MMT 2: GDP and Government Spending

July 3, 2018

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This is the second in a series of posts about MMT, Modern Monetary Theory.

I will now proceed to describe some of the fundamental principles of Modern Monetary Theory, as explained in the text by Mitchell, Wray and Watts. These may seem a little dry and abstract at first, but how they apply to real-world issues should become apparent very quickly.

GDP and its components

Since macroeconomics is interested in aggregate outcomes, especially the goal of using the available labor and other resources to the limit, its central concept is Gross Domestic Product. “GDP is the measure of all currently produced final goods and services evaluated at market prices.” It represents a country’s entire domestic output.

Economists measure GDP in several different ways, the easiest of which is to add up the various kinds of expenditures on goods and services. These fall into several categories:

  • Consumption (69%): spending on new goods and services by households. That does not include personal financial investments, which are considered savings and not goods or services; and it does not include new home purchases, which are part of Investment below.
  • Investment (17%): spending on plants, equipment and new inventory by firms, and real estate investment by households. It includes only real assets, not financial assets like stocks and bonds.
  • Government spending (17%): spending by all levels of government, including investments in long-term real assets like highways. It does not include transfer payments like Social Security checks or food stamps, which are counted in Consumption when they are spent.
  • Net exports (-3%): spending on exports minus spending on imports. Foreign spending on the products we export contributes to our domestic output, while spending on products we import contributes to foreign output. It is negative because our imports exceed our exports.

The percentages indicate the current contribution of each component to U.S. GDP. The first three add up to 103% because the last subtracts 3%.

This is summarized in the formula  GDP = C + I + G + NX

Domestic output and domestic income are two sides of the same coin, since every expenditure by one economic unit is income for another. “The basic macroeconomic rule then is that, subject to the existing productive capacity, total spending drives output and national income, which, in turn, drives employment.”

Modern monetary theory looks at the economy primarily from the demand side. It assumes that supply is usually pretty responsive to demand. If the government wants to order more airplanes, Boeing will be happy to fill the order. Increases in demand can boost GDP as long as the economy is not already running at full capacity, which it rarely is.

Government spending and GDP

Government spending accounts for 17% of U.S. GDP, not nearly as much as consumption but just as much as business investment and new home buying.

The potential benefits of government spending are twofold: first, it creates public goods and services like highways and public education; and second, it provides employment and profits for private sector enterprises, such as construction companies that build the roads and schools.

Although reducing the size of government is a popular conservative goal, cuts in government spending can be expected to reduce GDP because they are not offset by increases in other components of GDP. Reductions in highway construction are unlikely to be offset by increases in automobile purchases. Quite the contrary, since the spending cuts represent lost income to someone, and lower incomes reduce consumption, which is the biggest part of GDP. Spending increases, on the other hand, can increase GDP both directly and indirectly through their positive effects on income and consumption.

Multiplier effects

The indirect effects of spending changes on GDP are called “multiplier effects,” and they have a precise mathematical description.

Let’s say that for every additional dollar of disposable (after-tax) income, people devote 80 cents to consumption. The technical term for that .80 is the “marginal propensity to consume,” designated by c. Some people consume a larger proportion of their income than others (especially if they don’t have very much), but as usual we are interested in aggregating and using an average.

Thus if $1 was injected into the economy, through additional spending, total income would initially rise by $1. If the marginal propensity to consume was 0.8, then this initial rise in income would induce a rise in consumption of 0.8 x $1 or 80 cents in period 1. This initial $0.80 rise in induced spending would further induce a rise in income of $0.80 which would induce additional consumption in period 2 of 0.8 x 0.8 or 64 cents and so on.

The sequence of 1 + .8 + .64 + .512 is called a “power series” in mathematics because each number is a power of c. The sum of all the numbers comes out 1/(1-c), which in this case is 1/(1-.8) = 1/.2 = 5. In theory, a $1 increase in spending could result in a $5 increase in GDP. In practice, there are other variables that complicate things a bit. But in essence, this is the basis for expecting government spending to stimulate and grow the economy. We are asserting that real output has room to grow, that growth in output generates growth in income, and that consumer demand then drives further growth in output and income, in a virtuous circle.

Does that sound too good to be true? If you want to know where that first $1 came from, or whether there’s a catch somewhere, you are asking the right questions. But if you are sure that you can’t grow an economy by increasing spending, the modern monetary theorists have something to tell you.

What’s the limit, tax revenue?

Let’s play devil’s advocate. If growing the economy were so simple, why not let government spending go sky high? The obvious answer is that like a household, the government shouldn’t spend more than its revenue. That’s the wrong answer, as far as MMT is concerned, but let’s go with it for a moment.

If government has to raise taxes to pay for any spending increases, that wipes out the multiplier effect. That’s because the calculation of increases in consumer spending are based on disposable income, after taxes have been removed. If the government increases spending by $1 billion, but raises taxes by the same amount, gross income goes up $1 billion but disposable income doesn’t go up at all. (Of course it goes up for those who got jobs as a result of the spending, but in the aggregate that’s offset by the tax increase.) The increase in spending will expand the public sector and employ some people there, but there won’t be any further expansion in the economy as a whole.

Still, even that is something. G is part of GDP, so if the government can make good use of otherwise underutilized resources, that in itself adds to GDP. If the private sector is under-investing and under-employing, why shouldn’t the public sector take up the slack, especially if it can give people public goods and services that are otherwise lacking?

Suppose you live in a development with some common amenities and a homeowner’s association. The association raises everyone’s dues in order to hire an additional work crew to spruce up the common areas. That adds a service to aggregate output and new income to aggregate income. Your income remains the same, but part of it is allocated to supporting a common good instead of a private good. Aggregate disposable income is unchanged, because the new “tax” reduced yours, but the wages of the work crew increased theirs. The lesson is that reallocating income and labor to a sphere where it can be more fully employed can add wealth. Substitute government for the homeowner’s association, and you have a case for government spending.

Spending beyond revenue

The case for public spending goes beyond the previous example, into the realm of deficit spending. MMT questions the basic assumption that a sovereign government is like a household in needing to limit its spending to its revenue. That’s where aggregate thinking becomes crucial. Assuming that what is true at the individual level is also true at the aggregate level is known as the “fallacy of composition.”

At the individual or household level, living within one’s means is a cardinal principle of financial planning. If you spend less than you make, you can save and invest the surplus. The money you make adds to your income, setting up a virtuous circle that leads to higher net worth and financial security. Spend more than you make and you run up debt. That debt burden on your future income can then send you into a downward spiral of lower net worth and even insolvency.

MMT maintains that a sovereign state that issues its own currency never has to run out of money, although it does have to manage the currency so that it retains its value. Currencies such as the dollar are “fiat currencies,” no longer backed by any finite commodity, such as gold. The dollar’s value depends on the promise of the federal government to accept dollars in payment of taxes, and on the demand for dollars on world markets.

When the federal government spends, it injects money into the economy; when it taxes, it removes money. There is no economic law that prevents the government from injecting more money than it removes, and in modern times that’s what it usually does. The deficit spending boosts the economy by allowing the multiplier effect to work. And as we’ll see later, the excess money spent ends up as a financial asset in the private sector.

Governments without the power to create their own currency, such as state and local governments, or the homeowner’s association thought of as a kind of government, are much more limited in their capacity to stimulate their economies. They have to operate more like households, spending only what they’ve already received in revenue or cautious borrowing.

The real limit–productive capacity

The real limit on spending is not tax revenue, but the productive capacity of the economy. That is limited by the available resources and technologies. It does expand, but not as fast as we would like. Sometimes shortages of specific resources contract it, as in the case of the OPEC oil embargo of 1973.

If aggregate demand increases so rapidly that it starts to strain productive capacity, then the sustained price increases known as inflation can occur.

Once the capital stock is in place, firms will respond to increases in spending for the goods and services they supply by increasing output up to the productive limits of their capital and the available labour and other inputs. Beyond full capacity, they can only increase prices when increased spending occurs.

So when the government wants to build a highway, it may have to bid more for the job because construction companies already have as many jobs as they can handle. Or when it wants to staff a new department, it may have to hire workers away from other jobs by offering higher wages.

Deficit spending when the economy is at or near capacity may end up boosting prices more than GDP. Even if the spending produces a short-term increase in aggregate disposable income (because it wasn’t offset by tax increases), the increased consumer demand will push up prices rather than real private-sector output. A price increase is not the same thing as a multiplier effect on output and real income.

While acknowledging this limit to effective government spending, MMT theorists are far more interested in what can be done when the economy is operating below capacity. They believe that it is usually possible for the sovereign government to stimulate the economy, create employment, and increase domestic output and real income, while at the same time using monetary policy to control inflation and protect the dollar’s purchasing power. They do not believe that inflation fears justify tight monetary and fiscal policies that keep the economy and its workers from achieving their real potential.


Modern Monetary Theory and Practice

July 2, 2018

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William Mitchell, L. Randall Wray and Martin Watts. Modern Monetary Theory and Practice: An Introductory Text. Callaghan, Australia: Centre of Full Employment and Equity: 2016.

Blogging about a textbook is not something I normally do. This text represents a perspective that is especially relevant to current economic policy discussions, and the proposal for a “job guarantee” in particular. That’s been getting a lot of attention both on Wall Street and in progressive policy circles, two realms that don’t usually find much common ground. Here’s a short Huffington Post article on that issue.

Most people are vaguely aware that there are theories underlying the various policy proposals they hear, but they have trouble connecting the dots between theory and policy in any explicit way. We have all heard politicians say that cutting taxes will stimulate the economy, raising interest rates will control inflation, putting high tariffs on imports will save American jobs, or that allowing higher government deficits will impoverish future generations. We need to know how many serious economists agree with such claims.

This is a textbook on macroeconomics, the study of the workings of the economy as a whole, as opposed to microeconomics, the study of economic units like business firms or households. “Macroeconomics focuses on a selected few outcomes at the aggregate level and is rightly considered to be the study of employment, output and inflation in an international context.” I can’t cover this whole textbook–and I’m sure my readers don’t want me to–but I will try in this and the next few posts to explain how a contemporary group of economic theorists arrive at their policy recommendations.

The neoclassical orthodoxy

Let’s begin with a few basic assumptions. The authors describe two broad approaches to macroeconomics. They distinguish the more orthodox tradition, commonly called “neoclassical,” from a heterodox tradition with no single agreed-on name. They call it the “Keynesian/Institutionalist/Marxist approach. In this text, I see a lot more Keynes than Marx.

Keynesian and institutionalist perspectives were very popular in the early twentieth century, but the more orthodox approach had a resurgence in the 1970s as economists and policymakers shifted their focus from boosting employment and wages to fighting inflation. Theories in the neoclassical tradition have dominated public policy since then, but the authors of this text are among those trying to change that.

The neoclassical orthodoxy defines economics as “the study of the allocation of scarce resources among unlimited wants.” The non-government sector of the economy, which neoclassicists like to call the “free market,” has a natural, rational way of functioning that is both efficient and fair. Individuals pursue their self-interest, trying to maximize their utility–their use of the things they want. They compete in the market for various resources, goods and services, exchanging the things they have for the things they don’t have, using money as a medium of exchange. As they do so, they arrive at price points where supply meets demand and everything is efficiently allocated. If the price of a welder’s labor is too low because the supply of welders exceeds the demand, then that encourages workers to enter occupations where their labor is needed. In the end, what you get will reflect the market value of what you give.

Neoclassical theories acknowledge the role of government but limit it. Government has to perform certain basic functions like protecting national security and enforcing law and order. But when it intervenes in the market to set wages or promote one industry over another, it’s more likely to produce distortions and inefficiencies than to make the economy work better.

Although neoclassical economics provides an elegant model of how an idealized, perfectly-competitive economy might work, less orthodox economists question how well it applies to any real economy, especially a modern one:

Claims are sometimes made that a “free market” economy comprised of individuals seeking only their own self interest can operation “harmoniously” as if guided by an “invisible hand.”…In fact, economists had rigorously demonstrated by the 1950s that the conditions under which such a stylised economy could reach such a result couldn’t exist in the real world. In other words, there is no scientific basis for the claim that “free markets” are best.

In any case, these claims, even if true for some hypothesised economy, are irrelevant for the modern capitalist economies that actually exist. This is because all modern capitalist economies are “mixed”, with huge corporations (including multinational firms), labour organisations and big government.

Modern monetary theory

Modern monetary theory (MMT) relies on a less orthodox definition of economics: “the study of social creation and social distribution of society’s resources.” It does not assume any one natural way to run an economy, since economic organization depends on variable cultural norms and social institutions. Right away, this way of thinking makes more sense to sociologists like me.

Societies haven’t always favored self-interested competition over social cooperation, as the neoclassicists consider natural. That assumption may reflect the preferences of early English capitalists who wanted to pursue their self-interest unencumbered by traditional constraints imposed by English kings and their “feudal lord cronies.”

In the modern economy with its large and dominant organizations, prices are not set through free competition among many small economic actors, but mostly by big players with superior market power or political clout. The price you can get for your labor, for example, is not necessarily the price that will employ it most productively. It may be the price fixed by powerful employers who profit by keeping wages low, or by agreeing to devalue certain classes of workers, such as women or minorities. That leads to unnecessarily low incomes, low aggregate demand, and an underutilization of labor that hurts both the economy and society in general.

People working together in society can cooperate to create resources such as a skilled and fully employed labor force. And people can also influence how social benefits are to be distributed among employers, workers, and others, such as by supporting collective bargaining rights. Government is a major player in these decisions, not as some alien force that interferes with the economy, but as a means of taking collective action to influence economic outcomes. Collective action can produce aggregate outcomes more favorable than self-interested individuals could have achieved working independently.

The “key goal of macroeconomics” is “using the available macroeconomic resources including labour to the limit.” The authors relate the value they place on labor to the United Nations Declaration on Human Rights, which asserts that “everyone has the right to work, to free choice of employment, to just and favorable conditions of work and to protection against unemployment.” Lack of access to employment impedes full participation in society and undermines many of the other rights asserted in the Declaration. It is also associated with a long list of personal and social pathologies, such as physical and mental health problems, crime, and drug abuse.

From this perspective, macroeconomics and enlightened public policy are inseparable. Policymakers need to get it right because the stakes are very high.

Coming up…

What I will be trying to do in the next few posts is describe in fairly plain English how modern monetary theorists think the economy works. I will emphasize, as the authors do, the many forms of government influence: spending and its impact on output and income; taxation and transfer payments; the creation and management of money; and financial balances interconnecting government and non-government sectors. What I like about macroeconomics is that a few fundamental principles yield surprising insights.

Then I will turn to the the authors’ critique of recent public policy and their recommendations for new directions.