The Magic Money Tree

Modern Monetary Theory (MMT) is back in the headlines following a recent piece in the New York Times (here). In truth, the article is more a profile of one its best known proponents, Professor Stephanie Kelton of Stony Brook University, than an attempt to examine MMT. Mainstream economists have nonetheless queued up to criticise it, probably because the original headline was titled “Time for a Victory Lap” (it has since been changed to “Is This What Winning Looks Like” so the subeditor has a lot to answer for). However, the article still contains the phrase “Kelton … is the star architect of a movement that is on something of a victory lap”. This has enraged the mainstream economics community because far from enjoying a victory lap, MMT remains untried, unproven and untestable.

A lot has happened since I first looked at the subject three years ago: Kelton’s book The Deficit Myth has become a best seller whilst the pandemic has focused minds on the role of government deficits. This fascinating area is thus worth revisiting. However, the quip that Modern Monetary Theory is not modern, is not about money and is not a theory still holds true. It is not modern because it has its roots in Abba Lerner’s Functional Finance Theory which first saw the light of day in 1943 and which suggests that government should finance itself to meet explicit economic goals, such as smoothing the business cycle, achieving full employment and boosting growth. It is also more a fiscal theory than a monetary one. At heart it is based on the premise that since the government is the monopoly supplier of money, there is no such thing as a budget constraint because governments can finance their deficits by creating additional liquidity at zero cost (subject to an inflation constraint). It is most definitely not a theory about how the economy works. Instead it is closer to a doctrine to which its adherents passionately adhere whilst regarding non-believers as having not yet seen the light (or worse, economic heretics).

What particularly riles the mainstream community is that there is no formal model which can be written down and therefore no testable hypothesis. In the words of blogger Noah Smith, “MMT proponents almost always refuse to specify exactly how they think the economy works. They offer a package of policy prescriptions, but these prescriptions can only be learned by consulting the MMT proponents themselves.” This is particularly irksome because it allows MMT proponents to sidestep the criticisms of the doctrine, of which there are many.

Many of these criticisms centre around the role of money, upon which the fiscal analysis is founded. For example, it treats money as being primarily created by the state (defined as the government sector plus the central bank) and has little or nothing to say about the role of banks in the process. It also treats money as a public good which should be used to maximise social welfare rather than its more prosaic use as a medium of exchange. This in turn assumes there is only one form of money in the economy, but as I have pointed out before this is not the case. Domestic actors may choose to use foreign currency, for example, or opt for digital options. Thus, although governments can create money almost without limit, there is no guarantee that demand will match supply. Increasing supply way beyond demand will only lead to currency debasement. In an excellent paper by the Banque de France[1] (here) the authors do a good job of picking holes in the theoretical underpinnings of MMT, noting that none of its supporters acknowledge “the reason modern literature on money puts  forward for what makes legal currency “acceptable” by the public, i.e. monetary policy credibility.”

Whilst MMT does rest on shaky theoretical foundations, it is not the only area in modern macroeconomics to suffer from such problems. The New Keynesian school, which is the predominant model used by central banks, assumes no role for the quantity of money. It also imposes perfect pass-through from the policy rate to all other rates in the economy, thus giving the central bank a powerful lever to affect intertemporal decisions, which is extremely questionable. Nobel Laureate Joseph Stiglitz published a paper in 2017 which argued that “the DSGE models that have come to dominate macroeconomics during the past quarter-century [apply] the wrong microfoundations, which failed to incorporate key aspects of economic behavior. Inadequate modelling of the financial sector meant they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality.”

It is thus perhaps a little unfair to single out MMT which has fallen victim to the fetish for quantification in economics. Current academic practice seems to believe that if something cannot be quantified it is not a valid explanation of how the economy works. It is instructive to remember that the ideas of Keynes, which came to dominate the agenda after 1945, were also subject to significant criticism following their publication in the 1930s. Nonetheless there is a lot wrong with MMT and I concur with the conclusion to the BdF paper: “Such a stark contrast with mainstream economics analysis and recommendations would be understandable if MMT economists engaged into a debate with their colleagues to explain and justify their positions, from both a theoretical and empirical point of view. However, they rather prefer to talk between themselves, repeating consistently the same ideas that others formulated in a distant past, disregarding facts and theories that do not fit into their approach, and accusing those who do not share their ideas of being incompetent.”

Yet despite all these reservations MMT has opened up a debate about the role of government both during and in the wake of the pandemic. One of the core ideas of MMT is that governments are not like households because they have an (almost) infinite life and therefore debt can be repaid over periods extending over many generations. There is thus no rush to impose significant fiscal tightening as the economy recovers from the Covid shock. This view is, of course, not unique to MMT: It is a standard element in fiscal dynamics but it is a lesson that governments should heed as the rush to take away support after the pandemic gathers momentum.

If it has opened the eyes of politicians to the uses of fiscal policy after decades in the doldrums, then maybe MMT has served a useful function. But a policy of near unlimited fiscal expansion is for the birds. It calls to mind the other acronym often applied to MMT: The Magic Money Tree.

---

[1] Drumetz, F. and C. Pfister (2021) ‘The Meaning of MMT’, Banque de France Working Paper 833

Getting a grip on inflation

There is an old joke about a man who gets lost in the countryside and asks a local for directions to the nearest town. The local responds: “if it’s the town you’re going to, I wouldn’t start from here.” In many ways that perfectly sums up the position central bankers find themselves in today. Inflation has ramped up in a way that was unforeseen just six months ago and as a consequence interest rates are currently too low for prevailing inflation conditions. It is a very uncomfortable place to be because it opens up central banks to the charge that they are behind the curve on policy.

Onwards and upwards

It is very easy to make the case that central banks missed the inflation surge and have maintained a lax monetary stance for too long. On a literal interpretation this is true. There again, the consensus forecasts did not anticipate the inflation surge either so the noisy brigade perhaps ought to dial down some of the criticism about how slow central banks have been to react. We can see this very clearly in UK data using consensus forecasts for CPI inflation in Q4 2021 against the BoE’s projections (chart below). If anything, the central bank anticipated the inflation surge slightly quicker than most forecasters.

Perhaps the criticism is rooted in the fact that central banks were tardy in tightening policy as the economy normalised following the GFC of 2008-09. I have a lot more sympathy with this view. There was no justification for maintaining the lax stance adopted in 2009 once the economy started to normalise and those criticising central banks today perhaps feared a repeat of the policy mistakes of the 2010s which promoted significant inflation in financial asset prices.

At least the BoE has begun the process of raising interest rates, having increased them by a total of 40 bps over the last two months with more to come. Last month the Fed passed up the opportunity to raise rates and instead signalled a March rate hike whilst continuing its asset purchase programme for another six weeks rather than bringing it to an immediate end. As for the ECB, the depo rate has not been above zero since 2012 and has been stuck in negative territory since 2014. Negative rates may be an acceptable policy option for a limited period but eight years is way too long. At least this week’s press conference provided some indication that the ECB acknowledges “inflation is likely to remain elevated for longer than previously expected [and] risks to the inflation outlook are tilted to the upside, particularly in the near term. The situation has indeed changed." Suggestions from some analysts that this marked a “hawkish” stance from the ECB is rather to miss the point. Moving rates from negative territory to zero is not “hawkish” – it reflects the start of a long-overdue normalisation of the policy stance.

Given the nature of the supply-generated inflation shock it is clear that a rise in interest rates is not going to resolve the problem. But in one sense central banks have no choice but to react. By claiming credit for the fall in inflation during the 1990s they have created a paradigm in which they appear to have control over the inflation process. Under current institutional arrangements, in which central banks maintain responsibility for controlling inflation, their whole credibility is bound up in taking action to curb it which in turn requires tightening policy. However, there may be something of the emperor’s new clothes about this argument. A hugely simplified view of using monetary policy to control inflation is the assumption that it is (to use Milton Friedman’s phrase) “always and everywhere a monetary phenomenon.” As recent events have shown, that is not the case. How do we act then upon inflation?

Dealing with the energy shock

One of the problems facing consumers around the globe is the sharp rise in energy prices. European gas production has declined in recent years and to the extent that this was used largely to smooth out demand patterns during the winter, this has had a significant impact on the market. Last summer European countries were also unable to boost storage to levels that might prevent shortages from emerging during the coldest periods and the resultant scramble for gas has pushed up global prices.

This is making its presence felt in household fuel bills. UK domestic gas and electricity prices rose by 19% and 17% respectively in October and will rise again in April following the Ofgem announcement that the energy price cap will rise by 54% which is likely to push inflation to 7% or above in Q2. Whilst the problem of rising energy costs is not a uniquely British phenomenon, it has taken a different approach to other European countries. In the UK Chancellor Rishi Sunak announced that households would receive a discount of £200 on domestic energy costs in 2022 (around 10% of an average bill) which would be repaid over the following five years. The full impact of the price hike will therefore be borne by consumers.

Elsewhere in Europe, governments have taken a more aggressive approach. With one eye on the election, the French government has forced state-owned EDF to sell nuclear power to rivals at below the current market price, costing it €8.4bn in revenue, whilst limiting the rise in household bills to 4%. The German government plans to reduce the green energy surcharge by 46% and introduce subsidies for lower income households (one person households would receive €135 and a two person household would receive €175) whilst the Irish government has planned a €113 energy rebate to every household.

Calls for wage restraint are missing the point

BoE Governor Andrew Bailey came under fire for suggesting that this week’s 25 bps rate hike was implicitly designed to deter workers from demanding big pay rises. But as many people pointed out, nothing screams wage restraint like a big rise in basic living costs. In any event workers real wages have lagged productivity growth in the decade since the GFC (chart below). Even though there has been a narrowing of the gap since 2018, workers have not been compensated for such productivity growth as has been achieved since 2009. That said, the ratio is currently in line with its long-term average. But this implies that even in a zero productivity growth economy, workers are entitled to flat real wage growth and with inflation set to average close to 6% this year, a nominal wage rise of 6% could be justified on economic grounds.

The governor’s comments were (to be polite) somewhat insensitive. It would have been far better to suggest that the BoE is raising rates to keep down inflation in order that the pay packet can stretch a little further. The FT journalist Martin Sandbu also posed the question “why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins?” With BP set to announce a huge rise in profits at a time when energy customers are struggling to find the means to pay their bills, calls for wage restraint are not a good look.

None of this is to say that central banks should not raise interest rates further. But we have to recognise that this will do little to tackle the underlying problems and that a tightening of the monetary stance maybe should be accompanied by fiscal measures to offset some of the pain, especially since rapid inflation will also boost the government’s fiscal revenues. At a time when the government is struggling to remain credible, and when many prominent Brexiteers promised that prices would go down once the UK left the EU, they need to get a grip on the inflation problem soon or voters may be tempted to take their revenge at the ballot box.

The great Brexit trade-off

Two years ago Boris Johnson’s government had just won a thumping election victory promising to “get Brexit done” and on 31 January 2020 the UK’s formal departure from the EU came into force. A lot of water has since flowed under the bridge and little could they have known that two years later Johnson would be embroiled in a fight for his political survival following the publication of the long-awaited Sue Gray report into “Partygate.” Despite having delivered on his signature policy, Johnson’s premiership has today come into question as never before, with even MPs on his own side prepared to stick the boot in (this intervention from Theresa May was priceless).

It is no surprise, therefore, that a very different government report released today has received virtually no coverage. Benefits of Brexit “sets out some of our achievements so far” and outlines how the government plans to “seize the incredible opportunities that our freedom presents.” It is hard to know where to start. So far, according to the report, Brexit has “ended free movement and [enabled] control of our borders”; “restored democratic control over our lawmaking”; “taken back control of our waters; “reintroduced our iconic blue passports” and “enabl[ed] businesses to use a crown stamp symbol on pint glasses”. To use one of Johnson’s favourite phrases, it really is a pyramid of piffle.

The ending of free movement has been such a great success that last autumn it made a significant contribution to the lorry driver shortage that seemed to impact most heavily on the UK. As for control of the borders, all it has done is make life harder for everyone. Queues have been building up at ports on both sides of the Channel as border controls are reintroduced. Restoring “democratic control over our lawmaking” rings somewhat hollow following the shenanigans in parliament in recent months, with MPs prepared to rig the rules to protect their own and apparently failing to follow the guidelines that all other citizens have to follow. Taking control of waters counts for nothing if fishermen cannot sell their catch and there is mounting anger in fishing communities that Brexit has not delivered the promised benefits. If the restoration of blue passports and the crown stamp symbol on pint glasses really are of such importance to the government, far be it for me to suggest that there was nothing stopping either of these things from being introduced whilst the UK was a member of the EU.

The losses from trade

The most obvious problems are manifest in trade flows due to the form of Brexit implemented by the UK. Merchandise exports in November 2021 were 7% below the average level in Q4 2019 with services exports down 9.4%. Despite a rally from the depths of 2020 exports are struggling to get back to pre-pandemic levels. By contrast German exports in November were 6.9% above Q4 2019 levels. However the statistical office reported that German exports to the UK in November 2021 were down 7.9% compared to the same period a year earlier, suggesting that exporters are finding it more difficult to conduct business with the UK. 

This accords with the results from a paper by Fernandes and Winter (2021) looking at transaction-level export data for Portugal which suggested that exporters reduced export volumes and export prices in the UK market after the referendum shock in a bid to remain competitive. As the trading relationship between the UK and EU continues to evolve, the authors note that such behaviour is likely to make the UK a less attractive market for EU exporters with the decline in prices placing an increased squeeze on margins. Their estimates also point to “a high degree of exchange rate pass-through into consumer prices in the UK after the shock, implying rising inflation and living costs."

Aggregate data suggest that in real terms, UK merchandise trade volumes are currently 12% below Q4 2019 levels. According to the CPB World Trade Monitor global trade volumes have surged, with exports up 17% on late-2019 levels. As a consequence the UK’s share of world trade has fallen well below 2019 levels even if there has been a sharp rebound in the most recent figures (chart above). We only have a year’s worth of data and the Covid shock has obviously exacerbated the problem but it is clear that Brexit has got off to a bad start in terms of its trade impact. There is nothing on the horizon to suggest that the trade agreements currently in the pipeline will generate a big enough boost to offset the damage done to trade relationships with the EU.

Business investment has also clearly stalled (chart below) as the uncertainty effect kicked in. Between 2016 and 2019 there was very little growth in investment volumes and although it has come off its 2020 lows, it is still almost 10% below the 2016-2019 average. As a result, growth in the net capital stock slowed in the wake of the Brexit referendum, from around 2¼% per year prior to 2016 to a rate around 1¾% over the period 2017-19.  To the extent that this is a fundamental driver of the economy’s potential growth rate, the evidence does point to an uncertainty shock adversely affecting the UK’s growth rate and is consistent with the OBR’s prediction that Brexit will cost 4% of GDP in the medium-term.

Obviously it is still very early in the post-Brexit period and until the pandemic effect has fully unwound we will not be in a position to make any definitive assessment. But on the evidence so far many of the downsides which we warned about appear to be making their presence felt. In Johnson’s foreword to the Brexit report he noted that it will allow the UK to “seize the incredible opportunities that our freedom presents and use them to build back better than ever before—making our businesses more competitive and our people more prosperous.” The problem with much of the Brexit bluster is that it assumes the UK will have sufficient control over its future to realise these possibilities on its own. It makes no allowance for the fact that other governments may not want to play ball. Those who run businesses take a much more realistic view about what Brexit means for them and government boosterism cuts no ice. And even in the unlikely event there are considerable upsides, it is highly probable that on the basis of recent events Johnson will not be in office long enough to enjoy them.

The cost of living problem

The biggest economic surprise of 2021 was the resurgence of inflation. This was largely unforeseen at the start of last year and even by the spring was still not expected to become a significant problem. Thus the news that global inflation has hit multi-decade highs is an unwelcome development for households who have to deal with the fact that prices are increasing much more rapidly than wages and central banks who have to decide how to respond.

People aged 30 or younger were not even born the last time European inflation rates reached current levels. Data for December showed the German inflation rate at 5.3% – the highest since 1992, which was also the same year CPI inflation in the UK last exceeded the December reading of 5.4%. We have to cast our minds back to the era of Paul Volcker for the last time the US inflation rate exceeded the 7% rate posted in December (1982, for the record). Those who thought high inflation was a thing of the past have had an uncomfortable awakening in recent months. This is attributable to a combination of global supply bottlenecks in the wake of the pandemic and rising energy prices, both of which are likely to prove temporary (although temporary could mean anything up to two years). Both these elements were encapsulated in the UK data for the transport component of the CPI, which accounted for almost one-third of the annual inflation rate last month. The cost of vehicle purchases rose by 13.9% in the year to December with shortages of key components pushing up prices, whilst fuel costs were up 26.6% on the back of higher oil prices.

UK inflation is set to go higher still when the domestic energy price cap is raised in April. This sets a limit on the maximum amount suppliers can charge customers for each unit of energy consumed. The new cap will be announced in February but is expected to rise by anything between 46% and 56% on the basis of recent trends in wholesale energy prices. Other things being equal this may be enough to push CPI inflation close to 7% in Q2 (chart below). For the record, the BoE’s November forecast pointed to an inflation rate of 4.8% in the second quarter: we can expect a significant upward revision when the new forecast is released next week.

A cost of living “crisis”

All this has given rise to lurid headlines about a “cost of living crisis” and the possibility that many UK households will be pushed into fuel poverty, officially defined as above average fuel costs that push their residual income below the poverty line (a rough rule of thumb adopted in Scotland, Wales and Northern Ireland is that a household suffers from fuel poverty when it spends more than 10 per cent of its income on fuel). The poverty campaigner Jack Monroe made the point in a Tweet that subsequently went viral that the index used in calculating the cost of living “grossly underestimates the real cost of inflation” using the case of rising food prices as an example.

This is both right and wrong. It is right because the CPI is calculated on the basis of average spending shares on particular categories of goods and services, but these differ according to income. Thus if prices rise more quickly for those categories where poorer households have a high spending weight, the average CPI inflation rate will understate their “true” inflation rate. But that was not the case in 2021. I am indebted to the calculations by Chris Giles, which I have attempted to replicate, which demonstrate that price inflation has been higher for households at the upper end of the income scale because their spending basket has shown a faster inflation rate than for those lower down the scale. On my calculations, the inflation rate for households in the lowest income decile was 5.3% in December versus 5.8% for those in the highest decile.

None of this is to say that we can ignore the distributional aspects of inflation. The rise in the energy price cap will almost certainly hit households at the low end of the income scale disproportionally hard. This raises a question of what, if anything, should be done about it? The financial market response is clear – central banks should raise interest rates, and they probably will, but it is unlikely to have any impact on a supply-driven inflation shock. Indeed central bankers find themselves in an impossible situation. If they don’t raise rates at a time when inflation is overshooting target by a wide margin, the future credibility of inflation targeting regimes will be compromised. Against that, if consumers are facing a cost of living crisis in which real income growth is being eroded by exogenous price shocks, monetary tightening is more likely to exacerbate these concerns.

As MPC member Catherine Mann pointed out in a speech last week, the evidence suggests that the recent inflation surge is not based on a narrow range of goods and services but is increasingly looking more broad-based and “has seeped into those [components] that typically are rather stable.” She also pointed out that “Bank research shows inflation expectations tends to be correlated with wage demands, and that items that consumers buy frequently, such as energy, food, and clothing have particular salience for their short-term perceptions of inflation.” A gradual tightening of monetary policy to offset the threat of a wage-price spiral would thus appear to be a prudent move.

Alternative ways to tackle the energy inflation problem

However, it seems clear that monetary policy is only going to be part of the solution in the near-term. One temporary fix to offset the inflationary impact of higher energy prices might be to zero-rate domestic fuel bills for VAT purposes (in the UK it is currently charged at a rate of 5%). It would come as no surprise if this measure were to be announced in the spring budget in March. Another option might be to remove the green levy on household fuel bills, and instead fund them out of general taxation. At present, the Energy Company Obligation (ECO) requires medium and larger energy suppliers to fund the installation of energy efficiency measures, which is charged back to the consumer via their energy bills (primarily electricity). Permanently scrapping the ECO would obviously reduce energy bills, and thus inflation, but would require an increase in taxation elsewhere to fund the shortfall. This problem could be mitigated if the ECO were scrapped for just a year.

One downside with these solutions is that they would benefit both poor and wealthy households and do little to tackle inequality issues. Amongst the alternatives that have been floated are the extension of existing government-funded support to those on means-tested benefits or simply restoring the uplift to Universal Credit that was put in place during the pandemic but taken away in October. Whilst these measures will do nothing to tackle rapid price inflation in other areas they may help to avoid the worst case outcomes in 2022.

Unpleasant choices ahead

Nonetheless, we are likely to be faced with a series of unpleasant choices in the months and years ahead and tinkering with the tax and benefit system is unlikely to resolve them. On the one hand we will likely have to face up to higher taxes as governments attempt to claw back some of the fiscal costs associated with the pandemic. As it is, UK national insurance rates are set to rise in April, at the same time as the energy cap is due to increase. There is also a wider issue associated with the transition to green energy sources. If we are serious as a society about making this transition, there will be a price to pay and consumers will ultimately have to bear it.

Although the pressures on consumer incomes are particularly great at present, and will undoubtedly diminish with time, we may not return to the nirvana of strong income growth and low price inflation anytime soon (at least, not without a recovery in productivity growth to something like pre-2008 rates). The transition to the post-Covid economy may prove to be more painful than anticipated.