MMT perspectives on rising interest rates
from Lars Syll
The Bank of England is today wholly-owned by the UK government, and no other body is allowed to create UK pounds. It can create digital pounds in the payments system that it runs, thus marking up and down the accounts of banks, the government and other public institutions. It also acts as the bank of the government, facilitating its payments. The Bank of England also determines the bank rate, which is the interest rate it pays to commercial banks that hold money (reserves) at the Bank of England …
The interest rate that the UK government pays is a policy variable determined by the Bank of England. Furthermore, it is not the Bank of England’s remit to bankrupt the government that owns it. The institutional setup ensures that the Bank of England supports the liquidity and solvency of the government to the extent that it becomes an issuer of currency itself. Selling government bonds, it can create whatever amount of pounds it deems necessary to fulfil its functions. Given that the Bank of England stands ready to purchase huge amounts of gilts on the secondary market (for “used” gilts), it is clear to investors that gilts are just as good as reserves. There is no risk of default …
The government of the UK cannot “run out of money”. When it spends more into the economy than it collects through taxes, a “public deficit” is produced. This means that the private sector saves a part of its monetary income which it has not spent on paying taxes (yet). When the government spends less than it collects in taxes, a “public surplus” results. This reduces public debt. That public debt to GDP ratio can be heavily influenced by GDP growth, which explains the fall in the public debt to GDP ratio in the second half of the 20th century …
So, do rising interest rates in the future create a problem for the UK government? No. The Bank of England is the currency issuer. There is nothing that stops it from paying what HM Treasury instructs it to pay. Gilts can be issued in this process as an option. The government’s ability to pay is not put into doubt since the Bank of England acts as a lender of last resort, offering to buy up gilts on the market so that the price of gilts can never crash. Higher interest rates cannot bankrupt the UK government.
One of the main reasons behind the lack of understanding that mainstream economists repeatedly demonstrate when it comes to these policy issues is related to the loanable funds theory and the view that governments — in analogy with individual households — have to have income before they can spend. This is, of course, totally wrong. Most governments nowadays are monopoly issuers of their own currencies, not users.
The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credit, determined by supply and demand in the same way as the price of bread and butter on a village market. In the traditional loanable funds theory the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate.
There are many problems with this theory.
Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something they definitely are not. As emphasised especially by Minsky, to understand and explain how much investment/loaning/ crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y – C – G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.
A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. This is seriously wrong. There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is that what happens at the microeconomic level — both in and out of equilibrium — is not always compatible with the macroeconomic outcome. The fallacy of composition has many faces — loanable funds is one of them.
All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channeling money/savings/credit — are more or less left in the dark in modern formalisations of the loanable funds theory. Thanks to MMT that kind of evasion of the real policy issues we face today, are now met with severe questioning and justified critique.
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Great piece, Lars. There is a typo in the second to last sentence in the second to last paragraph.I think you mean “down” where you have “done.” But I am not done!
I really appreciate your identifying how loanable funds is a fallacy of composition. I am not always good at spotting those and it is helpful to my learning when you do that. Thank you.
Loanable funds theory is as dead as phlogiston. Practising macroeconomists have preferred to explain interest rates, at least since 1937, via the joint operation of goods and financial markets in a situation where output can vary. As for MMT, the whole business is what economists call product diversification – by economists. Lets all say the same things (sell the same goods) but say them using different words (brand them differently).
Here are two things which everyone accepts:
Governments or monetary authorities can print money so can’t run out of it.
Governments do not have the power to buy an infinite amount of real goods and services because –
supply responds to demand but not infinitely quickly and only up to a point where people are, and other capacity is, fully employed.
The implication is that while the government can print whatever money it likes, it is supposed to tailor its spending (and therefore its money creation) to what the economy can provide plus what its foreign credit is good for.
Everyone, I think, accepts that too. The constraint is not a monetary one at all but one of production capacity and its growth.
So what is the argument about?
The MMT folk say the government doesn’t have to finance its expenditures. It uses taxes or borrowing only to restrict private demand when otherwise the economy would overheat.
The Keynesians say the government has to ensure the excess of its spending over its tax receipts balances the desired excess of private saving over private investment in the economy (augmented by foreign savings obtainable at sustainable interest rates).
They are saying things which have identical implications for how the government is supposed to manage fiscal policy. Any fiscal deficit creates financial assets for the private sector.
Note there is a political question lurking behind those bland statements. When there are idle resources because private demand is deficient – i.e. when people in general want to save more than they or other people want to invest, the government via its spending can mobilise idle resources. But what if desired investment exceeds desired saving so the economy is at full stretch? (Not true at present but it does happen) Then the government has to reduce demand by taxation (MMT version) or fix the budget by taxing at least as as much as it spends (orthodox Keynesian version). Which comes to the same thing again.
The lurking question is what proportion of productive potential should be responding to government demands and what proportion to private demands? That is a political choice and not a matter of monetary policy at all. If the MMT folk are saying that the level of government spending is a political choice, they are right. If they are saying that choice can never crowd out private expenditure they are wrong.
So much for flows, now let’s turn to stocks, money stocks in particular.
Suppose the government appropriately runs a deficit and in doing so increases the money supply. People become confident that full employment will persist and may wish to anticipate future income. Businesses, confident of buoyant demand, decide to invest. Both increase demand for credit. If banks provide the credit, effective demand will rise because people are now not just wanting to spend current income, they are looking to spend future income too. The economy can overheat because of the secondary increase in the money supply caused by banks extending credit. (As Minsky said in another context: success breeds excess)
What is the government to do? Well it could run a surplus, reducing disposable incomes and draining money out of the system, or it could get the central bank to raise interest rates to reduce credit demand.
Whoops, we appear to have a trade-off – the one some MMT folk imply doesn’t exist – lower government net spending or higher interest rates. When MMT folk say higher interest rates can always be avoided they omit to say that they can sometimes be avoided only by allowing the economy to overheat or by the government reducing its net expenditure. (overheating implies running an eternal deficit, borrowing from abroad or triggering an inflation). Financial market speculation can make the trade-off worse but it exists in any modern economy with fractional reserve banking and widespread access to credit.
Right now post-Covid all major economies have people and capacity idled on a large scale. All governments are running deficits and all are being paid for by money creation just as both MMT and Keynesian economists would propose. No-one else is complaining much.
Policy arguments will come but probably not over Tweedledum versus Tweedledee, MMT or Keynesians. They will be traced to the technical question of when and whether the economy is approaching full capacity and the political issue of how much production capacity should be devoted to government procurement. At least it will be a real argument.
Admittedly there is some confusion around about the size and implications of government debt. But this note is too long already….
Not sure of the reason for your rant. The points being made by the folks re MMT is that economists advising government have NOT been doing as you say. They do NOT accept the things that you claim they do. Perhaps you have not been reading Sommers (sp?) and others. I see many economists in my country and the USA not to mention the UK who do not get the things that you say they get.
Gerald Holtham is not ranting. He makes some very valid points. Certainly, monetarists and neoliberals who have pushed the theories of sound money, budgets in surplus, austerity and the NAIRU all at the same time and while creating high unemployment, capacity under-utilization and falling equality DO need to have MMT prescriptions or the Keynesian equivalent pushed at them. At the same time, Keynesians have understood most of this MMT style stuff all along.
Governments can switch demand between the private and public sectors and they can use counter-cyclical spending to cool an overheated economy or pump up a flagging economy. However, there are always real limits. The UK right now could print as much money as they like, but if overseas countries cut the UK off indefinitely from people and goods movements because of the new more infectious variant of COVID-19, then the people in the UK will eventually suffer serious food shortages no matter how much money the government prints.
It’s all well and good in itself to get nominal flows in the numeraire optimal, according to MMT or Keynesian theory; that is a necessary but not sufficient condition for a healthy economy. The really important thing is real flows. Real materials, real energy, real food etc. etc. To imagine that we apply MMT and all problems are solved (if anyone really imagines that) would be to be deluded. Real stuff matters. Runaway climate change, for example, will collapse civilization whether or not we follow MMT prescriptions.
There is something much deeper wrong with conventional economics and capitalism than just monetarism and neoliberalism. I write about those issues from time to time but not now in this thread. This reply would get far too long.
I did not say that he — Gerald Holtham — did NOT make valid points. Although it is odd that the says loanable funds theory is as dead as phlogiston and then goes on to talk about the money supply and money stocks which to my mind implies fixed or limited amounts of money available for the economy and hence the amount available for lending. That may be a part of the archaic language of macroeconomics. It implies that there is a Quantity Theory of Money which the MMT folks deny. If you accept QTM and the existence of money stocks you are suggesting the CBs control the money supply. Not having looked up Keynes on the issue of the money supply but having read a lot of his work, I will hazard the statement that he agreed with the idea that there was a money supply.
There are a number of other differences including the approach about interest rates and the relationship to investment.
The tone of Holtham’s rant was that MMT’s and Keynes approaches are the same but branded differently. I disagree that it is simply rebranding. In addition to his tone that statement is the main reason for my suggesting that he was ranting. There are areas of overlap and Keynes has strongly influenced the thinking of those in the MMT school of thought but it is NOT rebranding.
And I agree with Ikonoclast that there is more wrong with conventional economics than monetarism and Neoliberalism. There is a lack of value analysis and a recent video featuring Herman Daly and Kate Raworth point to some of the other problems. That means a major paradigm shift is needed. And it must start with the purpose of money and government spending.
Our finance minister and the deputy governor BOTH have denied doing what Gerald Holtham said that they are doing and, of course, I agree with Holtham on that issue.
The QTM IS fallacious. However that doesn’t mean there won’t be higher than normal or so called “good” inflation with MMT. There will be, because what is to stop business decision makers from committing the economic vice of price inflation. Short answer: nothing, because economists and economic pundits confuse alternately goosed and restrained monetary and financial chaos with “free markets” and because palliative reforms are not pattern changes.
Money is issued against production and recalled via consumption within an accounting cycle that after the last word is financially unstable. This is referred to as “real business cycles” by neo-liberal economists that fail to perceive that for profit finance is an illegitimate business model with a monopolistic monetary and financial paradigm. Heterodox economists recognize the flaws in neo-liberalism, but have not recognized the new paradigm concept and how to best implement and regulate it.
It would be very nice if heterodox economists would wake up and die right by no longer contemplating their economic navels, realized that it’s all about “money, debt and banks” as Steve Keen says and the monetary and financial paradigm concept as I have been posting about here for years. Then they could start a mass social movement that communicates the benefits of the new paradigm to both the individual and enterprise….and most importantly would enable us to begin the green industrial policy and fiscal mega projects that might save us from climate change.
Your grand children and great grand children will appreciate your open mindedness to this and your actions regarding it.
Merry Christmas.
Herb Wiseman. At present all governments are running deficits paid for by money creation. They are supported in this by the majority of economists. If they don’t accept it, why are they doing it? The influence and importance of the academic Chicago school has declined since 2008 and it is much exaggerated by Fox News and also on this blog. Even Robert Lucas admitted that “everyone is a Keynesian in a foxhole”.
Ikonoclast: I agree with the points you make, not least the last two paragraphs.