A review from Andrew Smithers writing at American Affairs Journal Volume IV, Number 4 (Winter 2020):
REVIEW ESSAY
The Deficit Myth:
Modern Monetary Theory and the Birth of the People’s Economy
by Stephanie Kelton
Public Affairs, 2020, 293 pagesIn the past, as governments have “funded” deficits (rather than monetizing them), much of their debt took the form of long- and medium-dated bonds. Since the yield curve usually slopes upward, this was an expensive policy and one that must be seen as foolish if the funding brought no discernible benefit. Beginning with the introduction of “quantitative easing” in 2008, however, the United States has reversed direction by having the Federal Reserve buy long-dated government bonds. “To fund or not to fund” is thus an important and immediately relevant question, one which economists not only have no agreed answer to but seem reluctant to even ask.
Unasked questions are unanswered ones, and a virtue of Stephanie Kelton’s The Deficit Myth is that it forces attention on why governments ever go to the expense of issuing bonds in the first place. Her critique of the weaknesses of conventional economic policy should receive—and to some degree already has received—wide acceptance. Things become more complicated, however, when Kelton begins to propound solutions to the various problems that her critique has revealed. Dramatic changes in economic management, such as those Kelton proposes, must be based on relative risks, and the known risks in our current system will likely (and correctly) remain preferable to unknown ones. The Deficit Myth nonetheless raises important points about why our conventional economic policy approaches need to be improved and how this might be done.
Monetary Policy versus Fiscal Stabilizers
The book opens with an attack on the common analogy that likens government budgets to household spending, usually invoked to support arguments against budget deficits. This thinking holds that if governments spend more than their income, then they, like households, will end up in bankruptcy. But as Kelton points out, the United States and most other countries today, with the exception of those in the eurozone, operate a system of fiat money under which bankruptcy cannot occur. Instead, the main risks are inflation and exchange rate depreciation. Kelton’s view is shared by many economists, but she argues that a persistent misunderstanding of these issues has consistently resulted in insufficient fiscal stimulus—either because the deficit spending has typically been too small or because it is often poorly designed, reducing its multiplier effect.
Deficit spending is desirable when it reduces unemployment, but only insofar as this does not result in increasing inflation. The Federal Reserve has the “dual mandate” of containing the levels of both inflation and unemployment. The optimal point occurs when unemployment has fallen to what is called the non‑accelerating inflation rate of unemployment (nairu). Since the nairu is unknown and varies over time, and since monetary policy does not immediately impact demand, the Fed is bound to make mistakes. A less fallible way to manage inflation and unemployment would certainly be desirable.
Governments could use fiscal policy to maintain unemployment at the nairu rather than relying on monetary policy to manage demand. The current preference for monetary policy reflects the view, which The Deficit Myth challenges, that fiscal policy cannot be varied quickly and precisely enough to provide the necessary fine-tuning of demand. Typically, government spending and taxation are decided by a lengthy process involving both houses of Congress and the president. But it might be possible to devise a system in which the fiscal balance adjusts automatically to the level needed to keep the economy at its optimal level of output while maintaining stable inflation. We already have such “automatic stabilizers” in the form of unemployment insurance and other programs that cause budget deficits to rise, without any action by Congress, as tax revenue falls in periods when the economy is weak. If the automatic stabilizers were stronger, Kelton argues, then the role of monetary policy in balancing the economy could become less important, and the inevitable errors in its application less damaging.
Kelton thus proposes to introduce such a stabilizer in the form of government-guaranteed full employment. In place of unemployment benefits, anyone wishing to work would be offered a job by the government if none were available in the private sector. This program’s practicality depends on two different types of problems: is it possible to invent enough government jobs, and can hiring for them be flexible enough to cope with the fluctuations in demand for labor from the private sector?
Critiques of Quantitative Easing
Before evaluating Kelton’s job guarantee proposal, it is helpful to examine the problems associated with the current paradigm of economic management. A key question is whether Kelton’s preferred automatic stabilizers would be likely to produce more or less collateral damage.
One problem with the current system is its vulnerability to errors of judgment by the Federal Reserve. Another lies in striking the right balance between fiscal and monetary policy. Central banks cannot determine fiscal policy, so if demand is too weak to ensure full employment, the Fed must act to stimulate the economy in order to comply with its dual mandate. If this cannot be achieved by cutting interest rates, it must be done by other means. The approach chosen by the United States and by other jurisdictions has been quantitative easing (QE).
QE involves buying long-dated bonds, an action that pushes up bond prices and flattens the yield curve. By triggering a fall in its cost, QE encourages debt, either to replace equity or to finance investment. Critics argue that QE encourages the buildup of private sector debt, pushes up asset prices to dangerous levels, and increases the risks of future policy mistakes.
Bond, property, and equity prices have all risen following QE. In the case of equity valuations, they are now at levels similar to the peaks of 1929 and nearing the historic highs seen in the tech boom of 2000.1 This has discouraged savings and encouraged consumption, since the wealthier we think we are, the less we feel the need to save. But asset prices affect savings not only when they rise, but also when they fall. As we have seen after previous peaks, nasty recessions are a high risk when asset bubbles burst. This is amplified when, as today, there is a high level of private sector (and particularly corporate) debt, which, after falling briefly following the 2008 recession, has risen again to a record high level.
Moreover, although QE has served to inflate asset values, it has been much less effective in stimulating investment. Investment has recovered from the lows of the Great Recession, but it remains depressed compared with levels seen during past periods of full employment. Some claim that companies have been discouraged from investing by a desire to improve their balance sheets, and that QE will eventually encourage more investment once balance sheets improve. Kathleen Kahle and René M. Stulz have shown that this is an untenable thesis, however: rather than repairing their balance sheets, companies have increased their debt to fund growing cash payouts through dividends and share buybacks.2
The financing of QE’s bond buying involved a massive increase in commercial banks’ deposits with the Fed. The question is whether this level needs to be brought down again. If it doesn’t, then the funding policy of the past has been an expensive folly. If it does, then the Fed will need to decide how fast to sell its holdings of government debt, as well as the appropriate level of short-term interest rates, and the opportunities for policy error will have shot up—especially since the Fed is now said to be in “uncharted territory” with no agreed upon theory governing its actions.
QE thus seems guilty as charged. It has increased the risk of another financial crisis by encouraging debt and boosting asset prices. It has also raised the risks of future Fed policy mistakes. In 2002, Stephen Wright and I argued that the Fed had become hubristic in its belief that asset prices did not matter, whether because financial bubbles were considered impossible or because monetary policy was believed to be readily able to cope with asset price falls. The first error followed from faith in the Efficient Market Hypothesis (EMH) and the second from the “general consensus that monetary policy should be about controlling inflation and nothing else, which might be called the Efficient Central Banking Hypothesis (ECBH).”3 The hubris involved in these ideas was epitomized by Alan Blinder, a former vice‑chairman of the Fed, who remarked at the height of the tech bubble, “For the U.S. economy to go into significant recession, never mind a depression, important policy makers would have to take leave of their senses.” We added that “Time will tell whether Professor Blinder’s confidence proves to be admirable or foolhardy.”4
Time has duly told and, although it still has its adherents (and equivalent assumptions have not yet been eliminated from many models of the financial economy), it is now generally accepted that faith in the EMH was a disastrous mistake. And the widely accepted need to include financial stability in the responsibilities of central banks shows how the ECBH has also fallen into disrepute. Sadly, it took the Great Recession to change opinion, illustrating that events are more persuasive than debate....
....MUCH MORE
