A Skeptics Guide To Mankiw's Skeptic's Guide To MMT

N. Gregory Mankiw (writer of one of the best-selling economics textbooks) has recently written "A Skeptic's Guide to Modern Monetary Theory" (MMT). He discussed several assertions made in the textbook Macroeconomics, by William Mitchell, L. Randall Wray, and Martin Watts (link to article with my initial comments on that text). His conclusion was "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."

Professor Mankiw explains the genesis of his article as follows:

[...] So I recently tried to figure out what MMT was all about. I wanted to identify the key differences between this new approach to macroeconomics and the approach in mainstream textbooks, such as my own.
Fortunately, there was an ideal vehicle for this endeavor. In 2019, Red Globe Press published a new textbook, simply titled Macroeconomics, written by three MMT proponents: William Mitchell and Martin Watts (both of University of Newcastle, Australia) and L. Randall Wray (Bard College). This brief essay explains what I have learned about MMT from this textbook treatment.

The most natural way to approach a body of new theory is to pick up a textbook. It is exactly my mode of operation. The only issue here is that Macroeconomics is an undergraduate textbook. As was noted by Scott Fullwiler on Twitter, neoclassical academics get testy when people use the simplified models from introductory undergraduate textbooks as representing the entirety of neoclassical macroeconomics. As such, I would use a graduate level textbook  (or at least senior undergraduate level) when I needed to dive into a new subject.

Correspondingly, I think the implied claim in the title "Guide To Modern Monetary Theory" needs to be viewed to be closer to "A Discussion of the MMT Macroeconomics Textbook." Since the textbook is an academic work that needs to stand up to scrutiny, this narrowing of focus is legitimate.

The Difficulty with MMT Being a School of Thought

There is no doubt that it is difficult to get a handle on MMT if one does not want to dive into journal articles, at least if one wants a more advanced treatment. (If I had any commercial sense, I would have made an explicit primer. My book Understanding Government Finance (link) is a primer at the target reading level I am discussing, but it is not really a true primer for broad MMT theory.) As a result, Mankiw's description of difficulties of getting a handle on the topic is common.

 From an academic standpoint, MMT is extremely broad at this point, as it gone multi-disciplinary. My focus is on the "hard macro" core, but even that covers a lot of ground.

There are at least three main subjects of discussion within the MMT literature.

1. Constructive. Theoretical statements about the economy, which is the "MMT framework."
2. Criticism. Theoretical critiques of neoclassical theory. Although this is obviously related to the MMT framework, the critiques may be true even if the MMT theory is incorrect.
3. Policy Proposals. Policy proposals that are presumably related to the MMT framework, but may make even be viewed as good policy proposals from other frameworks (including neoclassical theory).

Having to cover all these bases is an imposing task, particularly when one considers that the various elements can stand on their own (as my italicised comments suggest). The breadth of the topics involved creates the main limitation of the Mankiw article, as they are missed.

What Does Mankiw Say?

The Mankiw piece is easy-to-read seven pages (plus references). He draws the following quotes from Macroeconomics (page numbers are for that text, denoted MWW); Mankiw's bridging text is in [brackets].

The financial constraint.

The most important conclusion reached by MMT is that the issuer of a currency faces no financial constraints. Put simply, a country that issues its own currency can never run out and can never become insolvent in its own currency. It can make all payments as they come due.” (MWW, p. 13) [As a result] for most governments, there is no default risk on government debt. (MWW, p. 15) 

Money and the price level.

[They assert that] “no simple proportionate relationship exists between rises in the money supply and rises in the general price level. (MWW, p. 263) 

Inflation.

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. (MWW p. 255). [Mankiw summary of p.264-265: "MMT advocates see these guidelines, and even government controls on wages and prices, as a kind of arbitration in the ongoing class struggle.]

Mankiw's summary of MMT's views on inflation and growth.

Mainstream theories of inflation emphasize not class struggle but excessive growth in aggregate demand, often due to monetary policy. This idea also appears in MMT. Its proponents admit that “all spending (private or public) is inflationary if it drives nominal aggregate demand above the real capacity of the economy to absorb it.” (MW&W, p. 127) The advocates of MMT, however, make this possibility seem more hypothetical than real.
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.” (MW&W, p. 263) 

That is the sum total of input from MMT. The remaining text in the seven pages is a discussion of the history and results of neoclassical (New Keynesian) macroeconomics. One may note that this guide to MMT has one (1) referenced MMT text, as compared to eight (8) neoclassical citations, including two (2) from N. Gregory Mankiw.

Can One Respond to the Mankiw Critique?

I would paraphrase Mankiw's criticism of MMT as follows: if we assume that neoclassical theory is correct, MMT is either incorrect (where it contradicts neoclassical theory) or trivial.

This is an obviously true statement, but it begs the question: is neoclassical theory correct? As my earlier discussion noted, one of core topics of discussion of the MMT literature are critiques of neoclassical theory. We need to investigate whether those MMT critiques are out to lunch. The concern with the Mitchell, Wray, and Watts text is that is very much an introductory text, without the complex discussions that would be needed to critique neoclassical theory at an advanced level, and unfortunately, the bibliographic information only has a limited number of citations to the more advanced critiques.

Nonetheless, if we dig further into the MWW text, some of the concerns appear to be addressed.

Financial Constraints

I will take an important example, Mankiw's discussion of the financial constraint on governments. I will strip out a few key points raised by Professor Mankiw.

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. 

This is related to an issue raised by Jeffray Gundlach (link to my comments). The obvious rebuttal is that the government can lock the risk-free interest rate at zero. What matters is whether MMT and neoclassical theory disagree with the implications of such a step.  I will return to this below.

The next observation by Mankiw:

Faced with these circumstances, a government may decide that defaulting on its debts is the best option, despite its ability to create more money. That is, government default may occur not because it is inevitable but because it is preferable to hyperinflation. 

I turned to my copy of MWW, and on pages 566-567, I found the following index entries:

hyperinflation, 255, 342-346
  definition 343
  MMT view, 343-4
  Quantity Theory of Money and, 343
  Weimar Germany, 344-5
  Zimbabwe, 345-346

Without even going back to pages 342-346, it suggests that there might be at least something in the textbook that MMT takes a slightly view on the subject.

Effect of Locking Rates at 0%

If we look at page 334, we see that MWW discussed the zero interest rate policy, which was not picked up by Mankiw.

This could happen if, for example, government adapted a zero interest rate target [emphasis in original]; in that case excess reserves would drive the overnight interbank lending rate towards zero and the government would not need to do anything further. [...] The decision depends on whether government wants to target a positive overnight rate, or a zero overnight interest rate.

To be fair, there is no extended discussion of the complex theoretical issues around this decision (at least that I could find).

We could summarise the neoclassical view on locking interest rates at 0% as being really, really, bad. This is an "interest rate peg" that shows up in graduate level dynamic stochastic general equilibrium (DSGE) introductory texts, and the implication is that the price level becomes indeterminate (whatever that means).

Obviously, the policy rate can be locked at 0% (or even lower) for years at a time, the question is whether such a peg can be maintained "forever." General equilibrium models with such a reaction function tend to result in an indeterminate price level.

The reason why this is an inadequate critique is clear to anyone with a background in mathematics. A DSGE model is a mathematical "system" (using terminology from applied mathematics). One starts with a set of variables, and assumed relationships between those variables. We then do some mathematical manipulations to derive a set of implications.

One might think that this implies that there is a true process of discovery behind these steps. This is not exactly the case. A set of internally consistent mathematical relationships is just a logical construct. In most cases, one can start from a wide variety of initial assumptions, and re-derive the entire logical relationship.

That is, we can do the following. Pick a set of "implications", assume them to be true, and the do proofs "backwards" to derive the initial assumptions as being "implications." To spell this out, assume that we can do the following.

1. Assume A is true.
2. Do N pages of mathematical operations ("proof").
3. Demonstrate that B is implied.

We typically will be able to accomplish the alternative.

1. Assume B is true.
2. Do M pages of mathematical operations.
3. Demonstrate that A is implied.

(Why do this? We may be able to derive proofs in a more elegant fashion from a different starting place.)

The effect is straightforward: one could view DSGE models that exhibit price level instability as being the models that result if we assume that fixed interest rates result in an indeterminate price level. If we do not make such an assumption, the models are invalid.

So we cannot pull out some random DSGE textbook and argue that locking interest rates at 0% causes hyperinflation in the real world, since those models are essentially built on the assumption that is the outcome. We need to see whether there is any empirical backing for the assertion about the disastrous effects of an interest rate peg.

I am not going to attempt to answer that debate here. However, this debate is what matters, and is not discussed in the Mankiw piece.

Quantity Theory of Money

Mankiw writes:

[...] They assert that “no simple proportionate relationship exists between rises in the money supply and rises in the general price level.” (MW&W, p. 263)
This assertion overstates the case against the mainstream view. 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. (Mankiw, 2019, pp. 109-110) 

Correlation is not causation.

Inflation

I will not cover further Mankiw's discussion of MMT views on inflation. I think the quotations provided above indicate that one could see some overlaps in the operational effect of theories (making MMT redundant if we assume neoclassical theory is true), and obviously in trouble where it disagrees (if we assume that neoclassical theory is true).

Concluding Remarks

Mankiw's piece at least offers readers a pointer into the MWW text on theoretical points of dispute. However, anyone wanting to undertake a scholarly discussion of the topic would need to spend far more time grappling with the criticisms of neoclassical theory in order to gauge whether MMT has contributions to make.

Note: The textbook Macroeconomics is available online at Amazon here (affiliate link).

(c) Brian Romanchuk 2019