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: The dose makes the poison Can government deficits be financed directly by central , as modern monetary theory suggests? The question should not be if but how much. By Peter Bofinger April 16, 2019 – Social Europe

All things are poison, and nothing is without poison, bonds, the supply remains constant and the dosage alone makes it so a thing is not a poison the LM curve is unchanged. Together with the (Paracelsus) upward shift of the IS curve the interest rate Modern monetary theory (MMT) has in recent then goes up (Figure 1) and the higher public weeks been strongly criticised by leading expenditures ‘crowd out’ private investments. Keynesian macroeconomists: Paul Krugman In the case of MMT—where the additional (here too), and Larry is directly financed by Summers. This reaction is surprising, as the the central —the LM curve shifts too. theoretical core of MMT can be easily Suppose the government pays an invoice to a reconciled with standard macroeconomic construction . To do so, it makes a principles. transfer from its central-bank account to the If one focuses on the of account of the construction company with a MMT—leaving aside the associated proposal . This transaction increases of a universal job guarantee—its core idea is the reserves of the bank as well as the deposits that government deficits can be financed of the construction company. Thus, the directly by the . Conventionally, monetary base (reserves of commercial banks governments have financed their deficits by with the central bank) and the money M1 issuing bonds sold on the market. (deposits of private households or The confusion can be explained by the fact with commercial banks) increase. In the IS/LM that, so far, the mechanisms of MMT have not model, the resulting increase in been presented in a simple macroeconomic causes a downward shift in the LM curve. model. A framework which allows the basic Overall, direct central-bank financing mechanics of MMT to be described is provided magnifies the expansionary effects of by the textbook ‘IS/LM’ model. additional government spending (Figure 2). It The model consists of two markets: an avoids, at least in part, the rise in interest rates aggregate goods market (the that is caused by capital-market financing investment/ or IS curve) and an (unchanged LM curve) in this model. The aggregate (the liquidity- financial crowding out of private that preference/money-supply or LM curve). It Krugman fears can be at least partly avoided defines an equilibrium point between them at a (LM1). Depending on the extent of the shifts in certain aggregate output (horizontal axis) and the IS and LM curves, crowding out can be a certain interest rate (vertical axis). fully avoided (LM2) and the result may even be an interest-rate decline (LM3), which would If one assumes that a deficit is caused by lead to more private investment. Abba Lerner, additional government spending, the higher the 1943 inventor of functional , demand for goods shifts the IS curve to the explicitly addressed this possibility of a right (Figures 1 and 2). This effect is ‘crowding in’. independent of the financing of the deficit. If the deficit is financed traditionally, by issuing 2

Interpreted in this way, the effects of MMT years only in that it provides for a coupling of financing do not fundamentally differ from the expansive monetary and fiscal policies. In monetary policy pursued in Japan for many Japan, by contrast, the two policies are effected years. There, the government financed huge separately, albeit in a quite co-ordinated deficits traditionally, issuing sovereign bonds manner. on the capital market. By purchasing these Surprisingly aggressive bonds from non-banks— companies, for instance—in its large ‘’ Given such a sober look at MMT financing, it programmes, the central bank generated an is surprising that leading economists have increase in the money supply (higher bank responded so aggressively to this concept. deposits on the part of non-banks) and the Rogoff speaks of ‘all the nonsense about monetary base (higher reserves of commercial MMT’. He quotes the chair of the Federal banks with the central bank as a corollary of its Reserve, Jerome Powell—‘The idea that increased liabilities with non-banks). deficits don’t matter for countries that can borrow in their own currency I think is just This combination of traditional capital-market wrong’—and adds that the deficit idea is ‘just financing of deficits with QE purchases by the nuts’. central bank leads to the same result as the direct financing of deficits by the central bank But it’s always a question of the right dose. which MMT supporters advocate. The LM Especially in the years 2009-12, Japan, the curve shifts downwards. United Kingdom and the United States were running very high deficits, which obviously Of course, MMT financing can be also did not matter to them. And, with massive considered in the context of a horizontal LM purchases from non-banks, the central curve, which implies that the central bank banks of these countries provided the parallel targets the interest rate. In this case the central expansion of the money stock which kept bank has to sterilise the impact of the increase interest rates at very low levels. of MMT financing on the monetary base and the money stock. This requires that the central With the simple model presented here one can bank sells bonds to non-banks, which can be also respond to the question posed by regarded as reverse quantitative easing. With Krugman—how expansionary fiscal policy such a policy, a financial crowding out of will lead to lower and not higher interest rates. private investment can be prevented. It is the shift of the LM curve that matters. The model shows furthermore that there is not As with any therapy, so with MMT—the dose necessarily a trade-off between monetary and makes the poison. The example of Japan fiscal policy, as both curves can be shifted makes it clear that such a policy can be carried independently. out even in a fairly high dosage without leading to . In fact Japan is still in a Summers regards MMT as ‘a recipe for deflationary environment. In addition, there disaster’. He points to the dismal experiences was never an indication that the record high of emerging market economies—‘As the government had a detrimental effect on experience of any number of emerging markets the trust of international investors in the demonstrates, past a certain point, this Japanese currency. On the contrary, the approach leads to hyperinflation’—and that of exchange rate was too strong for most of the France in the European Monetary System in time, rather than too weak. the early 1980s. But, of course, the deficit- spending concept of MMT is only applicable In essence, MMT differs from the macroeconomic policy operated in Japan for 3 to very large economies with a flexible The central idea is that government fiscal exchange-rate regime. policy, its spending and taxing, its borrowing He also mentions the problems of Italy and the and repayment of , its issue of new money UK in the 1970s. They increased their deficits and its withdrawal of money, shall be at a time when their inflation rates were undertaken with an eye only to the results of already very high—11 per cent in Italy and 9 these actions on the economy and not to any per cent in the UK in 1973. MMT should only established doctrine of what is sound and be applied in a low-inflation environment. unsound. The principle of judging only by the effects has been applied in many other fields of Today, in addition to Japan the best example of human activity, where it is known as the very effective MMT is China. method of science as opposed to scholasticism. If one does not look at the official fiscal deficit And both sides should also be able to agree that but at the deficit which includes the borrowing the combination of expansive fiscal policy and of local governments, the country has expansive monetary policy is a very powerful maintained a deficit of over 10 per cent for tool, which should be used if needed and at the years. So far, there are no signs that China has same time handled with great care. Once again: to worry about this. It is the dose that makes the poison. In the whole controversy about MMT, the Peter Bofinger is professor of at Würzburg critics and proponents should agree on two University and a former member of the German Council points. First, a consensus should be possible of Economic Experts. around the basic idea of functional finance, as presented by Lerner: