A Response to Tom Palley

Tom Palley wrote a strongly worded critique of Modern Monetary Theory last year, which got a lot of attention int he world of heterodox economics. He has just put up a second piece, MMT: The Emperor Still Has No Clothes, reiterating and extending his criticisms.

Palley is a smart guy who I’ve learned a lot from over the years. But this is not his best work.

By way of preliminaries: MMT consists of three distinct arguments. First is chartalism, the claim that the value of money depends on its acceptability to settle tax obligations. This goes back to G. F. Knapp. Second is functional finance, the claim that government (conceived of as a consolidated budget and monetary authority) seeks to adjust the budget balance to achieve full employment, it can never be prevented from doing so by a financing constraint. This goes back to Abba Lerner and Evsey Domar. And third is the employer of last resort (ELR), a proposal for a specific form of spending to be adjusted under the functional finance rule. This seems to be an original contribution of Warren Mosler goes back to Hyman Minsky.

Personally, I find it useful to set aside the first and third of these arguments and focus on the second, functional finance. My own attempt to restate the functional finance claim in the language of contemporary textbooks is here. In my view, the essential difference between functional finance and orthodoxy is that the assignments of the interest rate and budget instruments are flipped. Instead of setting the interest rate to keep output at potential and setting the budget balance to keep the debt on a sustainable path, we assign the budget balance to keeping output at potential and the interest rate to debt sustainability.

Palley wants to knock down all three planks of MMT. What are his objections to functional finance?

(1) In the absence of economic growth, government deficits will lead to inflation regardless of the output gap. This claim is asserted rather than argued for. [1] It’s not clear what the relevance of this point is, since he agrees that deficits are not inherently inflationary when there is positive growth. Perhaps more importantly, this is a rejection not just as of MMT but of almost all policy-oriented macroeconomics, mainstream and heterodox. Whether you’re reading David Romer or Wendy Carlin or Lance Taylor, you’re going to find a Phillips curve that relates inflation to current output. There are plenty of disagreements about how expected inflation comes in, but nobody is going to include the budget balance as an independent term. In his eagerness to debunk MMT, Palley here finds himself reasserting Milton Friedman-style monetarism.

(2) If we assume an arbitrary floor on spending and an arbitrary ceiling on taxes, then it may be impossible to achieve both full employment/price stability and a sustainable debt path with interest rates fixed at zero. Yes, this is true. But it proves too much: If we impose arbitrary constraints on tax and spending levels then there is no guarantee that we can achieve debt sustainability and price stability with ANY interest rate. At any given interest rate, there is minimum primary balance that must be achieved to keep output at potential. There is also a minimum primary balance that must be achieved to keep the debt-GDP ratio constant. There is no a priori reason to think the first balance is higher than the second. So Palley’s argument here could just as well be a proof that there is nothing government can do to prevent public debt from rising without limit. In any case, these arbitrary limits on taxes and spending are not a feature of standard macro models (including Palley’s own models elsewhere), so it’s hard to justify bringing them in here.

(3) MMT lacks a theory of inflation. On the contrary, MMT has exactly the same theory of inflation as orthodox macro: High or rising inflation is the result of output above potential, disinflation or deflation the result of output below potential. In other words, MMT is consistent with a standard Phillips curve of the same kind Palley (and almost everybody else) uses. To be fair, the Wray and Tymoigne piece Palley is responding to is not as clear as it might be on this point. But Palley is supposed to be writing a critique of MMT, not just of one particular article. And people like Stephanie Kelton state unambiguously that MMT shares the orthodox output-gap story of inflation; see for instance slide 13 here.

(4) MMT doesn’t work in open economies because it requires persistent interest rate differentials between countries. Palley claims that the idea that you can hold interest rates in a given country at zero indefinitely is inconsistent with covered interest parity, a “well-established empirical regularity” that “states there is no room for systematic arbitrage of cross-country interest rates.” It seems that Palley has confused covered and uncovered interest parity. CIP is indeed well established empirically, but it only says that there is no arbitrage possible between the spot and forward markets for a given exchange rate. It does not rule out interest-rate arbitrage in the form of the carry trade, and so does not have any implications for the viability of MMT. If UIP held, that would indeed rule out a persistent zero interest policy in the absence of an equally persistent currency appreciation. But UIP, unlike CIP, gets no empirical support in the literature. Japan has sustained the near-zero interest rates that Palley says are unsustainable for 15 years now, and in general, persistent interest rate differentials without any offsetting exchange rate movements are ubiquitous. Furthermore, if financial openness rules out a policy of i=0, then it equally rules out the use of interest rates as a tool for demand management. The best thing you can say about Palley here is that he is parroting orthodoxy; otherwise he is thoroughly confused.

There is one thing that Palley is right about, which is that substantially all of MMT can be found in the old Keynesian literature. This isn’t news — in the same Stephanie Kelton slideshow linked above, she goes out of her way to say that there is nothing “modern” about MMT. And so what? There’s nothing wrong with updating insights from the past. In my opinion, most useful work in economics is about pouring old wine in new bottles.

I don’t write this from a position within MMT. I tend to feel that the genuine insights of Lernerian functional finance are obscured rather than strengthened by basing them in a chartalist theory of money. It’s fine if Tom Palley disagrees with our friends at UMKC and the Levy Institute. But he needs to put down the blunderbuss.

[1] In fact it’s a bit hard to understand what Palley is claiming here. First he says that “money financed deficits” must lead to inflation in a static economy, even with a zero output gap. He adds in a footnote that money-financed are not inflationary in a growing economy; in that case, for price stability “the high-powered money stock must grow at the rate of growth.” Then when he writes down a model, this has become the condition that government budget must be balanced, which is something different again. Also, I must say I can’t help wrinkling my nose a little, when I read about the “stock of high-powered money,” at the smell of a musty antique.

EDIT: Thanks to Daniele Santolamazza for correcting me on the origins of the ELR proposal.

27 thoughts on “A Response to Tom Palley”

  1. Nothing specific to general debate here but since you bring in debt sustainability – you seem to think that balance of payments doesn't matter for debt sustainability. This notion is highly erroneous. The debt is usually made sustainable by deflationary adjustments to income and it affects both employment.

    1. I will send you a mail of a paper by finding your email address. The paper is an appendix by Bob Rowthorn and Wynne Godley in the 1994 book Unemployment in Europe, J. Michie and J. Grieve Smith (eds).

      The thing about debt sustainability is that ordinary proofs assume a constant deficit/gdp and then "show" that it sustains to some number. This assumption itself is an error. For if a nation is growing too fast compared to its exports, the current account is deteriorating and this acts on the budget balance. So to keep it sustainable fiscal policy has to give in. Of course if the rest of the world is growing fast, exports are also growing so good but there is no need to assume this – especially as is the case now.

      You can try to check this on an excel sheet. And it isn't too difficult. Suppose exports are growing at 1% and GDP/income is growing at 5%. Suppose we start with a CAD of 3%. The current account will continue to deteriorate which means our assumption is wrong, so it can't grow too fast. You can also test this by exaggerating the claim. Suppose debt is always sustainable independent of the external sector. As a corollary, it should be for zero exports as well. Which sounds wrong. So there is some dependence on exports/imports.

    2. I think a clearer way to state this is that we have both a public debt sustainability condition and an external debt sustainability condition. The second can — and often does — bind even if the first does not. But this is a problem for orthodoxy as much as for MMT. The implication is not that MMT won't get you to full employment, it is that you can't get to full employment, period.

  2. OK, after reading a bit on your blog and the email you sent me I understand what you are saying. Yes, the balance of payments may be a binding constraint that prevents full employment being achieved via the budget balance. But the thing is, this also prevents full employment being reached through interest policy either. To me, the interesting claim is that IF the orthodox policy assignment is possible then the functional finance assignment is also possible.

    If Palley had written an article saying, MMT has the same limitation as conventional monetary policy, namely, it can only achieve full employment with some kind of controls on the external account — that would have been a useful contribution. But that isn't the article he wrote.

  3. What gets me in these debates is how nobody ever seems to get around to the idea that the private and public sectors have to be sustainable together. If the combined debt/gdp ratio of the two is persistently growing , sooner or later you'll hit the wall , and then you'll be talking about things like permanent negative real interest rates , red money and green money — in other words , crazy stuff.

    I hope we never get to that point.


  4. I will confess, I am not really interested in the policy question on a literal level. I don't run the state, my friends don't run the state, I don't trust the people who run the state, so the question of the state "should" do is not really relevant to me. What I am interested in is the way that political choices get reframed as objective economic constraints. So to me, the important question is why, if functional finance and orthodoxy are basically equivalent at the formal level, there is such commitment to the idea that the state faces a financial constraint. In other words, clarifying what the state can and cannot do is a tool for understanding the goals of the people who do run the state.

    I'm also interested in the way the increasing elasticity of the monetary system is both necessary and threatening to the reproduction of capitalism as a system. On this point, chapter 2 of David Harvey's A Companion to Marx's Capital is useful.

  5. I'm still trying to understand the MMT model a bit better…

    The main aim of AD management policy is to keep RGDP as close to optimal levels as possible. I believe this can best be done via control of the size of the monetary base. But unlike Market Monetarists I believe this is best done via govt running deficits and reserving asset purchases for fine-tuning and stabilizing interest rates.

    I think this takes me close to a functional finance position.

    I'm just trying to see what additional value is added by the other things you list as features of MMT. I can't get too excited about their theory of money (could be right but not sure what difference it make0 . But the ELR bit interested me a bit.

    One potential problem with AD management (using combined fiscal/monetary policy) is that inflation may kick-in at a level of employment that is too low to be healthy. ELR could ,at one level, be just a better way of using the pool of unemployed thus created in a more productive and humane way. But I'm suspecting its meant to be more than that. Perhaps using ELR as a buffer between unemployment and inflation has some additional features that I'm missing. I'm know it s a bit off topic but can you elaborate on that bit of MMT. ?

  6. Yes, in principle ELR is supposed to pin down inflation by fixing the nominal wage. Personally I don't find that part of the package convincing.

    Lerner thought that if inflation turned out to rise while output was still below potential, the solution was to try to reduce markups via antitrust policy. As far as I can tell, MMT has not taken up that part of functional finance.

    1. I find people's misinterpretation of the ELR amusing. Not sure why it is quite so difficult to grasp.

      ELR declares by fiat that all those that were previously short of an 'ordinary job' have an 'ordinary job' and a wage.

      That's why there is no 'phillips curve' or NAIRU in MMT. Because both of those rely upon the notion of 'unemployment' and there is none in MMT. The 'trade off' changes to reference those on the ELR instead.

      It's counter-cyclical social security with a twist.

      The twist is three fold:

      (i) people can choose to go onto ELR social security, which disciplines the standard economy much more than a 'minimum wage' does, but doesn't disrupt the wage structure entirely like an income guarantee does.

      (ii) The size of the ELR is less of a social issue – no more 'bring down unemployment', no more 'shirkers' – and therefore normal businesses can be allowed to go bust, not pay redundancy, etc because the ELR will catch people who lose their jobs during a retrenchment. That disciplines the spending and wage channels since there need be no bailouts or 'special industries' that pump-priming requires. Overpaid workers get a forced wage cut when they move to the ELR as do greedy bosses.

      (iii) People on the ELR are working and producing output – so they are more productive than on unemployment benefit or income guarantees. And because they are working they become cheaper to hire from normal businesses' point of view (less risk if you see them working). That eliminates a current risk cost completely from the economy (the 'long term unemployed' issue).

      There are quite a few other benefits as explained in the literature which heavily drift into sociology and social cohesion and the nature of the way humans are (their innate need to see reciprocation).

    2. Nick-

      Thanks for the explanation. However, I still prefer to separate the ELR and functional finance strands of MMT. Not because I object to ELR — which may well have the merits you describe — but because I think the two arguments are logically independent and presenting them as a unit is a source of confusion.

      The one point I want to push back on is the notion that under ELR there is no Phillips curve. You can just as well think of the curve as a relationship between output and inflation, rather than between unemployment and inflation. And when you look at it that way, there is no difference between MMT and orthodoxy — both see inflation as a positive function of the output gap, and think that holding output at potential is a necessary and sufficient condition for price stability.

    3. Also, what I find less convincing is the idea that fixing the nominal wage for the ELR would be effective at stabilizing the price level. Not the desirability of a jobs guarantee as such.

  7. Thanks for the comment, Warren. I don't think I've read that article — will look at it.

    Question for you. I prefer to express the idea that the government is the monopoly currency issuer, by saying that the government sets the rate of interest. Do you see an important difference between those two statements?

  8. Eric – Glad you read the post. I've learned a lot from your stuff on interest rates. I think your critique of the idea if a "real" interest rate is correct and important.

    On the issue of inflation –is this a criticism of what I wrote? You're right, I said inflation is a function of the output gap when it would be more correct to say its a function if the output gap and the product wage. But still, isn't this the orthodox view also? Is there anything in your linked piece — which I just skimmed — that contradicts what you would find in a good mainstream textbook like Blanchard?

    1. Yes you can find concerns about cost-push and demand pull in New Keynesian models for example. Where the NEK and PK models will differ is in their modeling of the inflationary components. For example, for the output gap, there is no natural growth rate in the Post Keynesian approach. The structure of the economy responds to change in current economic activity (effective demand theory).

  9. I think the distinction between the output gap and the unemployment rate is an important one. The mainstream view that there is a unique NAIRU that exists in the future independently of the path of demand and growth does not make much sense in a heterodox world. There may be a NAIRU at any point in time, but its strongly path dependent, subject to hysteresis, as we are discovering unfortunately post 2008. So I think it makes more sense to use a Phillips type curve relating inflation to utilization in a heterodox model because that leaves open the possibility that the growth rate is endogenous, as Eric suggests. Rather than just writing n for the natural rate of growth and assuming the system adapts to that. Openness to the possibility of endogenous growth seems to be one of the things that unites us as heterodox (I prefer the term structuralist) macroeconomists?

    As always, terrific post and comment thread.

    1. Tom,

      Thanks for the comment. I'm delighted you're still reading the blog.

      I think the distinction between the output gap and the unemployment rate is an important one. The mainstream view that there is a unique NAIRU that exists in the future independently of the path of demand and growth does not make much sense in a heterodox world. There may be a NAIRU at any point in time, but its strongly path dependent, subject to hysteresis, as we are discovering unfortunately post 2008. So I think it makes more sense to use a Phillips type curve relating inflation to utilization in a heterodox model because that leaves open the possibility that the growth rate is endogenous, as Eric suggests.

      I agree! Or, I agree and disagree, I agree that there is no level of potential output that exists "out there" independent of the path of demand. But I don't see why that's an issue here. All we need (for both the function finance and orthodox views) is that both fiscal and monetary policy affect unemployment and inflation only via the level of aggregate expenditure. As long as that is true, then we can define a target level of expenditure, which will not depend on what instrument is targeting it. I think this assumption is unproblematic for unemployment, I think in the short run policy can treat employment and output as alternative measures of the same quantity. For inflation it's a bit trickier. You can tell stories in which monetary policy, in particular, affects inflation through channels other than aggregate expenditure. Palley seems to be suggesting a story of this kind. I personally think he is wrong here, but he is not trivially wrong. This question could be further elucidated.

      So in terms of the specific issues here: I don't think this the divide between Tom and Eric/Randy/etc. is along this dimension. I don't think the divide between MMT and the mainstream is along this dimension either. You can write a Taylor rule in terms of utilization rather than unemployment, that's fine. It's easier, because you don't have to worry about Okun's law. The question that is in dispute is not the level of output that should be targeted. It is, whether government financing constraints can prevent that target from being reached by fiscal policy. Do you see it differently?

      Openness to the possibility of endogenous growth seems to be one of the things that unites us as heterodox (I prefer the term structuralist) macroeconomists?

      I don't like the term heterodox either. But it's hard to coordinate on an alternative! Why structuralist, rather than Post Keynesian or (radical) political economy? I'm sure you saw Anwar's thing in the latest New School Review. He says we need to think of ourselves as developing a positive project for understanding the world, and not just a critique of established economics, which is a good reason to reject the "heterodox" label. But he also says, and I'm inclined to agree, that the Keynesian and Marxist-Classical alternatives are just two different bodies of theory. Yes, they overlap, but they each also overlap with the mainstream at different points. So if we want to drop a label that just says No to the mainstream and instead say Yes to an alternative, we may have to make some hard choices about which alternative we are choosing.

      Is that a wrong reading of him, do you think? Or do you think he's wrong about this?

      I would put structuralism on the Keynesian side of this divide. No?

  10. Of course I'm still reading Slack Wire. But its like The Economist–not easy to keep up! (My day job now is directing a study group in London which is time consuming.)

    I haven't read Anu's piece but it sounds like I would agree with it. Structuralist seems like a good description of the overlap between post keynesians and marxists; we share the view that aggregate social structures like class, the corporate form of organization, etc. are valid, and we pretty much share a common language. Let's coordinate on that term; Tom Palley calls himself a structuralist keynesian and Lance Taylor a structuralist so its just a question of broadening the use. Heterodox sounds so subaltern.

    I don't understand MMT very well. Your post that it doesn't matter how you solve the assignment problem was persuasive and cogent. It (and MMT) seems premised on assuming that g and r are independent. I've become convinced that the real interest rate belongs in the investment equation, g(r), which means that g-r is not something we can just set greater than zero to solve the problem of fiscal deficits. Also that fiscal policy, e.g. the debt ratio, affects the long run position of the IS curve (assuming interest payments go to rentiers who spend them on consumption), so it affects the r that stabilizes inflation.

    So the question of exo/endogenous growth is important to me b/c a given growth target puts constraints on the feasible fiscal policy, or given fiscal policy, on the ability of a monetary authority to set the inflation-neutral interest rate.

    1. I'm happy to coordinate on structuralist. Of course the nature of coordination is that everyone has to do it together. So we're a bit hostage to whatever terms people actually use.

      Re MMT, I'm less interested in the specific body of work that goes under that name and more in the general question of what it means to say that public spending and taxes are or are not subject to a financial constraint. Which is part of the larger question of the articulation of capitalism as a system of production and distribution with capitalism as a system of money claims.

      The rest of your comment I address in a new post.

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