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MMT bleg, one more try

Summary:
I received a number of comments from my previous post on MMT. No one gave me a satisfactory answer, but one commenter (Sam Levey) did actually answer the question. Recall that I wanted to know what would have happened in 1998, when T-bill yields were 5%, if the Fed had suddenly doubled the base from 0 billion to 00 billion by purchasing bonds. The standard model says that money is neutral in the long run, but the MMT textbook suggests that OMOs are “irrelevant”. But why?Levey said: MMTers essentially argue that any effect of OMOs have to happen through prices, not quantities. I.e. if it doesn’t affect interest rates, then it doesn’t affect inflation. And even if it does affect interest rates, it may not actually affect inflation, if there isn’t a large enough

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I received a number of comments from my previous post on MMT. No one gave me a satisfactory answer, but one commenter (Sam Levey) did actually answer the question.

Recall that I wanted to know what would have happened in 1998, when T-bill yields were 5%, if the Fed had suddenly doubled the base from $500 billion to $1000 billion by purchasing bonds. The standard model says that money is neutral in the long run, but the MMT textbook suggests that OMOs are “irrelevant”. But why?

Levey said:

MMTers essentially argue that any effect of OMOs have to happen through prices, not quantities. I.e. if it doesn’t affect interest rates, then it doesn’t affect inflation. And even if it does affect interest rates, it may not actually affect inflation, if there isn’t a large enough reaction from aggregate demand to actually cause prices to move.

That puzzled me for two reasons:

1. We know that banks don’t want to hold lots of excess reserves when interest rates are 5%, and the public’s demand for cash is very modest with 5% interest rates, say around 5% to 10% of GDP. So if interest rates don’t change, why would the public plus banks double their holdings of base money as a share of GDP? Why hold all this new zero interest base money? What about the hot potato effect?

2. If interest rate do adjust (and Levey implicitly allows for this option), then it is indeed possible that the public would hold the extra base money and prices and output would not change. So I’m going to assume that’s the assumption that MMTers would make. Option #1 is too bizarre to contemplate. After all, how plausible is it that the Fed could dump another $500 billion in base money into an economy with T-bill yields of 5%, doubling the monetary base, without dramatically reducing interest rates? (Sure, John Cochrane might argue that rates would go up due to the Fisher effect, but in that case MMTers would be wrong in claiming no effect on inflation.)

And if interest rates do fall to zero, bringing mortgage rates from say 7% to 2% in a booming economy. forever.how likely is it that this action is “irrelevant” for the broader economy? You wake up in the summer of 1998 and read the Fed cut rates from 5% to 0%—seriously; how do you react? Irrelevant???? Yeah, saver earn less interest—but irrelevant for investment decisions like building a new house?

I say “forever” because if you argue the interest rate reduction is just temporary then there would be a long run inflation effect from people trying to get rid of excess cash balances once interest rates rose again. That’s actually what would occur, but they seem to deny it. So the irrelevance claim seems to require that interest rates fall permanently.

I just don’t get it. What’s the new long run equilibrium for base money demand, interest rates, the price level, etc. after a big increase in the base when nominal interest rates are strongly positive?

I don’t know if Sam Levey correctly characterized MMT theory, but this explanation doesn’t really provide a satisfactory answer to my question. I wish MMTers would say, “I see why you are puzzled, but here’s the intuition of why you are wrong”. But some of the responders didn’t seem to understand why this claim is so perplexing at first glance. People, you need to understand the alternative model. Don’t be like those Trumpistas that can’t figure out why most of us are skeptical of claims of massive election fraud.

If I were to try to develop a radical new macro theory, I’d try to come up with a way of explaining my new model using the framework of existing models. Actually, I often do that here, translating market monetarism into New Keynesian language. I’m not seeing that with MMT. And it’s not just me. I see other bloggers like Noah Smith, Paul Krugman, Brad DeLong, Nick Rowe, etc., who seem to have an equally hard time trying to figure out what MMTers are claiming. MMTers should understand why we are confused, and have plausible answers. One sign that you are truly on top of an issue is if you can see why others hold a different view, and explain things in their language.

PS. And please don’t tell me the Fed can’t increase the base because they target interest rates. That’s completely irrelevant to the question at hand. It’s a thought experiment.

Update: After I wrote this I saw a few more responses. Sam Levey’s second response was more exasperating:

“This is one of those ‘paradigm shift’ issues. Your language doesn’t work within our paradigm, and clearly ours doesn’t work within yours. In our a paradigm “what are the effects of OMOs” isn’t a sensible question, because OMOs are not a discretionary instrument.”

So the MMT textbook says OMOs are irrelevant. When I call them on this point, asking what would happen if the Fed had bought $500 billion in bonds in 1998, they retreat to the claim that discretionary OMOs are impossible. Then why didn’t the textbook just say so! That’s a radically different claim, not to mention a false claim; discretionary OMOs are possible as long as you are willing to allow interest rates to move, which is exactly the monetarist position.

I see why Paul Krugman called debating MMTers a game of Calvinball.

And this is far worse (my statement then his response):

“Nominal lending is reserve constrained and real lending is demand constrained.”

I honestly have no idea what this means. “Nominal lending” and “real lending” refer to the exact same thing, but measured in different units. How can one of them be reserve-constrained and the other not be?

This is why I suspect that MMTers do not understand the theories they are criticizing. You may disagree with me on reserves and lending, but how can one fail to understand a basic EC101 point about money neutrality, about the distinction between what determines real variables and what determines nominal variables?

As for his question, take a look at figures for nominal and real lending in Zimbabwe in 2008. Nominal lending went up perhaps a trillion fold, while real lending probably declined.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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