Functional Finance and the Debt Ratio—Part V

By Scott Fullwiler

[Part 1] [Part 2] [Part 3] [Part 4] […]

This five part series will explore at length (warning!) and in detail (another warning—wonk alert!) the MMT perspective on the debt ratio and fiscal sustainability.  While the approach suggests a macroeconomic policy mix and strategies for both fiscal and monetary policies that most neoclassical economists currently believe are unsustainable, ultimately the MMT preference for a significant role for fiscal policy in macroeconomic stabilization is shown to be consistent with traditional neoclassical views on fiscal sustainability.

This fifth and final (!) part applies functional finance to CBO’s projections of the government’s long-term budget outlook and then offers concluding remarks for the entire series.

Functional Finance, the Debt Ratio, and CBO’s Projections

Finally, let’s apply this functional finance approach to the fiscal/monetary policy mix to the current debate over future entitlements and the recent projections by CBO.  As shown in Table 5 taken from CBOs own projections that it deemed most likely, the debt ratio is projected to rise to 199% by 2037 as a result of total budget balance deficits that rise to 17.2% of GDP and primary deficits that are 7.7% of GDP.  The primary deficits arise largely from the assumption that entitlement spending (Social Security, Medicare, Medicaid) rise by 6.2% of GDP.  As a result of the primary deficits, the debt service ratio rises from the current 1.4% of GDP to 9.5% of GDP.

Table 5

From the neoclassical perspective, this is a classic example of non-Ricardian fiscal policy, which explains why neoclassical economists are so concerned.  Regardless of whether they are deficit hawks or deficit doves, they view this in the same way for the most part, as most deficit doves are simply deficit hawks that aren’t in as much of a hurry.  At any rate, the non-Ricardian chain of causation is at work here—exogenous fiscal policy drives primary deficits too high and debt service then rises as a result; not shown by CBO is the fear of many that long before this happens, the rise in the debt ratio will encourage bond vigilantes to push debt service still higher long before 2037.  Of course, CBO doesn’t project estimates of inflation that might result from this outcome.  Oddly, CBO assumes the economy will be at full employment with stable inflation for these estimates, which enables it to project deficits and so forth as a percent of GDP.

A functional finance approach, on the other hand, would require CBO to instead provide estimates of the impacts on inflation that would result.  Obviously, one is supposed to assume that these outcomes would be inflationary, but in that case debt service does not rise as a percent of GDP as nominal GDP simply rises with debt service.  Or, absent inflation, one is then probably supposed to assume default, perhaps again as a result of bond vigilantes (the best refutation of this is here, though I’ve always been partial to this one).  At any rate, without an estimate of an economically significant increase in inflation, it’s unclear at least in theory what the macroeconomic outcome would be.  The only mention is CBOs brief discussion of the “dangers” of deficits is largely described in terms of rising interest rates, which is inapplicable given that interest on the national debt is a monetary policy variable.

From the functional finance view, CBO’s analysis is a clear case of assuming what I’ve called unsustainable monetary policy, as it assumes real GDP will grow at 2.2% while the average real interest rate on the national debt will be 2.7% all in the presence of large primary deficits.  That is, if CBO’s projections of non-interest spending relative to revenues turned out to be accurate, then why would a self-described inflation targeting central bank allow interest rates on the national debt to remain above GDP growth and thereby create rising inflation via unbounded increases in debt service? 

One could suggest as in the Godley and Lavoie functional finance rule that some combination of government spending and taxation adjustments occur in kind to reduce the primary surplus enough to avoid a rising debt ratio regardless of the interest rate.  This shows how functional finance—while it is an alternative approach to fiscal policy for stabilization purposes and relative to the “sound finance” approach—is simply a different angle on what economists are already urging fiscal policymakers to do when it comes to fiscal sustainability.  The difference is the focus is on pursuing a “neutral” budget balance that provides full utilization of capacity without rising inflation, not budget cuts for their own sake or out of fear of bond vigilantes.

This is why estimates of inflationary impacts of the projections of primary deficits in Table 5 are so important—will they result in an additional 2% inflation?  5%?  10%?  20?  100%?  CBO’s methodological approach in fact provides no information on how much primary deficit reduction—if any—is needed in the future absent accompanying projections of the private sector’s desired net saving at full capacity utilization relative to projected deficits for the same years and some guidance on how these will affect macroeconomic variables.

Beyond this, even from within the neoclassical paradigm the focus on budget cutting is off the mark, as many have already pointed out.  Given that CBO projects private health care spending will rise on average at a pace that is 1.6% faster than GDP growth—which themselves are driving the estimated growth in Medicare and Medicaid spending—aside from the obvious unsustainability of this assumption, CBO somehow neglects to point out that this will bankrupt much of the private sector long before the feared government deficits are projected to emerge.  And in that case, a larger government deficit will be necessary for a “neutral” budget balance to be achieved.  Stock-flow consistency matters, unfortunately for CBO.  As a result, cutting government healthcare programs obviously doesn’t solve the problem of less affordable private healthcare for the poor, elderly, and in this case the middle class as well; it makes it worse (again, obviously).

Once this is understood, as increasing numbers now do, the only possible solution is to reduce the growth in private healthcare costs.  Further, others such as the Center for Economic Policy Research (CEPR) have shown that modest reductions in aggregate spending on healthcare as a percent of GDP to bring the US in line with the nations spending the next highest amounts as a percent of their GDP (like France and Australia) entirely eliminate CBO’s projected increases in primary deficits, government debt service, and the debt ratio.  Figure 11—from the CEPR link above—shows how CBO’s debt ratio projections would look if total healthcare spending in the US as a percent of GDP was in line with that in other countries.  In short, the U.S. has a private healthcare crisis—which is still not fixed, unfortunately, whatever your view of Obamacare might be—not an imminent entitlement crisis or an imminent public debt crisis.

Figure 11

CBO’s Projected Debt Ratio (Red) vs. CBO’s Projections with Reduced US Healthcare Spending to Equal % of GDP in Other Countries (CEPR’s calculations)


In the end, what have we learned from all this?

First, the appropriate measure of the national debt for discussing fiscal sustainability is the debt held by private investors.  As it stands now, the US debt ratio is a very modest 60% of GDP.

Second, increases in the debt ratio and debt service traditionally deemed unsustainable are driven by the assumption that interest rates are higher than GDP growth.

Third, interest rates on the national debt are a policy variable for a currency-issuing government under flexible exchange rates, and consistent with this interest on the national debt has averaged less than GDP growth in the post World War II era aside from the 1979-2000 period in which monetary policy makers targeted higher interest rates.

Fourth, the neoclassical perspective on the macroeconomic policy mix is probably both inapplicable and untenable; there are good reasons to run a permanently low interest rate monetary policy coupled with a functional finance-driven fiscal policy, and these two together can be perfectly consistent with fiscal sustainability as well as full capacity utilization and low inflation.  At the very least, monetary policy should account for an appropriately designed functional finance fiscal policy strategy in its own reaction function.

Fifth, CBO’s long-term debt projections assume a non-Ricardian fiscal policy combined with a central bank setting interest rates on the national debt above GDP growth; these flawed and even inapplicable assumptions of an unsustainable macroeconomic policy mix are the source of the projections of unbounded growth in debt service and the debt ratio that so many fear.  But—as more economists are recognizing—the US has a private healthcare crisis, not a national debt crisis.  Instead of scaring people with studies that are dead on arrival as a result of faulty assumptions and methodology, CBO and others should focus their attention on potential solutions to growing private healthcare costs and estimating the macroeconomic impacts of specific projected spending plans or proposed budgets (which would require CBO to allocate resources to undertake the highly useful task of developing a detailed, empirically-based macroeconomic model incorporating desired net private saving, capacity utilization, the labor force, inflation, and so forth).

48 responses to “Functional Finance and the Debt Ratio—Part V

  1. How do you restrict the growth of private healthcare costs? Should we outlaw the really expensive procedures like organ transplants and cancer therapies?

    What percentage of US healthcare cost goes to lawyers, and how does that compare to the other countries?

    Are we less healthy, or do we demand (because we can afford) more care for the same state of health?

    Beyond comparing the% of GDP in each country, has anyone dived into the various things that make up healthcare costs? How do all of the elements compare to other countries, like doctor and nurse salaries, rent, taxes, etc., etc.?

  2. Thank you.
    Very well done.
    The best so far.

  3. Very good.
    Scott, quick question: As a student, my textbook (monetarist authors–dates back to the late 80s and early 90s) called the national debt a “net financial liability”. “Net financial assets” are the private sector corollary of the net financial liabilities that makes up the national debt? Is this true in MMT as well.
    I’m just trying to confirm whether the terminology I learned is consistent with the one used in MMT. Thanks!

  4. I am not an expert in the medical field, but I am a senior citizen, who receives Medicare part A for hospital coverage, which pays out 100% of any legitimate claim with a yearly maximum copay of $1,000. I also receive Medicare part B which covers doctor bills with a 20% copay for a monthly premium of $150. I am also eligible for Medicare part D for prescription drugs, but since I do not take any, I do not pay anything. I have to tell you that I am so relieved that I do not have to rely on very expensive private insurance anymore, since it was a costly minefield of denial of claims due to pre existing conditions, customary payments below the amount billed, copays and lifetime limits. Cancellation of coverage was also a worry.

    My brother in law is a primary care physician and therefore I have some insight concerning the issues of medical costs in the US, which are around 17% of GDP compared with 8% for the UK. Since medicine is conducted as for profit business in the US, there is a tendency on the part of doctors to over treat and over test, all of which is billable to the insurance carrier whether it be private, Medicare, Medicaid or the VA TriCare. If the insurance company reduces the payment per visit or procedure, the usual doctor reaction is to increase the frequency of office visits and tests.

    Medicare, which covers the elderly is particularly susceptible, since 50% of all medical costs are incurred in the last six months of life. Many old folk in the terminal phase of their lives are subjected to painful and humiliating treatments, which are questionable in their ability to prolong life. My brother in law’s view is that they should be treated with dignity and live out their final days in comfort, free of pain and not be pressured to undergo painful surgeries.

    Much the same can be said of cancer treatment. You are more likely to die from the ministrations of an oncologist before cancer kills you. Cancer surgery can also increase the risk of metastasis. Claims of cancer cure are also highly misleading since, most are based on five year survival rates rather than cure.

  5. I’ve never understood the US position on Healthcare – particularly as there is one of the most effective healthcare models in the world above the 49th parallel.

    The Canadian model works. Pinch it.

    • Basically, enough people are convinced by propaganda, parochialism and misplaced patriotism that the USA has a health care system which is the envy, rather than the laughingstock of other nations. Sadly, this may becoming truer – not because the USA is getting better, but because the superior systems are too efficient for their own good, not having enough Keynesian spending effects, and as particularly efficient, beneficial, healthy parts of their economies, have been under ceaseless attack.

      IMHO that’s what the Euro is all about. Get rid of the welfare state, but above all, particularly, the health systems. Which is different, and can destroy the predatory sectors all by its lonesome. As Grover Norquist has said, if the USA gets a real national health care system like the UK or Canada, then it is time for his kind of politics to admit defeat and just go home. Governments provide superior health care at lower cost. Once people get “socialized medicine”, once health care is an institutionalized right, they aren’t going to give it up, because giving it up means – killing them. There is no bound to health care spending as a proportion of GDP other than 100%. And the USA is leading down that road. So there is this slow but endless “socialization” of the entire economy.

      The US “Right” knows all this, knows Canada, perfectly well. As usual, better than much of the Left. They know that if: You lower the Medicare age once, Put a real health care system in in one state/province. Then it’ll spread like wildfire and become universal in no time. Nothing succeeds like success. That’s what happened in Canada.

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  7. Scott,

    I agree with your claim that “interest rates on the national debt are a policy variable for a currency-issuing government..”. So that raises the question as to what the OPTIMUM rate is. Warren Mosler and Milton Friedman said zero, and I agree. And at a zero rate, debt is the same as money. Which amounts to saying (as Friedman and Mosler both explicitly said) that governments should not issue debt: they should just issue money in the quantities required to keep the economy at capacity.

    So that’s it. A nice simple conclusion. Or have I missed something?

    • “interest rates on the national debt are a policy variable for a currency-issuing government.”

      The irony is that for a currency issuing government, there is no need to go into debt in order to create money.

      The Federal Reserve does not need go into debt to create money, so why should the US Treasury?

  8. Thank you for pulling it all together in an understandable way.
    Also, T R Reid, “The Healing of America, A global Quest for Better, Cheaper, and Fairer Health Care,” The Penguin Press, 2009, is an enlightening and entertaining exploration of the way health care is delivered in other parts of the civilized world. “Socialized medicine” became an epithet in the ’40s, but it works. We need a health care system not a health profit system. Incentives are very different in the two.

  9. Scott,

    This has been a great series. Very stimulating.

    I have a few questions for you. You write that,

    “Third, interest rates on the national debt are a policy variable for a currency-issuing government under flexible exchange rates”

    How would you characterize monetary policy under this scenario? Do you envisage a regime of “fiscal dominance”, where the Fed is passively setting the interest rate in response to fiscal variables, rather than acting in a dominant way, using monetary policy to respond to the economy etc, without regard for financing issues?

    How does this tie in with the zero interest rate proposal? An interest rate peg to me suggests monetary dominance, because it fixes the amount seigniorage the government can earn, effectively turning it into an exogenous process.

    Also, say for example that the Fed instigates the 0% Friedman rule. The Fisher relation predicts long run deflation, as the inflation rate becomes the negative of the real interest rate (assuming the real rate is positive, which seems likely). Do you agree with that story? How does MMT see inflation evolving in the long run under a Friedman rule?

    If the Fisher relation-story about inflation is correct, then the government still ends up paying interest on the debt, because nothing we’ve discussed pins down the real rate. How do you control the real rate?


  10. I thought I might add–in standard models, if the monetary and fiscal authorities are both dominant, the price level can be indeterminate, unless you assume something like the fiscal theory of the price level, where the price level will jump to whatever value will satisfy the government’s present value budget constraint. Are you making a similar sort of assumption?

    • Hi Vimothy,

      Hope Scott won’t mind me trying to answer a question you addressed to him.

      You seem to assume that the Fed tries to influence interest rates in a Friedman zero interest rate scenario. E.g. there is your phrase “passively set the interest rate” in reference to the Fed. And you ask “How do you control the real rate?”.

      I suggest that in a Friedman zero rate regime the Fed just IGNORES interest rates. In the latter regime the Fed and government just create and net spend enough money into the economy to provide whatever stimulus is needed. (Though possibly the Fed could occasionally wade into the market and offer to borrow money at above market rates if serious inflation loomed.)

      Re Fisher and deflation, I’m not the expert here, but haven’t you got cause and effect the wrong way round? Fisher’s point (as I understand it) was that GIVEN a sluggish economy or “deflation”, interest rates will tend to be low.

      If a recession occurred in a Friedman zero rate regime, then the Fed and government would create and net spend money in the economy. The effect of that on interest rates is not obvious. There’d be extra demand for borrowed funds, but against that, the extra funds recently spent into the economy would increase the supply of such funds.

      • Seems like, exactly so.
        Thanks, Ralph.

      • Hi Ralph,

        To explain the “passive” and “dominant” language, if the central bank is setting an interest rate (or whatever its policy instrument is) to ensure fiscal solvency, that can be described as “fiscal dominance” or passive monetary policy.

        If the central bank is running an interest rate peg, that can be described as “monetary dominance”.

        It is not generally thought that both the fiscal and monetary authorities can act in a dominant way, unless it is in what are known as “non-Ricardian” regimes (where the price level is determined by the government’s present value budget constraint), though the existence of such regimes are highly controversial.

        In the zero rate scenario, I’m supposing that the Fed does not move the interest rate to try to get a good price for the treasury. The nominal rate would instead be an exogenous sequence of constant values (at zero). Because it is exogenous, this is an active monetary policy, even though the Fed isn’t doing very much.

        The Fisher equation says that the nominal interest rate (approximately) equals the real rate plus inflation. If the nominal interest rate is zero and the real rate is positive then inflation must be negative: 0 = r + pi pi = -r. So the way the Friedman rule is thought to play out is that in the long run you get a slow and steady deflation at the real interest rate. (Assuming, I suppose, you can get there.)

        • Vimothy,

          I think the response would be that the interest rate is a monetary policy variable and there is no real, ‘natural’ interest rate that brings the economy into equilibrium. Rather, the real interest rate is just the residual of the nominal interest rate minus inflation, and inflation is driven by fiscal and monetary policy.

          What I need to figure out is why the mainstream thinks this is so implausible. What should I read?

          • wh10,

            I don’t know that the natural rate really has anything to do with my questions, but I’m open to revising that opinion. Perhaps if I fleshed out an example my thinking on this issue might be a bit clearer.

            Let’s say that the Fed instigates a 0% rule and that the economy transitions to the state implied by the Fisher equation. Let’s further say that the real interest rate is 3%, so that the rate of deflation is also 3%.

            What have we achieved with respect to government finances? We haven’t achieved anything. The government will still face a real interest rate on its debt (varying across the term structure). The fact that the nominal rate is zero doesn’t place any restrictions on the real rate the government borrows at. Presumably, it will be what it was before.

            Now, you said that the interest rate is a monetary policy variable, and of course it is. But the point is that you cannot peg the interest rate at zero _and_ try to use it to generate a particular level of revenue or manipulate the real rate on outstanding debt. If the interest rate is pegged then it is already specified across time. It can’t be both variable and fixed. It has to be one or the other.

            • But what is predetermining the real interest rate at 3%? Why can’t the world be such that the nominal interest rate is 0%, inflation is 2% as a result of fiscal policy and the 0% interest rate, and the real interest rate is = nominal – inflation = 0% – 2% = -2%. In other words, in this vision, the nominal interest rate and inflation drive the real interest rate, rather than the nominal and real rates driving inflation. The real rate is just a residual, essentially meaningless, not really a “real” rate.

              I brought up the natural rate because I thought this is what is behind your assumption that some sort of real rate exists in the background.

              • I was originally asking what was pinning down the real rate. 3% was just for exposition. It seemed like a plausible value.

                In my view, it seems unlikely that -2% could ever be a long run interest rate, because it implies that the further away stuff is in time, the more people value it. All else equal, I’d rather have my things today than at some point in the uncertain future.

                But whatever it turns out to be, if the real rate is given and the nominal rate is given (pegged by the CB), then inflation will have to shift. You need that one degree of freedom or you won’t be able to have i = r + pi.

                (I don’t agree that the real rate is meaningless,though. It’s a residual in the sense that it’s computed as the difference between two values. But it seems quite meaningful from a conceptual point of view.)

          • Ah–I think I see what you mean by the natural rate.

            Okay, well if you don’t believe in any sort of equilibrium Fisher equation, it’s still (it seems to me) the case that the government faces a real interest rate and that this the nominal rate plus the rate of change of prices (i.e. inflation or deflation). The nominal rate is fixed at zero so either the inflation rate determines the real rate (which seems unlikely as a long run outcome, because gradually people will react to the trend that’s resulting in them over or underpaying to lend to the government), or the real rate determines the inflation rate.

            If we assume that the former is true, it leaves unresolved the path of inflation and the real funding costs of the government. So my question to you is, how do you get them to the level you want them to be? You can’t use monetary policy, because that’s busy pegging the interest rate.

            • Yup, that’s what I meant, and it seems to me Scott is proposing a view of the world that is your former example.

              I understand but struggle with your reason for why you think the latter is more likely to be true, because I don’t think a desire to earn more over inflation when holding a bond is what drives interest rates on government debt. Forecasts of the short-rate seems like it should be a much more dominant driver of the long rate when investors know the Fed has ultimate power over setting interest rates (either short or long). This really is a finance issue in my mind. If expected future short run rates (which the Fed could communicate if needed) are so much lower than what the long rate suggests, there is a profit opportunity to be gobbled up by investors, keeping the long-term rate pinned down. And if necessary, the Fed could theoretically enter the market directly by using its unlimited purchasing power to pin the long rate wherever it wants.

              • Remember that we’re assuming that the central bank is pegging the interest rate. This means that the Fed can’t manipulate the real rate–at any duration–because it isn’t able to manipulate the nominal rate.

                If you want the Fed to manipulate interest rates in order to try to get more advantageous financing terms for the government or generate seigniorage revenues or whatever, then you can’t also have the Fed operating an interest rate peg. A peg is an “active” policy. Trying to generate revenue or ensure the solvency of the government is a “passive” policy. The central bank can’t be active and passive simultaneously. It has to pick one or the other.

                • I realize all that. I think we’re struggling to connect here (although I thought we were on the same page) because you keep assuming that it must be the case that the real rate places a constraint on govt finances and the path of monetary policy.

                  Suppose the world works this way, as you stated: ” The nominal rate is fixed at zero so the inflation rate determines the real rate.”

                  In that case, let the real rate be what it will be. To simplify, it doesn’t matter in the sense that the real rate will not determine inflation or place a constraint on where the govt sets the nominal rate in an effort to ensure debt sustainability. You’re right, you’re not going to set it. But this hypothesized world, why does it matter.

                  Now, if the world works, as you said, where ” the real rate determines the inflation rate,” then I think we have the problem of the govt needing to pick ‘one or the other.’

                  • Oh sorry!!! Ignore my above post. I wasn’t reading you carefully enough. I see – you’re saying the Fed picks whether it pegs at 0% or any other nominal rate. It can’t do both. Right, of course. I am with you.

                    So I think the question you are ultimately posing is –

                    “If we assume that the former is true, it leaves unresolved the path of inflation and the real funding costs of the government. So my question to you is, how do you get them to the level you want them to be? You can’t use monetary policy, because that’s busy pegging the interest rate.”

                    So again, we are assuming this is the world where the nominal interest rate and inflation determine the real rate. In that world, I think the path of inflation will be driven by fiscal policy. As far as the real funding costs – I don’t see why those matter if we assume the nominal rate and inflation determine the real rate. In other words, the real rate isn’t going to impact the nominal cost of govt debt (the govt is pegging the nominal cost), and the real rate doesn’t determine inflation.

                    BTW – I am not wedded to a 0% peg vs letting monetary policy actively manage. This is complex, and I have a lot to learn.

                  • Right, you got it. The Fed can’t peg the interest rate and move it about at the same time.

                    So, if inflation is going to be driven by fiscal policy, how does that work? If the government wants to lower the inflation rate, what does it do?

                    If we know the inflation rate and we know the nominal rate, then we know the real rate at which the government borrows. If the real rate is very high, then the governments funding costs are high. From the point of government finances, being able to set the nominal rate means that you can potentially mess around with this rate. Being able to set a nominal rate _in and of itself_ doesn’t allow the government to set its funding costs to low levels–it needs to be able to set the inflation rate _as well_.

                  • This is just functional finance. If you want to lower inflation, you cut spending or raise taxes. If you aren’t pegging the interest rate to 0%, you can also adjust the nominal interest rate.

                    You keep going back to the real rate, but remember, in our assumed world, we’re using fiscal policy to get inflation where we want it given the nominal interest rate which we also set (whether it’s pegged to o% or some other level). In other words, we’ve already set the interest rate and fiscal policy so that we’re at full employment and price stability. The real rate will then be whatever it will be, but it doesn’t matter, because we’ve assumed in this world that the nominal rate and inflation (both of which the govt is setting, the former via the central bank, and the latter driven by fiscal policy given the monetary policy stance) drive the real rate (it’s just a residual, a mathematical construct we call nominal minus inflation).

                    Now if we start talking about a natural rate etc, then we have a debate. But above we assumed that the nominal and inflation rate determine the “real” rate, not the nominal and real rates determining inflation.

                    BTW this is my current understanding based on the little I know of functional finance. I could be wrong. But this was exactly the purpose of Scott’s series. This kind of stuff is in Part 4.

                  • I understand what you are saying, but it’s a partial equilibrium answer. I want to know what happens in general equilibrium. I want to know what happens when the government is trying to set the inflation rate *and* the central bank sets its policy rate to zero. Count up equations and unknowns. They need to be equal. If you have more equations than unknowns, the system is overdetermined.

                    When you set the rate of inflation and you set the nominal rate, you can’t simply let the real rate be. The real rate is the difference between the two. With inflation and the nominal rate pinned down, the real rate is also given.

                    Since you’ve determined the real rate, you can then ask: what *else* has to happen for the real interest rate to be here, as opposed to somewhere else?

                  • “When you set the rate of inflation and you set the nominal rate, you can’t simply let the real rate be. The real rate is the difference between the two. With inflation and the nominal rate pinned down, the real rate is also given.”

                    That’s what I mean though. It will be the difference between nominal and inflation. I am just saying it doesn’t seem like it matters, in our assumed, simplified world.

                    “Since you’ve determined the real rate, you can then ask: what *else* has to happen for the real interest rate to be here, as opposed to somewhere else?”

                    That’s what I originally asked you :). Why does anything else have to happen?

                    I confess though, this is the point where my math, modeling, and economic knowledge are not sufficient to continue to the conversation on your plane. My vague sense of how this model would work is you have inflation resulting from the fiscal stance and the nominal interest rate chosen. There’s no need to include a ‘real rate’ variable – it has zero implications for the economy (in our assumed, simplified world). But if you want to define something called the ‘real rate,’ feel free to call it ‘nominal minus inflation.’

                • reserveporto

                  You seem to be asking what happens from the point of view of utility functions. For utility functions, the real rate is a consequence of future utility being generally lower than present utility. Supposing a central bank pegs the nominal to 0% and fiscal policy pegs inflation to 2%, that implies that the real rate must be -2%, which implies that future utility is higher than present utility, as you wrote.

                  For most items, this doesn’t seem to make much sense, clearly there must be some positive real rate. But what rate(s) is being pegged and who is borrowing? The discount rate and the central bank. Long term T-bill rates and spreads of corporates and munis are free to float. Regular investors aren’t going to tolerate for long a negative real rate so they’ll flee that particular market and other rates will adjust so that nominal is positive otherwise those markets will be unable to find lenders. But, what about that central bank? Why should its utility function be the same as that of private lenders? Is there something truly abhorrent about a central bank that finds holding tomorrow’s bonds more useful than holding today’s?

                  What if a central bank targeted some other interest rate? Regular investors need to satisfy their utility functions so they’ll move their funds away from bonds denominated at that rate, but the central bank has announced that its maximum utility is achieved by owning assets controlled by whatever interest rate it just set.

                  I think the answer to the utility question is to consider that the utility functions used in equilibrium calculations are summations of entire classes of economic actors. Some of those actors may very well prefer negative real rates. If those negative actors are predominant, market prices will shift to favour those actors and other unsatisfied actors will find themselves squeezed out of those markets and shift their resources to other markets.

        • Vimothy,

          You say, “If the nominal interest rate is zero and the real rate is positive then inflation must be negative”. And that, you claim, equals deflation. I think the flaw there is as follows.

          Under a Friedman / Mosler zero interest regime, governments don’t borrow. The only liability (if you can call it that) that they issue is cash, or monetary base to be exact. And they don’t pay anyone interest for holding cash / base.

          But that doesn’t mean that non central government entities charge each other a zero rate for loans. The rate for a near risk free loan (e.g. to a responsible US state or city) might be substantially positive. Indeed, the rates might be very much as they are now for that sort of loan: that’s an interest rate of about 2% (while inflation is at about 2%). So a zero nominal rate paid by the Fed to holders of cash / base does not lead to negative inflation or “deflation” as you put it.

          When someone lends (e.g. to a US city), they forego consumption and will want a reward for doing so. In contrast, when someone simply sits on a pile of cash, they ARE ABSTAINING from consumption, but they haven’t allowed anyone else to raise their consumption by lending them the cash. So they aren’t performing any useful service, so no one is going to pay them for their “abstinence”. In fact they’re being a bit a nuisance in that abstaining from consumption in the form of hoarding cash just means the central govt / central bank has to print and distribute more money so as to keep the economy at capacity.

          • Ralph,

            The Friedman rule is just an interest rate peg at 0%. It implies that the government should be indifferent between financing via cash or bonds, but only at the shortest maturities. That’s a similar scenario to the one we’re in now. It doesn’t imply that the government won’t want to issue debt at longer maturities, though, as far as I can see. Again, much like now.

            I know that Mosler has a no bond proposal, but it’s distinct from the Friedman rule, I think. And the government still borrows under a no bond proposal, unless it fully balances its budget. Assuming that the idea is simply to finance net spending by issuing money, the difference is that the government borrows at a nominal rate of 0%. It still borrows, and its real rate will likely be non-zero. If inflation is positive, this real rate will be negative (people will pay to lend resources to the government). If inflation is negative, which is I think the only plausible long run outcome consistent with the Friedman rule, then the real rate is positive, as before.

            The Friedman rule isn’t designed to make the government’s spending easier to finance. It’s designed to produce the _optimal_ quantity of money–the one that equates the marginal value of money with the marginal social cost of creating it, which is zero.

            • What I had in mind by “the Friedman rule” was what he said in his 1948 paper, “A MONETARY AND FISCAL FRAMEWORK FOR ECONOMIC STABILITY”. He said:

              “Under the proposal, government expenditures would be financed
              entirely by either tax revenues or the creation of money, that is, the
              issue of non-interest-bearing securities. Government would not issue
              interest-bearing securities to the public; the Federal Reserve System
              would not operate in the open market.”


              So he seems to be saying there that there is no government borrowing either at long or short maturities. But you may have a different version of the “Friedman rule”. Friedman certainly changed his mind left right and centre!!!

              • Ralph, I was thinking of the 0% rule in the optimum quantity of money paper. It’s only feasible to issue money to pay for spending if the economy actually transitions to the moderate deflationary state, in which case the government’s funding costs are the negative of the deflation rate. If people don’t believe that the government will stick to the 0% rule, for example, if it starts to cause inflation (as it probably will do in the near term) and there is pressure to raise the rate, then ultimately you won’t be able to issue debt without some nominal discounting.

              • Ralph:
                Thanks for that on Friedman’s Framework proposal:
                “government expenditures would be financed entirely by either tax revenues or the creation of money,……. the Federal Reserve System would not operate in the open market.”.

                Despite rather extensive MMT postings on the Friedman “Framework”, in Dr. Wray’s Primer on MMT and his latest book and elsewhere, this very clear language is either misinterpreted or denied by the cadre of MMT leaders.

                The fact that the Fed would not operate in the open-market means that monetary policy is removed from the FOMC and that new money must be created directly by the government.
                That radical! Milton Friedman. Who’da thunk it?


              • Ralph and Joebhed,

                Good stuff! Benes and Kumhoff 2012 note how the Friedman Rule would work, and indeed be needed, under their proposals (or any similar ones).
                Basically, Friedman had the right idea, just under the wrong system (under a mixed state and private credit-money system monetarism could not work).
                I am warming towards writing a post on how chartalism and Monetarism get along just fine under a pure state-money system.

                You can see some of these shared roots in my recent post (I need to work out more details for the shared monetarism/Minsky/MMT ideas) Some pre- Great Depression roots of The Chicago Plan (& Minsky’s Financial Instability Hypothesis)

                Just the tip of some fascinating shared intellectual heritage there I think, between Knight, Simons, Friedman, Fisher and Minsky among others.

                • That’s a great comment.
                  In terms of your planned research effort, Please do.
                  As to the Minsky connection….
                  A lot has been made on MMT Blogs of Minsky’s earlier criticisms of Fisher and what he called the ‘narrow-banking’ posture that is one possible aspect of 100 Percent Money.
                  Dr. Jan Kregel at the Levy Institute took aim at the IMF’s research paper by quoting from Minsky’s 1980s criticism and his reference to the Diamond-Dybvig research study done for the Fed, which was only tangentially related to Fisher’s concepts.
                  But Minsky, being the scholar, eventually came around fully for consideration of the Fisher 100 Percent Money proposal, going so far as calling for a new National Monetary Commission to study the needed changes to this system.
                  See Minsky’s Working Paper No. 127 at the Levy Institute.
                  The Conclusion of Minsky’s paper was this:

                  VII. A Modest Proposal
                  The time has come to open a national inquiry into the structure of the banking and financial system. The radical changes now underway in technology, computing, and communication mean that much of what we now have may be obsolete. The sluggish economy of the past decades, combined with the apparent
                  reluctance of the Federal Reserve to give full employment a chance, can mean that our financing structures are not consistent with the needs of a progressive democracy.
                  In the past, serious changes were the result of serious public inquiries. I suggest that enough is amiss in our
                  financial and banking structures that it is time to go back to the drawing board and determine what the monetary, financial, and financing arrangements should be in the 21st century.
                  A late 20th century National Monetary Commission should be on the public policy agenda.

                  In case anybody missed it –
                  “” our financing structures are not consistent with the needs of a progressive democracy.””

                  That’s why we NEED to change them.

  11. Scott
    Thanks for the series. Just one request.
    Next time can you bring it out before the holiday period.
    For obvious reasons.

  12. MMT has been a paradigm altering concept for me & I think the the thankless work that is being done in pursuit of policy change based on MMT is laudable. As I understand MMT, sovereign spending is only limited by fear of inflation and taxes are the mechanism to control that inflation. I was curious what MMT taxation policy would look like, would it be a floating consumption tax, much as the U. S. experiences at the gas pump? I’ve also read a great deal about the social programs that should/would be enacted under MMT policy but very little about other sorts of gov’t. spending. What about military spending increases and subsidies to attract more businesses to come to/return to our shores?

  13. Apologies for coming in late to this discussion. I just discovered this article through a link form Joe Firestone’s recent article.
    Anyway, if we agree that government must spend more to provide full employment, and we agree that debt IN AND OF ITSELF is a bad thing (as you say when complaining about debt due to health costs, and about private debt), than why not separate debt from spending? That is, why not have government issue money, debt-free?
    As you know, this was done in the Civil War with United States Notes, under Lincoln, and continued through 14 series until the Greenbacks were finally pulled from circulation in 1996. For that matter, coins have been produced debt-free since the original coinage act of 1791, and there was briefly even talk of producing a trillion dollar platinum coin to partly pay down the debt (personally, I would rather see a trillion dollars put towards repairing our infrastructure, but then I am not beholden to the banks!).
    In a fiat money system, as you know, we cannot “run out of money.” And you call for full employment – something we are even further from if the true unemployment figures were used, reaching some 17% un- or underemployed. So, why not have Treasury issue debt-free Greenbacks directly for government programs, as the LaHood bill HR1452 (1999 and 2004) attempted to do, or Kucinich attempted to do in a much more comprehensive (and therefore doomed) bill, HR2990 (2012)?
    Than we could directly address the disastrous wealth inequity too, by injecting money directly into middle class jobs.
    What am I missing?

  14. Pingback: A Plague on All Your Budgets | BirchIndigo

  15. Garrett Nordsiek

    Medicare offers all enrollees a defined benefit. Hospital care is covered under Part A and outpatient medical services are covered under Part B. To cover the Part A and Part B benefits, Medicare offers a choice between an open-network single payer health care plan (traditional Medicare) and a network plan (Medicare Advantage, or Medicare Part C), where the federal government pays for private health coverage. *”::