Most debates around modern monetary theory (MMT) revolve around the role of operations and the meaning of “budget constraint”: what are the limits of fiscal policy? (The emphasis on this one subject results either from the fact that it is the most interesting subject, and / or that the critics do not bother to read anything else in the literature of the MMT.) These debates are generally irrelevant because they end up being purely semantic debates, and both parties agree on the underlying principles. To avoid wasting time in such debates, we must reformulate the debate into a debate on something concrete. In the absence of discussion on a specific policy, I think the best way to frame the debate is this: is the government’s debt-to-GDP ratio important?
There is a secondary debate: should the government fear the “vigilants of the bond market”? Since the usual argument is that the vigilantes will rebel when the debt-to-GDP ratio becomes too high, it can be seen as a secondary argument in the main debate.
Context
Regular readers may have found some fatigue in my writings on the MMT debates. They have largely evolved into an extremely uninteresting form, where a critic maintains that MMT implies something, MMT responds that this is not the case, then critics complain that the writings of MMT are too vague or that the posts are moved.
In order to avoid wasting time, we need to focus on concrete concepts. In the case of financial constraints, the MMT literature will often say: “there are no financial constraints on the fiscal policy of a monetary sovereign (the federal government of the United States would be an example of monetary sovereign), only real constraints. “The crux of the matter: what is a” financial constraint “? Although I think the MMT literature clearly explains this point, obviously some people disagree.
My argument is that we can make a decent approximation to the concept “there is no financial constraint” by saying that “the ratio of debt to GDP does not matter”. It may not be enough to cover everything, but at the same time, I think it would eliminate almost all of the rather pathetic attempts to demystify MMT that I have encountered in recent years.
An important point to note is that this is a negative statement: that the report does not matter. In order to contradict MMT’s statement, the critic must find a story explaining why the debt-to-GDP ratio is important. The problem with failed critics is that they do not make a similar argument, but rather make hyperbolic statements about fiscal policy that MMTs accept (for example, very flexible fiscal policy is inflationary).
Update: A key point is that I wrote the debt-to-GDP ratio, not deficit. Since debt can be seen as linked to past deficits, I have the comment that they are linked. To further clarify, imagine that you are only given the debt-to-GDP ratio for a point in time, and that is all the information you have. Can you conclude anything based on this single data point?
introduction
I consider the arguments here as an offshoot of my discussion of Warren Mosler’s MMT white paper. The reason is simple: these are my thoughts on a verbal comment that Mosler made to me, which I remember as follows:
If statistical agencies did not publish the ratio of public debt to GDP, would it really matter (for good macroeconomic analysis)?
I would note that Bill Mitchell made similar statements (that the government should not target the deficit or the debt-to-GDP ratio), which influenced my thinking. I would like to note that I had independently estimated that the debt-to-GDP ratio was not particularly attractive thanks to the coverage of the Japanese interest rate market for a few years.
- A first point is that the debt-to-GDP ratio is a series of data on which many terrible analyzes of fiscal policy are based. My argument is that the appearance of the debt-to-GDP ratio is a pretty good guide to the dividing line between good and terrible analysis.
- The next point is that the discussion concerns countries with monetary sovereignty, which I prefer to define as sovereigns who do not have to worry about the involuntary default of debt. The countries that can claim this status can be debated, but if we want examples, the United States and Japan in 2020 are obviously sovereign currency, unlike Greece (with permission to be in the straitjacket in euros).
- Finally, we could find some uses for the debt-to-GDP ratio, but they expect to transform it to be equivalent to another variable. The most important example is that the budget deficit can be approximated by the change in the debt-to-GDP ratio (assuming we have an auxiliary variable), and the budget deficit can be used to approximate the policy stance budgetary. As noted earlier, imagine that we only have access to the latest value of the debt-to-GDP ratio, and therefore cannot make up the deficit.
No magic tipping point
To come back to the argument, the MMT’s declarations on the absence of a budgetary constraint for the government can result in: there is no level of the debt-to-GDP ratio which has interesting predictive powers.
In particular, there are the following implications.
- The debt-to-GDP ratio is not a useful measure for assessing the risk of default of a floating currency sovereign.
- The debt-to-GDP ratio contains very little or no information that is useful in determining nominal interest rates.
- The debt-to-GDP ratio has no predictive power for future growth or inflation (although we may be able to reverse forecasts of the debt-to-GDP ratio in light of inflation or rates of growth).
- It makes no sense for governments to define fiscal policy to bring the debt-to-GDP ratio down to a particular level.
The last point shows that there are real differences between the MMT and the conventional: the Maastricht criteria aim at a debt-to-GDP ratio of 60%, while the management of the debt-to-GDP ratio is commonly discussed in budget documents. (The Maastricht criteria could be defended on the basis that it is a monetary parity system.) (And once again, no cheating by relying on transformations on the debt-to-GDP ratio , in order to approximate the deficit.)
If we return to the concept of budgetary constraints, we see that the argument is that the debt-to-GDP ratio is not a limit to fiscal policy. Instead, MMT / Functional Finance is that the limits of fiscal policy manifest themselves in the form of real constraints: shortage of inputs (labor, capital, natural resources) and / or inflation. * As soon as an objection to a lack of constraint “turns to discuss these questions (” hyperinflation! “), They agree with the MMT / Functional Finance framework, and we are therefore free to stop paying attention to anyone Ignorantly raises these objections as a criticism of MMT.
Is MMT correct?
Once we accept that the best way to formulate a division between MMT and the conventional economy on the issue of financial constraints, one can reasonably ask: are MMTs correct? Well, since I’m in the MMT camp, it’s pretty obvious what I think.
If someone wants to convince me that the debt / GDP ratio is important, he must first face the horrible example: Japan. To date, I have not seen anyone clear this rather low bar.
Debt-to-GDP derivatives
If we know the evolution of the levels of indebtedness and monetary base, as well as of the GDP, we can make up for the budget deficit (modulo various national accounting rules which lead to a gap between the budget deficit and the evolution of government financial liabilities ). As such, we can arrive at an approximation of the budget deficit by examining the evolution of the debt-to-GDP ratio. To what extent the budget deficit provides macroeconomic information, we can use the variation in debt levels to approximate it. While the dollar budget deficit may be misleading, there is nothing in MMT to suggest that it is completely lacking in information in practice. As such, the debt-to-GDP ratio as a variable could be saved through the backdoor, but we are coming back to semantic games.
The other approach to saving the debt-to-GDP ratio is to look at debt service. We can generate scenarios where the average interest rate on the debt changes, and therefore the larger the stock of debt, the greater the effect on interest payments by the government. My argument is that once again, it is based on the budget deficit and is just another linguistic twist in trying to claim that the debt-to-GDP ratio is in itself relevant. Since the average interest rate on the stock of public debt can vary extremely strongly – and can be negative! – we are only debating the effects of public deficits.
Low rates justifying a flexible fiscal policy?
There is an argument about fiscal policy that is somewhat related to the lack of importance of the debt-to-GDP ratio. MMT supporters argue that the level of interest rates should not be used to justify an expansive fiscal policy, while conventional economists have argued that low risk-free rates in the aftermath of the financial crisis were a boost to large-scale infrastructure spending.
Since the two sides agreed on the policy (governments should have relaxed fiscal policy in the aftermath of the financial crisis), this easily turned into unnecessary semantic arguments. The real debate is whether financial considerations (such as the level of interest rates) should be taken into account in infrastructure spending decisions; MMTers say “no”. Since interest expenditure is linked to the debt-to-GDP ratio, this topic of debate can somehow be covered by the suggested dividing line.
(The other way to dispose of the argument from MMT’s point of view is to point out that the government can lock nominal rates at 0%, and it ends the call for low interest rates per fiat. However, this changes the terms of the debate, as it requires a modification of the political framework.)
Vigilant of the bond market?
Another formulation of budget constraints is to argue that if the policy is “unsustainable” (whatever that means), bond market participants will refuse to roll over public debt, forcing a default. My argument is that this argument is too vague: what triggers this behavior? It is very difficult to find legitimate examples of such behavior among sovereigns developed in floating currencies.
Although conventional economists tell campfire stories about the vigilantes of the bond market, some post-Keynesians shoot gothic horror stories where foreigners refuse to finance countries. Rather than forcing a default, we have to believe that the offer for a floating currency will be zero. Again, there are not many episodes where the currencies of developed countries have returned to zero, so this debate is also largely detached from reality.
In practice, followers of bond market (or currency market) vigils report either a stock market variable (the debt / GDP ratio) or flow variables (budget deficit, current account deficit) as triggers of the constraint . The stock market variable is exactly what I point to as the main dividing line, but we can increase it with a debate on the presence of a magic dividing line in the flow variables that trigger fiscal (or monetary) calamities .
Otherwise, discussions about litigants in the bond market are by nature useless. Like other MMTers, I argue that operational procedures should be adjusted so that involuntary default on debt is impossible. Since these changes are so minor, the argument is that there is no practical difference between these institutional arrangements and the current arrangements. One is stuck on highly implausible scenarios under current operational procedures, for which there are no good historical precedents.
Final remarks
It is a revealed preference that many people like to waste time doing semantic debates on the economy. For those of us who are not so inclined, we need to find concrete dividing points. One of these tactics is redesigning the arguments about financial constraint as a discussion of the importance of the debt-to-GDP ratio.
Footnote:
* Steve Roth questioned the use of the “real” when it comes to inflation. I follow standard usage in the MMT literature, which uses the “financial” versus “real” allocation. As inflation is not a financial constraint, it is qualified as “real”. It might be better to use the “non-financial constraint”, but this is a wording that we would not find in the literature.
(c) Brian Romanchuk 2020