I am currently working on an introductory chapter to a collection I have prepared for my publisher (Edward Elgar) which describes the evolution of Modern Monetary Theory (MMT). The task might appear to be straightforward but in fact is rather vexed. There is considerable dispute as to where the roots lie. A specific debate is the importance of the work of John Maynard Keynes. Many Post Keynesians, almost by definition, believe that Keynes was a central figure in the development of what we now call Post Keynesian economics, although that ‘school of thought’ evades precise identification and is certainly anything but homogenous. There are MMT proponents, who while sympathetic with much of Post Keynesian theory, disagree on key propositions – specifically relating to debt and deficits (as an example). But then they also point to Keynes’ work as seminal in the development of MMT. My own view is that many of the important insights in Keynes were already sketched out in some detail in Marx. Further, the work of the Polish economist Michał Kalecki was much deeper in insight than the work of his contemporary, Keynes. But for me the real sticking point against Keynes was his view that fiscal deficits should be balanced over the business cycle and that would allow governments to pay back debt incurred in the deficit years. That view has crippled progressive thought ever since and is antithetical to MMT. The debate also has resonance with the current leadership struggle within the British Labour Party about fiscal deficits and the claims by the ‘socialist’ candidate, Jeremy Corbyn that he will “balance the budget” when unemployment is low so as to avoid inflation. This view derives from the adoption by progressives of Keynes’ views, whether they know that or not. It is a mistaken view and retards progressive policy development.



In his 1961 book article (page 139) – The Burden of Debt – the founder of Functional Finance – Abba Lerner opened with the following parable:

“But look,” the Rabbi’s wife remonstrated, “When one party to the dispute presented their case to you, you said ‘you are quite right’ and then when the other party presented their case you again said ‘you are quite right’, surely they cannot both be right?” To which the Rabbi answered, “My dear, you are quite right!”

It was in reference to economists who were critical of the US government using debt to match spending on public projects. Lerner said the mainstream economists who were mounting such criticisms were “right” but only if they “redefine” key concepts in convenient (but perverse) ways.

Redux: Phelps article on austerity denial which I discussed in yesterday’s blog – Greece – now the conservatives are denying there was austerity

Keynes did not discuss fiscal policy in great length in his most famous work – The General Theory of Employment, Interest, and Money (1936).

But in two articles which appeared in the The Times (November 14 and 15, 1939) under the title “Paying for the War”, Keynes provided detailed analysis of the conduct of fiscal policy. These articles came out in his short 1940s book “How to Pay for the War”.

The context was the fear that if governments use debt to ‘fund’ fiscal deficits to prosecute the War effort it was likely that inflation would result from a shortage of productive resources.

The inflation would most likely come from stronger consumption on the back of higher incomes and a limited availability of consumption goods.

He disliked the distributional effects of inflation – and considered it to be a tax on workers and the debt issued by governments would be a source of wealth for the capitalist class.

So he thought fiscal deficits pushed resources towards the rich and as a result of their low propensity to consume (high savings rate) would endanger the viability of the capitalist system – bias it towards depression.

He also didn’t want the workers to be taxed more to ‘pay’ for the deficits.

His solution, outlined in those articles, was to introduce a ‘compulsory saving scheme’ with progressive income tax rates, which would reduce consumption (divert income into financial wealth accumulation) but ensure that the low income workers benefited from the deficits.

He wrote that this system would be beneficial because:

… it would be the wage earners, and not the profit takers, who would emerge from the war as the main holders (in the form of deferred pay claims) of the newly created National Debt.

Suffice to say the trade unions and labour activists were horrified by the proposal. They wanted heavy taxes to be levied on the rich capitalists to pay for the War.

Keynes’ fear of inflation also meant that he was not enamoured with fiscal deficits. He saw them as being necessary in times of recession but should not be a general tendency for governments.

Deficits were a means of resolving a “deficiency of effective demand”, which Keynes demonstrated was the principle cause of mass unemployment.

Keynes actually moved somewhat away from this position by 1943 when he supported the proposals by the British Treasury (from James Meade) to introduce a social security system to attenuate periods of deficient demand.

In other words, put the burden of adjustment onto the automatic stabiliser component of the fiscal balance rather than the discretionary component.

So when private spending fell and unemployment rose, workers would attenuate the loss of earned income by the receipt of income support payments through the social security system, which would provide some floor in the recession.

He also divided the fiscal balance into what he called the ‘current budget’ (we now use the term recurrent to describe revenue and spending flows exhausted within a year) and the ‘capital budget’, which relates to public infrastructure expenditure.

In correspondence to Sir Richard Hopkins (July 20, 1942) – which is recorded in his Collected Works, Volume 27, Keynes wrote:

… the ordinary Budget should be balances at all times. It is the capital Budget which should fluctuate with the demand for employment.

This is the precursor to the modern concept of the ‘golden rule’. which limits fiscal deficits to the rate of public investment in productive capital.

The ‘golden rule’ essentially means that over some defined economic cycle (from the peak of activity to the next peak) the government deficit should match its capital (infrastructure) spending.

All ‘recurrent’ spending (that is, spending which exhausts its benefits within the current year) should be ‘funded’ through current revenue (taxes and fines, etc.).

The ‘golden rule’ is considered equitable across generations because the current taxpayers ‘pay’ for the public benefits they receive now, while the future generations have to pay for the benefits that the infrastructure delivers to them in the years to come.

Thus, day to day spending that benefits the current taxpaying public should be covered by taxation revenue and capital infrastructure should be funded through debt.

The fiscal balance would thus always be zero net of public investment spending.

The ‘golden rule’ reflects the mainstream economics view that governments have to ‘fund’ their spending just like a household.

But Keynes went one step further and driven by his fear of inflation concluded in the General Theory (Chapter 13, Section III) that:

If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip

Monetary policy (adjusting interest rates) was uncertain and Keynes didn’t have confidence that it could constrain and inflationary boom.

So fiscal policy was the principle policy tool for constraining inflationary episodes, just as it was the most effective means of overcoming a recession.

So in Victorian times, the ‘golden rule’ was that in good times, the current ‘budget’ should deliver a surplus, which would then allow the government to repay the debt incurred in bad times, when it was running deficits.

This reasoning then lef to the conclusion that balanced ‘budgets’ as a principle was dangerous and that ‘budgets’ should, rather, be balanced over an economic cycle.

Run deficits in bad times and surpluses in good times to avoid inflation and build up the funds to run down the debt accumulated during the deficit years.

Most of this analysis was conducted under closed economy assumptions. Keynes was focused on fluctuations in private investment and national income and certainly didn’t consider what an on-going external deficit would mean for the conduct of fiscal policy if the private domestic sector desired to net save.

The point is that I depart from the view espoused by many Modern Monetary Theory (MMT) proponents who suggest that Keynes is one of the important precursor economists to the development of MMT.

As I explained in this blog – Corbyn should stop saying he will eliminate the deficit – there is no foundation in the idea that fiscal balances should ever be balanced much less over the course of some discrete economic cycle (peak to trough to peak).

Keynes’ views in this context were relatively conservative and mistaken.

1. Issuing debt to match fiscal deficits does not reduce the inflation risk of the initial spending, whether that spending be government or non-government.

It just swaps one financial asset – a saving balance (deposit) for a government bond. Moreover, the latter carries an income flow which is likely to be larger than the former.

2. There is no reason to believe that continuous fiscal deficits will be inflationary. Extending Keynes’ own logic, deficits are required when non-government spending is insufficient to generate sales that would justify firms fully employing all available labour.

As long as firms can continue to respond to nominal demand growth through increased output growth, there is no major likelihood of an inflation breakout.

In other words, a deficit could easily be a ‘steady-state’ policy position to support full employment when the other sectoral balances (external and private domestic) were in particular states.

For a nation such as Britain, we note the following:

1. A fairly sizeable external deficit which drains domestic spending in net terms (more cash flows out via imports than flows in via exports) and is not going to go away anytime soon and is not a problem anyway, given it means the British people enjoy advantageous real terms of trade (foreigners are willing to send them real goods and services in exchange for bits of paper – financial assets).

2. The private domestic sector is already highly indebted and cannot be expected to sustain even higher debt levels.

3. There is considerable idle capacity – unemployment, underemployment etc.

In this context, a continuous fiscal deficit is indicated.

Remember, a fiscal deficit is a flow of net spending that disappears each period and if not sustained will lose its impact.

As long as that flow is supporting a flow of production in each period then there is no inflation risk. That is the desirable policy position – to ensure all real resources are in productive use.

If from a position of full employment, the external deficit narrows (via export expansion), or private domestic investment increases, then depending on what the society sees as a desirable mix between private and public resource usage, the fiscal deficit will have to decline to avoid inflation.

But that is not the same thing as invoking a ‘balanced budget rule over the cycle’. Even when private domestic spending is stronger, public deficits will normally be required to maintain full employment.

Governments should not follow fiscal rules like a ‘balanced budget rule over the cycle’. Rather, they should be guided by evaluations which show the impact of different fiscal policy parameters on the well-being of the population.

If there is a need for the private domestic sector to have less purchasing power, then a tax increase is indicated. Not to generate revenue for the government but to reduce purchasing capacity of households and firms.

The tax increase is serving a specific function – to deprive the private domestic sector of purchasing power, presumably, because the government wants extra real resource space available to pursue its own socio-economic mandate and/or exports are booming.

It needs to create the extra resource space because if the taxes weren’t increased there would be incompatible claims on those real resources from all the claimants (households, firms, government, foreigners) which would result in inflation.

But no rule can be devised to automatically ensure that these functional decisions will be made effectively. It is the art of the policy maker that rules rather than a rule driving the policy.

Keynes did not take into account the sectoral balances. MMT makes them a central part of the macroeconomic evaluation and policy development framework. Understanding them in an accounting sense is only the first step. The art is to understand what drives these balances and how they interact.

So a ‘balanced budget over the cycle’ rule would mean the private domestic sector has a deficit equivalent to the external deficit on average over the same cycle.

Why is that desirable? It implies that the private domestic sector will be accumulating ever-increasing debt levels, which eventually will become unsustainable.

MMT focuses on the private debt dynamics and considers the public debt dynamics to be passe. It goes further and recommends that governments break the nexus between debt-issuance and fiscal deficits.

In this sense, governments should use Overt Monetary Financing rather than going through the pretence that they are being funded by private bond holders. The bond sales are made possible by past deficits, which generate net financial assets for the non-government sector.

Further, they are just an example of corporate welfare, which is totally unnecessary.

There is some progressive argument that the debt helps pension/superannuation funds provide safe returns to workers in retirement. My solution would be to nationalise superannuation funds, eliminating the managerial fee grab of workers’ savings, and using the government’s currency-issuing capacity to fund workers’ retirements.

That is pure MMT but very non-Keynes.

I have run out of time today but you might also like to reflect on David Colander’s article in the Journal of Economic Literature (December 1984) – Was Keynes a Keynesian or a Lernerian? – which mounts the argument that Keynes shifted ground in the 1940s and considered Lerner’s Functional Finance to be a sound framework.

[Full Reference: Colander, D. (1984) ‘Was Keynes a Keynesian or a Lernerian?’, Journal of Economic Literature, 22(4), December, 1572-1575].

Conclusion

Progressives should abandon the notion that they attribute to Keynes that the fiscal balance should be zero on average over the course of the economic cycle.

In this regard, the work of Abba Lerner in the 1940s on Functional Finance is much more seminal to the development of MMT than was Keynes’ offerings, which I believe are antithetical to the foundational blocks of MMT.

Progressive narratives should aim to educate the public as to the need in normal times for continuous fiscal deficits. Then we would start getting somewhere.

Off to catch a big airplane!

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.