Diary of a Financier

The problem with MMT/MR (and all your other economic theories)…

In Dissertation, Economics on Fri 19 Apr 2013 at 12:47

I recently had to voice my opposition to the burgeoning Modern Monetary Theory (MMT) economic school and its offshoots, such as Monetary Realism (MR). I wanted to record my comments here, because these valuable debates often get buried for eternity in a long comment thread.

For background, Cullen Roche, curator and proprietor of the wildly successful Pragmatic Capitalism blog, has been a major proponent of the MMT movement. Cullen subsequently co-led the transition to MR, which is a tweaked derivative of its MMT predecessor. I won’t delve into the mechanics of the theories herein, for which you can reference Google and the webosphere.

In the fallout of Reinhart & Rogoff’s shameful collapse this week, Cullen stepped back from the story to discuss the state of macroeconomics (the discipline):

“I think the problem in modern macro is that it is driven largely by ideology and confirmation bias. A plane does not fly because of ideology or personal biases. It flies because we know, for a fact, that an object can generate enough thrust to overcome its weight resulting in lift. Obviously, [flying a plane is] more complex than that, but it’s not something that’s theoretical or in need of experimentation. This common understanding of flight creates a basis for understanding within the engineering community…

“In macroeconomics, we do the opposite. There is no firm set of agreed upon understandings. No one agrees how the plane flies. Instead, we mostly just debate the optimal way to fly. We’re basically just throwing sheets of metal into the sky without actually working from an agreed upon foundation for why that piece of metal may or may not fly…

“Modern macro needs a firm set of understandings from which to base future experiments. And yes, the experiments are fine so long as they’re based on a firm understanding of the actual monetary system and how it operates [which MR accomplishes].”

Here’s my response to Cullen, for whom I have tremendous respect, by the way, as our conversations through the years have spawned a lot of intellectual evolution. That being said, I wholly disagree with his utopian intimations and his inflated self-confidence in the unequivocal veracity of MMT/MR, both of which I address in what follows:

“I disagree with you here Cullen. Your comments come off as naive, although from my trackrecord here at PragCap, I obviously don’t think you’re so obtuse. (Don’t mean to sound as harsh as that comes off…)

“First, part of the problem with macro is that there are many ideologies–as in politics–so good luck getting people to agree [on a basis of understanding]. We’re of a bipartisan Congress, and they have scarcely been able to untangle the gridlock. You can serve them MR, but you’re really just asking them to acquiesce to a rational theory, when they all believe they have their own rational theories (backed by much more data & academia). Second, in reality, it’s to hard to model human behavior using the sciences known to man today, hence so many economic theories have been carted out, then carted off, throughout the ages. (Sylvia Nasar’s Grand Pursuit: The Story of Economic Genius is a good place to start, for those interested.) MR feeds on the same confirmation biases as do all its predecessors.

“I guess this comes down to my personal problem with MR: it does correctly characterize the monetary system (as other theories fail to), but that’s of little use in practice. Specifically, sure deficits aren’t necessarily a problem to a sovereign currency issuer (100% agree), and history says issuers don’t default sans an exogenous shock (e.g. war or reparations), but the absence of evidence is not
evidence of absence. [While MR clearly and correctly articulates the mechanics of our monetary system, it makes the wild, baseless, unscientific, and biased claim that deficits don’t matter or sovereign issuers can’t default. Using that as a ‘basis of understanding’ leads us to implement experimental economic policy on top of theoretical assumptions.]
 Yes, a sustainable debtload isn’t subject to some arbitrary 90% debt/GDP figure–especially not for a currency issuer and even more especially not for the world’s reserve currency. Britain was in such a fragile state coming out of WWI, after which its role in the global economy was usurped by America. Sure, the British have had a decent standard of living since, but they were financed by America for American interests. That’s an awfully dependent state to hang your hat on. Maybe BOE should’ve left the gold standard before 1931 and/or launched QE, but it’s a zero-sum game: their choice was between tax by inflation or tax by disinflation. The US is in such a position today. Not all that dissimilar from 1920s UK, the US is dealing with issues from a dearth of secular innovation, sustainable growth rates & demographics. Is that not the case? How does MR resolve any of that?

“There comes a point when federal debt excess hinders growth, as in Japan, because private debt always gets crammed up to the federal entity, as today’s social engineers won’t let zombies die. Japan is in an extremely fragile state, wherein a material rise in interest rates would send the federal government into a death spiral [in which debt service rivals national income] (don’t say literal currency printing isn’t a problem with their age demographics), so the alternative to such inflation is ZIRP, wherein savers feel the equivalent pinch as in inflation–not good for a modern welfare state with that many retirees. There are always losers, and MR doesn’t change that, right?  [Having reached its sustainable growth rate, the US is basically a stodgy blue chip now, with steady cash flows and little growth.  Accept that, and stop pushing so hard.  If Natural Gas or alternative energy end up proliferating into magnanimous growth opportunities, then so be it, but stop forcing the defibrillators on an old man just because he’s not running as fast as he used to. Deficits are perfectly suitable for application after economic calamity wrought by the excesses at the peak of the business cycle.  But, they’re intended to temporarily nurse an economy back to health after the dead bodies have been carried out via writedowns & bankruptcies.  That assures a few things.  First, the yield off deficit spending is maximized, not eroded by keeping zombies on life support.  Second, deficits are temporary, ephemeral, not death spirals, and less susceptible to exogenous shocks.]

“Finally, you cannot argue that a country marred by deficit is not in a more vulnerable state than one in surplus. De facto, there will always be countries with trade deficits and others with surpluses. Some countries should run fiscal deficits too. But were a war or natural disaster to befall that nation who’s already running a deep deficit, is that nation not financially vulnerable? The best way to prepare for disaster is to always be prepared for disaster. Instead of having thousands of economists & econometric models trying to predict the business cycle and preempt geopolitics, just be prepared for all weather. Sure, run a budget deficit when the private sector needs help, but realize that monetary policy is a zero-sum game, a bridge over troubled water, and real growth requires natural resources, demographics, or innovation. MR will not attain any of those inputs, right?

“For MR to make a difference, it needs to jump a shark. It doesn’t need to become political or ideological, but it needs to make some concrete [policy] recommendations. At this point, MR is a foundation of understanding. It will need a set of prescriptions if it will ever make a difference in our world, and when an economic theory makes recommendations, how is that not ‘experimental’?”


  1. No one has ever claimed “deficits don’t matter” other than Dick Cheney, so it appears your understanding of the subject is flawed. The government’s negative balance should precisely meet the private sector’s desire to save, no more and no less.

    You also appear to believe that absolute relationship between revenues and yield payments has some sort of significance even though there is no evidence to support such a conclusion. In other words you focus on what you fear might, someday, be a problem.

    You state that . . . wild, baseless, unscientific, and biased claim[s] are being made, yet you then write that:

    . . . the US is dealing with issues from a dearth of secular innovation, sustainable growth rates & demographics . . .

    Which is itself a vague, unsubstantiated and unquantifiable claim. Just as with the following quote:

    Japan is in an extremely fragile state . . .

    Well, maybe to someone biased toward such thinking, but this is again a claim so vague and judgemental as to be useless.

    You should probably do some serious thinking sbout this, because you don’t appear to really understand it.

    • Hi Ben–
      My apologies as I was traveling since your comment. In response, I’d say that I’ve covered “US structural issues” and “Japanese fragility” throughout my blog, so I wouldn’t call my claims wild or baseless; I just choose not to reiterate my analyses and data ad nauseum.

      I know you’re not a regular reader or commenter, so please peruse the blog to find other references to US demographics, innovation & matters of sustainable growth rates. While I have a moment today, I can address Japan head on…

      The Japanese government had accumulated ¥1,037T in central government debt as of 2013q1, maintaining a 5-15% annual growth rate (in debt as a percent of GDP) since 2000. (http://www.mof.go.jp/english/jgbs/reference/gbb/201303.html) Total government debt reached 230.28% of 2011 GDP, which ratio is far higher today, after most recent quarter saw ~14% y/y growth in total government debt as % of GDP. (http://research.stlouisfed.org/fredgraph.png?g=iSS) So, growth of debt has far outpaced economic growth, as the linked charts can attest.

      That’s ok though, since interest costs have fallen remarkably. Looking at interest expenses per the 2013 budget, FY central govt debt service comes in at ¥22.24T (24% of budget or 47% of tax revenue), of which ¥9.9T is interest expense (10.7% of budget or 21% of tax revenue). (http://www.mof.go.jp/english/budget/budget/fy2013/01.pdf) Because of rising net issuance, that debt service as a % of GDP has remained steady between 20-25% throughout the decade, although we’re back at the high end now with Abenomics. (http://www.stat.go.jp/english/data/handbook/c04cont.htm) FY12 GDP was ¥475.9T (http://www.econstats.com/japcab/japcab_a9.htm) of which 2013’s interest expense would register 2.1% and total debt service 4.7%–again that’s central govt debt alone, which doesn’t include local/regional, off-balance sheet, or contingent liabilities that all come at a higher cost of capital (interest rate). To give you an idea of the difference between the two amounts, I’ll reiterate that central govt debt is ¥1,037T, and total govt debt ~¥1,168T–the latter now 245% of GDP & 12% in excess of the former. (http://www.forbes.com/sites/jamesgruber/2013/03/23/japan-is-the-real-crisis/) In addition, the math derived from the 2013 budget says that weighted avg cost of capital for central govt debt is currently 0.95%, down from 1.4% in 2010.

      Finally, Japanese demographics: the aging population skew will worsen over coming decade(s)–over 65 yr olds will swell from 25% of population to as much as 40%. (http://www.zerohedge.com/news/japans-demographic-death-rattle-3-charts-and-333-words) Combine with the giant debt ratios that Japan entered this era with, these demographics are the biggest difference between Japan & other nations–a structural hindrance I’d say.

      No, this is not a “vague, unsubstantiated and unquantifiable claim”; given this backdrop, I can quite simply refer you to Japan’s stagnant per capita income (GDP), from which you can infer their fragility amidst/associated with their demographics. (http://www.google.com/publicdata/explore?ds=d5bncppjof8f9_&met_y=ny_gdp_pcap_cd&hl=en&dl=en&idim=country:JPN:USA:KOR#!ctype=l&strail=false&bcs=d&nselm=h&met_y=ny_gdp_pcap_pp_kd&scale_y=lin&ind_y=false&rdim=region&idim=country:JPN:USA:KOR&ifdim=region&hl=en_US&dl=en&ind=false)

      With the stage now set by those data, let’s consider the possible outcomes here:
      1. If Abenomics fails and Japanese growth/inflation ends up waning…
      a- Rising interest rates are unlikely unless a slide toward default occurs, which outcome is self-explanatory, so I’ll only vet the converse case of falling rates.
      b- Falling rates would be indicative of a deflationary slide. Sub-par growth won’t allow the government to pare its debt, and the budget deficit will worsen as tax revenues decelerate (slower GDP growth). As you say, “The government’s negative balance should precisely meet the private sector’s desire to save, no more and no less.” That’s all good and fine; if a deflationary environment is onerous for the government paying its fixed rate debt, then at least the savers get a commensurate benefit. However, some of that debt is held by foreigners, so first off, there’s slippage. You may have been referring to the current account, as opposed to the govt’s budget, but remember that by simple accounting (T-G)=(S-I)+(X-M) we know the trade deficit can also increase as the counterbalance to a rising budget deficit, leaving savings (private sector balance) unchanged. So, there’s that other possibility that Japan could experience the same income stagnation as in the US currently, plus an added trade deficit. (Remember, the US had the benefit of a burgeoning domestic energy renaissance.) We also know that Abenomics has lured many savers’ savings into riskier assets than JGBs, like stocks, increasing “S” by definition of the govt absorbing more of the JGB market, as well as buying other assets (increasing financial wealth, as opposed to real wealth).

      2. If Abenomics succeeds and Japanese growth/inflation ends up rising…
      a- Pinned interest rates (deepening negative real rates) are a significant tax on the large savings demographic, which will either lower the aggregate standard of living or require the offset of social welfare expenditures as an added government expenditure, given aforementioned demographic headwinds.
      b- Rising rates of 100bps across the curve would more than double the government’s avg cost of capital for the ¥45.5T in annual new issuance with 4.5% 2013 rollover & 60% roll by 2017, not to mention ¥900B in duration risk to large & regional banks–all with increasing marginal convexity. (http://www.imf.org/external/pubs/ft/wp/2011/wp11292.pdf & http://www.economonitor.com/blog/2013/01/the-setting-sun-japans-forgotten-debt-problems/) This 100bps alone can take interest expense from 21% of tax revenue to a much higher eschelon; a rise to 2.2% rates would take it to 80% of tax revenue. (http://www.ritholtz.com/blog/2013/06/banzai-banzai-banzai/) That’s the power of the high debt ratios (245% GDP) seen in Japan: any increase in GDP will be outdone by an increase in debt service without the possibility of increasing government revenue to make up for it (raising taxes would be counterproductive given the large demographic skews). Japan could conceivably pare its deficit/debtload were it to start achieving growth, but demographics again foil the likelihood of that given their hyper-welfare state.

      Like I said, I don’t think there’s a magic debt/GDP or debtservice/income number at which a sovereign collapses under its debtload. I also agree that a sovereign currency issuer is not governed by the same properties of physics as is a household, but there exits an outer limit to that wider latitude. Yes, there is no historical precedent that tells us governments default by collapsing under the weight of 90, 100, 250% debt/GDP, but nobody’s tried this grand experiment before, especially given these persistently unfavorable demographics. Plus, THE ABSENCE OF EVIDENCE IS NOT THE EVIDENCE OF ABSENCE. The historical precedent is for defaults or hyperinflation given sever exogenous shocks, which is why a government shouldn’t regress to the point Japan has reached today–unforeseen shocks cannot be foreseen.

      Real wealth is created by the private sector, the government can just temporarily facilitate that wealth creation. When you have an economy like Japan’s–going nowhere for ~25 years and facing another couple decades of structural decline–I have to ask what the government has been (and continues to) facilitating…? Monetary & fiscal shuffling are bridges over structural economic cragginess. They are not replacements for real economic growth.

      Then there’s the ideological flaw with Abe/Kuroda’s QE. They’re buying secondary market securities with explicit inflation targets in mind. There’s no net new financial asset being injected into the system from ETF/REIT buying. In the US, the fiscal deficit was sufficient to displace private sector deleveraging, and combine with Treasury & Fed programs, a virtual supply squeeze was created in high quality assets (Treasury/MBS). This heavy activity in Japan’s secondary equity market waters down the effect, although it can pump up paper gains in asset markets.

      More importantly, I think you missed he thrust of my entry. While I can’t believe I have to explain the intuition of fiscal prudence, which is much different than fiscal hawkishness or austerity, that was exactly the point I was making in the entry above: it’s naive of Cullen to look at his MR approach and say ‘it makes so much intuitive sense, why doesn’t everyone else subscribe?!’ A lot of people have convictions in their own theories. Whether they’re held by convenience, intuition, or econometrics, all theories cannot be proven correct until they withstand the test of time & empirics. Just because a theory hasn’t been disproved doesn’t mean it’s upheld.

      *All raw data can be found in this single table: http://tinyurl.com/q4jp7rk

  2. […] of “Abenomics.” (A more quantitative macro/fundamental analysis of Japan can be found here.)  However, just to be clear, the whole Japan thesis relies on FX markets, specifically the […]

  3. […] I last reviewed Japan’s technicals/fundamentals here, and macro here. […]


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