Wren-Lewis vs MMT

12 Jun, 2019 at 09:43 | Posted in Economics | 6 Comments

Simon Wren-Lewis is obviously upset because some MMTers have called his economic policy proposals (providing the theoretical foundation for Labour’s Fiscal Credibility Rule) “neoliberal”. Neoliberal or not, what he does have to say about MMT and his own mainstream economics makes it clear what the debate really comes down to:

MMT’s key idea is that fiscal policy (changing taxes and government spending) is better suited to stabilise the macroeconomy than a central bank setting interest rates.

Almost without exception, advanced economies use interest rates set by an independent central bank to control output and inflation … A fundamental problem with today’s way of doing things occurred during the Global Financial Crisis. Interest rates fell to a level that became their lower bound … It is now received wisdom among academic economists that when interest rates hit their lower bound, fiscal policy needs to provide a large stimulus to the economy. Labour’s fiscal credibility rule is the first in the world to formalise this. If interest rates hit their lower bound, the normal rule is suspended and a fiscal stimulus occurs that is sufficient to end the recession. Labour’s rule is therefore designed to prevent austerity happening again.

MMT wants to go one step further. It wants to use fiscal policy to stabilise the economy at all times, and not just when monetary policy is out of action.

In Wren-Lewis world we don’t need fiscal policy other than when interest rates hit their lower bound (ZLB). In normal times monetary policy suffices. The central banks simply adjust the interest rate to achieve full employment without inflation. If governments in that situation take on larger budget deficits, these tend to crowd out private spending and the interest rates get higher.

What Wren-Lewis and other mainstream economists have in mind when they argue this way, is nothing but a version of Say’s law, basically saying that savings have to equal investments and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity, there is, of course, nothing to say about the law, but as such, it is also totally uninteresting from an economic point of view. What happens when ex-ante savings and investments differ, is that we basically get output adjustments. GDP changes and so makes saving and investments equal ex-post. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

For the benefit of Wren-Lewis and other latter-day​ ‘New Keynesian’ mainstream economists, let’s see what a real Keynesian economist has to say about crowding out and government deficits:

Fallacy 3
Government borrowing is supposed to “crowd out” private investment.

The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

It is true that MMT rejects the traditional Phillips curve inflation-unemployment trade-off and has a less positive evaluation of traditional policy measures to reach full employment. Instead of a general increase in aggregate demand, it usually prefers more ‘structural’ and directed demand measures with less risk of producing increased inflation. At full employment deficit spendings will often be inflationary, but that is not what should decide the fiscal position of the government. The size of public debt and deficits is not — as already Abba Lerner argued with his ‘functional finance’ theory in the 1940s — a policy objective. The size of public debt and deficits are what they are when we try to fulfil our basic economic objectives — full employment and price stability.

That governments can spend whatever amount of money they want is a fact. That does not mean that MMT says they ought to — that’s something our politicians have to decide. No MMTer denies that too much of government spendings can be inflationary. What is questioned is that government deficits necessarily is inflationary.