Daily Archives: August 14, 2011

TODAY ON MODERN MONEY PRIMER

Posted on August 14, 2011 by admin | 1 comment

Wray explains the implications of exchange rate regimes for Modern Money Theory:

Floating vs fixed exchange rate regimes. The previous blogs were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog we will examine the implications of exchange regimes for our analysis.

Read the full post at MMP#11: MODERN MONEY THEORY AND ALTERNATIVE EXCHANGE RATE REGIMES

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MMP BLOG #11: MODERN MONEY THEORY AND ALTERNATIVE EXCHANGE RATE REGIMES

Posted on August 14, 2011 by admin | 18 comments

L. RANDALL WRAY

Floating vs fixed exchange rate regimes. The previous blogs were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog we will examine the implications of exchange regimes for our analysis.

Let us deal with the case of governments that do not promise to convert their currencies on demand into precious metals or anything else. When a $5 note is presented to the US Treasury, it can be used to pay taxes or it can be exchanged for five $1 notes (or for some combination of notes and coins to total $5)—but the US government will not convert it to anything else.

Further, the US government does not promise to maintain the exchange rate of US Dollars at any particular level. We can designate the US Dollar as an example of a sovereign currency that is nonconvertible, and we can say that the US operates with a floating exchange rate. Examples of such currencies include the US Dollar, the Australian Dollar, the Canadian Dollar, the UK Pound, the Japanese Yen, the Turkish Lira, the Mexican Peso, the Argentinean Peso, and so on.

In the following sections we will distinguish between these sovereign nonconvertible floating currencies and currencies that are convertible at fixed exchange rates.

The gold standard and fixed exchange rates. A century ago, many nations operated with a gold standard in which the country not only promised to redeem its currency for gold, but also promised to make this redemption at a fixed exchange rate.

An example of a fixed exchange rate is a promise to convert thirty-five US Dollars to one ounce of gold. For many years, this was indeed the official US exchange rate. Other nations also adopted fixed exchange rates, pegging the value of their currency either to gold or, after WWII, to the US Dollar.

For example, the official exchange rate for the UK Pound was $2.80 US. In other words, the government of the UK would provide $2.80 (US currency) for each UK Pound presented for conversion. With an international fixed exchange rate system, each currency will be fixed in value relative to all other currencies in the system.

In order to make good on its promises to convert its currency at fixed exchange rates, the UK had to keep a reserve of foreign currencies (and/or gold). If a lot of UK Pounds were presented for conversion, the UK’s reserves of foreign currency could be depleted rapidly.

There were a number of actions that could be taken by the UK government to avoid running out of foreign currency reserves, but none of them was very pleasant. We will save most of the details for a later discussion. The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c) deflate the economy.

In the first case, the government changes the conversion ratio to, say, $1.40 (US currency) per UK Pound. In this manner it effectively doubles its reserve because it only has to provide half as much foreign currency in exchange for the Pound. Unfortunately, such a move by the UK government could reduce confidence in the UK government and in its currency, which could actually increase the demands for redemption of Pounds.

In the second case, the government borrows foreign currencies to meet demanded conversions. This requires willing lenders, and puts the UK into debt on which interest has to be paid. For example, it could borrow US Dollars but then it would be committed to paying interest in Dollars—a currency it cannot issue.

Finally, the government can try to deflate, or slow, the economy. There are a number of policies that can be used to slow an economy—but the idea behind them is that slower economic growth in the UK will reduce imports of goods and services relative to exports. This will allow the UK to run a surplus budget on its foreign account, accumulating foreign currency reserves.

The advantage is that the UK obtains foreign currency without going into debt. The disadvantage, however, is that domestic economic growth is lower, which usually results in lower employment and higher unemployment.

Note that a deflation of the economy can work in conjunction with a currency depreciation to create a net export surplus. This is because a currency depreciation makes domestic output cheap for foreigners (they deliver less of their own currency per UK Pound) while foreign output is more expensive for British residents (it takes more Pounds to buy something denominated in a foreign currency).

Hence, the UK might use a combination of all three policies to meet the demand for conversions while increasing its holding of Dollars and other foreign currencies.

Floating exchange rates. However, since the early 1970s, the US, as well as most developed nations, has operated on a floating exchange rate system, in which the government does not promise to convert the dollar.

Of course, it is easy to convert the US dollar or any other major currency at private banks and at kiosks in international airports. Currency exchanges do these conversions at the current exchange rate set in international markets (less fees charged for the transactions). These exchange rates change day-by-day, or even minute-by-minute, fluctuating to match demand (from those trying to obtain dollars) and supply (from those offering dollars for other currencies).

The determination of exchange rates in a floating exchange rate system is exceedingly complex. The international value of the dollar might be influenced by such factors as the demand for US assets, the US trade balance, US interest rates relative to those in the rest of the world, US inflation, and US growth relative to that in the rest of the world. So many factors are involved that no model has yet been developed that can reliably predict movements of exchange rates.

What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.

In practice, governments operating with floating exchange rates do hold foreign currency reserves, and they do offer currency exchange services for the convenience of their financial institutions. However, the conversions are done at current market exchange rates, rather than to keep the exchange rate from moving.

Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not.

The point is that on a floating exchange rate, attempts to influence exchange rates are discretionary. By contrast, with a fixed exchange rate, government must use policy to try to keep the exchange rate from moving. The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.

As we continue this discussion in coming weeks, we will argue that a floating currency provides more policy space—the ability to use domestic fiscal and monetary policy to achieve policy goals. By contrast, a fixed exchange rate reduces policy space. That does not necessarily mean that a government with a fixed exchange rate cannot pursue domestic policy. It depends. One important factor will be whether it can accumulate sufficient foreign currency (or gold) to defend its currency.

Next week, however, we will take a brief diversion to examine so-called commodity money. The fixed exchange rate based on a gold standard has been a reality in relatively recent times. And during much of the past two millennia, governments issued coins with silver and gold content. Many equate these with “commodity money”—a monetary system supposedly based on precious metal, indeed, one in which money derives value from embodied gold or silver.

We will come to a surprising conclusion, however. Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies.

I can already hear the teeth of our resident Austrian gold bugs rattling so hard their fillings threaten to shake loose.

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Anti “MMT Types” Memes Migrate to Stage II

Posted on August 14, 2011 by admin | 31 comments

By William K. Black

One of the famous statements attributed to Mahatma Gandhi is that opposition to new, powerful ideas goes through three stages. First, they ignore you. Then they attack you. Then you win. Modern Monetary Theory (MMT) has reached the second stage. It has, on the same day, been attacked by Paul Krugman and John Carney (CNBC.com’s “senior editor”) in their unrelated columns.

The attacks are particularly interesting because they share two characteristics. They independently use the meme “MMT types” to disparage their opponents and they do not engage the accuracy of MMT theory. The CNBC commentator dismisses MMT because he fears that if members of Congress understood how monetary operations worked they would be tempted to support government programs. The CNBC commentator has an intense ideological opposition to government programs, so he opposes MMT. Note that he opposes MMT because it is substantively correct. That is the oddest objection to a theory that I have seen presented.

CNBC’s hostility to MMT was predictable and its commentator was playing by modern journalistic rules with no pretense to academic objectivity. Krugman’s disparaging dismissal of “MMT types” based on a straw man argument that he falsely ascribes to MMT is far more embarrassing because he is a globally prominent academic.

I am not an “MMT type.” MMT is a macroeconomic theory. I teach courses in microeconomics, law, regulation, finance, and criminology at the University of Missouri-Kansas City (and previously at the LBJ School of Public Affairs at the University of Texas at Austin). I’m still trying to get past the first stage (being ignored) with Krugman. He cited one of my columns favorably in his blog in which I recounted ECB President Trichet’s 2004 speech in Ireland urging new EU nations to use Ireland as their economic model. My work explains how accounting control frauds drive our recurrent, intensifying crises and what policies create the criminogenic environments that produce fraud epidemics and hyper-inflate financial bubbles. Criminological research findings would add considerable support and new insights to Krugman. Scores of economists now cite our work, but Krugman still shares the characteristic reluctance of economists to use the “f” word (fraud) to describe frauds.

UMKC’s economic department has a storied reputation going back over a half century. It is one of the few remaining “heterodox” economics departments in America. “Heterodox” is not a euphemism for Marxist and it is not an oxymoron describing a department filled with intellectual clones. UMKC’s economics department is also cheerfully interdisciplinary. They welcome the research insights of other fields such as criminology and law. White-collar criminological theories about “control fraud” have shown far greater predictive strength than neoclassical and “modern finance” models. White-collar criminologists falsified the efficient markets hypothesis 25 years before the hypothesis was created.

As Jim Sturgeon, the chair of the economics department puts it: “UMKC, the place that got it right; and probably will again.” I love Jim’s use of “probably.” It is so wonderfully and appropriately Midwestern. Our students are taught both the neoclassical canon and critiques of that canon. The neoclassical model and “modern finance theory” have failed and are in their paradigmatic death throes. Unfortunately, their dogmas will likely persist for decades and cause several more crises. UMKC doctoral students have proven extremely successful in finding academic positions because of their broader training. As heterodox economists, we are a tiny minority, but we punch way above our weight class. (If you are interested in studying in an economics graduate program that is reality-based please contact us.)

My closest colleagues at UMKC include Randy Wray and Stephanie Kelton and my closest colleague at U. Texas was Jamie Galbraith. Wray is the nation’s leading MMT theorist. (Bill Mitchell of the University of Newcastle and Wray are the best known academic developers of MMT.) Wray was one of Minsky’s grad students and has continued to develop Minsky’s famous work on the paradox of financial stability leading to instability. Jamie Galbraith has several specialties; including MMT. Kelton is a younger colleague whose dissertation on government finance spawned two classic works on MMT, and the New Economics Perspectives blog — now a major player — was her creation. I have been privileged to see each of these colleagues present on the subject of MMT in the U.S. and in several other nations and I have read Wray and Galbraith’s congressional testimony on MMT and read other academic and policy articles that they have authored.

Mat Forstater is a colleague who is an active MMT scholar. Mat runs our Center for Full Employment and Price Stability (CFEPS) and is particularly active in developing programs to use the government as the employer of last resort (ELR). Warren Mosler, a hedge fund manager and leading MMT theorist, provided the primary funding for CFEPS and many of our grad students.

Wray, Galbraith, Kelton, Forstater, and Mitchell are serious academics by anyone’s standards. Mosler’s knowledge of actual monetary operations is legendary. They present at major economic conferences, often as prominently featured speakers. They are open to criticism and they engage in civilized dialogue with their critics. One of the odd aspects of MMT is that none of the scholars who developed the theory likes the phrase “Modern Monetary Theory.” Indeed, they do not like any of the three words in the term. “Modern” is something of an internal joke among MMT theorists because Keynes observed that the state theory of money described events that arose over 4,000 years ago.

MMT is a rich theory in that it is built from diverse supporting strands pursued independently that were eventually woven together to form a far stronger intellectual fabric. The heart of MMT is not a “theory.” It is a description of reality as opposed to an idealized theory with simplifying assumptions. It turns out that the description of monetary operations we were taught in conventional macro courses is inaccurate in several important areas. MMT theorists cite the statements of central bankers (even Alan Greenspan) that demonstrate that their actual operations accord with MMT’s description of those operations. If Krugman believes that the heart of MMT – the description of actual monetary operations – is incorrect he should explain what he believes is incorrect. He has never suggested that MMT’s description is inaccurate. MMT has found increasing popularity among financial market participants precisely because they know that it is an accurate description of actual monetary operations.

MMT is also woven with strands drawn from research of monetary and macroeconomic history. One component of this historical research has refuted the conventional “just so” story of the creation of monetary systems. MMT shows the closeness of the relationship between the sovereign and the monetary system. MMT research shows that it was normal for the U.S. government to be in deficit and normal for the U.S. government to be in debt. These deficits have not led to hyperinflation in the United States. Historical research shows that the age of the gold standard was not a golden era. The gold standard caused recurrent crises in many nations. MMT research shows that when President Roosevelt listened to his conventional economic advisors in 1937 and attempted to balance the budget the result was to throw the U.S. back into the depths of the Great Depression. MMT research has shown that the extremely uncommon periods in which the U.S. runs a material budget surplus are typically followed quickly by serious recessions. Wray, Galbraith, and Kelton are appropriately cautious in concluding that this historical pattern demonstrates that the surpluses caused the recessions. They do, however, offer a credible explanation of why budget surpluses could lead to recessions. Again, if Krugman has specific disagreements with these findings about monetary and macroeconomic history my colleagues will be delighted to discuss the merits. As we will see, Krugman is one of the scholars whose historical research has confirmed and extended these findings.

The leading MMT scholars have been among the strongest spokespersons predicting that the proposed U.S. stimulus program would prove far too small and explaining why the budget deficit is a consequence of Great Recession, why vigorous counter-cyclical fiscal policies are essential to our recovery, why austerity would worsen the recession and increase budget deficits, why our focus needs to be on restoring full employment (the MMT scholars are strong supporters of government ELR programs), and why these policies are not inflationary in the current circumstances. Krugman acknowledges that he agrees with each of these conclusions.

Regular readers of comments will notice a continual stream of criticism from MMT (modern monetary theory) types, who insist that deficits are never a problem as long as you have your own currency. I really don’t want to get into that fight right now, because for the time being the MMT people and yours truly are on the same side of the policy debate. Right now it really doesn’t matter at all whether the United States issues zero-interest short-term debt or simply prints zero-interest dollar bills, and concern about crowding out is just bad economics.

Krugman agrees that the MMT scholars are correct except as to one matter: “MMT … types … insist that deficits are never a problem as long as you have your own currency.” That is a straw man argument. I can personally attest that Wray, Galbraith, and Kelton do not argue that “deficits are never a problem.” MMT explains the economic circumstances in which “deficits are … a problem.” I am unaware of any MMT scholar who asserts that “deficits are never a problem” for a nation with a sovereign currency. It is not uncommon for academics to misunderstand an academic literature that they have not read. I invite Krugman to read the academic MMT literature and critique it substantively.

Three aspects of Krugman’s dismissal of “MMT types” strike me as unworthy of him. The term “MMT types” is deliberately ad hominem. Using the term to belittle and dismiss scholars such as Wray, Galbraith, and Kelton is unwarranted and diminishes Krugman.

The “stream of criticism” of Krugman from supporters of MMT is largely driven by his repeated straw man assertions that MMT predicts that “deficits are never a problem as long as you have your own currency.” Krugman then attacks the straw man he created by arguing that that because deficits mattered in France after World War I (one of the subjects of his dissertation) he has refuted MMT’s (non) prediction that deficits never matter. MMT supporters have repeatedly explained to Krugman that MMT does not predict that “deficits are never a problem as long as you have your own currency.” Wray, Galbraith, and Kelton have emphasized that MMT predicts the circumstances in which deficits can cause problems. World War I was fought largely on French soil, destroying and allocating real resources to the imperative of national defense. France went off, then on, then off the gold standard. Yes, France followed policies, in dreadful circumstances, that sometimes produced serious financial instability – as MMT would predict.

Making a dismissive straw man assertion once is a common error. Ascribing the same straw man assertion to “MMT types” after he had been warned repeatedly that his assertion was false evinces a serious flaw.

The final aspect of Krugman’s response that is so disturbing is his claim that he is the victim of “harass[ment]” by “MMTers.”

Now, all of this is remote right now. And notice too that France in the 1920s stabilized with debt of 140 percent of GDP — far higher than the numbers that are supposed to terrify us now. So none of this is relevant to the current policy debate.

But since the MMTers seem to have decided to harass those of us who want stronger action now but think there really is a long-run fiscal issue, I needed to put this out there.

This passage is odd on several different levels. He asserts that MMT predicts that deficits never matters. MMT supporters point out to him that he has erred – MMT theory predicts the circumstances in which deficits can cause severe problems. Krugman does not respond: “thank you, I am delighted to learn that MMT does not make such a prediction.” Instead, Krugman repeats the straw man assertion that he knows to be false. He gets called on it – again. He now plays the victim card: “MMTers … harass” him when he writes about MMT. Critiques of what we write are valuable, particularly when we commit error. There is nothing better for an academic than being saved from error by a commenter’s correction. Krugman is both a journalist and a scholar, so he should take special joy in receiving vigorous critiques from readers of his New York Times column.

The passage is also bizarre with regard to the substance of this argument about MMT. Recall what I have explained about MMT scholars’ historical findings. While MMT theory explains why severe deficits could indeed cause problems, historical research shows that nations with sovereign currencies are far less vulnerable to deficit levels than the deficit hawks assert should “terrify us.” Deficit hawks’ primary strategy is to create what criminology and sociology call a “moral panic” (think “Reefer Madness”, the “crisis” of “illegal immigrants”, and the plague of “voter fraud” led by ACORN). As the term implies, the goal is to moralize the issue and generate a panic that makes immediate action imperative to save the Republic. Anyone who opposes immediate action is immoral and disloyal to the Republic. Government deficits are generally not a “moral” matter. Governments are not like private households. Deficits are “just business.” They may be good for the economy or bad for the economy. Given the roughly 25 million Americans who want to be fully employed and cannot find such jobs, it would be far easier to craft a moral argument in favor of a larger federal budget deficit during the current economic crisis than a moral case for consigning millions more to unemployment – which is what “balancing the budget” would do. MMT scholars are the “owls” in the debate between the deficit hawks and doves (Krugman is a dove). MMT scholars seek to alert the public to the deliberate generation of a moral panic. President Obama has appointed (think Simpson-Bowles) leaders of the campaign to create a moral panic. Krugman has decried this, but he seems to believe that we have an inherent budgetary (as opposed to cost containment) crisis in health care. I will respond to the roots of the rise in health care costs in a later column. Hint: I will often cite Krugman.

Krugman’s historical research into France’s deficits for his dissertation is part of the academic literature supporting MMT. He found that France “stabilized” “with debt of 140 percent of GDP – far higher than the numbers that are supposed to terrify us now.” An MMT theorist could not have said it better. The nature and magnitude of the deficit can cause a problem, but the deficit hawks and the deficit doves are both allowing current U.S. deficits that are far lower than France ran to “terrify us now.” Like Krugman, in his dissertation, Wray, Galbraith, and Kelton’s research findings refute the claim that the current U.S. deficits are too large and should terrify us. Once one strips away Krugman’s straw man misconception about MMT (“deficits are never a problem”) one is left with Krugman agreeing entirely with MMT scholars on substance with regard to current policies. I believe that he would also agree with me that the hawks are deliberately generating a moral panic for political and ideological purposes and that it is essential that economists fight this panic and show that the policies its proponents advocate would be disastrous for the nation. Indeed, I believe that Krugman would agree that this has been the thrust of dozens of his columns.

Now, if I could only find him a way to get him to read the research on accounting control fraud….

*Bill Black is an Associate Professor of Economics and Law at UMKC. He is a former senior financial regulator, a white-collar criminologist, and the author of The Best Way to Rob a Bank is to Own One.