By Dan Kervick
Josiah Neely enters into a recent discussion in the economics blogosphere about the potential impact of religious orientation on attitudes toward monetary policy. I find that discussion, which began with a partially tongue-in-cheek Project Syndicate piece by former Moody’s VP Christopher Mahoney, to be a bit tasteless for my tender sensibilities, and I have no intention of entering it myself. But Neely doesn’t actually spend much time on religious beliefs and instead zeroes in on cultural and political attitudes:
Still, I do think Mahoney has put his finger on one reason why many conservatives and libertarians view monetary expansion with such a jaundiced eye. If there is one economic lesson the Right has internalized, it is Heinland’s aphorism that There Ain’t No Such Thing As A Free Lunch. And attempts to improve the economy by what is often derisively described as “printing money” can at first blush seem like, if not a free lunch, then at least as free lunch money.
This reference to Heinlein’s free lunch proverb put me in mind of a piece that I wrote last December called “Paying for Lunch – MMT Style.” I began the piece by noting that:
A common criticism of Modern Monetary Theory is that it is a naïve doctrine of free lunches. The critics grant that a country like the United States, which issues its own freely floating fiat currency, can always make the policy choice to issue whatever quantity of that currency it deems appropriate. The US government can spend as many dollars into the private sector economy as it chooses, without obtaining those dollars from some other source first, and it can always pay any debts that have been incurred by borrowing dollars. But the critics will go on to charge that MMT mistakenly concludes from these few institutional and operational facts that there are no economic limits to the wealth-generating capacities of the government. They caricature MMT as a doctrine of manna from heaven, in which the power of issuing a generally accepted medium of exchange confers the power of conjuring real wealth into existence by prestidigitation. In short, they see MMT as a disordered syndrome characterizing people who are experiencing massive money illusion.
Without recapping the whole argument of that piece, I think the central point can be put fairly simply: It is true in the aggregate that there is no free lunch. There is almost always a price to be paid for increasing our prosperity, and the price is a lot of very hard work. We take some of the things we already have and decide to use them as inputs for some productive process. By the enterprising application of our industry and intelligence, we transform those inputs into different and better things, and we exchange our work and the products of our work among ourselves to enhance our lives.
But the MMT approach is fully cognizant of this reality. What it points out are the different ways in which government control over modern monetary systems can and does play a role in mobilizing underutilized capacity and unemployed labor. It argues that economic expansion almost always requires an expansion of the consolidated government balance sheet, unless the private sector as a whole is willing to reduce its savings, and it points out the options a government has in its kit of policy choices regarding the order in which the expansion of economic activity and expansion of the government balance sheet will occur. Let me expand on this:
As the economy grows, the volume of daily exchanges in the economy tends to increase. And if more things are being bought and sold, then people will tend to need more money to carry out these exchanges. A well-functioning monetary system has mechanisms that adjust the supply of the medium of exchange up or down in accordance with the needs of the economy, and in a way that keeps prices as predictable and stable as possible while economic conditions change dynamically.
One way this monetary expansion can happen is through the initiative of private enterprise working with the banking and financial system. The perception of potential markets for new products, or for greater supplies of existing products, gives producers an incentive to invest in expanded production. If existing monetary savings are inadequate to finance the entirety of the new production, or if risk-averse producers are unwilling in the aggregate to reduce their financial savings even though those savings are adequate to the task, there will be demand for a sharply increased net supply of credit to finance the production. Banks issue their own negotiable liabilities (deposit balances) to accommodate this demand, in exchange for borrowers’ promises of future repayment. The expansion of bank balance sheets and economic activity in turn drives an increase in the volume of interbank payment obligations and withdrawal obligations, and increases the demand for settlement liquidity in the banking system. Since most banks in our system settle their payment obligations with the liabilities issued directly by the central bank, the increased demand for bank liquidity takes the form of increased demand for central bank liabilities, which the central bank then accommodates by issuing money in both electronic form and physical currency form.
One way the demand for settlement balances can be accommodated is by an expansion of net lending by the central bank at the discount window. But while this process expands the government’s balance sheet, it concurrently increases the net indebtedness of the private sector to the central bank by an even greater amount than it increases the private sector’s holdings of central bank liabilities. In other words, while the supply of central bank money to the banking sector has increased, the net financial asset holdings of the banking sector have decreased, and this can have an inhibitory effect on growth.
So an alternative way the government as a whole can accommodate the need for settlement balances, while increasing the net financial assets of the economy, is to supply those liabilities for free. The main way it does this in our present system is by selling and repurchasing securities. The sale of the security increases the net financial assets of the private sector, since the amount paid for the security is less than the value of the security. The repurchase of the security at a higher price than the sale price then converts some of those assets back into the form of money – which appears in the banking sector as settlement balances (“reserves”). (The central bank also adds reserve balances to the system by paying interest on existing reserve balances, but the amount is relatively small and the interest rate is determined by the use of that rate to help target the interbank lending rate, so this is not an important part of the provision of liquidity.)
As a result of all of this activity, economic production expands, employment expands, and the balance sheets of both commercial banks and the central bank expand. More importantly, the consolidated balance sheet of the entire government expands, since the treasury is the agency responsible for issuing securities, and the sale and repurchase of securities involves coordination between the treasury and the central bank. The process then looks something like this, with the arrows representing the direction of causal influence:
Scenario A: Decision to expand production —> Increased demand for bank credit —> Increased bank demand for central bank settlement assets —> Government accommodation of demand with a balance sheet expansion and either an increase or decrease in private sector net financial assets —> Increased income to households —> Effective household demand to purchase added output.
But there are various ways in which this process, which is driven by markets and private enterprise initiative, can break down, and so complete reliance on the mechanism just described will be inadequate to maintain a healthy economy. We could have a a situation in which producers are stuck in a low-employment, underutilization equilibrium. Since the income to purchase goods produced following production, in the aggregate, comes from the prior compensation to labor for participating in their production, we might have a situation in which (i) all producers would benefit if all producers expanded at more or less the same time, but in which (ii) any individual producers will lose if they expand their own production while others don’t. We have a huge social coordination problem, and since no individual producer controls the production decisions of any significant number of other producers, we have the obvious possibility of the economy settling into an equilibrium at a low level of production. We could also have a situation in which traumatized producers are suffering from extreme risk aversion, and so will not expand, even in circumstances in which they would expand if their risk acceptance was more normal. There is sometimes a clear need, then, for effective government action to get us out of the low-employment equilibrium by solving the coordination problem on terms more favorable to the public interest.
And here is a way out: The government can emit its financial liabilities directly, without regard to demand in the credit markets, and either distribute those liabilities to people outright, or use them to purchase more goods and services as it expands its own role in the economy as a consumer and investor. The treasury can issue its securities and, working with the central bank, swap those securities for money at a price profitable to the purchasers. It can then either issue monetary transfer payments or purchase goods and services, without increasing taxes, thus increasing the size of the consolidated government balance sheet and the private sector’s net holdings of financial assets. As payments are made to households and firms in the non-banking sector, reserves also flow from government accounts to commercial bank reserve accounts, and the balances of both non-bank entities at their banks and banks at the central bank increase. The provision of income up front to households and businesses drives the demand for expanded production while reducing the risks involved in that expansion; and the government’s own expanded role as a customer and producer forwards this process.
The end result is roughly the same as the process described previously. In the end, there is more production; more employment; more work. That work is the price of lunch, and the added output is not free. The commercial banks’ balance sheets have expanded, and the central bank’s balance sheet has expanded. The consolidated government balance sheet has also expanded. But in this case, the government balance sheet expansion occurs first, and the injection of income to households and businesses starts the process. The additional real asset creation and commercial bank balance sheet expansion follows and catches up with the income increase, rather than the other way around. So the process now looks something like this:
Scenario B: Government balance sheet expansion and increased transfers and spending —> Increased income to households and business and expanded bank balance sheets following government payments —> Effective household and business demand to purchase more output —> Decision by producers to expand production —> Increased demand for bank credit —> Increased bank credit drawing on expanded reserve balances without additional central bank accommodation.
MMTers have inveighed frequently on behalf of fiscal expansion and against reliance on central bank action alone in restoring economic health. But the above description focuses quite a bit on the role of money. Since central banks are usually taken to be the agencies responsible for monetary policy, isn’t there a tension here? No, not at all from the MMT perspective. As I have argued recently, monetary policy is not central bank policy. Neo-monetarist and New Keynesian economics focuses on the central bank as the instrument of monetary policy, and has therefore pinned a lot of hopes for economic recovery on unconventional operations such as quantitative easing. But the central bank is not a omnipotent money god in the sky. As currently organized and institutionally constructed, a central bank can carry out no helicopter drops. It is a specific kind of institution with important statutory and customary constraints, and limited mechanisms available for influencing the economy. Nor do we want central banks conducting autonomous fiscal policy in a democratic society. Also, the payment assets the central bank provides acting alone are generally not free; and the provision of these assets does nothing in itself to increase the the antecedent demand for production and credit. If there were a restriction on bank credit due to an excessive cost of funds and an excess of illiquid financial securities, the provision of more money could reduce that cost and loosen credit markets. But the potential for a significant impact is limited. And once the cost of funds question is out of the way, and the economy is still struggling, clearly the problems lie elsewhere.
And there is one other issue that needs to be raised in considering the choice between central bank expansion and comprehensive government expansion. I have been discussing these issues at an abstract level looking at the aggregate economy and different ways of getting it out of a low-performance equilibrium into a high-performance equilibrium. But in the real world, in response to real policies, not everybody benefits equally. The central bank-oriented approach favored my many conservative economists directly benefits the most prosperous firms and individuals in our society, those with an abundance of financial assets to sell. It aims to create a disequilibrium in that sector by changing the portfolio composition of financial assets, hoping that as equilibrium is re-established the resulting spill-on effects will trickle out to everyone else. The more comprehensive government approach involved in Scenario B that employs a combination of fiscal and monetary tools starts with individual households and businesses. It delivers income to those sectors directly, which is then used to drive further demand and production, with less risk to producers, less leverage and less reliance on financial sector credit. As a result, the end result delivers somewhat greater benefits to the broad economic foundation of the economic pyramid, and somewhat less to the concentrated financial apex. The central bank-driven approach is a trickle down approach which is much less effective in stimulating demand; and even where it is effective, it does its work by injecting money into the apex of the economic pyramid, hoping it will pour down to the bottom, with many financial intermediaries taking many cuts along the way. So the central bank approach is unlikely to have the same positive aggregate impact as the comprehensive approach, and the impact it does have is more concentrated at the top.
Cross-posted from Rugged Egalitarianism