Debt, Deficits, and Modern Monetary Theory

Bill Mitchell is the Research Professor in Economics and the Director of the Centre of Full Employment and Equity at the University of Newcastle, Australia. The following is an edited transcript of the interview, conducted August 15, 2011.


Thanks for joining us, Professor Mitchell. I wanted to talk with you today about Modern Monetary Theory (MMT)—the theoretical approach you’ve been integral in developing—and its relevance to current debates over public finances. I know you’ve been quite scathing of mainstream economic discourse. For example, you wrote in your blog recently that “the economics media is dominated with financial issues – too much public debt; debt ceilings; fiscal sustainability; sovereign risk; and all the rest of the non-issues that have taken center-stage.” Could you take a moment to explain why MMT renders these things non-issues?

The most important misperception is that MMT is in some way outlining an ideal or a new regime that could be introduced. The reality is that MMT just describes the system that most countries in the world live under and have lived under since 1971, when the US president at the time, Richard Nixon, suspended the convertibility of the US dollar into gold. At that point, the system of fixed exchange rates—in which all countries agreed to fix their currencies against the US dollar, which was in turn benchmarked in price against gold—was abandoned. So since that day, most of us have been living in what we call a fiat currency system.

In a fiat currency system, the currency has legitimacy because of legislative fiat: the government tells us that’s the currency and then legislates it as such. The currency has no intrinsic value. What gives it value, what motivates us to use the currency that the government suggests, is the fact that all tax obligations are denominated in and have to be extinguished with that currency. We have no choice. If you live in America, for example, you have to pay American taxes to the IRS with American dollars. So demand for the currency, otherwise worthless bits of paper, is driven by the fact that all tax obligations have to be extinguished with that currency. Once you consider that, then you immediately realize that the national government is the monopoly issuer of that currency. That means that the national government in such a system can never be short of that currency; it can never run out of money. It doesn’t need you or I to lend it money or you and I to pay taxes to get more money. It can never run out of money. That’s the first basic insight of MMT: governments are not constrained in their spending by a need to raise revenue.

If you extend that logic a little further, you might ask, “Well, don’t we pay taxes and buy bonds so that the government can spend?” Well, you first have to ask yourself the question, “Where do you get the money to pay taxes and buy bonds?” And the answer is that we can’t get our hands on the currency until the national government spends it. Spending is the prior act in a fiat monetary system; taxing and borrowing are following acts. In effect, the government is only taxing what it has already spent, and it’s only borrowing back money that it has already spent. Once you start pursuing this logic, you realize that most of the propositions that are occupying the current debate around the world are based upon false premises.

Another basic premise of MMT is that we now live in a world of floating exchange rates, so all of the imbalances in the foreign exchange market are resolved by the price of the currency fluctuating. What that means is that domestic policy instruments—the central bank and fiscal policy—are free to target domestic policy goals knowing that the exchange rate will resolve the currency imbalances arising from trade deficits, trade surpluses, et cetera.

 

I want to touch on a few things there. The first is MMT’s basic insight that governments don’t have to tax or borrow in advance of spending. Given the recent furor over credit rating downgrades, one might wonder: if that's true, why do governments continue to issue debt and bother themselves with the discipline of the bond markets and the credit rating agencies?

Yes, it’s an interesting question, and it’s one of the things that really trips people up in trying to understand MMT. Under the so-called Bretton Woods system—the fixed-exchange rate system that prevailed in the post-WWII period until 1971—governments were revenue-constrained because the central bank could only allow so much money in the economy according to its holdings of gold and the currency value. So if the government wanted to spend more, it had to make sure that it took money from someone else in the economy so that the overall money supply would be constant. In that sort of monetary system, the government had to tax or borrow to spend. This sort of reasoning has crept into the modern monetary system, where it no longer holds because we use fiat currencies instead of convertible currencies.

But there’s probably more to it than that. One set of explanations is that the profession hasn’t worked out the implications of a fiat monetary system. I don’t subscribe to that because people aren’t that silly. So I think you’ve got to dig deeper as to why we’re holding onto gold standard–type behaviour in a system where we don’t need that sort of behavior.

If you look back through history and examine discussions in various government documents, what you pick up is a solid indication that governments have combined institutional arrangements such as issuing debt with certain accounting practices to make it look as though the debts were actually funding government spending. These institutional arrangements were strengthened in the late 1970s and the 1980s because the mainstream economics profession knew that those arrangements would place constraints on the freedom of governments to spend. The mainstream believes that taxation distorts individual incentives, that government borrowing pushes interest rates up and thereby undermines private sector investment, and that ultimately the danger of government spending is hyperinflation.

 

So is it all ideology, or is it also a lack of understanding about how the modern monetary system actually operates?

Well, there is certainly a mischaracterization among mainstream economists about how the modern monetary system operates. In mainstream textbooks you’ll find a chapter about the role of the central bank, and that chapter will describe how the central bank’s main function is to control the supply of money through open market operations—that is, buying and selling government bonds to regulate the demand of money relative to the supply. Through this process, the story goes, the central bank is able to target interest rates.

That textbook explanation is quite wrong. Central banks cannot control the money supply. And not many central banks past the mid-1980s gave any credibility to monetary targeting. They realized that central banks can control only interest rates, not the money supply. After this realization, monetary policy became expressed through setting a short-term interest rate by managing the liquidity in the overnight cash markets.

Each of the commercial banks have an account with the central bank—a reserve account—and those reserves accounts are used on a daily basis to make sure that the cheques we all sign clear each day. Typically reserves don’t earn any interest from the central bank, so if the volume of reserves exceeds what each bank thinks is required on a daily basis, the bank is stuck with dead money. Now in some countries that’s not true, but even in countries such as Australia where the central bank has always paid a return on overnight reserves, the return is less than the lending rate.

In the US and Japan, for example, there has historically been zero return on those reserves. So banks will try to lend out excess reserves to other banks that may be deficient in reserves. The competition in this market, called the interbank market, starts to drive interest rates down, because the banks will take any return instead of zero. If the central bank allows that process to continue, it loses control of monetary policy.

The way the central bank can maintain control of its target interest rate is to manage that liquidity that’s embodied in these reserves. So if the central bank perceives that the banks consider their reserves to be excessive on any particular day, it drains those reserves out of the system by offering an interest-bearing asset in the form of a government bond. The role of government bonds, then, is to provide the central bank with the capacity to ensure that there is no competitive pressure on the target interest rate. So you can see that the function of government bonds is something quite other than to lend the government money.

 

You'll hear many politicians speak of “paying down the national debt.” What do you make of this refrain?

The historical reality is that national governments very rarely run down their overall stock of debt. A debt instrument is a commitment by the national government to pay a certain principal at a specified time, and in the meantime pay some yield or interest on that debt. So governments pay back debt in that individualized context, but overall, in a macroeconomic sense, governments generally don’t run down their overall stock of debt.

There are some rare instances where governments have run down their overall stock of debt, like in Australia between 1996 and 2007. The conservative government of the period was enamored of this neoliberal idea that it would get rid of all its holdings of outstanding debt, and so it started running very large surpluses and paying back its debt. After about five years, the public bond markets became so thin—that is, there was such a small amount of debt left in the system—that the big investment banks started to protest, since they relied on government debt as a risk-free asset upon which to benchmark all other risk. Curiously, the Austrialian federal government agreed that even though it would continue to run budget surpluses, it would also continue to issue debt at a certain amount to ensure that the corporate sector would have its risk-free asset. So while the Wall Street Journal runs op-eds condemning the evils of debt, the reality is that the financial sector can’t get enough of it. This is a very beautiful example of the function of debt in modern times.

In MMT, we see public debt as private wealth and the interest payments as private income. The outstanding public debt is really just an expression of the accumulated budget deficits that have been run in the past. These budget deficits have added financial assets to the private sector, providing the demand for goods and services that have allowed us to maintain income growth. And that income growth has allowed us to save and accumulate financial assets at a far greater rate than we would have been able to without the deficits.

The only issues a progressive person might have with public debt would be the equity considerations of who owns the debt and whether there an equitable provision of private wealth coming from the deficits. There is a debate to be had about that, but there is no reason to obsess over the level of outstanding public debt. The government can always honor its debt; it can never go bankrupt. There’s no question that the debt obligations will be met. There’s no risk. What’s more, this debt provides firms, households, and others in the private sector a vehicle to park their saved wealth in a risk-free form.

 

Put simply, when should governments begin to run budget surpluses?

Particular budget outcomes should never be a policy target. What the government should be targeting is real goals, by which I mean a sustainable growth rate buoyed by full employment.

Why do we want governments? We want them because they can do things that improve our welfare that we can’t do individually. In that context, it becomes clear that public policy should be devoted wholly to making sure that there are enough jobs, that poverty is eliminated, that the public health and public education systems are first class, that people who are less well off are able to become better off, etc.

From a macroeconomic point of view, the spending and tax decisions of government should be such that total spending in the economy is sufficient to produce the level of real output at which firms will employ the available labor force. This is the goal, and the particular budget outcomes must serve this goal.

None of this is to say that budget deficits don’t matter at all. The fundamental point that the original developers of MMT would make—myself or Randall Wray or Warren Mosler— is that the risk of budget deficits is not insolvency but inflation. In saying that, however, we would also stress that inflation is the risk of any kind of overspending, whether investment, consumption, export, or government spending. Any component of aggregate demand could push the economy to that point where we get inflation. Excessive government spending is not always to blame.

In sum, we’re quite categorical that we believe that budget deficits can be excessive and can be deficient as well. Deficits can be too large, just as they can be too small, and the aim of government is to make sure that they’re just right to employ all available productive capacity.

 

How does this differ from the dominant New Keynesian paradigm?

Well, the New Keynesian paradigm is built upon a series of false premises that affect policy prescriptions. False premise number 1: government has to borrow to fund spending. False premise number 2: there’s a fixed supply of savings available at any point in time. False premise number 3: the government, by borrowing from that fixed supply of savings, denies private sector borrowers those funds, and competition for those funds drives up interest rates.

MMT says the following:

There is no finite pool of savings in the economy. Savings is a function of national income. When you have rising national income, you have rising savings. So if government spending stimulates economic activity, and thereby GDP and national income, savings will rise simultaneously. That’s the first part of the story.

The second part of the story is that private sector borrowing is not dependent upon a fixed supply of savings. The concept of a bank in the New Keynesian model is that the bank sits there waiting for depositors to come with their savings, and only once the bank attracts those deposits is it in a position to lend. In other words, the New Keynesian conception is that banks are constrained by their existing reserves. In reality, however, banks always have the capacity to create loans for credit-worthy borrowers because they can always get more reserves. Banks can get reserves from a number of sources, but at the end of the evening the banks know they can cover their reserves by borrowing from the central bank. So the conception of banking in MMT is much different from the stylized treatment in New Keynesian economics.

The third story is what happens when the government runs a budget deficit. What happens in the money market is as follows: the US government buys something from the private sector. They pay the manufacturer, who then pays the workers. A whole range of transactions follows from that initial government purchase. All of those transactions work their way through the system and find their way to the reserves of the banks each day. Typically—though not at the present because we are in an extraordinary situation where the central bank is paying interest on reserves—those reserves would just sit there and earn zero interest for the banks. And so typically, as I’ve explained before, banks try to get rid of those reserves, driving down the interest rate in the interbank market in the process. What you can understand from that is that budget deficits, independent of any monetary operations, drive interest rates down, not up. This is the complete opposite of what orthodox economists claim is the case, and it’s confirmed by the present combination of record low interest rates and very large budget defecits.