ALEXANDRIA, VIRGINIA – In a recent Project Syndicate commentary, James K. Galbraith of the University of Texas at Austin defendsModern Monetary Theory and corrects some misunderstandings about the relationships among MMT, federal deficits, and central-bank independence. But Galbraith does not explore what is perhaps the most important issue of all: the political conditions needed to implement MMT effectively.
MMT owes its newfound relevance to the fact that deflation, rather than inflation, is becoming central banks’ main concern. For a high-debt, high-deficit economy like the United States, deflation is an especially serious threat, because it delays consumption and increases debtor anxiety. Consumers forego major purchases on the assumption that future prices will be lower. Homeowners with mortgages cut back their spending when they see home prices falling and the equity in their homes declining. These cutbacks worry the Federal Reserve, because they add to deflationary pressures and could trigger deeper spending cuts, stock-market declines, and widespread deleveraging.
The Fed’s inability so far to reach its 2% target for annual inflation suggests that it lacks the means to overcome persistent disinflationary forces in the economy. These forces include increased US market concentration, which diminishes aggregate demand by weakening employee bargaining power and increasing income inequality; population aging; inadequate investment in infrastructure and climate-change abatement; and technology-driven labor displacement. Making matters worse, US political gridlock assures continued commitment to economically exhausted strategies such as tax cuts for the rich, at the expense of investment in education and other sources of long-term growth. These conditions cry out for significant changes in US government spending and tax policies.
MMT is seen as a way to accomplish the needed changes. It holds that a government can spend as much as it wants if it borrows in its own currency and its central bank can buy as much of the government’s debt as necessary – as long as doing so doesn’t generate unacceptably high inflation. Both tax-cut advocates and supporters of public investment find little not to like.
MMT has been roundly criticized by economists across the political spectrum, from Kenneth Rogoff and Lawrence H. Summers of Harvard University to Paul Krugman of the City University of New York. All contend that it is a political argument masquerading as economic theory. But Galbraith and Ray Dalio of Bridgewater Associates see MMT differently. Dalio argues that MMT is real and, more to the point, it is an inevitable policy step in historically recurring debt-cycle downturns.
In his book Principles for Navigating Big Debt Crises, Dalio documents the steps that central banks have historically taken when faced with a booming economy that suddenly crumples under the weight of debt. The first step (Monetary Policy 1, or MP1) is
- to cut overnight official rates to stimulate credit and investment expansion. The second (MP2)
- is to buy government debt (quantitative easing) to support asset prices and prevent uncontrollable waves of deleveraging. If MP1 and MP2 are insufficient to halt a downturn, central banks take step three (MMT, which Dalio calls MP3) and
- proceed to finance the spending priorities that political leaders deem most essential. The priorities can range from financing major national projects to “helicopter money” transfers directly to consumers.
Achieving political agreement on what to finance and how is essential for implementing MP3 effectively. In a financial meltdown or other national emergency, political unity and prompt action are essential. Unity requires a strong consensus on what should be financed. Speed requires the existence of a trusted institution to direct the spending.
In the early 1940s, when the US entered World War II and winning the war became the government’s top priority, the Fed entered full MP3 mode. It not only set short- and long-term rates for Treasury bonds, but also bought as much government debt as necessary to finance the war effort. MP3 was possible because the war united the country politically and gave the Roosevelt administration near-authoritarian rule over the economy.
The core weakness of MP3/MMT advocacy is the absence of an explanation of how to achieve political unity on what to finance and how. This absence is inexcusable. Total US debt (as a share of GDP) is approaching levels associated with past financial meltdowns, and that doesn’t even account for the hidden debts associated with infrastructure maintenance, rising sea levels, and unfunded pensions. For the reasons Dalio lays out, a US debt crisis requiring some form of MP3 is all but inevitable.
The crucial question that any effort to achieve political unity must answer is what constitutes justifiable spending. Alexander Hamilton, America’s first Secretary of the Treasury, offered an answer in 1781: “A national debt,” he wrote, “if it is not excessive will be to us a national blessing.” A government’s debt is “excessive” if it cannot be repaid because its proceeds were spent in ways that did not increase national wealth enough to do so. Debt resulting from tax cuts that are spent on mega-yachts would almost certainly be excessive; debt incurred to improve educational outcomes, maintain essential infrastructure, or address climate change would probably not be. Accordingly, it will be easier to achieve political unity if MP3 proceeds are spent on priorities such as education, infrastructure, or climate.
The political test for justifying MP3-financed government spending, is clear: Will future generations judge that the borrowing was not “excessive”? Most Americans born well after WWII would say that the debt incurred to win that war was justified, as was the debt that financed the construction of the Interstate Highway System, which literally paved the way for stronger growth.
As the 1930s and 1940s show, MP3 is a natural component of government responses to major debt downturns and the political crises they trigger. We know much more about what contributes to economic growth and sustainability than we did in the first half of the twentieth century. To speed recovery from the next downturn, we need to identify now the types of spending that will contribute most to sustainable recovery and that in hindsight will be viewed as most justified by future Americans. We need also to design the institutions that will direct the spending. These are the keys to building the political unity that MMT requires. To know what to finance and how, future Americans can show us the way; we need only put ourselves in their shoes.
You know the moment in a horror movie when the characters are going about their business and nothing bad has happened to them yet, but there seem to be ominous signs everywhere that only you, the viewer, notice?
That’s what watching global financial markets the last couple of weeks has felt like.
In a lot of ways, nothing looks particularly wrong. The S&P 500 was down 0.7 percent Wednesday, tumbling for a second consecutive session, but over all is down only about 5.5 percent from its early May high. The unemployment rate is at a five-decade low. With major companies nearly done releasing their first-quarter results, 76 percent had results above expectations.
But along the way, global bond prices have soared, driving interest rates down sharply. Ten-year Treasury bonds are yielding only 2.26 percent as of Wednesday’s market close, down nearly a full percentage point since November 2018. The outlook for inflation in the years ahead is falling as well, as are the prices of oil and other commodities.
Most significant, the fall in longer-term bond yields has not been matched by a fall in shorter-term rates. For example, a 30-day Treasury bill is yielding 2.35 percent — meaning you can earn more on your money tying it up for a month risk-free than you can tying it up for a full decade.
This is not normal. It is called an inverted yield curve, and historically it has been viewed as a sign of a recession in the offing. At a minimum, it indicates that bond investors believe the Federal Reserve will soon need to cut interest rates — in effect, that it overshot with those four rate increases last year.
There is also a soft underbelly to some of the good economic data of late. Orders for capital goods like business equipment fell 0.9 percent in April, suggesting companies may not be in an expansionary mood. The Institute for Supply Management’s index of activity at manufacturing companies fell sharply in the most recent reading, though it remained in expansion territory.
The financial markets don’t always tell a tidy little story about what is happening, but here’s a theory about reconciling the apparent calm in the economy with the many worrying signs.
The breakdown in trade negotiations with China and the imposition of tariffs on Chinese goods are part of the story, but only a part.
Businesses have weathered escalating tariffs for two years now, and while tariffs can be costly, they do not need to wreck the economy. After all, prices for products fluctuate for all sorts of reasons, and market economies are pretty good at adjusting.
President Trump reportedly chose Stephen Moore for one of the vacancies at the Federal Reserve Board after reading a Wall Street Journal op-ed Moore wrote attacking the Fed. The piece, co-authored with Louis Woodhill, made two central claims: (1) we’re experiencing deflation, and (2) the way to address it is to follow a rule adopted by Paul Volcker in the 1980s.
Slight problem though: Both of those claims are flat-out false. There is no deflation, and Volcker never created the imaginary “rule” Moore is now attributing to him. I know, because I asked Volcker — as Moore once suggested I do.
Deflation, for those unfamiliar, means prices are falling. There are three major measures of price changes: the consumer price index, the personal consumption expenditures (PCE) price index, and the “core” PCE price index (which excludes energy and food, which can be volatile). All three show modest but positive year-over-year price increases.
.. Moore and Woodhill explain this away by saying that in fact we shouldn’t be looking at overall price changes — instead we should be looking at just a small subset of prices, specifically commodities. Commodities refer to goods that are interchangeable with one another, such as metals, oil, soybeans, wheat, etc.
Now, there’s a reason why when people talk about inflation or deflation they usually focus on the overall index rather than some cherry-picked subset of products. Some products see prices go up (doctor visits); others see them go down (TVs); what we want to know is the big-picture trend. Sure, it’s possible that changes in commodity prices might eventually flow through to elsewhere in the economy. It’s also possible that commodities have weird, anomalous price changes driven by sudden shocks — a crop failure, say, or discovery of gold, or an oil embargo. These supply or demand shocks tell us little about whether there is too much money chasing too few goods, which is really what the Fed is trying to track.
Moore historically has had trouble distinguishing whether price changes in commodities are driven by monetary policy (that is, the Fed allowing too much or too little money to slosh around) or market-specific shocks. For instance, when I’ve appeared with him on CNN before, he has cited as evidence of “deflation” the fact that U.S. soybean prices have fallen. And hey, soybean prices are down! But as everyone in America except apparently Moore is aware, soybean prices have fallen primarily because China stopped buying U.S. soybeans in retaliation for Trump’s trade war, not because of changes in the money supply.
Nonetheless, Moore claimed in this op-ed, as well as in that CNN appearance, that his confused understanding of inflation and Fed policy was endorsed by none other than the godfather of sound Fed policy: former Fed chairman Paul Volcker.
.. On CNN, Moore said that we should follow the “Volcker Rule,” which he claimed was a rule Volcker set when he was chair in the 1980s that required linking interest rates according to movements in commodity prices. That is not actually anything close to what the Volcker Rule is about. It’s actually a regulation that prohibits banks from conducting certain investment activities with their own accounts, and has nothing to do with commodity prices or interest rates. I figured he’d misspoken, or gotten confused (this was around 7 a.m., after all), and moved on.
I was then surprised to see that Moore resuscitated this claim again in his recent Journal op-ed — you know, the one that earned him his Fed nomination. This time he didn’t foolishly refer to it the “Volcker Rule”; he said it was Volcker’s “commodity-price rule”:
The solution is obvious. The Fed should stabilize the value of the dollar by adopting the commodity-price rule used successfully by former Fed chief Paul Volcker. To break the crippling inflation of the 1970s, Mr. Volcker linked Fed monetary policy to real-time changes in commodity prices. When commodity prices rose, Mr. Volcker saw inflation coming and increased interest rates. When commodities fell in price, he lowered rates.
.. On Monday, I wrote to Moore to ask him where I could find more information about this rule, explaining that I had consulted Fed transcripts and other documents to no avail. He replied to say that Arthur Laffer, his longtime business partner and frequent co-author, had written “two very famous pieces” for the Wall Street Journal about the subject in the 1980s.
He eventually sent me one Journal op-ed from 1982, by Laffer and Charles Kadlec. It does not in fact say that Volcker adopted a price rule; rather, it says that Laffer and Kadlec speculated that such a relationship might be able to explain interest rate movements over the previous four months, and proposed how to test their theory. The headline, ending in a telltale question mark: “Has the Fed Already Put Itself on a Price Rule?”
Turns out Cato Institute senior fellow and economic historian George Selgin was also looking into Moore’s claim, and dug up another Laffer essay from this era. In this one (in Reason), Laffer explicitly says Volcker replied to that 1982 Journal op-ed to explain to Laffer why the Fed was not targeting commodity prices. Selgin also found a paper by another Fed official — written just after Volcker stepped down, in 1987 — arguing (apparently unsuccessfully) that the Fed should start adopting a rule such as the one Moore describes. Which, of course, implies that the Fed had not had any such rule when Volcker was in charge.
.. When I first, shall we say, expressed skepticism about Moore’s claim in that CNN debate, he suggested I get things from the horse’s mouth.
MOORE: Do you know what the Volcker Rule was? You know how he killed inflation? He followed commodity prices. Every time commodity prices went up, he — he raised interest rates, and every time —
RAMPELL: That’s not what the Volcker Rule is.
MOORE: Yes, it was. That’s what he did, and that’s how we conquered inflation, and that’s why —
RAMPELL: Google the Volcker Rule, people. That’s not what the Volcker Rule is.
MOORE: Yes, it was. Ask him. Ask him.
So I figured, why not ask Volcker? I sent an inquiry through his book publicist, who passed it along to Volcker’s assistant. The assistant replied: “I showed this to Mr. Volcker and he says that he does not remember ever establishing a commodity-price rule.”
There you have it. Trump has nominated to the world’s most powerful central bank a guy who has trouble telling whether prices are going up or down, and struggles to remember how the most famous Fed chair in history successfully stamped out inflation. But hey, Republican senators still seem keen on him because “the establishment” keeps pointing out how inept he is.
The latest liberal spin is that the economy is on a “sugar high” from deficit-financed tax cuts and spending hikes. When the rush wears off, they warn, watch out for a crash landing. It’s true that in fiscal 2018 the budget deficit swelled to nearly $800 billion, or about 4.2% of gross domestic product. But the Bureau of Economic Analysis estimates that the economic “contribution” from extra government spending added only 0.23 percentage point to growth in 2018. So even without all the budget bloat, the economy would still be growing well above 3%... The same BEA data confirm that this year’s growth comes predominantly from a boom in production and investing—particularly in construction, manufacturing, and oil and gas development. While the housing market is weak, consumers are spending more as their wages rise... The real contradiction in the “sugar high” argument is that it ignores the slow growth of the Obama years, which featured an avalanche of debt spending. Deficits as a share of GDP were 9.8% in 2009, 8.6% in 2010, 8.3% in 2011 and 6.7% in 2012. Where was the sugar high then? Instead of the expected burst in output coming out of the 2008-09 recession, borrowing more than $1 trillion a year for four years yielded the worst recovery since the Great Depression. Even excluding 2009, Mr. Obama’s deficits averaged more than 5% of GDP throughout the rest of his presidency but produced less growth than Mr. Trump has with lower deficits.
This wasn’t what Keynesians expected. Mr. Obama’s economic team predicted 4% growth every year coming out of the recession. Instead the “sugar high” from record peacetime deficits produced measly 2% growth. By 2016 GDP was running about $2 trillion below the trend line of a normal recovery.
The fastest growth rate over the past three decades was recorded in Bill Clinton’s second term, when federal government spending fell from 21.5% to 18% of GDP and deficits disappeared into surpluses. So much for the idea that deficit spending is a stimulant.
Mr. Trump’s fiscal policies have produced more growth than Mr. Obama’s because they were designed to incentivize businesses to invest, hire and produce more here at home. The Obama “stimulus,” by contrast, went for food stamps, unemployment benefits, ObamaCare subsidies, “cash for clunkers” and failed green energy handouts.
.. Massive government spending blitzes don’t produce “sugar highs” or anything like them. Even some conservatives erroneously argue that military spending stimulates the economy. But as Milton Friedman said, the government can only put money into the economy that it first takes out.
.. Those pushing the “sugar high” fallacy also don’t realize that the Trump tax cuts aren’t going away soon. The 2017 business tax cuts can’t cause a recession in 2019 or 2020 because they don’t expire until 2025. They aren’t sugar pills.
The biggest threats to the economic boom and financial markets today are a deflationary Federal Reserve and the specter of a global trade war. Solve those problems and the American economy can keep flying high on its own power. And Mr. Trump’s critics will be proved wrong again.