Previous posts ( MMT Macro Final 1/3 , and MMT Macro Final 2/3 ) have covered questions 1-4 and 5-8. This post covers the last 4 question of the MMT based Advanced Macro course I taught last semester at PIDE. The central methodological difference at the heart of my course was the principle of Entanglement: Theories cannot be understood outside their historical context, and history cannot be understood without understanding theories used by human agents to understand and respond to that history. This is one of the three methodological principles that I have extracted from a study of Methodology of Polanyi’s Great Transformation . This issue is discussed in the answer to question 11 below. Because of its central importance, I have also tried to explain it in greater detail in a separate 18 min video lecture. I recently came across a paper by Yair Kaldor on The cultural foundations of economic categories: finance and class in the marginalist revolution which explains the birth of marginal utility theory in the historical context of emergence of finance and international trade as important influences on price, which were not compatible with traditional labor theories of value. The paper shows how strongly these emerging theories were influenced by the historical context, as well as by the point of view of the groups which created and spread these theories. This provides an illustration of the entanglement principle that history shapes theories, and also is shaped by theories.
ANSWERS to question 9-12 of MMT Macro Final Exam at PIDE in June 2019
9. Whereas it is commonly thought that Banks are financial intermediaries, collecting from depositor to lend to borrowers, the central business of banks is “Maturity Transformation”. Explain in detail, in context of modern economies.
Common belief about bank is that they act as financial intermediaries. It means that people who have extra money deposit it with banks who pays them return them on saving. Bank then lends this money to borrowers and charge interest (higher than saving rate) on lending. This higher return (difference in lending and saving rate) is their earning. Now it is possible that depositors want to withdraw their money while returns on lending starts later. For this it seeks loans from interbank market (if its own reserves are not enough for daily transactions) or from central bank (lender of the last resort). This is the wrong picture of how banking works, but this is widely taught and believed.
Banking actually works by maturity transformation. A thirty year mortgage loan is transformed into a sequence of one day loans. The simplest way to understand this is to consider a bank AA with ZERO assets, which makes a 30 year loan of $100,000 at 5% interest. The borrower withdraws the money and deposits it in another bank BB creating a liability which bank AA owes to bank BB. Millions of such transactions takes place everyday. Assume there is ZERO money in the system, in order to get clarity about how it works. Also assume that no one actually uses cash – everybody writes checks for every purchase, so all money created actually stays within some bank or the other. At the start of the day all banks made loans of varying maturities – say from one year to thirty years – by simply opening checking accounts in the name of people who borrowed. Then people wrote checks on these accounts to other banks. All the money got re-shuffled between the banks. A lot of liabilities for bank AA were generated when people wrote checks on their (empty) accounts, but also a lot of credits came in when people deposited checks from other banks into their accounts at AA. At the end of the day, bank AA will have either a net credit or a net loss. Overall, the entire banking sector will have net position of zero – no credit or loss. This is because no money has flowed into or out of the banking sector. So if some bank is down, then some other bank must be up. At the end of the day, inter-bank clearing takes place. Banks which are short of money borrow OVERNITE from those who have surplus at the Inter-Bank borrowing rate of 3%. Since the maximum they borrow is limited by the amount they have lent, they will always make profits on the differential between the overnite borrowing rate of 3% and the long run rate of 5%. This same process repeats every day for thirty years. So the bank AA finances a thirty year loan by daily borrowing everyday for the entire thirty years. This is maturity transformation – transformation of a thirty year loan into a sequence of one day loans over the period of the loan. Leakages of cash from the system only add some addition wrinkles which don’t matter much for the basic picture described above. See my post on Monetization, Maturity Transformation and Modern Monetary Theory. Note the dramatic difference between the Maturity Transformation and the Financial Intermediation picture of how banks work.
10. Explain the Job Guarantee Program, where the government becomes Employer of Last Resort. Explain why conventional economists think this will lead to inflation. Explain why a poorly designed JG can indeed lead to inflation but a well-designed program should not.
Minsky’s JG program suggests that govt. should act as the “Employer of the last resort”. It should give jobs to all those people who are looking for jobs according to their skills and area of expertise – as they are, where they are. Govt. should provide them on job training. Let us classify laborers as A, B, C, …, Z category according to their attractiveness to private firms, and therefore their employability. The goal of the job guarantee program is to tend to the bottom of the pool, to give jobs to Z-category workers first and then work up. The private sector has the opposite priorities and starts with A-category and work down. The government should provide a guaranteed minimum wage which anyone who wants a job can get. This should be low enough so as to not compete with jobs in the private sector. When the economy is doing well, the private sector will go down the rankings to lower categories and workers will shift out of the minimum wage government jobs to the better paying private sector jobs. In downturn the opposite will happen as workers laid off from private sector will go back to less well-paid government jobs. Full employment will be maintained throughout the business cycle.
Conventional Views: Mainstream economists find two problems with this scheme. One is: How will the government finance a massive job creation program? Where will it get the revenues for this? The MMT answer is that a sovereign government does not need to raise money. It creates money by fiat, and can just print as much money as is required for this purpose. After all, the USA government spent $29 Trillion to bailout the financial sector following the GFC without any obvious adverse effects. Many other examples throughout the world of Keynesian deficit financing and fiscal policy leading to good results are available. The second objection is that printing money and giving it to the workers will lead to inflation. The output produced in the economy will remain the same, but there will be a lot more money in the economy so prices will have to rise to achieve supply and demand equilibrium.
MMT Answers: If laborers are employed in non-productive jobs, so that they add nothing to the total output of the economy, then the conventional view is valid. If the Government hires millions of people who do nothing at all, then inflation would result, exactly as predicted by conventional theory. However, the key to the Job Guarantee program is to ensure that all people who are hired actually add to the output of the economy. By looking the least desirable and worst paid jobs in the economy, Minsky estimated that newly hired zero-skill and experience workers could contribute at least 5 times their salary in terms of production of new goods and services to the economy. Thus, additional money created to pay salaries would be counterbalanced by the additional output produced by the newly hired workers, so that there is no necessary inflationary pressure. More delicate inter-sectoral accounting is needed to ensure that this idea actually works in practice. If all new workers are hired in any one sector (like services), they will all generated demands for food, housing, education and other basic needs, leading to inflation in these sectors. So one part of the JG program involves balancing the job creation strategy in such a way that the additional demand generates is actually met by the additional production. For example, anticipating an increase in demand for food due to the JG program, we could allocate a sufficient proportion of jobs to the agricultural sector, so that additional food is created in sufficient quantities to meet the additional demand generated. Similarly, we can actually anticipate the additional demand which will be generated by using the detailed information from Household Income Expenditure Surveys and provide extra jobs and productive capacities in sectors which will receive the greatest additional demand. For more information, see “ Employment for All ”.
11. Explain the idea of “Entanglement” and illustrate the concept by showing how monetary policy in post-World War 1 era had opposite effects from those in the pre-World War 1 era, due to changed historical context.
The idea of entanglement suggests that theory and history are tangled with each other.Theories are based on attempts to understand and learn from a particular historical experience, and hence cannot be understood in isolation, separately from the historical context. For example, to understand Keynesian economic theory, we must understand the Great Depression. More complex is the other direction – we cannot understand history, without understanding the theories used by people to understand that history. This is because the response people made to historical events was governed by the theories they used to understand history. When the phenomena of poverty emerged and became widespread in England, and in European economies, people made an effort to understand this, in order to devise suitable policies to combat poverty. Most theories places the responsibility on external factors and hence recommended gentle and sympathetic treatment of the poor. However, Malthusian theories came to dominate the scene, and the English poor laws were designed in the light of these theories. Malthusian theories place the blame for poverty on the high birth rate of the poor, and recommend harsh treatment to control the population. Similarly, economic policy in the post-WW2 era in Western world was governed by Keynesian theory and this accounts for the widespread prosperity and full employment that was observed from 1945 to 1975 roughly.
The concept of entanglement is well illustrated by monetary policy in pre and post WW1 period. As the lecture on Global Financial Architecture Part II explains in detail, the same policies had different effects in the pre an post war periods. In the pre-war era, Central Banks were committed to stability of international exchange rates and prioritized this over the needs of the domestic economy. A temporary suspension of convertibility to gold was a stabilizing factor, where Central Banks sought time to borrow reserves to fulfill international obligations. Private actors assumed that Central Banks would seek to strengthen the currency and therefore moved to support the currency, in order to profit from the anticipated policy. In the post war period, Central Banks were more committed to restoration of war-ravaged domestic economies. In this period, a suspension of gold payments signaled a weakening of the currency and the currency was attacked in anticipation of further weakening. The same policy led to entirely different outcomes in the two periods because the historical context. This clearly illustrates how effects of policy depend on the historical context. To understand how policy shapes history, we can show that wrong policy, based on wrong theories about how money functions, was responsible for both World War 1 and World War 2, although the causes for the two wars were radically different.
12. Explain the sequence of events which shows how the Global Financial Crisis 2007 was the revenge of East Asia for the crisis created by over-investment by foreigners.
Atif Main and Amir Sufi explain the casual chain of GFC via East-Asia. In the beginning the East Asian emerging economies had high interest rates which attracted the foreign capitalists to invest here. They had strict controls over capital mobility but IMF and big financial investors persuaded them to remove these restrictions. They were offered the temptation that inflows of foreign capital would further enhance their growth, but they were unaware of the risks attached to this hot capital. A huge amount of foreign capital, seeking high returns, flowed into the East Asian economies. Inflow of foreign capital led to an asset price bubble in land and housing. The banks took loans with a promise to return in dollars. The bubble then burst, with a small disturbance in currency value leading to jittery speculators withdrawing huge amounts of foreign capital. Even though the ground realities of the economies remained solid, foreign investors refused to lend more money because of damaged expectations about the future. The East Asian banks did not have dollars to pay back, even Central Bank or govt. did not have enough dollars to pay back. This led to massive crises, so the countries had to go to IMF to borrow dollars. IMF imposed austerity policies on them which put them in deeper recession. The lesson they learnt was that to prevent future crises, Central Banks should have high reserves of dollars. Dollar reserve holdings at Central Banks throughout the world increased by trillions of dollars over the decade leading up to the Global Financial Crisis. Central Banks holding dollars reserves, and private institutions, wanted to hold dollars in safe liquid assets with highest possible returns. In U.S. in 1970, the rules were strict and only safe assets were securitized but this foreign demand put pressure on U.S. to securitize risky assets also in 1990’s. These extra savings or capital was put into U.S. mortgage and bond market which created house bubble. The certification agencies participated in fraud to make Mortgage Based Securities appear as AAA, almost as safe as US Treasury, even though these assets were actually very risky. Inflows of trillions of dollars of foreign investors created a bubble in US real estate and stock prices. Eventually the bubble burst, and foreign investors took out their capital and the financial sector collapsed, requiring a bailout amounting to $29 Trillion eventually. That’s why it is said that GFC was the revenge of East Asia.