By Philip Pilkington, a writer and research assistant at Kingston University in London. You can follow him on Twitter @pilkingtonphil

Dreaming, I was only dreaming

I wake and I find you asleep – Billie Holiday “Gloomy Sunday”

The criticisms of Modern Monetary Theory (MMT) on the internet and in academia can be placed into three categories: the cranks; the nit-pickers; and the Kaldorians. The cranks make up by far the largest group. These are the people that simply have not bothered to understand the theory. These, which include some prominent academics, say things like: “The MMTers say that deficits don’t matter; they forgot about hyperinflation!” These people can usually be safely ignored as they are not arguing in good faith.

The nit-pickers are a smaller group, but perhaps more vocal. They do understand the theory to a large extent but they try to pick holes on minor points. “Taxes,” they might say, “aren’t the only thing driving money; money is also ingrained in the legal system because it can be used to settle legal contracts and this gives it value.” In this the nit-pickers don’t appreciate the difference between a general theory and an additional consideration that might be included as an afterthought. Apart from this, the nit-pickers often misrepresent their “opponents” (mentors?) by cribbing throwaway comments from blogs and insisting that MMT explain itself (over and over again) when MMT has proponents have already developed a considerable literature that does just that.

The Kaldorians are an altogether different breed. Where the others simply constitute noise in the blogosphere crowding out debate, the Kaldorians’ argument is rigorous, academic and extremely relevant to the potential success of certain policy approaches advocated not just by MMTers, but also more mainstream New Keynesians like Paul Krugman. This is not just an academic debate. It has very real implications for what policies we might suggest to get us out of the present crisis.

However, there are two serious problems with the Kaldorian approach – both of which are inextricably linked to one another. First of all, the Kaldorians are utopians in their politics and have a fairly airy grasp of what we can and cannot potentially achieve given the international political scene today. Secondly, they seem at odds with their own mentor, the British economist Nicholas Kaldor, on their understanding of current economic problems.

What follows may at times feel a bit “he said, she said” and it’s all a bit long, but I would ask the reader to follow through. The implications of the following argument and the understanding of our current problems they contain are extremely important to where we are today.

Kaldor Versus the Kaldorians

Nicholas Kaldor was one of the most famous economists of the 20th century. He was considered by many to be the direct heir to John Maynard Keynes as he was not only an extremely accomplished theoretical economist but also played a key role in the construction of British economic policy after World War II and was an all-round politically savvy individual – he ended his life, like Keynes, with a Lordship.

We mention this because if you read his writings you note that there were really two Kaldors. One was the Kaldor of the halls of Cambridge University. This was the Kaldor of abstract mathematical models of how capitalist economies function (some of the finest ever produced, mind you). The other Kaldor was the Kaldor that actually analysed economic problems and proposed solutions – while keeping firmly in mind the political situation of whatever time he was giving advice.

The Kaldorians, following the British economist Anthony Thirlwall, have picked up the first Kaldor and left the second to rot on the shelf. They have attempted to turn Kaldor into an economic model that immediately and fully explains the real world economy. The difference here between them and Kaldor is key to understand: Kaldor would have never applied a model directly to understand the world, for him it could only guide you in investigating problems from all angles – economic, social, political and so on. But for the Kaldorians this does not appear to be the case.

Their gripe with MMT is that it ignores that government spending policies will cause trade deficits to widen and this will… well… something bad will happen. In this they reference what they call “Thirlwall’s Law”. The Law itself seems to be set up only with very strict conditions in mind, but some of the Kaldorians apply it to everything they see in every economy at every time. This is the problem with confusing an economic model for a perfect description of the world: in the same manner as a recent religious convert, you start to see the Holy One everywhere you turn.

The annoying thing is that the problems that the Kaldorians raise are actually very important – in specific contexts. As most MMTers acknowledge, for example, it is probably not advisable for developing countries to run high trade deficits for too long as this may result in currency crises and all sorts of other economic nasties. So, the Kaldorian argument, in some ways, has a lot of merit – it led me, for example, to discuss policies that developing countries might use to avoid such crises while maintaining full employment.

However, the problems the Kaldorians raise probably do not apply to many advanced Western countries. Countries like the US have been running trade deficits for literally decades and this has not led to crisis. When the Kaldorians are asked what the crisis they think will happen is they either start muttering rather vaguely or they say that the Chinese and others are going to crash the value of the US dollar. The latter is, of course, the same argument put forward by many Austrian doomsayers who use it to flog gold to punters. It is also extremely unlikely – such a move would be suicidal for the Chinese in just about every way imaginable. The US dollar may gradually depreciate over the coming years – and then again, it may not – but the likelihood of it crashing is extremely miniscule; unless China and the US went to war, but then the exchange rate would be the least of our problems.

The reason for this is that the world today – indeed, the world since World War II – is completely dependent on the dollar to function. The Kaldorians simply do not recognise this political reality. This is because, as we said above, unlike Kaldor, they think purely in terms of models and cannot properly understand politics and aspects of political economy. So, let us turn now to how Kaldor himself thought that the system functioned.

The US Dollar as the Fuel of Worldwide Growth

In the last of a series of phenomenal lectures that Kaldor gave in Italy in 1984 entitled “Causes of Growth and Stagnation in the World Economy,” he posed himself a complicated and crucial question: why, between 1945 and 1973, had the world economy grown at rates never seen before in human history but then after this it had fallen into stagnation? And Kaldor gives an answer that, I think, would resonate with the advocates of MMT today – and, it should be added, grate on the ears of the Kaldorian modelling crowd.

Kaldor gives many reasons why the world economy boomed for thirty years and then went into a slump, but only one was given central importance. This was the inflation of the 1970s. Kaldor notes that the inflation started in the late 1960s when the US ramped up deficit spending to fund Vietnam – an already unpopular war that the government didn’t want to pay for out of taxes. But the inflation really began to have serious effects on growth when OPEC raised its price in 1973 thus setting in motion an enormous inflationary surge which then led to a wage-price spiral.

So far, so familiar – right? Well, Kaldor gave another reason too and while it interests us for the purposes of our argument he thought it minor. This peripheral argument was that in the post-war era the US government had been flooding the world with dollars – mainly through Foreign Direct Investment (which was mostly probably Cold War spending either in the form of aid, development funds or military spending). Since these economies had their currencies pegged to the dollar they were then able to run trade deficits and government deficits with impunity, thus boosting growth. Here’s how Kaldor explains it and who, for the sake of his disciples, we shall quote in full:

I would attribute primary importance to the role of the United States dollar which, after the adoption of the Bretton Woods arrangement concerning currencies, became de facto the international reserve currency, so that America had, in fact, an unlimited borrowing power – she was able to borrow automatically by incurring deficits on “basic transactions” (on current and capital accounts taken together) and thereby provide other countries with additional reserves, thus enabling them to expand their economic activities without running into a balance of payments constraint. Moreover, the balance of payments of the United States, after the large-scale currency realignments of 1949, turned into a deficit on “basic transactions” (i.e. on current and capital account) , and remained in deficit in almost every single year until 1971. At first this was due to net foreign investment (public and private) exceeding her current account surplus. Later, in the 1960s, it was supplemented by a growing deficit on current account. Deficits of both kinds implied an addition to the demand for goods and services in the world outside. They implied an increase in world investment which had much the same international “multiplier” effects as if the annual production of gold had increased by an equivalent amount. For the rest of the world, it meant increasing reserves (in the form of ever rising dollar balances) earned through rising exports or externally financed domestic investment. (P. 77-78)

According to Kaldor, then, the capitalist world economy was ticking over in the post-war years because the US was flooding the world with dollars. These dollars were then entering countries and circulating within the economy – while also allowing these countries to buy US produced goods and services. The US dollar was literally the lifeblood of the world economy in this era and it was this political dimension that allowed countries, Kaldor writes, “to expand their economic activities without running into a balance of payments constraint”.

So, what happened? Well, certain countries – especially France, who was a rather more assertive power in that era than she is today – got sick of the arrangement and crashed the system by calling in their debts in gold thus forcing the US off the Bretton Woods system. We’ll quote Kaldor again:

At the beginning, the world was hungry for dollars and was delighted to accumulate dollar reserves, which yielded interest, in preference to gold, which did not. But as countries had more and more dollars, and as the U.S. official liabilities began to exceed several times the total value of gold in their possession (at the official price, which until March 1968 corresponded also to the market price), the willingness to accept dollars was progressively impaired – especially when the U.S. deficit assumed larger dimensions during the Vietnam War. France demanded to be paid in gold; Germany revalued her currency repeatedly in a vain attempt to stem the speculative flight from the dollar into the Deutschmark, and in the end the whole Bretton Woods system collapsed in August 1971 with America’s formal abandonment of convertibility coupled with a demand for a large-scale readjustment of currency parities. (P. 78)

Well, this is all sounding a bit MMT isn’t it? The US was running deficits with the rest of the world – just as they are now – and this was supporting world economic growth. Now, the Kaldorian must surely assume that Kaldor himself should turn around and jump us with the consequences of these irresponsible actions. Surely when the Bretton Woods system collapsed there was some direct, dire consequence for the US and everyone else. Well… not really. Instead Kaldor shrugs it off and points to the real culprit for the stagnation: the oil shocks and the resulting inflation. He does mention that exchange-rates fluctuated and this was a problem but he indicates that it was far from fundamental:

Since that time, large-scale and unpredictable variations in exchange rates – between the dollar and the EEC currencies, and for some years also between the dollar and the yen – continued, which must have been one of the factors preventing economic recovery, though it is impossible to assess its precise importance. (P. 78)

What an anti-climax, eh? The good Kaldorian would expect some sort of explosion. But the Bretton Woods system of world growth ended with a whimper, not a bang. Kaldor himself says that the fluctuations in the exchange rate that followed were “impossible to assess” in terms of their importance for the stagnation of the 1970s. And indeed, if you read the rest of the lecture you’ll see clearly that they play a very small part, if any, in his story which is mainly focused on the oil shocks, the inflation and the idiotic monetarist policy response. This is not the Kaldor of the models, to be sure! This is Kaldor the political economist – and what a better analyst he is to the “dollar crash” scaremongers!

What Happened Next?

As we have said, Kaldor’s lecture was given in 1984. He died two years later. So, what happened next? Well, basically when the inflation stabilised and the oil prices came down the US started pumping more dollars into the world economy – the whole system reset. Growth resumed for a long time as the US ran persistent trade deficits with the rest of the world. The growth was never quite the same as it was in the post-war era – mainly because idiots were managing the world economy – but growth did resume; and it resumed precisely because the flow of dollars began once more.

Financial inflows into Wall Street propped the dollar up where trade surpluses combined with gold backing did in the post-war era. As Yanis Varoufakis and Michael Hudson have pointed out numerous times before: during and after the Reagan era, dollars flowed into the world economy, buttressing economic growth, while foreign money circulated back to Wall Street to buy up financial assets. This is how the system maintained a fairly steady rate of growth through dollar issuance. But when the 2008 crisis hit, the US economy slowed and fewer dollars flowed into the world – this was mainly because US consumers were broke and couldn’t buy foreign goods. The unfortunate fact of the matter is that many of these dollars, especially during the Clinton budget surplus years, were being issued by private banks and this turned into a giant Ponzi mess that was sure to topple when a strong wind hit.

So, this is where we stand today. The world economy is grinding along slower than it should be for want of dollars. Related to this the US consumer is spending less than he wants to also for want of dollars. And smart economists have their eyes peeled for signs that another debt bubble might begin to inflate thus risking another financial crisis because, you guessed it, US consumers want those damn dollars. What an absolutely ridiculous situation! The US government issues dollars – and everyone and their mother wants dollars. The US government can thus start issuing dollars to people who want employment and higher consumption in return for labour. Since the US government has no default risk there is no problem. The real risk comes when the private sector starts borrowing these dollars, not when the government issues them to hire people and bring down the unemployment rate.

“But, but, but,” says the dollar crash fantasist, “What if the world spits these dollars back at us and the currency collapse?” Well, I’ve got news for you: the world isn’t going to suddenly reject these dollars. The world craves these dollars. They have been the lifeblood of the world economy since the end of World War II and now that they have dried up the world economy looks pale and anaemic. But this need not be the case if the US government got its act together and started enacting some good macroeconomic policy.

Is This Wrong?

One question here, however, is whether this is a good state of affairs or not. Should the US government have this level of control over the world economy? Do US consumers have the right to consume more than they produce? After all, the Bretton Woods system was imposed by force. After World War II Keynes and the British wanted to put an international currency, the bancor, in place to ensure that trade imbalances were rebalanced through reinvestment in the poorer countries but the Americans decided that they wanted control over the whole system. Isn’t this a tad unfair?

Yes, it most certainly is. This world of ours would have a lot fewer problems today had Keynes’ bancor plan gone through and replaced the dollar standard we now basically live with. And it is this bancor plan that the modern day Kaldorians push for today. But again we must play Kaldor against the Kaldorians. Did Kaldor constantly harp on about the bancor in his writings? No, of course not. Why? Because he knew it wasn’t on the table when he was working and writing. It was on the table at Bretton Woods in 1945, but the Americans won and Keynes lost. Kaldor knew that there was no point in crying over spilt milk. He knew that we just had to get on with it and work with what we had.

Well, the Kaldorians would do well to learn this lesson today. Look, if the bancor plan is ever truly put on the table again I’ll be the first to support it. But it is such a distant possibility that it seems absurdly unrealistic to champion today. Every day we watch the Eurozone falling further into chaos due to national squabbles and mismanagement and then we’re to assume that all world leaders are tomorrow going to come together, hold hands and put the bancor plan in place? Yeah right. Indeed this appears more so a fantasy to hide from the terrible economic problems we face today than anything else. Faced with the very real problems of today it must be nice to have The One True Model that explains all – but in reality it’s just a fantasy and it’s not coming true any time soon.

This is not to say that getting the US government to start pumping dollars back into their own economy – and thus the world economy – in order to promote recovery is going to be an easy task. But at least we can see to whom or what we have to appeal: that is, to the US government. With the bancor plan we don’t even have an institution to appeal to – the appeals process then becomes like something out of a Kafka novel. At least with the MMT proposals we have somewhere to aim. It’s not perfect, no. But then, if we lived in a perfect world you wouldn’t be reading this article, would you?

Gloomy Sunday, a lyric from which we opened this piece, is a pretty bleak song. But that’s not why I opened with it. It’s the lyrical mixing of the themes of sleep and death and suicide that is relevant to this dilemma. Because the Kaldorians – in a spirit totally alien to Kaldor himself – want to put themselves to sleep with their Model of Perfection and Balance so that they can hold the grim political and economic realities of today’s world at bay. But to do this – to insist on a proposal like the bancor that is not even remotely realistic – is to suicide yourself. In putting yourself to sleep, to dream sweet dreams, you simply die to the real world. What good is that going to do for anyone?