MMTed is a project run by the Centre of Full Employment and Equity
Business Office:
G15V 162 Albert Street
East Melbourne 3002 Victoria
Australia
© MMTed 2024
Contact
Phone: +61-(0)419 422 410
E-Mail: Bill.Mitchell@newcastle.edu.au
Video Transcript: (use scroll bar as required)
So let's now talk briefly about fiscal and monetary policy, which is a two major arms of macroeconomic policy. Fiscal policy, which is run by the Treasury, is government spending and taxation.
Monetary policy, which is run by the Central Bank, involves typically adjusting interest rates up and down, with the view that higher interest rates will stifle spending and lower interest rates will stimulate spending. And also, in more recent period, we've had what's called non-standard monetary policy, like quantitative easing.
Now, in this neoliberal period over the last three or so decades, we've had a bias within macroeconomics towards the use of monetary policy as the primary adjustment tool for total spending in the economy, allegedly run by independent central banks, which are outside the political influence of government and fiscal policy, has been biased towards austerity.
And the presumption was that that would give much better policy settings because the independent central bank, inverted commas would be resistant to political flavours and only implement policy that was appropriate to the times.
But what we've learnt is that that bias has failed.
First of all, monetary policy delivers ambiguous effects. Take an interest rate rise that helps creditors, people who who have lent money, but it punishes debtors. We don't know what the balance of those distributional effects are.
We also don't really know whether interest rate rises stifle inflationary pressures in the economy or actually add to them because they push up the cost of business. That's likely to be the latter.
And we think of monetary policy as a very blunt instrument. It relies on changing behaviour among borrowers and creditors, which then might or might not seep through to total spending. And this is why in MMT, we prefer fiscal policy to be the primary macroeconomic policy tool to adjust spending in the economy when it's necessary because it's direct.
If the government spends an additional dollar into the economy that goes straight into the spending stream, or if they withdraw that goes directly into the economy, it can be targeted spatially by demographic cohort and it's much more immediate in its impact.
And this reliance on monetary policy has pushed the monetary parameters to extreme limits, which are now starting to undermine the prosperity of the economy.
An example is quantitative easing. What is it? The Central Bank buys government bonds off the private banks and gives the private bank reserves. Now, the logic was that the private banks weren't spending enough. And this started in the global financial crisis basically. If private banks weren't loaning enough because they didn't have enough money and this goes back to the mainstream idea that banks only lend out their reserves.
Now, of course, as we learnt when we considered the crowding out fallacy. Banks don't lend out reserves. They create loans which create deposits. And so the whole reason the banks weren't making loans during the GFC and subsequently is because there weren't enough creditworthy borrowers to come in to the banks to borrow money. So QE wasn't a solution to that problem.
And the only way QE can work is if it lowers interest rates in the economy so much that investors will borrow more. But they won't borrow more because even if interest rates are low, if if they can't sell the stuff that they would make from the new capital equipment. And so QE basically failed in its purpose and it failed to push inflation rates up, which has been the major objective of central banks. So when we talk about fiscal policy, we can't leave out the discussion of public debt and the issuing of bonds.
So the government issues bonds to the non-government sector. And we've been led to believe that those bonds being issued provide the funds that governments use then to run spending greater than their taxation revenue, in other words, funding the government deficits.
But of course, as we've learnt already, their governments who issue their own currency face no financial constraint. And so the question then is why would they issue debt?
Now in Modern Monetary Theory, we believe that a government that's not financially constrained has no reason to issue debt. And so then the question is, well what does the debt do? Now, students learn in mainstream theories that the issuing of debt reduces the inflation risk of the government deficits.
The problem with that analysis is that it's wrong - that there's no reduction in risk because the inflation risk is in the government spending. How that interacts with the productive capacity of the economy and all the debt issuing does is allow the non-government sector to shuffle its wealth into preferred assets or non-preferred assets, their financial assets.
And in MMT, we characterise the issuance of debt as corporate welfare because what it basically offers to the non-government sector is a risk-free asset, which you can park its funds when it's uncertain about returns and viability of other financial assets.
And so it's really not the purpose of fiscal policy to be providing that sort of security to speculators in financial markets. There's no other reason to issue debt and so MMT extrapolation is for the government not to issue any debt.
It's not necessary.
End of Transcript
Fiscal policy adjusts spending and tax structures to influence total spending in the economy, while monetary policy adjusts interest rates to achieve the same end.
In the Post World War 2 Keynesian consensus, fiscal policy was the primary tool used in this respect, partly because monetary policy had to maintain the agreed currency parities. But fiscal policy was also considered to be more effective in countering fluctuations in the non-government sector spending cycle and for maintaining full employment.
Major dislocations in the world economy occurred after the massive OPEC oil price rises in October 1973. Milton Friedman's Monetarists, who opposed the Keynesian approach, blamed the resulting inflation on irresponsible use of monetary and fiscal policy, driven by a desire to win votes. As a result, they said that nations should ‘assign’ the macro policy instruments towards monetary policy and eschew the use of discretionary fiscal policy – which is just fancy terminology to say that fiscal policy would no longer target full employment, and, that central banks would use unemployment as a policy tool rather than a policy target to fight 'inflation first'.
Monetarists also spawned the idea of independent central banks, who would make decisions without bowing to political pressures. The notion of independent central banks is one of many examples in the neoliberal period of a phenomenon known as depoliticisation. This refers to the way that elected governments have reduced their responsibility and accountability for economic decision-making by appealing to decisions taken by bodies external to the political process (for example, central bank boards, the IMF, etc), which the nation just has to accept.
Agendas that would normally be rejected by citizens, such as, harsh austerity, were now possible because the politicians, channelling Margaret Thatcher, claimed There Is No Alternative (TINA).
The Monetarists claimed that excessive money supply growth caused inflation, and, so many central banks attempted to control the money supply in the 1970s and early 1980s but failed. This exposed the shifts in economic thinking as ideological, without a firm foundation in robust theory. In fact, central banks cannot control the money supply, which is largely driven by the demand for credit from borrowers.
In determining whether central banks are independent or not, some observers note that it is politicians that appoint central bank boards; can in many jurisdictions overrule monetary policy decisions and can always change legislation defining the roles and functions of the bank.
MMT economists go further and show that it is an operational sense the central bank cannot be independent of treasury. The two arms of policy have to work closely together to maintain financial stability.
The central bank sets the target short-term interest rate (available on overnight funds) as a statement of monetary policy, which then influences interest rates offered for longer term funds.
Each commercial bank has to have a reserve account with the central bank with sufficient balances each day, to ensure that all cross-bank transactions clear and no 'cheques bounce'. A Bank A customer might send a cheque to a supplier who banks with Bank B. Bank B must be able to get the funds from Bank A. These transfers are all accomplished by adjusting balances in the respective reserve accounts.
Reserve account funds have typically not earned a competitive return, although since the GFC, many central banks offered such returns on reserve balances.
Prior to that, if there were excessive reserves in the system, the banks with excesses would try to make loans in the interbank market (a market for overnight or very short-term loans between banks) to other banks, which might have shortfalls on any particular day. In the absence of central bank intervention, this process would drive the interbank market down towards zero because any return is better than none.
To avoid losing control of its monetary policy target, the central bank conducts daily liquidity or reserve management operations. When there is a system-wide shortfall in reserves, then the central bank will always make the necessary reserves available to the banks. When excess reserves arise, the central bank would exchange interest-bearing government bonds for bank reserves and thus eliminate any excesses. This would ensure the interbank interest rate would remain aligned with the central bank's policy target rate. Economists call this an Open Market Operation. It allows you to understand one function of government debt - to stabilise short-term interest rates so they are consistent with the monetary policy target rate.
Since the GFC, many central banks just pay interest on excess reserves, which accomplishes the same outcome. So, there is no need for government to issue debt at all.
The tie in with fiscal policy then arises because when government spends, bank reserve holdings at the central bank increase. Tax payments do the opposite.
If government spending exceeds taxes, overall bank reserves grow and if fiscal deficits are of any significant size, excess reserves in the banking system will result. Banks do not want to hold more than they need for cheque clearing and to meet required reserve ratios (if they exist). Thus, the central bank and treasury must coordinate their daily operations closely to ensure that the impact of fiscal policy on bank reserves is anticipated and central bank liquidity management is effective to maintain the target interest rate.
While fiscal and monetary policy must work closely together, MMT prioritises the use of fiscal policy as a more effective in stabilising national income movements.
Monetary policy is called a 'blunt' or indirect instrument because it must rely on the expenditure sensitivity to interest rate changes to influence private spending. While lower interest rates reduce borrowing costs, what if the economy is in recession? No matter how cheap funds are, firms will not access them if they are pessimistic about future sales.
There is also considerable ambiguity about the impact of interest rate changes on inflation. Central banks think that increasing interest rates stifles inflation. The evidence is unclear. For example, by increasing business costs, it is likely that interest rate rises will push up prices.
Further, when interest rates rise, creditors (those making loans) benefit, but debtors suffer. We have no reliable way of assessing the net outcomes of these different distributional impacts.
By way of contrast, fiscal policy is very direct. When the government spends an extra dollar, it immediately impacts on sales, which stimulates employment. It can also directly create employment whenever it chooses by spending more.
Finally, fiscal policy can be closely targetted to particular demographic groups and/or regions/communities.
MMTed is a project run by the Centre of Full Employment and Equity
Business Office:
G15V 162 Albert Street
East Melbourne 3002 Victoria
Australia
© MMTed 2024
Contact
Phone: +61-(0)419 422 410
E-Mail: Bill.Mitchell@newcastle.edu.au