AM02 MMT13

Modern Monetary Theory - Chapter 13 -- Monetary and Fiscal Policy

1. Watch Video Lecture below; also read short post on Modern Monetary Theory, which explains one of the key concepts covered in this lecture

2. Read Burning Billions: Explains the Dutch Disease, problems caused by perpetual over-valuation of Rupee - contrary to MMT advice of free flotation of exchange rates

3. Read the link on the page linked above which have further information about Dutch Disease, and also about how the over-valuation of PKR is an old problem, which caused the de-linking of Pakistan and Indian economy. This de-linking is one important cause of permanent hostility and warfare between the neighbors.

Questions

1. Explain the positions of the Deficit Hawks, Deficit Doves, and Deficit Owls.

Deficit Hawks:

This term refers to the people who place great importance on keeping the government budget under control. They advocate decrease in government spending and increase in taxes to reduce budget deficit treating government budget just like a household budget. They believe that unsustainable government deficit could lead to significant long term challenges for the economy and also for future generations. They are extreme fiscal conservative who says that the government should not spend a penny more than it takes in taxes and balance its budget in every fiscal year.

Deficit Dove:

They are more of a Keynesian view who believes in running deficit in times of recession or when the economy is weak but having surplus as the economy recovers, so surplus over strong years and deficit over weak years. According to them the government should increase its spending in times of recession to stimulate aggregate demand and to encourage economic growth in the economy but adopt austerity in times of boom.

Deficit Owls:

They are the proponents of MMT theory. They say that our fears about debt and deficit are driven by an outdated gold standard ideology but now since we don’t have gold standard anymore so money is not a ‘finite’ thing. Now all money is created and circulated by the government so it can never run out of money because it can always make more. They strongly believe that deficits are not the cause of economic difficulty rather they are the results of it. According to them, the government goal should be a balanced economy rather than a balanced budget and sees government surplus as a danger because this surplus can be transferred to ordinary people who would spend it to boost the economy. Owls see deficit as integral to economic growth in bad as well as in good times.

2, Read Ruml: Taxes for Revenues are Obsolete -- Explain the conventional idea (Ricardian Equivalence) which says that if government spends then it must raise taxes to pay for the spending. Explain the opposite MMT idea that government does not need to raise taxes to generate revenue for spending. Evaluate

Ricardian Equivalence suggests that when the government attempts to stimulate the economy by increasing its spending, the aggregate demand does not increase and remains unchanged in the economy.

The government runs deficit either by tax cuts or by debt-financed spending to increase public spending but according to conventional idea this deficit spending will not have any effect on the overall economy. This is because the public assumes that a government deficit has to be paid off later on in future and this will be done only by increased taxes so they use this excess money to increase their savings in order to pay for expected future tax increases. People will reduce their current consumption to increase their current savings. Therefore, any attempt by the government to increase spending in the economy would yield no gain because people assume that whatever is gained now will be offset by higher taxes due in future.

According to MMT, sovereign government (who prints its own currency) does not really need revenue in its own currency in order to spend. The notion ‘taxes pay for government spending’ is only true for local government, provinces or states who does not issue their own currency and for nations that adopt a foreign currency or peg their own currency to gold or foreign currencies. But in the case of a government that issues its own sovereign currency without a promise to convert at a fixed value to gold or foreign currency, this does not hold. MMT argues that government should never have to default so long as it’s sovereign in its currency i-e; it issues and controls the kind of money it taxes and spends. The Pakistan government, for instance, can’t go bankrupt because that would mean it ran out of rupees to pay creditors; but it can’t run out of rupees because it is the only agency allowed to create rupees. It would be like a bowling alley running out of points to give players. MMT says that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends.

Now the question arises that why do we need taxes then?

There are several reasons. One, taxation gets people in the country to use the government-issued currency. Because they have to pay income taxes in rupees, Pakistanis have a reason to earn rupees, spend rupees, and use rupees other than bitcoins or euros. Second, taxes are one tool governments can use to control inflation. They take money out of the economy, which keeps people from bidding up prices. Also, it helps in the distribution of wealth and income through progressive income taxes.

To conclude we can say that the conventional idea assumes that government spending has to be financed by its revenue (taxes) clearly ignoring the power of sovereign government who creates money whenever it spends. On the other hand, MMT says that the sovereign government can never defaults or run out of currency because it has the power to print as much money as it wants.

3. Explain the traditional theory of Crowding Out of Private Investment by Government Investment. Explain Why MMT says that this is wrong.

The crowding-out effect is an economic theory which argues that rise in public spending (investment) drives down or even eliminate the private sector investment.

How it works:

Whenever the government increases its spending (investment), it can finance this higher spending either by increase in taxes or by increase in government borrowing.

Now in case of increased taxes, the govt. increase taxes on pvt. Sector which will decrease the net income of consumers and firms. This decrease in income will result in decreased spending hence decreasing the overall demand in the economy.

In case of increased borrowing, the govt. borrows from private sector by selling bonds. Now if people buy these bonds in order to earn high interest rate, this will lead to decline in lending capacity to the private sector projects. Secondly, when govt. increases its borrowing, this lead to increase in the overall interest rate hence increasing the cost of borrowing money for the private sector which discourage them to make any capital investment.

MMT View:

Myth 1: About increase in taxes:

Monetarily Sovereign Government who has unlimited power to create its own currency does not depend on taxes for govt. spending rather it can always prints or create more money for the purpose of spending which lead to increase in the aggregate demand and increase in the net income of private sector.

Myth2: Absorbing economy’s lending capacity:

The government does not borrow nor does it need to. Government borrowing is actually the issuance of treasury bonds and the government debt is the total of treasury security accounts at the central bank. The government does not borrow from banks rather it issues bonds which does not have any effect on bank’s lending capacity.

Myth 3: increase in interest rate:

The interest rates are determined by central bank and it can choose to set any interest rate that comes from the government funds target rate which the govt. set. For eg; in Japan, where there is high borrowing the government issued treasury bills at 0.0001 % proving that govt. lending does not result in high interest rates.

Government spending increases liquidity in the economy by pumping money into the economy which leads to increase in AD. As a result, businesses demands more loans which put downward pressure on the interest rate. MMT reject the idea that there is a supply of any loanable funds out there that govt. and prvt. Sector compete over. Instead loans given by banks themselves create money in accordance with market demand for money so there is no force that pushes interest rate to rise. Secondly, when government issues bonds, it increases the amount of money to private banks accounts and increases the amount of reserves in the banking system hence increasing the supply of loanable funds which will push down the overall interest rate.

[Alternative Response to Question 3(Dilavar Khan)]

As per traditional economics theories, the financial resources are limited. The banks can lend out of what they receive in the form of deposit. Further, the money creation is limited by the value of multiplier. Keeping in view these constraints, the private and government sectors compete for the resources from the same pot - the banks. If the government borrows from banking sector and opts deficit financing for the fiscal projects, the private sector does not get the financing, due to limited remaining resources available, and also the cot of these funds increase due to high demand for the limited resources.

However, the MMT says that there is no constraint on banks with respect to money creation, the banks can create money by keyboard strokes and there is nothing like multiplier. The banks can create money as much as there is need or demand for the financial resources. There is no deposit base needed to creat credit. This implies that the government and private sectors do not compete for the same financial resources. The government and the private sectors can get loans as much as they need or want. Hence no crowding out happens.