Home > Uncategorized > The main insight of MMT

The main insight of MMT

from Lars Syll

Understanding Modern Monetary Theory: Part 1 - EconlibMMT is, first and foremost, a balance sheet approach to macroeconomics. At its very core lie reserve accounting, then deposit accounting, and then sectoral balances accounting. There is very little behaviour in any of this. Equilibrium rules as all balances balance – in both flows and stocks – and there are no assumptions apart from the existence of a central bank, a Treasury, a banking system and some households and firms. MMT can only be learned by mastering its balance sheet approach. It can only be engaged by discussing the balance sheet operations it puts forward. It is here where value is added …

First of all, the main insight of MMT is that the mainstream has the sequence wrong. Whereas they assume that government expenditure is financed by taxes, MMT assumes that government spending is financed by money creation. MMT stresses that the central bank, empowered by the law and serving the state, is the monopoly issuer of currency … This logically means that the state has to spend before taxes can be paid … When taxpayers pay their taxes (or banks buy government bonds on the primary market), they first need to have state money.

Dirk Ehnts

Fiscal deficits always lead to an increase in the supply of financial assets held in the nongovernmental sector of the economy. This real-world fact, of course, constitutes a huge problem for mainstream (textbook) macroeconomic theory with its models building on ‘money multipliers’ and ‘loanable funds.’

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 — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

In the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — 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.

As argued by Kelton, there are many problems with the standard presentation and formalization of the loanable funds theory. And more can be added to the list:

1 As already noticed by James Meade decades ago, the causal story told to explicate the accounting identities used gives the picture of “a dog called saving wagged its tail labelled investment.” In Keynes’s view — and later over and over again confirmed by empirical research — it’s not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.

2 As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real-world​ phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something they definitely are not. As emphasized 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.

3 The loanable funds theory in the “New Keynesian” approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a realist Keynes-Minsky point of view, this can’t be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more and more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more and more come to be questioned and replaced by an “endogenous” money view, and I think the same will happen to the view that Central Banks determine “the” rate of interest.

4 A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was seriously wrong:

gtThe classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shifts​, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts to 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 — iter — 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 (the “atomistic fallacy” of Keynes) has many faces — loanable funds is one of them.

5 Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in “The Process of Capital Formation” (1939):

Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.

What is “forgotten” in the loanable funds theory, is the insight that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

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 channelling​ money/savings/credit — are more or less left in the dark in modern formalizations of the loanable funds theory.

kaleckiIt should be emphasized that the equality between savings and investment … will be valid under all circumstances. In particular, it will be independent of the level of the rate of interest which was customarily considered in economic theory to be the factor equilibrating the demand for and supply of new capital. In the present conception investment, once carried out, automatically provides the savings necessary to finance it. Indeed, in our simplified model, profits in a given period are the direct outcome of capitalists’ consumption and investment in that period. If investment increases by a certain amount, savings out of profits are pro tanto higher …

One important consequence of the above is that the rate of interest cannot be determined by the demand for and supply of new capital because investment ‘finances itself.’

  1. April 20, 2022 at 6:59 pm

    Put simply, the equivalence between investment and saving in Keynes is a post-hoc outcome, and not an ex-ante causal relationship.

    Similarly, the necessary identity between sectoral balances in the MMT accounting view of the economy noted by Francis Cripps and elaborated by Wynne Godley, is also a post-hoc identity and not an ex-ante equation.

    Much MMT exegesis does however treat the identity as an equation, where a change in one sectoral balance is poured into or out of the buckets of the other two sectoral balances in a static equilibrium.

    What in fact happens in a dynamic economy is that an exogenous change in one balance feeds through all the functions of the macroeconomic model to generate a new equilibrium where the balances again obey the identity, but, importantly, at different levels. MMT should therefore incorporate behavioural functions in its analytic.

    • Robert W. Parenteau CFA
      April 21, 2022 at 2:12 am

      On close reading, you will find MMT advocates do posit some behavioral tendencies, and they tend to be institutionally and historically specific, rather than general laws or tendencies. For example, Randy Wray will often refer to the government sector financial balance as the main adjustment mechanism, passively accommodating the net financial balance of the foreign and domestic private sector financial balance. This emphasis is in no small part because of the prevalence of so called automatic stabilizers. One might also find the business sector financial balance within the domestic private sector plays this role, as profit income is the ultimate residual flow in capitalists economies with smaller government sectors, or economies with government sectors that do not have many automatic stabilizer mechanisms. If you look at the application of the sectoral balance map I proposed (based on Godley’s work over a decade ago) to the eurozone situation by Jan Kregel, you will see him reasoning through some ex ante dynamics using that tool. Ideally, yes, a mix of behavioral equations and accounting identities to maintain coherence and help with closure of models is often a productive approach, and you can find this in some of the stock/flow coherent macro financial models developed at the Levy Institute, or in reduced form (though not MMT per se) in Lance Taylor’s decades of simple analytical models at the New School.

  2. Romar Correa
    April 21, 2022 at 2:15 am

    Thank you, Dirk Ehnts and Geoff Crocker! I would like to see the specification of dynamics in MMT and the imposition of a transversality condition, at least. Nobody wants a model without a No-Ponzi-games condition imposed at the end of time. The absence of a budget constraint for the government is well taken but what does that imply for the expectations of people? The balance sheet of the economy will unfold over time. As a sequence of numbers, there will be negative net worth at some points of time and positive net worth at other points of time. The positive series must be demonstrated.

  3. April 21, 2022 at 5:58 am

    We do have a project in hand to simulate the injection of basic income to replace income lost to automation, funded by debt-free sovereign money in a stock-flow consistent macroeconomic model with an explicit financial sector. We’ve run into a project funding problem which we hope to resolve soon.

  4. Ikonoclast
    April 22, 2022 at 1:18 am

    MMT has no main insight that is new. It is theoretically impoverished in this sense. It is also empirically impoverished.

    1. There are absolutely no new insights in MMT. It is entirely derivative. MMT derives entirely from Chartalism and earlier understandings of the nature of state (fiat) money. Those who think MMT is new or has a single new insight have not read a word of political economy or else they have not read with attention or memory. That was me once but I read further and learned. Other people ought to do so too.

    “A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money; even though the term of its final discharge and redemption should depend altogether on the will of the prince. – Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations.

    2. It is trivially true that MMT shows that sectoral accounts balance using identity equations. It’s a case of formal definitions and accounting axioms. It is trivially true that nominal taxed amounts of the fiat currency do not pay for nominal outlays. The numeraire is a fictitious, nominal entity, not a real entity. It can be created out of nothing and extinguished into nothing. This is unlike a real thing (a widget say) which is created out of something else,(raw energies and materials) and can only be extinguised into something else, (waste energies and resources) some of which may or may not be recyclable.

    3. However, it is not trivially true but centrally and fundamentally true that real resources used for private consumption cannot be used by the state for state activities and public consumption. Hence, consumption must be withdrawn from the private sphere to permit the operation of the state and public sphere. In this sense taxes do count. Public finance is the system which does this. Taxation is a plank of it. Taxation not only enforces that the fiat currency must be obtained and then used to extinguish tax liabilities it also enforces that the private sphere must consume less for the public sphere to consume more, all else remaining the same.

    Of course “enforces” must be read with irony. If modern corporations escape taxation, which they largely do, why do they need to use fiat currency any more? That is a question to ponder and might suggest the interest in cryptos and other non-state money.

    4. But my main “beef” with MMT is that it emphasizes axiomatic control of reality without seeming to understand that the real escapes axiomatization. It seems to posit that all societal and economic problems can be overcome if only we adopt MMT (chartalist) principles wholly and in an implicitly more socialist manner. I actually agree that following such principles consistently and in a socialist manner would help in some ways. I don’t agree with the completely outrageous apparent presumption that MMT is the radically new holus bolus, complete explanation and prescription for everything which will miraculously “solve” society and economics.

  5. Hepion
    April 29, 2022 at 7:12 pm

    Perhaps the most significant insight of MMT is that money has hierarchy.

    Mainstream economics depicts all money as loaned from banks, ie. it’s all homogeneous and same, whereas MMT insists there are at the minimum two types of money, government issued and bank loaned. There is indeed a hierarchy of money, and government is not a bank customer. Government runs monetary system, and banks are totally dependent on government’s money.

    I think understanding this changes your worldview profoundly.

    • Hepion
      April 29, 2022 at 7:22 pm

      Mainstream: “Money is money, right?”

      MMT: “Not quite. There are at least two types of money that never mix and mingle, ie. become each other. Two separate entities with separate quantities. Analysis of economy starts from understanding these.”

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: