By L. Randall Wray

*The title of this post was inspired from a post by Mike Sax.

First an admission. I’m not really a blogger. I occasionally write pieces that somehow find their way onto blogs, but I rarely read or respond to blogs. I have no idea who is who in the blogosphere. For example, I do not know someone named Scott Sumner, who is apparently a Very Important Person in blogoland.

I note that he’s associated with the proposal that the Fed target nominal GDP. When I first heard about this, I thought it was a joke. Yeah, right, might as well have the Fed target the Earth’s Wobble. Gee, I’d really like the Fed to stabilize the tilt, to achieve San Diego’s invariantly moderate climate in upstate NY where I spend much of my time!

You see, the Fed has tried and failed to target Bank Reserves, Money Supply, and Inflation. So, what the heck, let’s have the Fed try and fail to hit Nominal GDP. As if the Fed has any tool that would allow it to do that. Anyone who understands central banking knows that central banks have one tool in their tool kit, and it is not a Hammer. It is the overnight interest rate—the rate at which it lends to banks, and at which banks lend to each other against the safest collateral. That target, in turn, impacts other short rates on other very safe lending and on Treasury Bills. Most bets are off once we move beyond that, however. The Fed has been trying for years to get the mortgage rates low enough to stimulate home buying—using ZIRP and QE1, QE2, and QE3 up the ying-yang to very little effect.

So, I still laugh anytime I hear anyone suggest that the Fed target NGDP. Good luck with that.

In any case, Sumner claims to have found MMT’s Achilles’ Heel. He sets up a hypothetical example. Presume GDP is growing at 5%, unemployment is 5%, and the nominal interest rate is 5%.

An Aside: I can recall when I visited the Mayor’s office in Istanbul where it was reported that national inflation was about 29%, the nominal interest rate was about 29%, and the government’s budget deficit was about 29%–whereupon I told the Mayor that Turkey had hit the perfectly sustainable Trifecta! (See below for more discussion.)

But, Sumner interjects: suppose the central bank lowers the nominal rate to a big fat Zero. He predicts that GDP would DOUBLE and the price level would DOUBLE!

And somehow that proves MMT is wrong? Here’s his argument as well as his claim.

“Suppose we pick a fairly “normal” year, when NGDP growth and nominal interest rates and unemployment are all around 5%. It might be 2005, 1995, 1985, whatever. The exact numbers aren’t important. Now the Fed does an OMP and doubles the monetary base by purchasing T-securities. They announce it’s permanent. What happens? One MMT answer is that the Fed can’t do this. It would cause interest rates to change, and they peg interest rates. But the more thoughtful MMTers seem to be willing to let me do this thought experiment, as long as I acknowledge that interest rates would change and that it’s not consistent with actual central bank practices. I’m fine with that. So let’s say they double the base and let rates go where ever they want. I claim this action doubles NGDP and nearly doubles the price level. MMTers seem to disagree, as I haven’t changed the amount of net financial assets (NFA) at all. But here’s the Achilles heel of MMT. Neither banks nor the public particularly wants to hold twice as much base money when interest rates are 5%, as that’s a high opportunity cost. So they claim this action would drive nominal rates to zero, at which level people and/or banks would be willing to hold the extra base money. Fair enough. But then what? You’ve got an economy far outside its Wicksellian equilibrium.” http://www.themoneyillusion.com/?p=10238

Now, my own projection (and what I told the Turks) is that bringing down the interest rate will simultaneously reduce the budget deficit and nominal GDP growth—with falling inflation accounting for most of that. So, lowering Turkey’s interest rate from 29% to 0% would have eliminated most of the budget deficit (since government would spend far less on the Trillions of Turkish Lira debt it had to roll-over every month) and also inflation. So Turkey might have managed to bring interest rates, nominal growth, and budget deficits all down to the sustainable Trifecta of Zero! (By the way, Italy ran that experiment before joining the EMU—her interest rate and budget deficit were double digits, and after Warren Mosler talked to the Treasury to convince them that Italy would not default on Lira debt, rates were reduced, deficits came down, and inflation also fell.)

But let us ignore for a moment the possibility that lowering interest rates actually reduces budget deficits and growth, while raising unemployment. How does Sumner get from a 500 basis point reduction in overnight interest rates to a GDP that DOUBLES? Really?

Let’s give him the benefit of the doubt, and ignore the usual impact of Fed reduction of rates of 300 or 400 bp—which historically has had an impact of just about nil, nada, zip. Sumner argues we must ignore all the previous cases of interest rate reductions, because these occurred outside “normal” times. So let us say we are in a “normal” time, where the economy is humming, in conditions where the Fed would normally begin to think about raise rates because unemployment is already down to 5% and GDP growth is at 5%. So the Fed instead tries Sumner’s experiment, reducing them by 500 bp. Sumner claims GDP will DOUBLE and prices will DOUBLE. Just how plausible is that? What kind of interest rate spending elasticities are required? And what is the time period required?

Some time ago my colleague Linwood Tauheed and I surveyed the orthodox literature to obtain estimates of interest rate elasticities. You need to remember that the Fed only directly controls the fed funds (and discount) rate, so lowering that rate by 500 bp is not going to lower the rates that really matter for private spending—longer term rates—by nearly so much. Indeed, operation QE has been relatively impotent—in the Fed’s own reckoning—even as it tried to directly lower longer-term interest rates. As the following graph shows, interest rate spreads over 10 year treasuries (which track the Fed’s policy rate reasonably well) are no where near constant. Indeed they vary by 200 bp to 300 bp–which is as much of the maximum “umph” that we could expect from Sumner’s experiment.

Lowering the fed funds rate also won’t necessarily lower the risk premium—overnight interbank borrowing is collateralized by safe treasuries, so firms and households are not going to get anything like zero rates since their borrowing is riskier. Let us be generous and presume that Sumner’s scenario can lower rates to actual borrowers by 200 or 300 bp—which would be quite a feat, far exceeding QE’s impact on loan rates. How much would private borrowing and spending rise? In Sumner’s view, they would rise sufficiently to DOUBLE GDP—ie from approximately 15 Trillion to 30 Trillion dollars. That is a big impact.

Real world, mainstream, estimates of the interest rate effects on spending are orders of magnitude lower than Sumner’s claim.

However, let us say that Sumner’s own fairly outrageous presumptions turn out to be correct. Would that invalidate MMT? Is a substantial impact of interest rate changes on aggregate spending a refutation of MMT?

I cannot see how. All that MMT claims is that if the Base is doubled, increasing banking system excess reserves, then the overnight rate will fall towards zero or the support rate paid by the central bank on reserves (presumably above zero). While MMT is skeptical that this would simulate spending, no part of MMT stands or falls due to an inverse and substantial interest rate elasticity of spending. If monetary policy is potent in that respect, so be it. Use it if it works, when it works. If it doesn’t work, then use fiscal policy. Our bet is that it won’t work. But that is a projection that can be decided by experiment. So far, it has failed handily—monkeying around with interest rate hikes and cuts have had no discernible stabilizing influence on the economy. But we can pretend the Jury is still out.

Nay, Sumner’s battle is with economics—both mainstream and heterodox. There isn’t any theory or evidence in support of his claim that a 500bp reduction of the overnight rate would lead to a doubling of GDP and the price level. It is the claim of the unschooled or the ideologue.

In short, Sumner’s thought experiment does not expose any weakness of MMT. If anything, it exposes a weakness in his thinking. He invokes Wicksell in his argument that doubling the monetary base would double GDP because neither banks nor the public will want to hold twice the base—hence they lend and spend until the cows come home and NGDP doubles. For those who do not know, Wicksell was a pre-Keynesian economist who had some interesting ideas. But drawing on Wicksell when you’ve got Keynes would be like an astronomer going back to Copernicus when you’ve got Galileo.

He concludes:

“That’s the flaw with MMT; it’s not net financial assets that matters, it’s currency…. It was hard sifting through all the comments, which were often on side issues, but it seems they regard base money as just another financial asset. But it’s not, which is why their view of monetary policy is wrong. Indeed in a sense they don’t even have a theory of monetary policy, they have a fiscal theory that implies open market operations don’t matter.”

That looks confused to me. By definition, net financial assets in the private sector = government liabilities. These are Treasuries (bills and bonds) plus Base (currency and reserves). Budget deficits, for example, lead to nongovernment surpluses, accumulated as either Treasuries or Base. Open market operations change the composition of NFA held: a purchase of Treasuries by the Fed reduces Treasuries and increases Base held by the nongovernment sector—but does not affect NFA. (A sale has the opposite impact.) Monetary policy is about liquidity—reducing or increasing the liquidity of private portfolios. Rates will adjust to balance portfolio composition with desires. But since the Fed targets the overnight rate, it needs to prevent movement of rates away from target—and does that by accommodating desires.

Fiscal policy is about spending—reducing or increasing NFA. These are statements of fact, not theory. MMT certainly would not say that OMOs “don’t matter”—they affect liquidity, which can be very important when the Fed stops a run on financial institutions by lending reserves or providing them in OMPs. Sumner is just plain wrong if he thinks that simply buying Treasuries in “normal” times causes banks to increase lending, which is transmitted to more spending, more NGDP and more inflation. All it does is to substitute Reserves for Treasuries. Again, Fact, not Theory.

Some years ago I co-authored a paper with my colleague Linwood Tauheed, titled SYSTEM DYNAMICS OF INTEREST RATE EFFECTS ON AGGREGATE DEMAND, that investigated the likely impacts of interest rate changes on aggregate demand. We used conventional estimates of interest rate elasticities for investment spending, as well as for parameters like the marginal propensity to consume. Unlike most conventional studies, however, we included the effect of rate hikes on government spending on interest—hence the interest income channel. As rates rise, the nongovernment sector earns more interest income, of which some is spent on consumption. We tried different government debt ratios and found that with a high enough debt ratio, raising rates would indeed stimulate spending. We can call that a “perverse” effect of monetary policy. Let me provide a few paragraphs from that paper to give you a flavor of the analysis. (Note this is from around the year 2000.) In particular, pay attention to the discussion of conventional estimates of interest rate elasticities—which are surprisingly small, and far too small for Sumner to get the results he wants.

However, note that validity of MMT does not hang on these results—even if monetary policy is as powerful as he believes, and the interest rate elasticities are much higher than those found in the literature, this is not inconsistent with MMT.