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MMT and the Consolidation Hypothesis


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MMT, Functional Finance and ELR session at 12th International Conference

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MMT and the Consolidation Hypothesis

  1. 1. The Consolidation Hypothesis: The Case of the United States Eric Tymoigne Assistant Professor, Lewis & Clark College Research Associate, Levy Economics Institute THE 12TH INTERNATIONAL POST KEYNESIAN CONFERENCE, Kansas City, September 25, 2014
  2. 2. Road Map 1. The Consolidation Hypothesis 2. Critiques 3. Theoretical justifications 4. Institutional justifications 5. Policy justifications
  3. 3. Consolidation hypothesis  Simplification for theoretical purpose: the Treasury and the central bank can be consolidated into one sector, the (federal) government sector. Assets Liabilities and Net Worth A1: Physical assets and financial claims on the domestic and foreign sectors L1 is the monetary base L1: Monetary liabilities held by banks and the rest of the domestic non-federal- government sector L2: Other liabilities held by the domestic non-federal-government sector and the rest of the world, and net worth
  4. 4. Consolidation hypothesis  The government sector spends by issuing monetary instruments to the non-government sectors: Higher L1 + Higher A1  The government still taxes and issues bonds (or interest-earning deposits to simplify even more) even though it funds all its spending via monetary creation: inflation and interest-rate stabilization purpose  Taxes: Lower L1 + Lower A1 (or lower L2 if taxes liability is an off-balance sheet liability)  Bond offerings: Lower L1 + higher L2
  5. 5. Consolidation hypothesis  Conclusion:  Government cannot run out of money, no hard financial constraint: Government has no money, i.e. it has no monetary assets that can dwindle to zero. Monetary instruments are its liabilities so government can create an infinite amount of them (this does not mean it should)  No economic risk of default: any default on bond is voluntary  Taxes do not fund the government: no increase on the asset side, taxes reduces the amount of monetary instrument in the economy (L1 declines)  Treasuries issuance do not fund the government: reduces L1  Taxes and treasuries are essential to the stability of the economic system: not alternatives to monetary financing of Treasury.  Monetary creation (increases L1) must occur before taxes and bond offerings occur (reduce L1)  The only economic limit to government intervention in the economy is the real side of the economy: potential inflationary pressures.  The government budget constraint is not a constraint but rather accounting identity that shows the sources of injection and removal of government monetary instruments: A fiscal deficit represents an net injection of government monetary instruments. This net injection usually needs to be drained through bond issuance to maintain interest-rate stability (i.e. avoid downward pressures on interest rates that result from a fiscal deficit).
  6. 6. Consolidation hypothesis: Critiques  Probably the most contested aspect of MMT:  Does not describe institutional realities: The Treasury does not fund itself mostly through monetary creation, central bank is limited in its capacity to intervene in the primary market for treasuries (forbidden or limited to maturing treasuries)  Does a disservice to the relevant insights provided by MMT: Leads to over-the-top conclusions that usually immediately put off new readers  Leads to inflation and to financial instability because all funding is done through monetary creation  Promotes ill-suited policies because it ignores existing constraints: Taxes and bond offerings are a funding sources for the Treasury  Promotes dangerous policy insights: uncontrolled spending by government, socialism, etc.  Ignores instability that can result from self-imposed constraints: Debt Ceiling
  7. 7. Consolidation Hypothesis: Theory vs. Reality  Economic theories are intellectual constructs that aim at gaining insights through specific causalities and hypotheses  Economic theories are not descriptions of the economy system, they are simplifications to get to the core of the logics at play in the economy system  Consolidation hypothesis, and the associated “government” logic, is a theoretical simplification  Hypotheses are based on detailed analysis of institutional aspects behind the financing and funding of the government sector (different from Friedman’s positivism).
  8. 8. Consolidation Hypothesis: Theory vs. Reality  Circuit approach helps to understand causalities at play. Simplest case (consolidation) Note: word currency is used broadly
  9. 9. Consolidation Hypothesis: Theory vs. Reality  Circuit without consolidation: Note: word currency is used broadly
  10. 10. Consolidation Hypothesis: Theory vs. Reality  Closed-economy circuit without consolidation and actual U.S. institutional framework for federal government’s financial operations:
  11. 11. Consolidation Hypothesis: Theory vs. Reality  While richer in its explanation of the institutional details, the more realistic circuit does not provide any additional theoretical insights compared to the first circuit:  All central bank currency comes from the central bank  Treasury spends by using central bank currency  Treasury obtains that currency either directly from the central bank or indirectly from the non-government sectors (indirect financing of the Treasury by central bank).  Logically central bank currency must be injected before bond offerings and before taxes are settled  Only interaction between the federal government and the other sectors affects aggregate income and interest rates.  The more complex circuit  hides these points under a layer of institutional complexities  Leads economists into thinking that Treasury faces hard financial constraints: focuses economic discussions of government programs on the financial aspects (how to pay?)
  12. 12. Consolidation hypothesis: Institutional Justification  Currently the federal government of the U.S. and other countries have imposed on themselves all or some of the following financial constraints:  Treasury cannot get a net advance of funds from the central bank: Treasury must acquire central bank currency through non-central bank channels, i.e. it needs to taxes and offer treasuries to finance itself.  Treasury spends only through the use of central bank currency: taxes and bond offerings must come before Treasury spending  Debt ceiling: limit to the outstanding amount of treasuries.  Treasury is artificially financially constrained.
  13. 13. Consolidation hypothesis: Institutional Justification  While these constraints do exist there are additional institutional aspects of Central Bank and Treasury cooperation that effectively by-pass these constraints:  Central bank does intervene in the primary market to replenish its maturing treasuries: major refinancing channel for the Treasury  Central bank does intervene in the primary market as net buyer if a treasuries auction fails  The central bank has asked the Treasury to issue treasuries to help interest-rate targeting: recently SFP bills  The Treasury chooses to allow banks to credit Treasury’s bank account (TT&Ls in the US): monetary creation by banks to fund the Treasury is a discretionary choice of the Treasury.  The Treasury was the central bank in the past, and today can issue coins of any domination and can spend them, or sell them at par to the central bank for credit on its central bank accounts  The main goal in all these cases has been to preserve financial stability, when threatened, the central bank and the Treasury find means to promote the stability of the financial system.
  14. 14. Consolidation hypothesis: Institutional Justification  MacLaury from the Federal Reserve Bank of Minneapolis summarizes all these points quite nicely: “The central bank is in constant contact with the Treasury Department which, among other things, is responsible for the management of the public debt and its various cash accounts. Prior to the existence of the Federal Reserve System, the Treasury actually carried out many monetary functions. And even since, the Treasury has often been deeply involved in monetary functions, especially during the earlier years. […] Following the 1951 accord between the Treasury and the Federal Reserve System, the central bank was no longer required to support the securities market at any particular level. In effect, the accord established that the central bank would act independently and exercise its own judgment as to the most appropriate monetary policy. But it would also work closely with the Treasury and would be fully informed of and sympathetic to the Treasury's needs in managing and financing the public debt. […] The Treasury and the central bank also work closely in the Treasury's management of its substantial cash payments and withdrawals of Treasury Tax and Loan account balances deposited in commercial banks, since these cash flows affect bank reserves.” (MacLaury 1977)
  15. 15. Consolidation hypothesis: Policy Aspects  Greenspan uses the consolidation hypothesis in a reply to Paul Ryan about the solvency of social security: “I wouldn’t say that the pay-as-you-go benefits are insecure, in the sense that there is nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase.” (Greenspan in House of Representative 2005, 43)  HE CORRECTLY FRAMED THE PROBLEM: not a financial problem, it is a real problem (demography)
  16. 16. Consolidation hypothesis: Policy Aspects  The consolidation hypothesis changes the nature of the debate:  Explains why one should not be afraid of direct financing of the Treasury by the central bank:  Monetary financing is not inflationary per se: inflation resulting from spending (however financed) depends on the state of the economy  Taxes are still needed to contain inflationary pressures that are demand-led  Monetary financing of the Treasury, does not mean that the Treasury will spend like crazy:  Size of government is a political issue: determine the size of the budget  There are accountability mechanisms to constraint spending: budgetary procedures, popular vote. Improve transparency and accountability of government where needed  Move the focus away from financial considerations (How to pay for a government program?) to real considerations (How to provide for the demand for the goods and services created by the program?):  Taxes create winners and losers by changing the structure and level of purchasing power: How to set up taxes to maximize price stability and fairness, and to change incentives? (avoid discussion in terms of government finances)  Once a society has decided what the proper size of the government should be, there is no reason to put artificial financial barriers:  eliminate debt ceiling: It creates financial instability and it does not add any political accountability  eliminate trust fund and pay for social security as needed.