MMT and CBI – a thought experiment

According to Modern Monetary Theory (MMT), the fiscal budget isn’t constrained as fiscal expenditures create money while tax collection is destroying it. The argument behind is that these budget operations are practically carried out by the central bank. Hence, all public expenditures can be “financed” (although MMT would reject this word) by taxes, issuing bonds or directly by the central bank. There is no constraint by taxes and limitations of the bonds market as the central bank directly transfers the salary of the civil servant without waiting for tax income. In an “ideal” MMT world, there is no central bank independence (CBI) but the central bank more or less accomodates the needs of the fiscal authority. I don’t want to comment here on the fundamental objections against this view and its radical policy implications. Most “mainstream” authors would claim that there would be no clear policy assignment, time inconsistency and credibility problems of monetary policy, the danger of fiscal dominance and undiscciplined deficit policies due to moral hazard. They would expect a strong inflation bias as well as problems with sustainable public debt because of political incentives to inflate the budget. And they would argue that a couple of economic problems arise from supply-side and cannot be tackled by demand management. All that are very good arguments. MMT proponents would counter by denying the underlying Phillips Curve goal conflict, and also saying that sustainability of public debt isn’t a problem because the fiscal authority cannot default by construction. As I said, I do not want to comment on this debate here.

Now relax and try to see the debate as an amused outside observer. Instead of seeing two incommensurable paradigms clashing, there might be some pragmatic policy paths between these views. Regarding the practical accounting records when the government spends money which has not been “pre-financed” by tax collection, indeed money is created. Insofar, MMT is practically right. But claiming that having an unlimited right to do so because an “ideal” central bank accommodates what a “sovereign” state wants to do, doesn’t follow from accounting records. So let us consider that in fact we have goal conflicts and thus a policy assignment, and that CBI holds true. And let us consider that the fiscal authority is constrained as there is no unlimited possibility to create money. Inflation targeting central banks are using the interest rate as their operating tool like in standard macro models, and they are accomodating the commercial bank’s demand for reserves such that the target interest rate is achieved. But this doesn’t imply anything about how the reserves in the market are produced, either by buying bonds from commercial banks, or granting central bank loans to them. Or instead, and this would be the new one, by the fiscal operations as described by MMT. This can be seen as a shortcut for issuing a zero coupon bond (eventually without maturity) which is bought directly from the central bank on the primary market. Hence, deposits and reserves are created. As long as the central bank is doing that independently (not forced), within their mandate and within their self-determined policy strategy, it relaxes the fiscal constraints and makes the government less dependent on the capital market. Insofar the prohibition that e.g. the ECB must not buy sovereign bonds on the primary market and must not directly finance the budget could be seen as an unnecessary restriction of their instruments – even from a mainstream point of view. In a certain sense it also diminishes CBI as the central bank is not as free in the choice of instruments as it could be within their mandate.

What would happen if the new instrument, creating reserves by fiscal operations, is available? As the central bank autonomously decides about its use, there is no fiscal dominance, and CBI is still in place. We still have no automatic bailout, and no automatic accomodation of fiscal demand. However, in times of ZLB it wouldn’t be necessary to buy out secondary sovereign bonds markets, thus creating a lot of reserves, keeping down interest rates, and hoping that all this would stimulate bank loans and thus debt financed private demand. Instead, it would directly stimulate public demand. Hence, the transmission link to the real sector and thus to the targeted inflation rate is shorter than via the financial sector. But in the current arrangement, the fear of undermining CBI led to an institutional design that this powerful monetary tool is not available. Isn’t it possible to consider such an instrument even if rejecting the MMT view as a macroeconomic paradigm? To forestall one objection: each softening of a budget constraint will lead to a moral hazard incentive to politically inflate the budget. OK. This means that the inability to design proper rules for fiscal policies should be compensated by restricting the abilities of monetary policy, even if this makes win-win situations (e.g. in case of ZLB or the current Corona flu) impossible? Seriously?

A thought experiment: consider a monetaristic Friedman world with a strict k-rule. The central bank has control only over the money base, they do not follow an interest rate rule. Consider that they let the money base grow with a constant yearly rate k by directly financing the fiscal budget, means: buying zero coupon public debt on the primary market. This would be a combination of ultra left-winged MMT policy with ultra-conservative monetary policy advice. So what? I do not want to recommend such a policy. The thought experiment should just remind us not to think in terms of schools or paradigms. Forget their labels. Relax, take economics as an intellectual playground where you can experiment with ideas. Rigor comes later when you take the ideas to math and data.