Classical vs Modern Monetary Theory

Classical vs Modern Monetary Theory

I am intrigued that both Classical Monetary Theory (CMT) and Modern Monetary Theory (MMT) have a way of explaining how macroeconomics works, yet both think the other theory is wrong, while their own theory is right.  

I think it is generally agreed that it is bad to let a sovereign currency inflate, i.e. devalue. It is tantamount to stealing from anyone who holds cash in that currency. It is embarrassing and to be avoided. But deflation is also to be avoided. It seems there is an international consensus that a currency should inflate, but only by a steady 2% per annum. 

CMT believes that a thrifty, well run country should not run a deficit but should raise in taxation as much money as its government spends.  If there is a deficit, CMT believes that printing money, or simply writing it into existence, causes inflation –– at least, in the absence of growth in the economy.  For it believes that the value of a currency is a simple but inexorable function of the total quantity of 'Goods' divided by the total quantity of 'Money'.  The preferred CMT response to a deficit is to borrow on the international bond market. But the CMT economists warn that too much borrowing will 'spook' the markets and interest rates will go up. The country will find itself stretched over a barrel as more and more of our tax goes straight off to pay interest on our National Debt. Were inflation to occur, the Bank of England would raise interest rates, which inhibits the economy. That would curb spending by the poorer (indebted) citizens while cushioning (or even rewarding) the better-off lenders.

MMT believes that deficits are vital if the economy is to grow, as it is the only way that money (currency) can enter the private sector. MMT holds that taxes are not required to "pay for government", for there is no reason why the money cannot be created (by a sovereign government; provided that it does not cause inflation). If there is idle capacity in the economy, printing money should stimulate the economy. If the economy is at full employment and surplus money is still chasing goods and services there will be inflation. The MMT answer to inflation is to raise taxes (rather than interest rates). This takes money off those that have it (rather than those that do not have it). Taxes can have other beneficial effects besides reducing demand for goods; it can reduce inequality, and it can reduce e.g. smoking or carbon dioxide emission.

Where CMT thinks that the value of a currency is set by the ratio of the total quantity of 'Money' (defined narrowly, or broadly?) to the total quantity of 'Goods', it could be argued that prices are set much more locally, by people who know neither the total quantity of 'Money', nor of 'Goods'; prices even respond to 'expectations'. Look at the way BP's profits soared when the Iranians closed the Strait of Hormuz. Perhaps the biggest difference between the two theories is in the different ways in which they propose to handle inflation. Though both schools aim to reduce the local availability of money, the CMT school would raise interest rates, inhibiting business and penalising the indebted, while the MMT school would raise taxes. 

The Failures of Macro-Economics

The Failures of Macro-Economics

    I wrote some 7 years ago about the Failures of Macro Economics (q.v.), concluding that both academic and journalist writers were insufficiently rigorous with themselves and each other; their words could be ignored; opinions in this quasi-science held more sway than data and rigorous logic.  

    Today, Timothy Taylor has raised a similar subject in his Conversable Economics blog. 

 

"When you listen to economists who have worked in or near government about their role in the mechanisms of policy-making, they are appropriately humble. They harbor (sic) few illusions that a quick lecture ....... will convert politicians to their point of view.  They are aware that political figures will grab an economic argument if it tends to support their pre-existing views, and ignore the argument otherwise."

     I immediately wonder if the power of the academic analysis is being correctly or incorrectly assessed by the politician. And if, in some cases, the politicians are ignoring sound advice, how can they be punished? It is often months, sometimes years, after policy steps are taken that their effects are known. 

     Taylor quoted George Stigler, who wryly wrote (1976) that:

"economists exert a minor and scarcely detectable influence on the societies in which they live."

    Taylor also quoted a perceptive and far reaching remark of Milton Friedman (1980): 

“The only person who can truly persuade you is yourself. You must turn the issues over in your mind at leisure, consider the many arguments, let them simmer, and after a long time turn your preferences into convictions.”    

     This, of course, is the academic; for the politician does not have the time, nor the right type of mind, to reflect in this way. He reacts to events with a knee-jerk response; afferents and efferents, but no frontal-lobe involvement. It may be necessary to lay before the politician the entire argument, right down to the calculated results on the GDP and the voters' response. 

    All, or a significant majority, of academic opinion must agree. Not that the majority is in all cases correct –– a point that my colleague Peter Mitchell enjoyed pointing out, after he was awarded the Nobel Prize for Chemistry in 1978. 

    It may also be crucial that this entire argument be laid before the voters, for it to have significant effect on the political mind. The academic economist must 'raise his game'.

(See also: https://occidentis.blogspot.com/2014/06/keynes1.html )

 Should we expect (or fear) inflation?

(Open letter to Simon Wren-Lewis)

Dear Simon,

     I like reading, and struggling to understand, your blog posts. But there are two points in your latest post [1] that I would like to query.

Q1. You write: “ All the evidence, direct or indirect, points to the story about fairly anchored long term inflation expectations due to inflation targets and independent central banks being correct.”

 Does this mean: ‘ All the evidence points to the story being correct, that fairly (firmly? appropriately?) anchored long term inflation expectations due to inflation targets and independent central banks.......‘ ?  In which case it seems to me that the sentence in incomplete.

Q2. You find ‘bizarre in the extreme’ any fear about inflation when short-term interest rates approach zero (I do not like the vagueness and jargon of ‘lower bound’): “In that context, and when short term interest rates are at their lower bound, it seems bizarre in the extreme to start worrying about inflation expectations becoming unhinged. “

So your sentence becomes: 

‘When independent central banks control inflation by manipulating interest rates, and when short term interest rates are close to zero, it seems bizarre in the extreme to start worrying about inflation expectations becoming unhinged.‘

     I suppose many people in the UK are not confident that they fully understood inflation as it occurred in the seventies and eighties, when a strongly unionised labour market, forced a wage spiral and induced an expectation of an ever increasing rate of inflation. They fear the apparent loss of control. 

     UK house-price inflation is currently running at 10% p.a. That does not seem to be in accord with the explicit policy of either government, or bank. It suggests that neither agent has a complete grip on the situation (nor even understands fully what it is that the do not grip; supply of land? population? expectations?)

      In the last 12 months the US$ has slumped 10.87% against the Euro, 13.41% against the GB pound, and 16.7% against the Mexican peso. May that be the result of their use of helicopter-money in response to COVID?  That is steep, though I grant that there is no sign that it is “unhinged”. I suppose that expectations, at this stage, are that the dollar will claw its way back up, and that there will be considerable willingness on the part of workers to restrain wages. But we shall see.

      I have been trying (for my own benefit) to tease apart the linked and overlapping concepts of (a) true growth, (b) inflation,  and (c) interest rates [2]. I have some way to go for a solid understanding, and these are topics that call for numerical treatment. It will be noticed that I have not regarded over-night interest rates as a cause of inflation. Such interest rates may operate to manipulate expectations, by indicating (or sometimes mis-indicating) the intentions of the financial authorities.  But it is expectations that seem crucial to understanding inflation, and they elude mathematical treatment; they may not even be rational.

Yours sincerely, Ian West.

(Comments are welcome, direct to cawstein@gmail.com)

References

[1]  https://mainlymacro.blogspot.com/2021/06/how-should-we-think-about-talk-of.html 

[2]  http://occidentis.blogspot.com/2021/04/growth-inflation-and-interest.html

What is Wrong with Macroeconomics

Macro Mess

     People complain that macroeconomics is a confused mess. It is said that macroeconomists disagree among themselves, that the government is pursuing the wrong policies, that the opposition is not mounting an effective opposition. 

     Diane Coyle in 2012 put the case in a well argued lecture (1), and again in a shorter, less formal, way in a passionate blog (2). Jonathan Portes, in his rebuttal blog (3), summarizes Coyle’s case succinctly as:  

a) "although macroeconomists will insist that there are known scientific facts, they do not appear to agree on what these are”,

b)" the discussion among macroeconomists is so shouty”,

c) "all economists need to do far, far better at explaining their work to the general public”.  

Portes partly rebutted each charge, but in doing so seems to concede each, in large part. 

     That was in 2012; but the argument persists. Last month ‘Unlearning Economics’ (4) weighed in against macroeconomists, and last week Simon Wren-Lewis rushed to his own defence in Mainly Macro (5). But now the argument brings in the extra dimension of politics. Both these bloggers assume ‘progressive’ means ‘distributing downwards the benefits of labour’, and is ‘good’, while ‘regressive’ means ‘reinforcing the power of capital’ and  is ‘bad’. 

     It seems rather pompous of me to join this learned debate, but I have a point or two of my own that I want to make. In my own field of expertise I have seen intellectual tribalism, and well understand a reluctance to grapple properly with alternative ways of rationalising the data. “Intellectuals”, my illustrious colleague often said, “seldom  concede; but they do eventually die”. Natural scientists can usually (in time) be shamed into testing their theories against data; arguments can only persist if both theories are able to rationalise the facts. Does this hard filter operate adequately in macroeconomics?

     However, much of the argument is occurring at levels less rational than the purely academic; between politicians, business men, media commentators, bloggers and the average voter. There are hidden agendas, and consequent confusion, not only about the means, but about the objectives of government policy. Are we trying to increase GDP, or actually trying to reduce taxes; trying to decrease unemployment, or secretly trying to increase it (to bring down costs)? Are we seriously trying to bring down the cost of housing when we ourselves have houses and are getting rather rich thereby, or are we trying to increase profit margins in the industry? Are we simply trying to win an election?  Even phrases like ‘fair taxation’ sow confusion, for some will think it means making the relative burden equal across the spectrum of wealth, while others may think it means we all pay the same absolute amount, like the 'poll tax'. 

     

     It alarms the laymen when they see professors of economics disagreeing (6) and calling each other idiots (7).  It is fair to say that the subject matter of the discipline is complex. But most cutting-edge academic work is complex, and effectively closed to the layman. Macroeconomics, however, is additionally hampered by a traditionally cryptic exposition. Keynes was obviously very clever, which enabled him to conceive the most convoluted and arcane pronouncements (8). Imagine the thrill of finding that your academic competitors do not see the relevance of IS-LM. You will need to explain it! (9), but not clearly enough to be understood; you do not mention what I,S,L and M signify, do not explain that the graph is rotated 90º and uses jumbled axes. (c.f. wikipedia, and https://www.youtube.com/watch?v=mTr2PVbbpxg). 

     Yet there is a simplicity in macroeconomics, as in most things, if you have a mind simple enough to see it. Suppose government wants businesses to produce more goods and employ more men, so that more people have more money and buy more goods. It urges the Bank to lowers interest rates. The people with money buy, those without money borrow and buy. The businesses borrow and build, take on workers, who in turn can now buy goods. Success! But what if interest rates are already near zero? And still people are not buying. (There is clearly no requirement for cash, no point in building factories, no confidence in the near future.) What does 'Marcoeconomics’ suggest? "Fiscal loosening”, says Krugman; but does he mean increasing government spending, or lowering taxes to leave more money in the people’s pockets, both of which increase public debt? (See Chick and Pettifor, 10). 

Now here comes the real problem. What does government do but cut Government spending, and flood the banks with ‘quantitative easing’. (Hadn’t we just established that it was not money we were short of but ‘demand’, and confidence?) The rich get richer, and the poor get poorer, and there is barely a flicker of a recovery. The bosses can invest in new plant! — but there is no point, as there are no customers, no demand.

It is not so much that ‘Macro got it wrong’ as ‘Macro got ignored’. But Macro did get it wrong, twice. It failed to get its point across to those who would have heeded. And in my opinion cutting taxes is not remotely as effective as increasing taxes and increasing government spending; it is merely easier. (See my “Tax and Spend”, 11).  There was no need to scare the public by increasing public debt; and therefore no point in advocating it. Crikey! 

References:

(1) https://www.bnc.ox.ac.uk/downloads/news/tanner_lecture_2012_text.pdf

(2) http://www.enlightenmenteconomics.com/blog/index.php/2012/06/a-macroeconomist-tells-me-off/

(3) http://www.niesr.ac.uk/blog/macroeconomics-what-it-good-response-diane-coyle#.WNkH0GU0mdE

(4) https://medium.com/@UnlearningEcon/no-criticising-economics-is-not-regressive-43e114777429#.iwfjl01sl

(5) https://mainlymacro.blogspot.co.uk/2017/03/on-criticising-existence-of-mainstream.html

(6) https://krugman.blogs.nytimes.com/2016/12/24/dont-blame-macroeconomics-wonkish-and-petty/?_r=0

(7) https://www.forbes.com/sites/timworstall/2016/12/25/paul-krugman-gets-his-recessionary-macroeconomics-wrong-again/#5cc30754701e

(8) http://occidentis.blogspot.co.uk/2014/06/keynes1.html

(9) https://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/

(10) http://www.debtonation.org/wp-content/uploads/2010/06/Fiscal-Consolidation1.pdf

(11) http://occidentis.blogspot.co.uk/2016/07/tax-and-spend.html