the longer we operate policy consistent with economic conditions prevailing in 2009, the greater will be the potential adverse long-term consequences. Whilst this is all part of Draghi’s “doing whatever it takes” strategy outlined in 2012 to hold the euro zone together, we are now at the point where the ECB needs help from governments to get the economy back on its feet.