Simon Wren-Lewis's recent post and work that he cites provides a fascinating insight into how modern monetary theory (MMT) and mainstream neo-classical views on the effect of government deficits can be reconciled.
According to MMT government debt represents accumulated net private sector financial assets and, since government's create the money and can never default, the level thereof should not be considered as a constraint. It represents the private sector's desired level of net savings. It never needs to be repaid, and even if it did, it could easily be repaid as the government/central bank could just issue the money. MMT regards the only constraint of deficit spending to be demand-led inflation. The deficit should be reduced if inflation rises above an agreed target. It should be used a second tool of monetary policy, in addition to interest rates, to hit inflation targets.
The neo-classical view, based on the notion of rational expectations, is that the debt has to be paid off and so a rational consumer will view this government debt as a future tax liability and adjust their behaviour accordingly. In other words they would not consider the debt to be a net financial asset. Simon Wren-Lewis discusses the implication of using 'printed money', which he refers to as outside money, instead of government debt to fund the deficit. Would this have a beneficial wealth-enhancing effect now that this debt did not need to be paid of by future higher taxes? He cites work suggesting that it would, but then argues that it may not if the authorities had an inflation target, as the printed money would be expected to expand the monetary base and inflate prices. He argues that, in order to hit the inflation target the authorities may increase taxes to contract the monetary base, neutralising the wealth effect of outside money.
The problem with this argument is that it assumes that the authorities to act in a way that conforms to the neoclassical view, and that this will be anticipated by the the rational consumer. How realistic is this? The authorities would surely not contract the monetary base under circumstances he cites (a liquidity trap) to counter inflation. First, the liquidity trap arises because there is a recession that the authorities will be trying to counter by loosening monetary and fiscal policy. Why would they raise taxes and contract the monetary base? The whole point of QE is to increase the monetary base. Second, the usual way to decrease the monetary base is by the authorities issuing securities (e.g. government debt), or reverse QE. Why would they not do this instead of increasing taxes? Third, the monetary base has a very weak, if any, relationship with the broad money. Look at the data. This is what you would expect if you understood how broad money is created, by bank lending, which is not reserve constrained.
The MMT view is that the rational consumer, if they really understood the monetary system, should and would consider government deficit spending to be financed by 'outside money'. In reality when government spend they introduce new (outside) money increasing the monetary base. Taxes remove most of this new money in order to ensure that demand is not excessive. Current self-imposed rules require that the difference or ’deficit' is borrowed back by issuing government debt certificates. In reality all this involves is them moving the money from reserve accounts at the central bank to interest bearing accounts at the central bank. In some countries this 'reserve drain' is necessary in order for central banks to hit their overnight interest rate target. The key point is that this government debt really represents government backed savings accounts for the 'outside money' that has already been introduced, much like National Savings Certificates in the UK.
So government debt actually is 'outside money' and represents net financial assets of the private sector. There is no need for it to be fully repaid and so no reason to expect tax increases just to pay this debt. A truly rational agent would not expect tax increases unless growth was so vigorous that it resulted in inflation, which would be associated with full employment and an economy functioning at full capacity. A rational agent would expect such growth to result in a reduction in the deficit (as tax revenue increase and welfare spending drops) and a reduction in debt/GDP ratio as GDP increases, and historical experience backs this up.
According to MMT government debt represents accumulated net private sector financial assets and, since government's create the money and can never default, the level thereof should not be considered as a constraint. It represents the private sector's desired level of net savings. It never needs to be repaid, and even if it did, it could easily be repaid as the government/central bank could just issue the money. MMT regards the only constraint of deficit spending to be demand-led inflation. The deficit should be reduced if inflation rises above an agreed target. It should be used a second tool of monetary policy, in addition to interest rates, to hit inflation targets.
The neo-classical view, based on the notion of rational expectations, is that the debt has to be paid off and so a rational consumer will view this government debt as a future tax liability and adjust their behaviour accordingly. In other words they would not consider the debt to be a net financial asset. Simon Wren-Lewis discusses the implication of using 'printed money', which he refers to as outside money, instead of government debt to fund the deficit. Would this have a beneficial wealth-enhancing effect now that this debt did not need to be paid of by future higher taxes? He cites work suggesting that it would, but then argues that it may not if the authorities had an inflation target, as the printed money would be expected to expand the monetary base and inflate prices. He argues that, in order to hit the inflation target the authorities may increase taxes to contract the monetary base, neutralising the wealth effect of outside money.
The problem with this argument is that it assumes that the authorities to act in a way that conforms to the neoclassical view, and that this will be anticipated by the the rational consumer. How realistic is this? The authorities would surely not contract the monetary base under circumstances he cites (a liquidity trap) to counter inflation. First, the liquidity trap arises because there is a recession that the authorities will be trying to counter by loosening monetary and fiscal policy. Why would they raise taxes and contract the monetary base? The whole point of QE is to increase the monetary base. Second, the usual way to decrease the monetary base is by the authorities issuing securities (e.g. government debt), or reverse QE. Why would they not do this instead of increasing taxes? Third, the monetary base has a very weak, if any, relationship with the broad money. Look at the data. This is what you would expect if you understood how broad money is created, by bank lending, which is not reserve constrained.
The MMT view is that the rational consumer, if they really understood the monetary system, should and would consider government deficit spending to be financed by 'outside money'. In reality when government spend they introduce new (outside) money increasing the monetary base. Taxes remove most of this new money in order to ensure that demand is not excessive. Current self-imposed rules require that the difference or ’deficit' is borrowed back by issuing government debt certificates. In reality all this involves is them moving the money from reserve accounts at the central bank to interest bearing accounts at the central bank. In some countries this 'reserve drain' is necessary in order for central banks to hit their overnight interest rate target. The key point is that this government debt really represents government backed savings accounts for the 'outside money' that has already been introduced, much like National Savings Certificates in the UK.
So government debt actually is 'outside money' and represents net financial assets of the private sector. There is no need for it to be fully repaid and so no reason to expect tax increases just to pay this debt. A truly rational agent would not expect tax increases unless growth was so vigorous that it resulted in inflation, which would be associated with full employment and an economy functioning at full capacity. A rational agent would expect such growth to result in a reduction in the deficit (as tax revenue increase and welfare spending drops) and a reduction in debt/GDP ratio as GDP increases, and historical experience backs this up.
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