Observations on Modern Monetary Theory
20 November 2016 | Pago Pago, American Samoa
A notion implicit in economics is everything is bounded or has limits. One much discussed limit is the maximum size of our country's and other countries' public debts. The issue, in each country instance, is where are those limits and why are they there. That is what MMT should address, properly conceived, I argue, regarding a fiat sovereign currency.
Until MMT was developed, the limits for public debt size for such a currency were hugely misunderstood and, worse, very much under-estimated. The error was gross and is still believed and misunderstood by almost everyone. Modern monetary theory adherents try to address that but alienate more people than they persuade, I argue. The problem is this.
Too many MMT adherents seem to suggest (but don't actually say) that the limits on the public debt are infinite and the sky is the limit and that is false and misleading. The suggestion has alienated many unnecessarily from the ideas of MMT and has undermined the cause of MMT which is really, I argue, to show what and where those true limits are and demonstrate that they are usually very much underestimated by most and by conventional orthodox economic analysis.
The limits exist, but they are country specific. They depend on many things which is why the World Bank, Peterson Institute and Rogoff & Reinhart numbers on allowable public debt/GDP ratios are so badly off and demonstrably wrong. MIT economist, Rudi Dornbusch, made a fool of himself when he insisted Italy was on the verge of default because the public debt to GDP ratio exceeded 110 and the lira interest rate was higher than the country's growth rate.
So what are those limits under MMT? First and foremost is that of inflation. The supply of credit/money can be increased by government, the banking system and the fed thereby increasing reserves so long as there are sufficient idle human and other economic resources so as not to generate significant inflation. Where inflation develops, reserves must be reduced by taxation, and by the Fed. The adjustments are difficult to fine tune, but they work.
As second limitation is really a whole set of limitations. All but one are tied to the perceived credit worthiness of the nation's currency. - investors' confidence. They include some of the things rating agencies look to in determining a nation's credit rating, but there is no hard and fast set of formulae. What people view as creditworthy in turn substantially DEPENDS on what they and their governments understand and believe about modern monetary theory. A vicious circle of sorts has developed here in many regards.
These factors used by the rating agencies are typically, the amount of the current deficit, the level of the public debt relative to GDP, the prospects for economic growth, the economic stability of the country, the political stability of the country, the manageability of the interest payments, the debt maturity profile of the country, who owns the countries debt, and, the last one -- and the credit worthiness exception not considered by the rating agencies -- is the extent to which politicians and investors reject and oppose modern monetary theory and create problems for the country by their actions in opposition.
Interestingly, in considering the current deficit and the level of public debt, the rating agencies appear to accept the general conclusions of MMT because the levels of deficits and the high public debt levels in the US, UK and Japan have not prevented them from being A rated or better by those agencies, which obviously eschew the level tests of the World Bank, the Peterson Institute and Rogoff & Reinhart for debt levels.
Similarly, the UK has borrowed over 10% of its GDP without losing its AAA rating and Spain's national debt has been quite low (around 70% of GDP, but it has a worse credit rating than Japan which has debt of 230% of GDP. The rating agencies seem to understand the outlines of modern monetary theory, but don't say so expressly and are not infallible as we know from their role in the 2008 crash on Wall Street.
Prospects for economic growth matter because growth increases GDP relative to public debt levels and, conventionally understood, that is viewed as a good development. Debt interest payments as a % of GDP can matter, too. When countries face rising debt interest payments, it can undermine investor confidence in the country regardless of whether it should.
Who holds the debt? If the debt is significantly owned by the government itself, it is not conventional debt. If the debt is owned by domestic individuals and pension funds, the debt is less subject to capital flight. Japan has been able to borrow a great deal, because there is a large domestic demand for buying Japanese government bonds. Japan is not reliant on foreign investors. The facts that much of the US's and Japan's public debt is held by the government itself also matters.
What is the public debt's maturity. The UK has quite a high debt maturity. The average debt maturity in the UK is over 17 years. This long term borrowing puts less pressure on the UK to refinance in the short term. If country finances its debt by selling short term notes and bonds, it keeps having to resell bonds. Therefore, they are more at the mercy of investors confidence, but wouldn't be under MMT.
The economic and political stability of a country strongly bears on its credit worthiness. When Ted Cruz and his gaggle of tea baggers shut down the US government briefly and threatened to default on the US public debt, one of the three rating agencies reduced its credit rating for US public debt, citing political and governance problems. These factors cut many nations out, under modern monetary theory properly conceived, such as the often cited examples of Zimbabwe and Venezuela.
The final factor, ill considered by all, is what people view as creditworthy in turn substantially DEPENDS on what they and their governments understand and believe about conventional finance and modern monetary theory. The latter theory, I argue has been oversold in a way that could not be better designed to alienate people of conventional financial views, from it. The summary argument that deficits and public debt levels don't matter does contain a kernel of truth, but it alienates the very people we need to have better understand modern monetary theory and gives it its present bad name in conventional quarters.
The goal instead should be to have people understand real monetary theory and its fundamentals first and its implications and ramifications more slowly and later. But that hasn't happened and the present result is not good -- too much rejection of the obvious into many quarters and among mainstream economists as well.