Bill Mitchell 2011 Debt Deficits and Modern Money Theory

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Debt, Deficits, and Modern Monetary Theory

October 16, 2011 | 3:56 AM

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 youve been integral in developing

and its relevance to current debates over public finances. I know youve been quitescathing 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 thetime, Richard Nixon, suspended the convertibility of the US dollar into gold. At that point, the

system of fixed exchange ratesin which all countries agreed to fix their currencies against theUS dollar, which was in turn benchmarked in price against goldwas abandoned. So since thatday, 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 thats 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 issuerof 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 doesnt need you or I to lend it money or you andI to pay taxes to get more money. It can never run out of money. Thats 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, dont we pay taxes and buy bonds

so that the government can spend? Well, you first have to ask yourself the question, Where do


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you get the money to pay taxes and buy bonds? And the answer is that we cant get our hands

on the currency until the national government spends it. Spending is the prior act in a fiatmonetary system; taxing and borrowing are following acts. In effect, the government is only

taxing what it has already spent, and its 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 allof the imbalances in the foreign exchange market are resolved by the price of the currency

fluctuating. What that means is that domestic policy instrumentsthe central bank and fiscal

policyare free to target domestic policy goals knowing that the exchange rate will resolve thecurrency imbalances arising from trade deficits, trade surpluses, et cetera.

I want to touch on a few things there. The first is MMTs basic insight that governments

dont have to tax or borrow in advance of spending. Given the recent furor over creditrating 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, its an interesting question, and its one of the things that really trips people up in trying tounderstand MMT. Under the so-called Bretton Woods systemthe fixed-exchange rate system

that prevailed in the post-WWII period until 1971governments were revenue-constrainedbecause 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 borrowto 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 theres probably more to it than that. One set of explanations is that the profession hasnt

worked out the implications of a fiat monetary system. I dont subscribe to that because people

arent that silly. So I think youve got to dig deeper as to why were holding onto gold standardtype behaviour in a system where we dont 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 werestrengthened 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 borrowingpushes interest rates up and thereby undermines private sector investment, and that ultimately the

danger of government spending is hyperinflation.


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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 themodern monetary system operates. In mainstream textbooks youll find a chapter about the role

of the central bank, and that chapter will describe how the central banks main function is tocontrol the supply of money through open market operationsthat 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 cannotcontrol the money supply. And

not many central banks past the mid-1980s gave any credibility to monetary targeting. Theyrealized 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 banka reserve accountand

those reserves accounts are used on a daily basis to make sure that the cheques we all sign clear

each day. Typically reserves dont earn any interest from the central bank, so if the volume ofreserves exceeds what each bankthinks is required on a daily basis, the bank is stuck with deadmoney. Now in some countries thats 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 lendingrate.

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. Thecompetition 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 tocontinue, it loses control of monetary policy.

The way the central bank can maintain control of its target interest rate is to manage that

liquidity thats 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 ofgovernment 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?


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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 ata 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 dont 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 enamoredof 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 thinthat is, there was such a small amount of debt left in the systemthatthe 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 cant get enough of it. This is a very beautiful example of the function of debt inmodern 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 havebeen 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 wealthcoming 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. Theres no question that the debt obligations will be met. Theres no risk. Whatsmore, 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 cant do individually. In that context, it becomes clear that public policy shouldbe 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.


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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 whichfirms 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 dont matter at all. The fundamental point that theoriginal developers of MMT would makemyself or Randall Wray or Warren Mosleris that

the risk of budget deficits is not insolvency but inflation. In saying that, however, we would alsostress that inflation is the risk ofany 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, were 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 theyre 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: theres 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. Thats 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 waitingfor 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 froma 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 themoney 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


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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. Typicallythough not at the presentbecause we are in an extraordinary situation where the central bank is paying interest on

reservesthose reserves would just sit there and earn zero interest for the banks. And so

typically, as Ive 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 thatbudget 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 its confirmed by the

present combination of record low interest rates and very large budget defecits.

Bill Mitchell 2011 Debt Deficits and Modern Money Theory

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