I’ve recently finished two great books about the 2008 financial crisis: Tim Geithner’s Stress Test and Ben Bernanke’s The Courage to Act. Both of them are talking about how the crisis has started and how they managed to block an even larger meltdown, yet I sensed a subtle but significant difference in their tone; while Stress Test directly suggests what the government should do to prevent the next crisis, The Courage to Act doesn’t clearly address the solutions for future monetary policy.
Of course, Geithner is a bureaucrat and Bernanke is a scholar. Their way of expressing opinions must be different. Still that gap partly derived from their different responsibilities. Unlike Bernanke who was one of the highest decision makers of U.S. economic policy since 2006, Geithner had little to do with the beginning of the crisis. Some could say that Bernanke fueled the fire around U.S. financial sector. Furthermore, Geithner could say much about his choices with confidence because the policies he implemented worked quite well.
I’m not saying that the Fed’s actions like 0% interest rate and Quantitative Easing were bad ideas. Geithner’s fiscal policies would be much less effective if there were no support from the monetary policy side. Expansionary monetary policy certainly made normal people to spend more and large investors not to withdraw their money from those supposedly problematic banks. The only problem is that we still don’t know what the Fed should’ve done to predict and prevent the crisis.
One of the greatest issues in recent debates about the monetary policy after World War II is that, before the crisis, there was no visible connection between the Greenspan era’s low interest rate and the U.S. housing market’s bubble in the early 2000s. At that time, it was hard to identify whether a sudden increase in housing prices was really a serious bubble or simply a transition of capital from the U.S. government bond market. After all, there was no strong pressure of inflation above 2%.
The lesson we should learn from this experience is that there’s no widely approved way of identifying the right level of monetary expansion. People might think that the central bank just lowers interest rate when there’s a recession and raises it when there’s a boom. But, as you can see here, the reality is much more complicated than that. Economists still don’t know much about the exact relationship among the amount of currency, various government policies, and the inflation rate.
As I’ve pointed out at the end of the last writing, policymakers hesitate to embrace Modern Monetary Theory (MMT) almost entirely because of the high possibility of hyperinflation. Those of us who are deeply skeptical about MMT acknowledge that the government cannot go bankrupt because they always have enough cash. The point here is that the government’s endless deficit spending will necessarily bring inflation, and that will eventually destroy the value of currency and weaken the government’s purchasing power.
Why am I so confident about hyperinflation? It’s not just because we haven’t found out a better equation for those things; MMT’s logic itself has a clear limit. To reveal that, we must first examine the impact of MMT policies case by case. Let’s say that the government decides to finance their excessive spending by issuing more government bonds and selling them to investors. Since the government’s credibility is very high, investors should have a strong willingness to buy all of them.
Yet it’s true only until the market thinks that the government’s financial stability is high. Modern governments are normally credible because they always make a lot of efforts to stick to the right level of government debt and to defend their economy from sudden booms and busts. Investors will increase the amount of government bonds they hold only when they are confident that the government will eventually cut the deficit and return to a normal state of spending. But the government with MMT economists won’t do that.
MMT economists should study more about the psychology of financial sector. During an ordinary financial crisis, banks are usually capable of fighting the recession even if their investments will be damaged a bit. However, if the depositors start to think that their money isn’t safe at all and that they should withdraw all of their savings, massive bank runs will destroy the banks. MMT’s case is just the same. Even if MMT is totally correct, the government must understand that their investors’ decisions are the most important thing.
Two scenarios are possible when the bondholders feel insecure. First, they won’t buy additional government bonds and will keep the existing bonds. This will automatically finish MMT’s extreme spending, for the government cannot remain deficit spending anymore. Second, when the investors consider the status quo as a real threat, they will even sell their bonds to the market and the market will demand repaying the debt. Those government bonds’ interest rates will go up dramatically, and the government will default.
Since a deficit financed by additional money printing brings a greater inflation than a deficit financed by additional bond issuing, MMT economists will first issue government bonds and expect wealthy people to buy them. But we’ve seen that alone cannot solve the problem. MMT teaches us that the government should just print out cash at this point to repay the debt and finance the increased spending without issuing additional bonds. Now the whole economy will become much more inflationary. Paul Krugman well summarized this process.
“The point is that there are limits to the amount of real resources that you can extract through seigniorage. When people expect inflation, they become reluctant to hold cash, which drive prices up and means that the government has to print more money to extract a given amount of real resources, which means higher inflation, etc. Do the math, and it becomes clear that any attempt to extract too much from seigniorage—more than a few percent of GDP, probably—leads to an infinite upward spiral in inflation.”
To avoid this vicious cycle, people must purchase enough amount of government bonds so that the economy can minimize idle money and prevent inflation. Yet two psychological barriers will block those potential investors from buying government bonds endlessly; people basically trust neither the government nor their peer investors. The investors will rationally worry that the government might print money excessively. It’s also possible to expect that other investors suddenly decide to stop buying bonds. Either of them will cause inflation.
Under this circumstance, strong social trust would be the only solution. If every investor trusts each other and believes that the government will always be on the right track, hyperinflation won’t happen. Nevertheless, this goes back to our insufficient knowledge about the impact of monetary policy on the real economy. The government cannot get a precise number for the management of the speed of printing money, because, figuratively speaking, there’s no equation that can give us that number.
Good economic policy should not bet everything on an irrational expectation. Political activists and some non-mainstream radical economists might say that we should urge people to follow our leadership. Modern governments, however, have to focus on what mainstream economists are saying until mainstream economics is completely rebutted and conquered by outside ideas. If MMT’s economic policy cannot change the incentives for those who have a stake in its result, MMT economists should find another way to achieve their goal.
What can be the alternative for MMT? The ultimate goal of MMT is to boast the aggregate demand so that the economy gets enough impetus for further growth. That’s why MMT economists don’t assert tax rate increase. Considering their goal and methods, I think that our current major economic policies—moderately expanded government spending and low interest rate—are doing just fine. Even if a stronger stimulus is implemented, the basic strategy itself should not be changed.
Just like MMT economists, I also think that something more should be done to save our economy. A new round of quantitative easing and negative interest rates can be effective. Still, to maximize the efficiency of newly introduced monetary policies and thus to support the aggregate demand, aggressive investment to basic infrastructure should be done by the government. Improved social infrastructures around the world will certainly make people to spend more and invest more.
Here are some examples of social infrastructures: formal educations and job training, roads and bridges, and research and development. To spend money on all of these areas, the government will need some deficit spending. But the crucial difference between this plan and MMT is that our deficit is temporary and will be covered by issuing additional bonds. If the government sends the market a clear signal that the budget will soon be balanced, people will buy those bonds. This is the way Franklin Roosevelt approached to the Great Depression.
I’m not an irresponsible fanatic of mainstream economics. I strongly believe that mainstream economists should be ready to give up their hegemony when there’s a better way to explain our economy. However, I haven’t felt a serious threat to the principles of modern macroeconomics yet. Economic policymakers around the world should be aware of the questions that MMT raises, but it’s too hasty to accept their policy suggestions. In economic issues, we shouldn’t just let things go while expecting everyone to have a warm heart.
-Jiin
It's Really Not Rocket Science 