Talking Past Each Other: MMT and Mises
In 1896, economist and marginal utility theorist Eugen von Bohm-Bawerk published what is still today considered the definitive criticism of Karl Marx's economic system. Despite the positive academic reception of his work, Karl Marx and the Close of His System, the response from Marxians can only be characterized as silence. Did they reject it as ad hominem? On the contrary, Eugen had gone out of his way to avoid direct criticism of the man, Karl Marx. Did they not understand it? Did they simply have no response to the powerful criticisms? No. In fact, as we know too well, there is always some response in heated economic debates.
It was about thirty years later, when a brilliant German socialist economist named Rudolf Hilferding burst on the scene, that we learned why the Marxians had continued to write volume after volume as if Bohm-Bawerk had never existed. Hilferding was a big picture guy, the kind that can read a passionate debate from both sides and find the root of their disagreement. And so it was that Hilferding (note 1), in his response to Bohm-Bawerk, became the first far left economist to make serious headway in debating marginal utility theorists. Hilferding identified the disconnect between the two schools of thought as one of relevance. Hilferding conceded to Bohm-Bawerk that he was correct in his formulation of value, but the key point to Hilferding was where does one begin their analysis. For a left leaning economist, value does not proceed from the individual and then out to society. Sure, Hilferding admitted, if you begin from the starting point of one man and attempt to build general theory in terms of his exchanges, the Marxian system is wrong and the marginal utility theorists are correct. However, if you start from how value exists in society and work in the opposite direction, Marx's theories, though admittedly incomplete, are more relevant (Coincidentally, Marxians ignored Hilferding as well!)
So the question left to the reader of Hilferding's work was not the correctness of each theory, but rather what is relevant to an economic analysis.
And so that is why I am temporarily pulled out of retirement. I have been drawn into a fascinating discussion with binve concerning the approach of MMT and how it differs from the framework of the Austrian School. As always, there is tension. This one, however, is different. I feel a bit of extra pressure because I am so fond of binve personally that I don't want to misrepresent his work or give him less than the full attention I can deliver.
I have been traveling a great deal recently, living up to my Fool handle, “whereaminow.” I flew from Qatar to Baltimore to Anchorage to Baltimore to Chicago to Baltimore in the past two weeks. I am really really sick of BWI airport ;) But this has provided me with a chance to blaze through the library on my iPad, which is how I came across the Marx-Bohm-Bawerk-Hilferding debate. I was immediately struck by how similar the problem was to my debate with binve. In no way should you construe that as implying that binve is a Marxian! But let me show you what I mean after I provide some brief background on the schools of thought present in this debate. I don't want to take for granted anyone's knowledge level.
Introduction to the debating schools
The Austrian School of economics is among the oldest schools in existence, but it has existed completely outside the mainstream for roughly 80 years. Its present day explosion in popularity is directly linked to their success in not only identifying the housing and dot com bubbles but their ability to explain the reasons for the booms and busts that plague our economy. The Austrian Theory of the Business Cycle (sometimes called The Austrian Theory of the Trade Cycle) is the school's most famous contribution to modern day economic debate. Austrian School economists believe that economic science is a deductive exercise that starts from the premise that all human economic activity is purposeful action and proceed from there in order to discover general laws or truths about economics. The school does not rely on empiricism or mainstream positivist approaches in order to reach its conclusions. Austrians support sound money, i.e. money that derives its value from voluntary exchange (notably, gold and silver).
Modern Monetary Theory has also seen a surge in popularity in recent years. Like the Austrian School, MMT has benefited from the total failure of orthodox mainstream economists to predict or adequately explain the volatile swings in the global economy over the past decade and a half. MMT starts from an empirical framework, taking as given that our monetary system is fiat and unbacked paper, for better or worse. They see their significant contribution in developing an understanding of how a fiat unbacked paper money system operates, for example they argue that the Treasury's bond sales are unnecessary and a relic of the gold standard. MMT tends to promote economic stability by advocating policies that smooth out the business cycle. They also advocate stable money, i.e. that the value of money in terms of the price level should remain stable.
In many arguments, MMT and the Austrian School find themselves on the same side. Both usually argue that monetary policy is useless in directing economic activity. Both argued against QE, though for slightly different reasons. (Note 2) But on very significant issues with long range implications for all economic participants, they diverge, such as on the questions of business cycles, deficit spending, and inflation.
I see your 10,000 words and raise you 10,000
I want you to refer back to this post (http://caps.fool.com/Blogs/why-deficit-spending-and/621467) in which binve attempts to set the record straight on the many misconceptions surrounding Modern Monetary Theory. I get a kick out of binve's work. He is so driven to understand the economic theories he encounters that he really gets carried away with his enthusiasm. When I copied that blog into a Open Office document for further review it was 18 pages at 12 point font! When it comes to being long winded, I think I have met my match =D
But binve's work is important because he lays out, albeit in general strokes, the entire framework from which MMT views economic activity. The business cycle is taken as a given and follows the Schumpeter-ian analysis that capitalism's destructive nature (i.e. cut-throat competition) leads it to chronic booms and busts that are inevitable and necessary. From this point of view, if anything can be done to smooth out these fluctuations, particularly if you have the tools of proper macroeconomic accounting, it seems stubborn, foolish, and dangerous to propose anything else (e.g. austerity or balanced budgets).
So let's dive right into an example of how two schools can talk past each other. I cannot quote binve in length, or we'd end up at 36 pages =D, but this passage will help you get the concept of why we diverge:
1. A bank makes a loan (creates money out of thin air) to any credit worthy customer.
2. However, the bank cannot simply give the money away, it must record that transaction as a liability on its own balance sheet.
3. Which means that the bank did not increase the *net* amount of money in the financial system.
4. It created an asset (money out of thin air) but also created a liability of equal magnitude (that loan/money must be paid back).
5. The fact that this transaction did not generate any *net* financial assets is why it is called a 'horizontal' transaction.
For MMT the relevant sentences are #2-4. For the Austrian School, the relevant sentence is #1. Let's walk through it.
According to the Austrian School, the business cycle is not an inherent feature of the free market. The business cycle boom is created by the expansion of bank notes from a fractional reserve banking system (usually with a central bank acting as the engine of this expansion, though government intervention such as suspension of specie redemption can create the same effect). So what is important is that money is created out of thin air (the credit worthiness of the customer is less important in this analysis.) This new money increases the supply of available funds, thus lowering the interest rate – or the price of money – below what it would be without this injection of new money. (What that exact rate, sometimes called the natural rate, should be at any given instance is impossible to know a priori as that information is based on the subjective value scales of market participants and can only be revealed through action.)
Double entry bookkeeping has been around since the 13th century, at least. It was a major breakthrough in financial record keeping as it provided an easy way for the accountant to discover his mistakes. Just mark each asset with a corresponding liability and the two sides of the ledger should always add up. For 800 years, humans paid little attention to this novelty other than to note its convenience.
And here is where we start to talk past each other. From my perspective, I fail to see what it matters that Banker Bill marked this new money as a liability on his ledger sheet. Of course he did. He's been doing that for 800 years, under gold standards, paper standards, silver standards, etc. That's how he keeps track of his assets. But to say that this is important, well I have to differ. From an economic standpoint the important matter is how his action of creating new money distorts economic activity.
I agree that at some point the banker will be paid off. In fact, if that were the end of the story MMT would be correct in stating that there is nothing to see in sentence #1 and that it is sentences #2-4 that matter. But that's not where this story ends.
Let's take the scenario that Banker Bill at Bank A loans $10,000 to Joe Blow. Joe Blow borrowed that money for a reason, let's say to build a new garage for his small repair shop. He gives the $10,000 to the garage maker, who then deposits that check into his bank, Bank B. Bank B is now going to redeem the $10,000 from Bank A. Bank B can now pyramid off these new reserves, creating even more new money, assuming Bank A can actually cover the $10,000 it loaned out. (Note 3) And here is where the party starts for an Austrian. In a fiat unbacked paper banking system cartelized under a Federal Reserve, this continuous bank note expansion goes on for so long that it creates a boom. Interest rates are driven far too low, stimulating investment that would be seen as unprofitable in a higher rate environment (particularly for goods further away from consumption, such as housing or titles to capital goods i.e the stock market).
Now it is true that at no time during this boom has there been any new net financial assets created by the bank. But of course, there never would be anyway! Banks don't ever create new net financial assets in this way, even during the biggest bubbles in world history. So I fail to see why this matters at all in any economic discussion It is the nature of double entry bookkeeping that banks will mark a corresponding liability on the opposite side of the page. Big deal. (See us talk past each other?!)
So when MMT tells me that a reduction in government spending will cause a reduction in net financial assets, I simply shrug. Who cares? Net financial assets are the banker's bookkeeping entries. They have no relevance to a nation's true wealth or an economy's true health.
A bust is inevitable anytime that the expansion of bank notes creates a boom. But before we get to the bust, we need to talk about inflation.
Preaching Stable Inflation
Here again, MMT and the Austrian School talk past each other. Rather than quoting MMT economists at length, we can separate the two schools fairly easily. MMT believes in stable money. The Austrian School believes in sound money. As such, what they believe to be inflation is vastly different.
Stabilization theory came into popularity in the 1920s. Irving Fisher is probably the most famous stabilizer. Basically, the goal here is simple: the general price level should remain stable and it is reasoned that this will smooth out fluctuations in the economy and promote general stability. How you get from point A to point B through logical deduction is a bit less clear. (note 4) As long as the price level is considered stable, they argue, the environment is not inflationary. But there is a serious flaw in stabilization theory. Prices in a free market should generally be falling. The great thing about the market is that as prices fall, the benefits of increased production are spread out among an ever increasing amount of the population. So the poor can actually benefit and see their standard of living rise but only if you allow prices to fall. Second, if you are purposefully keeping prices stable, you must be creating new money (although, the banks are certainly going to mark the corresponding liabilities, lol). This was the case during the inflationary boom of 1921-1929. The reason Fisher and Keynes didn't see the Great Crash of 1929 coming is that they were staring at the price level, which was relatively stable and so they thought “well, nothing wrong here. We have a stable healthy economy!” Austrians such as Von Mises and Hayek saw that the total money supply was growing at unprecedented rate and thus interest rates were lower than they should have been. To an Austrian School economist, this is inflation.
We see the same disconnect today. Binve points out that the price level is relatively stable. But that means that the money supply must be continuously increased! That is inflation! Yet to binve it is not, since prices aren't rising and new net financial assets are not created thanks to an 800 year old bookkeeping practice. (Let's set aside the fact that prices are rising which means that the inflationary picture is even worse than during a stable money environment.)
That leads us to the bust, which only the Austrians see as inevitable once you have purposefully expanded the supply of bank notes. Prices do not rise in uniform through an economy. In fact, if they did, there would be no point to increasing the money supply in the first place, since no one would benefit and no one would suffer. During an inflationary boom it is the rise in prices in the complimentary factors of production that eventually undo the boom. As entrepreneurs compete for scarce resources, prices rise. At this point, just the slightest movement in interest rates upward can cause a wave of bankruptcies and a massive contraction of the supply of money (note 5). Prices fall and the economy slumps into depression.
At this point, would it help to create new money and start the cycle all over again? Of course not, yet that is exactly what MMT advocates.
The economy needs to be allowed to readjust, to find a sustainable level of growth, not to suffer the constant gyrations of funny money booms and busts.
In that sense, MMT is correct to say the business cycle is natural to capitalism under an unbacked paper money standard. General booms and busts are most definitely NOT part of a free market capitalist system, however. General booms and busts require government intervention, either suspension of specie redemption (prominent throughout Europe in the early days of loan banking) or cartelization under a central bank (usually couple with suspension of payment anyway.)
So from here I leave it to the reader to decide what is relevant. Does it matter that national accounting identities (aggregate bookkeeping entries) match up nicely or does it matter that a non-market institution (the Federal Reserve) is allowed to influence interest rates to create the booms and busts that plague the post sound money economy? Does it matter that money is stable or sound? Does it matter that we counter the business cycle or that we end it? Does it matter that the price level is stable or that new money is being created?
Although this is certainly not the last time we speak past each other, hopefully the readers can see why we do, and how it is up to them to decide what is truly important. After all, it is their economy that we are arguing over.
David in Qatar
1: Hilferding like Bohm-Bawerk's student Ludwig Von Mises, was at the top of the Nazi hit list. Sadly, Hilferding did not see the danger coming, once remarking to a friend that “Hitlers come and go”. In 1941, at last recognizing the peril, he tried to escape, was caught, and was never heard from again.
2: MMT argued that QE caused distortions in the market by increasing inflationary expectations but did not actually cause inflation. The Austrian School argued that QE was both inflationary and damaging to economic calculation. Again, who is right depends on what you conclude is relevant much like our discussion of net financial assets versus inflation.
3. Outside of an unfortunate chapter of Scottish banking history, Murray Rothbard's Mystery of Banking is an excellent overview of how banks operate both under the conditions of free banking and under the cartelization caused by government intervention and a central bank.
4. See Rothbard's America's Great Depression for both a complete discussion of various business cycle theories as well as a look at the different stabilization theories in vogue in mainstream economics. The book is a must read for any serious economic enthusiast.
5. At the end of the 1921-1929 boom, a jittery Federal Reserve took rather drastic steps to force rates up and curtail the boom leading to history's most famous stock market crash. Again, see Rothbard's AGD.