Author Archives: Asad Zaman

The idea that knowledge is only of observables, and observables can be measured are both important drivers of policies and business and terribly wrong.

An Islamic WorldView

For reasons explained briefly in “The Emergence of Logical Positivism“, the Western intellectual tradition came to the disastrously wrong conclusions that (1) Only science can provide us with valid knowledge, and (2) science is based on observables, unlike religion which is based on unobservables. Furthermore, since qualitative aspects of observables are often subjective, a preference for the objectivity created by measurement was expressed by Lord Kelvin as follows:

When you can measure what you are speaking about, and express it in numbers, you know something about it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science

This idea, that everything worth knowing, can be reduced to numerical measurements, has led Western intellectuals to attempt to measure everything, without concern about whether…

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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.

Excerpt from:  Real Statistics (3/4) Statistics as Rhetoric 

{Preliminary material explains that conventional approach statistics separates theory and application — the job of ths statistician is to analyze numbers – without knowing where the come from. The job of the Field Expert is to use objective statistical analysis of numbers to get better understanding of the realities which generate the numbers. In “Real Statistics”, we assert that these two tasks cannot be separated. Theory must always be studied within the context of real world application. Also, real world phenomena cannot be understood without application of theory}}

So the statistician must always analyze numbers in the context of the real world phenomena which generated the numbers. See  My Journey from Theory to Reality  for more details about this argument. The Islamic approach rejects the idea that numbers are objective measures of reality. As we will see, most numbers being analyzed involve subjective judgments. We take the point of view that Statistics is a branch of rhetoric. We need to learn how to make ARGUMENTS with numbers.

The key rhetorical strategy of conventional statistics is hiding of the subjective elements of a statistical analysis. Both the data being analyzed, and methods of analysis, involve HUGE numbers of Subjective Assumptions. Conventional statistical analysis pretends that numbers, and analysis, is objective and factual, no room is left for arguments and persuasion. In this course, we will bring out the hidden value judgments, so that different perspectives can be explored, in light of different values, while having the same set of numerical measurements.

The key insight here is that most numbers are MADE UP, and involve HUGE numbers of subjective judgments. There are TWO types of Numbers – Facts and Fictions. The factual and objective numbers are about the External Reality. For example, Number of trees in forest, Number of people in Pakistan, Rupee Income of People in Pakistan, Prices of different goods in different places, the Quantity of Carpets produced for export. These can all be counted by numbers, and the numbers actually count something which is present in external reality, and therefore is objective.

However most numbers which enter statistical analysis, especially in the context of economics are number fictions, not number facts. These numbers are computed using subjective decisions which represent values, but these are hidden in the analysis. Instead the numbers are presented as if they are just like number facts, and hence objective measures of external reality, to which all observers would agree. Here are some examples of numbers which are fictional: IQ of a person, Wealth of Pakistan, Value of the Rupee in terms of purchasing power, Inflation Rate, Quality of Universities, Quality of Research produced by a faculty. Since this point is never made in conventional statistical texts, which treat all numbers alike, we will explain further why these numbers are fictional, not factual.

Why is IQ a Fictional Number? {… to read more, see:  Real Statistics (3/4) Statistics as Rhetoric  … }

See also, related post on Beyond Numbers and Material Rewards

A (free) online course on “Real Statistics” starts on Saturday 27th July 2019. This course develops a radical new approach to the subject. This course is designed for teachers. Registration form is linked in the first paragraph of the post linked below. Register to get put on the email list for the course.

An Islamic WorldView

[] Insha-Allah, starting Saturday 27th July 2019, I will launch an online course entitled Real Statistics: An Islamic Approach (RSIA)- The POSTSCRIPT below lists seven previous posts which discuss the ideas which led to the creation of the course. This introductory material is too deep, difficult, and complex, for students of a basic statistics course. I am planning to cover the bare essentials in my online course Real Statistics which is meant for teachers of statistics, to give them both the understanding, and the course materials they need to run the course. Teachers can register for the course via: Registration: RSIA,[shortlink:] They will be put on an email list which will provide weekly assignments of readings, together with tasks/quizzes to test understanding. Taking the course should enable teachers to teach students using a radically different approach, which provides deep conceptual understanding, as well as hands-on ability to…

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Last semester I taught an MMT-based Macro course which attempted to re-integrate history into economics. The course was based on the premise that economic theories cannot be understood outside the historical context in which they were born. Standard graduate macro courses attempt to teach a body of theory which has been empirically falsified (see  Romer: Trouble With Macro ). My course had the goal of giving the student the ability to understand major economic events of the past century.  A previous post on  MMT Macro Final (1/3)  provided the first 4 question and answers for the Final Exam, as a sample of what was taught. This post provides questions 5 to 8, together with the answers.

  1. Atif Mian wrote that “Starting a major credit-fueled housing program in the middle of a Balance-of-Payments Crisis is not a good idea”. Explain why this statement is true when the PKR is overvalued, but false when undervaluation holds.

Answer: A credit fueled housing program will substantially increase the amount of money in the economy, as people borrow against future earnings to spend on purchase of current houses. The money will go into the firms of the construction sector, and into the pockets of their employees. Seeing the increased demand, the firms will seek to build capacity and expand, by increasing investment. The firms demand for imports required to build capacity, or imports used as raw materials in the construction process will increase. Employees aggregate demand for consumption will also increase and some of it will be directed towards imports. So overall, the demand for imports will increase.

As discussed in my note on “ Rupee Over-Valuation ”, increased imports under a regime of over-valuation means that the government subsidizes all imports. Increased demand for imports will lead to loss of foreign exchange reserves, and will exacerbate the BOP Crisis. On the other hand, with under-valuation, the government actually collects a tax, denominated in foreign exchange, for each unit imported. In this situation, an increased demand for imports will lead to increased foreign exchange reserves at the SBP, and will actually help to improve the BOP, instead of destabilizing the economy.

  1. Provide some empirical evidence which supports the view that the East Asian Miracle was based on free market policies. Provide some empirical evidence for the opposite view that East Asian Miracle was based on government led policies, which involved distorting free market incentives.

East Asian economy grew at an accelerated pace during the 1970s and 1980s. A major part of this miraculous growth was stimulated by increase in private investment, international trade especially exports and industrial development. The openness and market orientation gave the impression that free markets were responsible for this miracle.

However, the government had a significant role to play in the economy by instituting land reforms and rural development, investing in development of human capital the government makes sure that raw material was readily available and skilled labor force is in place. Also, government gave credit at lower rates than market which shows they did not acquire loan on basis of market determined rates. The government carried out a vast range of industrial policies, directing subsidies and credits towards export-oriented industries, leading the development of sectors like semiconductors, where there was no private sector present.  By following the policy of “produce what you can” the government controlled the sequence of industrial development. Also, the policy of import substitution provided domestic demand stimulus to the industrial sector. The government intervened in the foreign exchange market, using subsidized FX rates for critical imports, and prohibiting or making expensive unnecessary imports. Public spirit, generated by a variety of community-based programs, also played an important role.  The World Bank publication on the “East Asian Miracle” documents the vast range of government interventions in the markets which created this miracle.

  1. Explain why the Gold Standard broke down after World War 1 because Central Banks supported needs of domestic economy over international trade.

World War I depleted the treasuries of European economies, because of heavy war expenditures and borrowings.  After WW1, the amounts of money required by needs of the domestic economies were very large, and the amount of gold available to back them was very low. A solution which could have worked was to do a simultaneous increase in gold prices. A joint initiative by all countries to double the price of gold would have reduced the stock required for backing gold by 50%, and allowed countries sufficient flexibility in printing money so as to meet the needs of the domestic economy. This would also have maintained stable international trade prices. However, this could not be done one country at a time because depreciation of currency would make domestic goods more attractive to foreigners, reducing aggregate demand in foreign countries while increasing domestic aggregate demand. This was known as a beggar-thy-neighbor policy, and led to retaliations by other countries. The level of cooperation and trust required for a simultaneous one-time postwar devaluation did not exist. The option of competitive devaluations would have de-stabilized trade. So most countries chose to try to restore the pre-war gold standard at the same parity. This was a disastrous mistake.

To restore gold standard to pre-war parity required constricting the money supply, imposing heavy costs of unemployment and low output on the domestic economy, in order to maintain stable prices for foreign trade. With democratic governments, this was not possible – the people would not allow so much pain to be inflicted. Expanding the money supply to accommodate the needs of the domestic economy created enough leakage into imported goods that the Central Banks could not afford to honor foreign requests for conversion of notes into gold. This led Central Banks to suspend payments in gold, or convertibility, as a temporary measure. In the pre-war period, such suspensions would occur due to temporary BOP deficits, without any adverse consequences. This is because with strong domestic economies, the Central Banks ensured stable exchange rates and everyone assumed (correctly) that the Central Bank would undertaken policies to restore convertibility at regular standards. In the post war period, this was no longer assumed. Suspension of payments led to suspicions of weakness of the currency, and cause speculative attacks. Anticipation of possible devaluation led to selling off of currency creating further pressure to devalue. Massive efforts by Central Banks to restore pre-war gold standards failed because of these destabilizing effects of Central Bank policies, and the strong conflict between requirements of domestic economy, and needs of international trade. Breakdown of trade due to hyperinflation in Germany is said to be one of the causes of WW2. Hyperinflation destroyed trading links, and made war more profitable than trade.

  1. Explain how Krugman and Minsky have different views regarding “equilibrium”. Put this in context of Krugman’s explanation of the GFC versus Minsky’s explanation based on the Financial Instability Hypothesis.

Krugman’s view: Krugman shares the standard neoclassical view that the economy naturally tends towards equilibrium, in absence of constraints which prevent reaching equilibrium. Krugman is a Keynesian and believes that narrow money supply is one of these constraints. If we expand money supply removing constraints which prevent the achievement of equilibrium, then economy would automatically move towards full employment, with high levels of investment, output, and growth.

Minsky’s view: Minsky says that stability is destabilizing. This means that equilibrium itself is unstable, and generates forces towards disequilibrium. The general tendency of capitalism is towards unsustainable booms fueled by financial expansion. During stability, the returns are very high, aggregate demand is high; there is room for more money so people start borrowing and increase their spending. Investors invest in risky ventures, markets and financial institutions are deregulated. Investors and capitalists are backed by govt. and banks due to which they influence govt. to deregulate banks and financial institutions. Basically, stability leads to financial system instability because they make risky investments, extensive borrowing, shadow banking etc. rises which makes the financial system very fragile.

Krugman’s explanation of GFC: According to Krugman the conventional theory could not predict GFC because of the following reasons:

  1. It was a black swan event (which happens rarely) so financial markets miscalculated risks of collapse because it was out of line with past experience.
  2. FED kept interest rate too low (intervention) which enable large amounts debt accumulation.
  3. Shadow banks went unattended. A huge unregulated financial sector came into existence which generated near-substitutes for money, vastly increasing the money supply. This did not show up in standard macro statistics, leading it to be ignored by economists.

In contrast, Minsky predicted the pattern of the Global Financial Crisis almost perfectly. It corresponds exactly to his financial instability hypothesis. In quest for higher returns investors started taking risk because they think that this prosperity is forever and the macro models that they follow do not include a crisis in banking sector. Credit is readily given because asset prince inflation makes apparently good collateral available, and returns are high. Loans are readily taken because returns to investment are high. Loans move from being hedge financing to speculative financing to Ponzi financing. There are a number of different ways that this unstable financial bubble bursts.

We have all read fiction about how true names give us the power to control the named objects. The comment on my previous post (MMT Macro Final 1/3) by Gregg Hannsgen, regarding my use of orthodox terminology and frameworks, led to me to reflect on the tremendous real power exercised by false names. From this reflection, I realized that the power lies in the ability to name things, and to popularize the use of these names. The article on Framing Modern Monetary Theory  by Connors and Mitchell in JPKE states that one of the central obstacles to the widespread acceptance of MMT is “The deployment of key macroeconomic terms (incorrectly) in the context of pervasive cultural metaphors to support policy interventions that effectively benefit a privileged few at the expense of the majority.” Personally, I first learned about the power of false names from a discussion by Noam Chomsky. With reference to the Vietnam War, the public debate was between the Hawks and the Doves. The Hawks felt that it was the responsibility of the USA to defend freedom, wherever it was threatened, across the globe. The Doves felt that the USA did not have this global responsibility. Effectively, the truth that US was actually replacing the previous imperial power France, and establishing its own hegemony over the Far East, was buried deep under, and made almost impossible to think of, by the terms of this debate.

In a similar way, just the name “deficit” exercises a tremendous power over the minds of the public, and ensures that the terminology of “financing the deficit” makes perfect sense to everyone. It fits perfectly with everyone’s lifetime experience of balancing household budgets. This name is used to justify policies of austerity, raising taxes, cutting spending on social welfare, raising interest rates, and other types of interventions which favor the 1% against the interests of the 99%. Thus Gregg’s complaint about my use of orthodox terminology and framing for the “financing of deficits” (see Q2 of  MMT Macro Final) is perfectly justified. Acceptance of orthodox terminology furthers the conventional agenda, even if it is used to debate against the merits of orthodox policy recommendations. Of course, this creates a real dilemma and difficulty for those who would make Radical Paradigm Shifts.  We cannot introduce new frameworks and concepts, while simply ignoring dominant terminology, since everyone uses that framework. But engaging with the terminology by using it, even for debate, further strengthens that conceptual framework.

Anyway, I propose to make up for my sin by devoting this post to explaining why it should be a crime to use the terminology of “financing the deficit”, as I did in my last post. One of the strategies suggested in the paper “Framing MMT” is to re-introduce the true names which have been replaced by false names of power. As a prime example, we should re-name Government Deficits as Government Injections (which I did in a later question on the MMT Macro Final).

A central MMT insight is that the government creates money in the process of spending. It does not acquire money in order to spend it. A large portion of government expenditures is not discretionary. The government is legally obligated to pay salaries, pay for various kinds of legislated public works programs, etc. Payments are made by government in form of checks written on its account at the Central Bank. This account is just an electronic entry created by the Central Bank. There is no limitation on the ability of the Central Bank to modify this entry to any amount. That is, the amount of money held by the government in its account at the Central Bank is really a fiction — there is no such number.  When the government writes a check, the Central Bank bank creates a corresponding entry in the government account to cover the check, effectively creating the high powered money which will end up as reserves with private banks. For deeper understanding of this process, see my posts on The Origins of Central Banking and Monetization, Maturity Transformation, and MMT. In order to maintain the fiction that the government “should” try to balance the budget, when the Central Bank writes an entry into the Government account, it also creates a corresponding entry calling this deposit a loan from the Central Bank to the government. This is pure fiction, in the sense that the Central Bank is an integral part of the government. It is as if I give a loan to myself. It does not make any real sense. However, now that the Central bank has acquired an artificial number as a target for the government budget, it CAN proceed to seek financing for this number, and this is what is actually done.

The magic of false names is amazingly powerful. The whole nation is engaged in an intense battle, fighting the mythical monster of the Deficit Dragon, using the sword of taxation, and other weapons for revenue generation. Just recently, while in the midsts of a foreign exchange crisis, Pakistan agreed to pay USD 1 billion to improve taxation systems.  The truth is that when the government spends, high powered money automatically comes into existence, by that very act of spending. The issue of where we will get money to finance this spending does not make any sense, even though this is where the maximum amount of policy discussion takes place. The real issue which must be discussed is going forward: what are the consequences to the economy of this new money which has been created by the government? This real question receives little or no attention in the literature. The answers which are available in the orthodox canon are shallow and nonsensical. One of these answers is given by the Ricardian Equivalence: government spending will drive out private spending on a dollar for dollar basis, so that total aggregate demand remains unchanged. Another answer is the hyperinflation will result.

Instead of these magical answers, designed to prevent us from looking at what really happens, we need to study step-by-step the consequences of government spending. Once we do that, it is almost immediately obvious that the consequences will depend on where this money goes. One of the immediate conclusions is that if government spending is targeted at the rich (reductions in taxes for the wealthy, or bailouts for billionaires), there will be very little effect on aggregate demand. The marginal propensity to consume of the rich is very low. The aggregate demand for super-luxury products will increase – for example genetically tailored personalized medical treatments for billionaires. Alternatively, if government spending, or injections, go to middle class or the poor, then aggregate demand will increase. Atif Mian and Amir Sufi in House of Debt made the point that if government bailouts had been correctly targeted, the Great Recession which followed the Global Financial Crisis could have been prevented. Similarly, if government injections are targeted at sectors which have excess capacity for production, then they will create additional output, and hence not be inflationary. It is this insight which leads to Job Guarantee programs by the government, designed to produce Employment for All.

To close, I seek forgiveness from God for my sins in using wrong terminology, which provides power for policies which keep millions in misery, and hope that this present offering compensates by creating clarity. Below, I link a 90m video lecture on the paper “Framing Modern Monetary Theory” by Connors and Mitchell referenced above:

During the last two semesters, I taught Macroeconomics based on a new approach which re-incorporate the history that Economists forgot (See  Method or Madness?). The central idea of the course is that economic theories cannot be understood outside of their historical context. Conversely, economic history cannot be understood except by studying the economic theories (right or wrong) which were used by contemporaries to shape policy responses to historical events. The website for the entire course is Macroeconomics. In particular, Lecture 18B explains the principle of Entanglement. Below I provide Final Exam questions and answers, to give the flavor of the course. This post is about the first 4 out of 12 questions.

Q1: Stiglitz: “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” Explain the theory, and arguments for it. Then explain why it is sheer nonsense.

A1: The Theory:The Ricardian equivalence theory states that if government tries to increase aggregate demand through deficit spending, it will not succeed. The people will start saving because they expect that govt. will raise taxes to pay for the higher spending. As a result of saving, their current spending decreases, their current saving increases, hence resulting in no effect on aggregate demand.

Counter Argument: The assumption that govt. require taxation to generate resources and finance its spending is absurd as a sovereign govt. does not rely on taxes but can print its own money. There is no long run constraint on the government to balance budgets, and it can run any level of deficit forever. MMT states that the purpose of taxation is not to generate resources of govt. but to regulate consumption, redistribute income and in some cases to relieve inflationary pressure.

See also post on:   The Fallacy of Ricardian Equivalence .

Q2: Standard Theory: There are two ways to finance deficits – one is inflationary, while the other raises interest rates and reduces investments. Both methods cause economic harm. Explain the standard theory and explain the MMT view that this theory is sheer nonsense.

A2: There are two methods by which governments finance deficits.

  1. Printing Money: Printing more money will lead to increase in money supply resulting in inflation.
  2. Borrowing Money: It will increase in demand for loanable funds, leading to an increase in interest rate. This will increase cost of investment, as investment will go down. The so called “crowding out” for private investors, if they have to compete for finances.

MMT views: [i] Printing more money will not necessarily lead to inflation if full employment does not hold. In such cases, Govt. spending directed at the sectors with underemployment will increase employment which will raise output without increasing inflation.  Financing budget deficit by printing money will not create inflation because increased money is accompanied by increase output. Of course, government spending directed at sectors where full employment obtains will cause prices to rise in that sector (inflation). However, even this may not be harmful, since the increased price would signal excess demand, which would be met by an increase in productive capacity in the long run.  [ii]  Government borrowing does not cause “crowding out” as per traditional macro mechanism. The price of government borrowing from private sector is set by the policy rate determined by the Central Bank. This price is not affected by demand and supply considerations, since the Central Bank Open Market Operations ensure that the supply of money is adjusted to match inter-bank borrowing rate to the policy rate. Bank lending to private sector is done by money creation, and is not constrained by the money supply created by the Central Bank. Bank provide loans and then borrow reserves to meet the reserve requirements. The lending will depend on the demand for loans, the policy rate, and the market conditions (expectations). It will not be affected by government borrowing except indirectly. The indirect mechanism is that banks operate to maintain ROI at a certain minimum acceptable, or achievable level. If they can achieve the required rate of profits by utilizing certain investments in government bonds, they will not be motivated to lend to the private sector. This would a kind of “crowding out”, although the mechanism is very different from the standard theory.

Q3: The Central Bank cannot control both the overnight discount rate and the supply of money; it can only do one or the other. Explain this statement, and how it shows that the theory of the money multiplier is wrong.

A3: If the Central Bank decides on maintaining a particular discount rate, it will have to carry out open market operations to maintain this rate. If there are excess fund in the inter-bank borrowing market, there will be downward pressure on the inter-bank borrowing rate. The Central bank will have to mop up extra money by money market operations, to prevent the KIBOR from falling below a specified amount under the target policy rate. If the inter-bank borrowing rate rises above the target policy rate, the Central Bank must inject money to prevent the rate from rising above the specified target policy rate, The Central Bank injects reserves (HPM) by purchasing T-bills, and does mop-up operations by selling T-bills. The quantity of reserves being supplied or withdrawn depends on the policy rate, and cannot be varied independently.

The multiplier theory is wrong for two reasons. One is what has been pointed out above – the quantity of reserves being supplied to the private banking sector is not freely controlled by the Central Bank; rather it is varied to maintain the overnight discount rate at the target policy level. Secondly, private bank lending is not constrained by the reserves the that Central Bank creates. If the private bank finds a good loan (credit-worthy borrower with suitable collateral), it will not be constrained by lack of reserves. It will make the loan, and then borrow reserves to meet the reserve requirement. The Central Bank is required to provide these loans as demanded by private banking sector, so reserves will be generated as per needs of the private sector banks.

Q4: Explain the key identity of MMT: Government Injections + Foreign Injections = Private Surplus. Also explain the implications of this identity in terms of how we should think about government budget deficits and trade deficits (BOP).

A4: Government Injections into private sector money holdings are created by budget deficits, while Foreign Injections are created by Trade Surplus. Thus sum of these two injections equals the private sector surplus, which the sum of domestic household savings plus profits of domestic firms. This is further explained below

Budget deficit means that govt. expenditure is greater than govt. revenue. Govt. spending results in the earnings of the private sector while govt. revenue constitutes taxes collected from the private sector. Budget Deficit means that the government spends money into the private sector which it has not collected in taxes thereby injecting money into the economy. This money translates into a surplus in the private sector which creates profits and savings, and represents aggregate demand for goods and services coming from outside the private sector.

Trade surplus means that export receipts are greater than spending on imports. Domestic spending on imports is a leakage, and lowers the aggregate demand for domestic goods. Foreign demand is an injection which increases the aggregate demand, injecting foreign money into the domestic economy. The difference is the net increase in aggregate demand for domestic goods, which is paid for by foreign injections, which create private saving and firm profits.

This equality has enormous implications for fiscal and monetary policy. In an economy which runs a trade deficit, the private sector is spending more on imports than it is earning in exports. Thus net private surplus must be negative – the money being sent outside to foreigner can come from savings of households, or from losses (instead of profits) of firms. The government must run a deficit larger than this amount in order to make it possible for the firms to make profits and for the households to make savings. As MMT shows, and our classroom models confirmed, the government can run a deficit indefinitely, without worrying about sustainability. However this situation, with permanent trade deficit is not sustainable because the government and/or private parties must borrow foreign exchange to pay back foreign debt. That is, unless foreigners are willing to hold your currency in the long term. Only In situations of trade surplus is it possible for the government to balance the budget while the firms makes profits and household savings increase. Even in such cases, depending on particulars, it may be advisable for the government to run a deficit, in order to allow greater profits and savings in the domestic sector [There are many other ways to explain the implications of the fundamental sectoral balance equation of MMT]