In an economic crisis such as in 2008, monetary policy is not effective. Fiscal policy is the only thing that works.
Juan Laborda teaches Financial Economics at the University of Carlos III and Money and Banking, Syracuse University (Madrid)
Originally published in Spanish at vozpopuli
Translated and edited by BRAVE NEW EUROPE
Curious, the champion of austerity, that is to say the Bank of Spain, is now asking for budgetary stimulus, that is to say, public spending from those European economies that have a positive margin. Well done state bankers. Didn’t you read Richard Koo’s lessons in 2008? Your failure is not the result of structural incompetence, either! It is something else. It is the defense of the interests of the 1 %. In a balance sheet recession like that of 2008, monetary policy is ineffective, only fiscal policy is fit for purpose. Fortunately for Spain, since 2014, for political reasons, Europe has permitted our government to ease up on its austerity policy.
But the performance of the Bank of Spain, and the rest of the central banks in the eurozone, presents another, even weaker flank. They are primarily responsible for the biggest economic policy error in modern history: not cleaning up bank balances at the expense of creditors. The result, a brutal increase in sovereign debt. And that’s where we find ourselves now that an economic slowdown is spreading across the eurozone, so that when the risky financial markets explode anew there will be another systemic crisis. By the way, watch out for high-risk U.S. corporate debt, spread via CLOs (Collaterlaized Loan Obligation).
The mistakes committed were therefore the result of a combination of several factors. On the one hand, requiring fiscal austerity. On the other hand, a bank bailout paid by taxpayers. To this we add the dystopia derived from a wage devaluation, and the inability to understand the current deflationary forces. In economic theory there are many paradoxes that explain the sad performance of the dominant economic orthodoxy. The Keynes savings paradox; the Kalecki cost paradox; the Kalecki budget deficits paradox; the Steindl debt paradox; the Minsky tranquility paradox; the Nesvetailova liquidity paradox; and the Wojnilower risk paradox.
A flexible exchange rate
But in the face of their nonsense, in the face of the hackneyed idea that there is not alternative or TINA, there is another possibility. We have been repeating this from this column now for months. We are referring to Modern Monetary Theory (MMT). The current environment is ideal for developing MMT. After the Bretton Woods rupture in 1971, most governments began issuing their currencies through legislative decrees under a floating exchange rate. A flexible exchange rate frees monetary policy from having to defend a fixed parity.
Therefore, fiscal and monetary policies can concentrate on ensuring that domestic expenditure is sufficient to maintain high levels of employment. Governments that issue their own currencies no longer have to finance their spending, as currency-issuing governments can never run out of money. The cult of austerity derives from the logic of the gold standard and is not applicable to modern fiat monetary systems.
The reaction of the elites was not long in coming, and from the moment the money issuers, the states, began to be governed democratically, the political-financial elites responded. It was kept secret from citizens that sovereign states can never go bankrupt. The independence of central banks was promoted just when democratic states could exercise full monetary sovereignty and generate full employment. And it is the central bankers who become the guardians of this reactionary orthodoxy. The objective was twofold. On the one hand, to limit the effectiveness of government fiscal policy. On the other hand, to move from a system of public debt where power was held by the Treasury to another where it is transferred to the market: business benefitting the 1%. Central bank were forbidden to buy sovereign debt in primary markets.
Modern Monetary Theory (MMT)
As James Montier, the extravagant and lucid chief investment strategist of GMO, points out in Why Does Everyone Hate MMT?, he states, “I judge economic theories by their usefulness in framing and explaining the world, not by their mathematical elegance. For me an economic approach should help me understand the world, and provide me with some useful ideas (preferably about my day-to-day work, investing). With respect to these measures, let me assure you that MMT wins by a landslide and destroys the neoclassical economy, without a doubt.”
Montier then explains the most important elements of MMT. Let’s look at them:
1. Money is created by the state. Money is effectively a promissory note (IOU). Although anyone can issue money; the problem is getting it accepted. However the ability to impose taxes (or other obligations) makes a country’s “money” valuable.
2. Understanding the monetary environment is vital. The basic monetary regime under which a country operates is important. Any country that issues debt only in its own currency and has a floating exchange rate may consider itself monetarily sovereign. This means that you cannot be forced to pay your debt. We are referring to the United States, Japan, the United Kingdom, Sweden, Switzerland, Denmark, Canada, New Zealand… but not the Eurozone or most emerging markets.
3. An operational description of the monetary system is essential. It is necessary to understand that loans create deposits (which in turn create reserves, i.e. money endogenously) is a much more realistic starting point than the general view that deposits create loans. For example, knowing that public spending creates reserves and lowers interest rates is vital to understanding Japan’s bond market.
4. Functional finance, not sound finance. Fiscal policy is much more powerful than monetary policy. Fiscal policy should be geared towards generating full employment while maintaining low inflation (rather than, for example, achieving a balanced budget). A guaranteed employment plan is an example of a useful policy option for this outcome (acting as a buffer in a commodity market) in the eyes of MMT.
5. Limits are real resource and ecological limits. If any sector of the economy pushes beyond the limits of capacity, then inflation will occur. If a government spends too much or taxes too little, it can create inflation, but there is nothing unique about this. These are the limits that matter – people, machines, factories – not the “financing” restrictions.
6. Private debt matters. Even in a monetarily sovereign state, private debt matters. The private sector cannot print money to pay its debts. As such, it has the potential to create systemic vulnerability. Think of Minsky’s hypothesis of financial instability: stability breeds instability.
7. Macro accounting (Wynne Godley’s Sectoral Balance Sheets) tell us the truth. The debt of one sector is an asset for another. Therefore, government debt is the asset of the private sector. Understanding how one sector relates to another using a sectoral equilibrium framework is very useful, as is understanding the equation of Kalecki’s earnings, or the way reserves work in a financial system. Macro accounting can help us detect unsustainable situations.
In the face of MMT, critiques inspired by gregarious thought, characterized by a tendency to examine very few alternatives; by a lack of critical evaluation of the ideas of others; by a high degree of selectivity in information gathering (manipulation); by the lack of contingency plans; by the rationalization of bad decisions; by an illusion of invulnerability and shared morality; by an illusion of unanimity; and by the self-designation as guardians of truth to protect the own group from negative information. Certain economists are acting more as guardians of a broken orthodoxy than as academics. What can be more simple than evaluating an idea by its merits?