Modern, erm Monetary Theory

Ambrose EP tells us of this IMF paper.

We know absolutely that the basic idea is entirely crap for this reason and this reason alone:

He was backed by the campaign group Positive Money and the New Economics Foundation.

If you\’ve got those two loons on board then you must be wrong.

From the paper itself:

control of credit growth would become much more straightforward because banks would
no longer be able, as they are today, to generate their own funding, deposits, in the act of
lending, an extraordinary privilege that is not enjoyed by any other type of business.
Rather, banks would become what many erroneously believe them to be today, pure
intermediaries that depend on obtaining outside funding before being able to lend. Having
to obtain outside funding rather than being able to create it themselves would much
reduce the ability of banks to cause business cycles due to potentially capricious changes
in their attitude towards credit risk.

Sigh. Banks do require outside funding.

It may well be true that they lend first then worry about how they\’re going to fund it. But they do indeed have to go and fund their loans. The banking system may well create credit. Sure, the deposit of one loan into another bank means the whole thing can spin another turn. But one individual bank does not create, ab nihilo, the funding for its own lending.

If banks did not require outside funding then Northern Rock would not have gone bust. Northern Rock did go bust. Therefore banks require outside funding. That logic isn\’t perfect. Yet. Except that Northern Rock went bust because it required outside funding of loans it had already made. Which makes that logical circle complete.

Banks do currently require outside funding therefore the argument being out forward here is rubbish.

The second advantage of the Chicago Plan is that having fully reserve-backed bank
deposits would completely eliminate bank runs,

At which point we kill maturity transformation. Bad idea.

Oh, by the way, the heterodox economists who love this and similar sorts of ideas. There\’s a real problem with the proof that this paper is trying to offer.

We study Fisher’s four claims by embedding a comprehensive and carefully calibrated
model of the U.S. financial system in a state-of-the-art monetary DSGE model of the U.S.

They\’re using as their proof exactly the DSGE models that you heterodox economists insist do not model the economy well: or even at all. You\’re not allowed to accept proof of your cherished theory via a method that you normally abhor.

And I\’ve a political point to make as well. Or a public choice point. Part of this system is that the government just creates the money. Then goes and spends it as a way of getting it out into the economy (this is MMT, the sort of thing that Anne Pettifor and Positive Money keep talking about). There is no requirement to tax or to borrow as a method of financing government expenditure. Because government is printing the money and actually has to go spend it in order to get it into the economy.

Which is lovely, state creation of credit, not private.

The function tax plays in this system is rather different. We all know that excessive creation of credit (or, in this case, government money) leads to inflation. Tax is the method by which this inflation doesn\’t happen. The government taxes only and exactly at the right level to ensure no (or perhaps that 2% that greases the wheels) inflation by reducing the money supply in collecting tax to offset the creation of money by spending.

Which again is lovely. And now look at the incentives on offer to politicians.

Under the current system they have to either tax or borrow in order to spend. And they\’re not really very good at matching up the tax and the spend thing as we can see from the borrowing. Under this new, MMT method, there is no correlation between how much they can spend and how much they need to tax. They can just print money in order to fund each and every one of their fantasies. The only reason to tax is to reduce or prevent inflation.

We are supposed to think that the incentives to politicians will be to reduce or prevent inflation here are we?

Hardy har har.

Inflation takes time to appear. 18 months to two years according to the monetarists. Which really is rather longer than the time horizon of a politician facing election, ain\’t it?

My prediction is that giving the politicians the control of the printing presses will lead to 5-10% inflation in no short order. With bursts of 20% or so just after elections. For that\’s the way the incentives would go.

Not a good system I\’m afraid.

8 thoughts on “Modern, erm Monetary Theory”

  1. It’s very important in this debate to distinguish between INDIVIDUAL BANKS and the commercial bank system as a whole. As Tim rightly points out, an INDIVIDUAL commercial bank cannot create money / credit in limitless amounts. If it does, it loses reserves. However, there is no theoretical limit to the amount of money / credit that the SYSTEM can create. In fact in the four years prior to the crunch, M4 expansion was racing ahead of monetary base expansion. I.e. it’s the very fact that commercial banks can create money / credit that was a major contributor to the crunch.

    The above first quote from the IMF paper claimed that “banks” can create money / credit. That is poor wording. If they MEANT the bank system (which is what I assume they meant) then they are correct. But if they meant INDIVIDUAL banks, then Tim’s criticism is valid.

    Tim then says, “At which point we kill maturity transformation. Bad idea.” Maturity transformation equals “borrow short and lend long”. It is PRECISELY that risky strategy that results in bank failures. Northern Rock ran out of anyone to borrow from. Abolishing maturity transformation on that basis looks a good idea.

    Tim then claims that having the government / central bank machine control the economy by creating and spending money into the economy as required will be too big a temptation for politicians: they’ll boost spending before elections and all that.

    Tim needs to study Positive Money’s proposals in detail. PM is well aware of the above problem, which is why it advocates decisions on money creation / spending be in the hands of some sort of committee like the Monetary Policy Committee.

  2. @Ralph Musgrave: “decisions on money creation / spending be in the hands of some sort of committee like the Monetary Policy Committee.”

    What, like the politically appointed MPC we have today?

    Fundamentally the whole MMT thing is doable. But it requires the turning on its head of modern democracy – that the people we vote for are ultimately in control of the spending of money, and taxation . Because who controls the money spending and the tax system, controls the country. Call me a naive fool, but I would prefer to be able to vote out the people who are taxing me. Under MMT the people have no power. If the monetary committee is to have any ability to do its job efficiently, it must be above democratic control. As such if the people don’t like its decisions, they can do nothing about it. If they can do something about it, then its back to politicians using the system for their own means.

    One cannot square this particular circle. The country either becomes a dictatorship by monetary committee, or we continue with what we have. There is no third way.

  3. Jim,

    First, I’m glad to see both you and Tim conflating MMT with Positive Money and like minded folk. I’ve been saying for some time there are strong similarities between these groups.

    You claim that having the decision on how much stimulus we need put into the hands of a committee like the Monetary Policy Committee would turn “modern democracy on its head”. That point is somewhat weakened by the fact that the decision on how much stimulus to effect IS ALREADY to a large extent in the hands of committee like the Monetary Policy Committee: it’s called the “Monetary Policy Committee”.

    Next, the governor of the Bank of England and the MPC are acutely aware that it is not their job in intervene in political decisions: e.g. channel stimulus towards the public rather than private sector. Exactly the same would apply under the proposals put by Positive Money, Prof Richard Werner and the New Economics Foundation. That is the new committee would be charged ONLY WITH determining the amount of stimulus required. The major POLITICAL decisions, like what proportion of GDP to allocate to public spending, and how that is split between education, heath, roads, etc etc would still be ENTIRELY the preserve of the democratic process.

  4. And what about the taxation – who gets to decide how much of the printed ‘stimulus’ is removed from the economy via taxation? The elected pols or the unelected gauleiters?

    Incidentally, who chooses the members of this committee? Quite an important post don’t you think? Do we pick people at random? Or co-op the great and the good? Are there any ways they can be reined in? Are they subject to the law? What if the politicians change the law? Basically it comes down to who is in charge – those who make the law (politicians), or those in charge of the money.

    And given that spending decisions are fixed in stone (once you’ve told people they’re getting X amount of benefit its hard to take 10% of it away, let alone remove it entirely), the only weapon you have to remove money from the economy is taxation. Which means taxes would have to rise and fall all the time. Inflation starts to rise, taxes have to be whacked up sharpish. Then reduced as the inflation falls again. This is hardly going to be popular, given the people paying the taxes will, by and large not be same ones getting the benefit of all the spending. And long term planning will be impossible, because you’d never know what tax rates would be a year down the line.

    If one had a flat rate income tax, a flat rate CGT and a flat rate VAT, with a fixed proportion between the two, and no other taxes, it might just be doable, as then there would be no incentive to spend more on section X of the electorate but get section Y to pay for it. If ALL taxes had to rise and fall as one the pain would be spread out (and therefore less likely to be considered as a viable option). But with the millions of pages of tax law we have now, it would be impossible, practically speaking, even ignoring the democratic deficit.

  5. I do have serious reservations about that IMF paper, as indeed I do about Positive Money’s proposals generally – as you well know, Ralph (how many comments on your Positive Money post now??).

    One of the points I HAVEN’T made yet is – why on earth do you think that “abolishing maturity transformation” would make it disappear? And what makes you think that abolishing the right of licensed banks to create credit money would prevent unlicensed ones from doing so? Both credit creation and maturity transformation are done to a considerable extent by the shadow banking system, as this fascinating paper from the Philly Fed explains (h/t Cullen Roche):

    A major cause of the financial crisis was a run on the shadow banking system (well, two runs actually – one after Bear Sterns, one after Lehman). And to stop that run, the Fed had to bail out quite a number of “shadow” financial insitutions.

    Nowhere in PM’s proposals, or indeed in this IMF paper, do I see any consideration of the (significant) role of shadow banks in our modern financial system. There is in my view a serious risk that restriction of the credit-creation powers of licensed banks would allow the shadow banks to grow even larger and more powerful. Sow the wind, reap the whirlwind.

  6. Jim,

    Re your first paragraph, if stimulus is printed, by definition does not come from tax!!!!!

    Re your second paragraph on the question as to who chooses the committee, EXACTLY THE SAME problem (if there is a problem) applies to choosing people to serve on the Monetary Policy Committee.

    Re your third paragraph and your point that raising taxes to rein in demand might prove unpopular, again, EXACTLY THE SAME PROBLEM applies to our current system. For example, many have expressed concern about whether the vast quantities of central bank money created under QE can be reined in if and when inflation looks like getting out of hand.

    Re your point that “long term planning will be impossible, because you’d never know what tax rates would be a year down the line”, again, EXACTLY THE SAME POINT applies currently. That is the Chancellor of the Exchequer is free to alter tax rates at every budget!!! And Chancellors almost invariably do alter tax rates at every budget!! Indeed, it’s far from unknown for them to indeed BETWEEN budgets.

    Re your last paragraph, I completely fail to see why the RATIO of different taxes needs to remain constant. It hasn’t been constant for the last fifty or hundred years. Why on earth does it need to remain constant in the future?


    I don’t blame you for having “reservations” about Positive Money’s proposals. While I back the BASIC IDEAS they propose, I think some of the peripheral points they make don’t stand inspection. But if PM are incompetent, that’s nothing compared to the incompetence of their critics (e.g. Jim above isn’t exactly 100% clued up).

    Re whether it’s possible to abolish maturity transformation, no doubt it’s impossible to TOTALLY abolish it: whatever law we pass (e.g. relating to fraud, theft, drunk and disorderly, etc etc) there will always be naughty people trying to circumvent the law.

    However, I worked for a firm of accountants for a few years, and I can’t see the difficulty framing a law that states how far down the maturity transformation road banks can go, and enforcing the law with reasonable efficiency.

    Re the systemic effects of shadow banks, if any legislation relating to banks does not include entities which act like banks but don’t call themselves banks, then the legislation is of limited use. I.e. if I were framing the law that effects PM’s ideas, shadow banks would be included.

    And assuming the PM/Werner system was applied to shadow banks, it would make runs on those banks impossible (in the traditional sense of the word “run”). Reason is that under those proposals, banks as such don’t carry the risk of loans going bad: its depositors who want their money loaned on that bear the risk. I.e. when things go wrong, depositors do not lose money: what happens is that the value of the investments fall. And as Mervyn King pointed out, the deflationary effects of a big stock market fall are much less severe than the effect of people losing large amounts of cash.

    So I think the PM/Werner system is a brilliant solution to SOME banking problems. In contrast, it probably doesn’t entirely deal with the systemic risks posed by casino and shadow banks, but it would bring benefits in that area. BTW, Vickers doesn’t deal with the systemic risks posed by casino banks either, according to Laurence Kotlikoff, far as I remember.

  7. 1) No of course printed stimulus doesn’t come from tax. But in any given year if you print X you’d have to tax Y, otherwise it would be massively inflationary from day one. I assume you are not suggesting that there are zero taxes while the government prints £700+bn/year, and only introduces them when inflation starts to rise? So decisions on the level of taxes need to be made from the start. Who makes them?

    2) Yes the problem exists today, though not to the same extent as the MPC only fix interest rates. They don’t decide on spending levels/tax rates etc as well. Given you admit its already a problem, what is your solution to it, given they new MPC would have infinitely greater powers than the MPC does today?

    3)Yes taxes are unpopular now, but the rates don’t go up and down like a whore’s drawers either. It’ll be ten times as unpopular when rates are going up at the same time as living costs are rising, and you can’t vote the buggers out who are deciding it.

    4) Yes Chancellors are free to change taxes at every budget. But generally they don’t have to that much, plus they are using the tax system to direct the economy in long term ways they approve of, so keeping certain tax rates on an even keel is beneficial. If taxes are the main weapon against inflation, they would have to rise and fall on a regular basis, as often as interest rates are changed. Taxes are normally only altered annually whereas rates change monthly. Are taxes to be changed similarly?

    5) The reason for linking all taxes (and having a simple tax system) would be so that tax extracted from the economy came from across the board, and all income levels, so that there would be no incentive for politicians to spend money on one section and try and get the tax out of others. If taxation is merely a way of removing the excess money in the system to reduce inflation, then it should be done fairly across the board and not targeted at certain sections of the population.

    Tell you what, if the population as a whole got to decide the level of spending via electronic voting, on a regular basis, I reckon it might work. Because the vast majority would vote against extra spending because it would mean higher taxes in the future. And if the public vote for extra cash, they’ll have to suffer the consequences. Make it truly democratic and you could be onto a winner. But no-one will want that, its far too radical. It might end up with a smaller State!

  8. Ralph,

    I can’t see how the PM solution could possibly apply to an international shadow banking network in which the vast majority of transactions are collateralised with government debt. That collateralisation means that funds loaned out in the shadow banking system are nominally at risk but in reality effectively guaranteed by Government. Government guarantees the Fed and the Bank of England, too. There is no difference, really, is there?

    The other problem with the shadow banking network is that it is just that – a network. The overall effect of transactions through the network amounts to maturity transformation and credit creation, but you can’t identify a single institution that does this, and neither can you call every player in the network a “bank”. Most of them aren’t banks by any normal definition of the word. You want ABCP conduits, SPVs, MMMFs and the rest of the weird and wonderful objects in the surreal world of shadow banking to be subject to PM’s rules too? Or do you just want them closed down and all the funds moved into licensed banks (which would probably be simpler)? I suppose that would solve PM’s funds shortage problem (the fact that most “risk” savings aren’t in traditional banks so aren’t currently available for lending), but how would you deal with the fact that this money would no longer be effectively guaranteed by government or backed with any other “safe” assets? You would be expecting the owners of that money to take on a lot more risk than they do at the moment.

    Positive Money’s proposals only apply to traditional credit intermediation – which these days is less than half the international financial world. As I said in my comments on your post, they really do need to look at how people actually use banks these days, not how they used to fifty years ago.

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