A Skeptic’s Guide to Modern Monetary Theory

By Greg Mankiw.  It seems like alot of this MMT rests on market failure. Milton Friedman said something like if you try to fix market failure with government you might get an even worse problem, government failure. Government just will not have enough information to fix the problem.

Excerpts:

"First, in our current monetary system with interest paid on reserves, any money the government prints to pay a bill will likely end up in the banking system as reserves, and the government (via the Fed) will need to pay interest on those reserves. That is, when the government prints money to pay a bill, it is, in effect, borrowing. The money can stay as reserves forever, but interest accrues over time. An MMT proponent will point out that the interest can be paid by printing yet more money. But the ever-expanding monetary base will have further ramifications. Aggregate demand will increase due to a wealth effect, eventually spurring inflation. 

Second, if sufficient interest is not paid on reserves, the expansion in the monetary base will increase bank lending and the money supply. Interest rates must then fall to induce people to hold the expanded money supply, again putting upward pressure on aggregate demand and inflation. 

Third, the increase in inflation reduces the real quantity of money demanded. This fall in real money balances, in turn, reduces the real resources that the government can claim via money creation. Indeed, there is likely a Laffer curve for seigniorage. A government that acts as if it has no financial constraints may quickly find itself on the wrong side of this Laffer curve, where the ability to print money has little value at the margin."

"In U.S. decadal data since 1870, the correlation between inflation and money growth is 0.79. Cross-country data exhibit a similarly strong correlation."

"MMT proponents advance a very different approach to inflation. They write, “Conflict theory situates the problem of inflation as being intrinsic to the power relations between workers and capital (class conflict), which are mediated by government within a capitalist system.” (MW&W, p. 255) That is, inflation gets out of control when workers and capitalists each struggle to claim a larger share of national income. According to this view, incomes policies, such as government guidelines for wages and prices, are a solution to high inflation. MMT advocates see these guidelines, and even government controls on wages and prices, as a kind of arbitration in the ongoing class struggle."

"We are also told that “capitalist economies are rarely at full employment. Since economies typically operate with spare productive capacity and often with high rates of unemployment, it is hard to maintain the view that there is no scope for firms to expand real output when there is an increase in nominal aggregate demand.”"

"Because so much of the Keynesian tradition assumed that wages and prices fail to clear markets, subsequent new Keynesian research, mostly during the 1980s, aimed to explain wage and price adjustment. This literature explored various hypotheses: that firms with market power face menu costs when changing prices; that firms pay their workers efficiency wages above the market-clearing level to promote worker productivity; that wage and price setters deviate from perfect rationality; and that there are complementarities between real and nominal rigidities."

"There is an important but often neglected relationship between these two lines of new Keynesian research. In particular, one can view the later work on wage and price setting as establishing the centrality of the Keynesian regime highlighted in the earlier disequilibrium research. When firms have market power, they charge prices above marginal cost, so they always want to sell more at prevailing prices. In a sense, if most firms have some degree of market power, then goods markets are typically in a state of excess supply. This theory of the goods market is often married to a theory of the labor market with above-equilibrium wages, such as the efficiency-wage model. As a result, the Keynesian regime of generalized excess supply is not just one possible outcome for the economy, but the typical one. This logic brings me back to MMT. The conclusion that “economies typically operate with spare productive capacity” can be interpreted as meaning that economies are usually in the Keynesian regime of generalized excess supply. In that sense, MMT is akin to new Keynesian analysis.  

At this point, it is worth distinguishing the natural level of output and employment from the optimal level. The natural level is the level where the economy finds itself on average and toward which the economy gravitates in the long run, whereas the optimal level is the level that maximizes social welfare. When generalized excess supply is the norm due to pervasive market power, the natural level is below the optimal level.  

Inflation tends to rise when output and employment exceed their natural levels, even if they remain below their optimal levels. After all, price setters do not aim to maximize social welfare. They aim to maximize private welfare, and they do so by hitting their target mark-ups of prices over marginal cost.

Here is where MMT economists diverge from new Keynesians. An MMT economist might say that policymakers should aim for the optimum. If price setters are thwarting that goal by raising prices, policymakers can fix that problem by using price guidelines or price controls. A new Keynesian would admit that, in a world of pervasive market power, private price setting is not first-best. But while getting the government involved in price setting might improve the allocation of resources from the standpoint of simple theory, the complexity of the economy and the history of price controls suggest that this solution is not practical.  

In the end, my study of MMT led me to find some common ground with its proponents without drawing all the radical inferences they do. I agree that the government can always print money to pay its bills. But that fact does not free the government from its intertemporal budget constraint. I agree that the economy normally operates with excess capacity, in the sense that the economy’s output often falls short of its optimum. But that conclusion does not mean that policymakers only rarely need to worry about inflationary pressures. I agree that, in a world of pervasive market power, government price setting might improve private price setting as a matter of economic theory. But that deduction does not imply that actual governments in actual economies can increase welfare by inserting themselves extensively in the price-setting process. 

Put simply, MMT contains some kernels of truth, but its most novel policy prescriptions do not follow cogently from its premises."