Thursday, June 30, 2022

Levy Economics Institute MMT Seminar Post-Mortem (Part II)

Last week, I wrote part I of a post-mortem from a fantastic MMT seminar at the Levy Institute earlier this month. There is a TON of material to cover, so I am sharing what I consider to be the most important takeaways. Last week I wrote about the Fed; below are notes on inflation. Without further ado:


Inflation has been all over the news for the past 6-9 months, and the public's discourse around it has intensified. Inflation is an incredibly emotional/moral/political topic, which I suspect is because it effectively serves as a tax on rich and powerful people. As we have written about in the past, modest inflation and low rates helps low-income people who are net debtors: they generally experience higher incomes while their debt obligations remain fixed. Rising rates and unemployment are devastating for this cohort, which is why it is so shameful that people in positions of power and privilege are demanding the Fed to hasten its rate hikes in order to put people out of work. It's astonishingly cruel and out of touch with the American people to be spewing this rhetoric. I will never understand how intentionally putting people out of work can possibly give us a collective better quality of life in real terms. But that is a discussion for another day.

Anyway, the most important fundamental takeaway from our roundtable on inflation came from Randy Wray, who put it concisely, "money is a stock; spending is a flow." This is critically important. Most of us think of inflation as a general rise in prices due to an increase in the supply of money (i.e. all things being equal, increasing the supply of money makes it less valuable and depreciates its purchasing power). However, Wray's point is an important distinction. Prices going up (or down) reflect transactions. Transactions reflect spending, where money flows from one party to another. We use transacted prices (and some imputed ones, based on surveys) in order to come up with a reasonable guess of the rate of inflation (e.g. CPI, PCE). So using concepts like the "money supply" (as most mainstream economists and analysts do) is nonsensical for the purposes of predicting and analyzing inflation. The water in a bathtub does not magically become "faster" when one has increased its supply; however once the drain pipe is pulled, the increased mass would cause the flow rate of the water moving through the drain pipe faster. Gravity forces the water through the drain pipe, and the additional force from the added water mass causes it to move through the pipe faster. Arguing that increasing the stock of money causes inflation is like arguing that increasing the quantity of water in a tub makes it faster. It's a ridiculous assertion, because if the drain hasn't been pulled, then the velocity of that water is still zero, just as it was before!

Two additional points on the money supply myth. First, the panel confirmed my proposal that, to the extent there may be periods when both inflation and increases in the money supply are high (which is questionable at best), analysts and economists have the cause and effect backwards: increasing the supply of money doesn't by itself make prices go up, but an increase in the real costs of goods and services may be the cause, rather than the effect, of new money creation. The example I used is if a retailer normally buys a product from a wholesaler with a four-week lead time, and supply chain disruptions suddenly causes that same product to have a four-month lead time, then the retailer can't realize a sale of the product until it is actually delivered, and will need additional credit to make up for the shortfall in cash flows it would normally generate. The real shortage of that product, combined with the additional money/credit required to finance it may be reflected in a higher price.

This example provides a bridge to the second point, which is that the demand for money is equal to the supply. Because modern money is simultaneously one party's asset and another's liability, the demand for money must equal supply. There must be a party willing to have a money deficit in order for another to have a money surplus. This is why the "increased money supply causes inflation" trope is so ridiculous. Increasing the money supply requires a party to simultaneously be in deficit, so the aggregate change in financial assets and liabilities is zero! What matters is how that money is spent. Looking at things like M2 as a measure of the money supply is misleading, because it assumes money exists on its own. The Fed defines M2 as:

 "A measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds."

It ignores the fact that currency and coins held by the non-bank public, checkable deposits, travelers' checks, savings deposits, small time deposits, and shares in retail MMMFs are assets for their owners but liabilities for their issuers! It's this dual-entry accounting, "two sides of the same coin" reality that most people fail to understand. Increasing one person's supply of money requires an increase in someone else's deficit. So unless the government, as the monopoly supplier of money, is willing to run a deficit, then the only way for a person to have a surplus of money is for someone else to be willing to take on debt. Therefore, treating money as if it were a fixed, scarce commodity that follows simple supply/demand curves is incorrect. Money supply is equal to demand.

Some may argue that the American Rescue Plan may not have caused inflation but it increased the "potential" for inflation. Going back to our bathtub water analogy, the money printing is akin to doubling the supply of water, causing an increase in potential energy that, once the drain was pulled, created conditions for higher kinetic energy output. The problem with this argument is that the US federal government already has an unlimited amount of money it can create. Thus, there is already infinite "potential" monetary energy in our modern money system. Actually converting that potential energy into kinetic energy requires a political process. If the votes are there, the checks will clear. If the new money is used productively, we all experience a raise in living standard. If not, we don't.

Turning to MMT's view of inflation: MMT makes a distinction between true inflation (i.e. fiscal spending beyond real capacity) and bottleneck or supply-side inflation. The current bout of inflation is very clearly the latter. There is ample evidence that we are nowhere near our full productive capacity, the current inflation is supply/bottleneck-driven, and that it's real resources that matter. As Keynes wrote in How to Pay for the War, by thinking about real resources, the government can increase its spending by a large degree without causing excessive inflation. See selected slides below:

Source: Y. Nersisyan (Levy Economics Institute)

The last slide is illustrative here: between 1942 and 1944, federal government spending as a % of GDP went from 30% to 45%, while the rate of inflation collapsed from 11% to 2%. By executing a successful "war bonds" program, the US government was able to convince consumers to tighten their belts and hold off on spending until after the war. If it hadn't, and consumers kept regular spending patterns on goods, inflation would have exploded, because the supply of consumer goods was limited thanks to the government requiring producers to shift from goods to supporting the war. Indeed, I visited the Sagamore Rye distillery in Baltimore, MD a few years ago and they explained how rye distilleries were common in the area pre-WWII, but they were all forced by the government to switch to producing ethanol to help fuel aircrafts for the war. By encouraging thrift, the US government was able to free up real resources  that helped it win the war, and the savings that Americans had accumulated were spent after the war was over, leading to an economic boom. This was a far better outcome than prior instances, such as post-WWI, when an inflationary war period was followed by a huge bust as people's savings were depleted.

To further drive the point home that increased money supply does not cause inflation, consider the following, which compares the year-on-year change in M2 (blue) with the year-on-year change in CPI (red):

The change in M2 appears to be inversely correlated with the change in inflation, which runs completely contrary to the neoliberal/monetarist view. Even Fed Chair Powell admitted recently that an increase in M2 has little correlation with inflation.

Looking at the latest CPI data, it becomes overwhelmingly clear that the cause of the recent inflation is predominantly supply-driven. Most of the inflation is directly related to higher energy prices, which feed directly into food prices:

Source: M. Nikiforos, Levy Economics Institute

Energy prices are high for a variety of reasons, including declining production in the US, which is still below pre-COVID levels:

And two substantial oil refineries have been closed since December 2020:

Which has led to crack spreads (i.e. what oil refineries charge for refined product vs. the price of crude) at all-time highs:

Meanwhile, the Saudis (who are a quasi-monopolist as they are the swing producer for oil) continue to raise their prices.

The other big items are shelter and things related to transportation: new and used vehicles as well as transportation services, which have been supply-constrained thanks to a chip shortage.

Importantly, the inflation is NOT driven by higher wages, as real wages have on average declined year-on-year, so the idea of a wage-price spiral is taking place is total nonsense:

Source: M. Nikiforos, Levy Economics Institute

Meanwhile, the 10-year breakeven rate for inflation is around 2.3%, and trending lower:

Finally, Randy Wray recommended an inflation measure I had not heard of before: the Trimmed Mean PCE Inflation Rate, published by the Dallas Fed. The definition of this measure is as follows:

The Trimmed Mean PCE inflation rate produced by the Federal Reserve Bank of Dallas is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). The data series is calculated by the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are thrown out or trimmed. The inflation rate is then calculated as a weighted average of the remaining components. The trimmed mean inflation rate is a proxy for true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.

The result is a smoothed measure of inflation that is arguably a better measure of the change in the "general price level." The latest reading for this measure is roughly 3.5% - high for recent history, but by no means extraordinary relative to the 1970s and 1980s:

As we can see, too, this is arguably a more useful measure than PCE and CPI, which are much more volatile:

Bottom line: this is a supply/bottleneck driven inflation that will prove to be a temporary setback. Unfortunately, the Federal Reserve is buckling under the political pressure to "do something" about inflation, and is hiking rates as the economy slows down. This is likely to exacerbate the slowdown and cause a recession, and unless Congress passes a new spending package, we are risk of a financial crisis. More on that in Part III.

UPDATE 7/5/22

I wanted to include this on the original post but couldn't find a source for it. Federal Reserve Chairman Jerome Powell spoke recently at the European Central Forum and said the following:

"I think we now understand better how little we understand about inflation"

This is an absolutely remarkable admission. The Fed employs over 400 Ph.D. economists, and yet here is the person in charge acknowledging that they don't even understand one of the most important topics in economics! The problem here is that these Ph.D. economists have all been taught a fraudulent form of economics, known in the MMT community as "neoclassical," "neoliberal," or "market fundamentalism" which became the standard in US universities in the 1970s thanks in large part to the influential University of Chicago economics department. They use Dynamic Stochastic General Equilibrium (DSGE) econometric modelling to make forecasts that ostensibly have a terrible track record. As one young Ph.D. economist explained to me during the week at Levy, and I am paraphrasing here, but basically these models "work very well 95% of the time...but the 5% of the time they don't work, they blow up spectacularly." I don't think it is a stretch to say that sounds like a terrible framework to use for an institution that is supposedly in charge of overseeing the economy.

A recent paper released by Jeremy Rudd of the Richmond Fed found the following (emphasis added):

"Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors."

This highlights how broken the economics institutions in this country are. The Neoclassicals are the gatekeepers to power, prestige, and influence in the economics field, and some insiders are starting to realize their profession is profoundly uncritical and lacking in analytical or empirical rigor. Debunking their ridiculous myths, and offering better, more coherent, more accurate economic models and frameworks is critical for the future prosperity of the people in this great nation. Jay Powell is admitting the quiet part out loud, acknowledging that they don't know what they're doing. This is an opportunity for the MMT community to step up and right the ship!

Thursday, June 23, 2022

Levy Economics Institute MMT Seminar Post-Mortem (Part I)

Last week, I travelled up to Annandale-on-Hudson, NY to visit the Mecca of MMT: the Levy Economics Institute at Bard College. Indeed, the term Modern Monetary Theory was coined there when Warren Mosler first visited Randy Wray and crew in 1997.

The program ran Saturday-to-Saturday, each day with lectures beginning at 9am and ending at 6pm (we had one afternoon off to visit FDR’s home). One attendant calculated we had 41 lectures from 32 speakers. Needless to say, it was one of the most intense, and enjoyable, academic experiences of my life. I kept describing it as a “firehose” of information to the other attendees and they seemed to agree.

The official agenda was “Minsky, Godley, and Modern Money Theory” but the topics covered a broad range, including the history of money (with a focus on US colonies), the Job Guarantee, FinTech, strategies for developing nations, and current outlook/projections for the next few years. In preview, things are not looking particularly rosy for the US economy. Needless to say, there is a LOT to cover, and I won’t be able to fit it all in one post. Plus, I want to keep this relevant for financial markets. Without further ado, let’s dive in:

The Fed

A core tenet of MMT is that the Fed sets the price for money; it doesn’t affect the actual supply. Money is created and destroyed by commercial banks and/or the federal government. The Fed sits between the two, acting as an agent of the federal government and ensuring payments clear. It also conducts monetary policy (i.e. setting interest rates) through its open market operations. But it does NOT affect the aggregate stock of money in the economy. It can impact the composition of bank balance sheets by adding or removing reserves, but doing so necessarily involves swapping those reserves with US Treasury securities. As we have argued in the past, Treasuries are not loans made to the US federal government. Rather, they function as a “reserve drain” for banks. Banks tend to play “hot potato” with reserves because they offer meager yields and occupy space on their balance sheets, so they are incentivized to hold as few as possible. They purchase US Treasury securities with excess reserves in order to maximize their profitability. As an aside - I recently asked Warren Mosler on Twitter whether the Fed’s RRP (which has attracted much attention in the press and recently surpassed $2T) whether that program was functionally the same as US Treasuries, in that they served as a reserve drain, which he agreed.

Another important point about the Fed is that it’s power is limited. It can raise or lower interest rates, but these are blunt, ineffective tools for achieving its goals, which include maximum employment and price stability. There is a perception that the Fed is in the “driver’s seat” for the US economy, but we have seen repeatedly over the decades since WWII that that is a farce.

For example, consider the Global Financial Crisis of 2007-2008. A few days after the failure of Lehman Brothers (September 15, 2008), Fed Chair Ben Bernanke realized that credit markets were freezing up, meaning banks were at risk of failing. Capitalism and the entire economy was at risk of disappearing. Recognizing the gravity of the situation, he urged US Treasury Secretary Hank Paulson to lobby Congress to pass a $700 billion spending bill so the Fed could purchase toxic mortgage assets. Think about that for a moment - the Fed needed money. It needed Congress to pass a bill because only Congress has the legal authority to create new money. After the Emergency Economic Stabilization Act of 2008 failed to pass, financial markets were in full meltdown mode, with the DJIA recording its largest ever daily point decline.  The panic forced Congress’ hand and they eventually passed the bill. While financial markets continued to sell off, the country momentarily avoided a complete extinguishment of the financial system. It’s worth noting that Warren Buffett’s famous “Buy American” Op-Ed came after Congress approved this bill. Clearly, he understands that it’s Congress, NOT the Fed, who has the power of the purse in the US. In February 2009, President Obama signed the American Recovery and Reinvestment act, which authorized nearly $800 billion economic stimulus package. The stock market would eventually bottom out a few weeks later in March before an incredible 12-year bull run.

This episode is illustrative, because the Fed clearly lacked the power and/or legal authority to authorize new money creation to save the financial system from a complete meltdown. Only Congress has that power. And it also shows the impact that spending from the US federal government has on financial markets. People on Wall St love to talk about how the Fed “injects liquidity,” but the reality is that Congress is the only entity that can actually add new dollars into the economy. And financial flows into and out of the US Treasury impacts financial markets - when the Treasury spends, it adds to the net financial assets of the economy, and likewise removes them when it collects taxes. This dynamic played out again in the COVID crisis of 2020 - financial markets bottomed out following Congress’ passing of the CARES Act in March 2020, and financial markets continued to roar all through the end of 2021. Many of the programs passed in that period were not renewed in 2022, and the progressive nature of our tax policies has meant that spending by the US federal government has dropped by over $1T year-on-year so far in 2022, financial markets have been in a tailspin all year. The takeaway for investors is that fiscal flows can at times be used for opportunistic buying (and selling) of financial assets.

That’s not to say that Fed policy is completely irrelevant. Raising and lowering interest rates do have impacts on financial markets and the economy; raising rates makes it more expensive for people who need to borrow money to subsist, raises the cost of capital for companies to expand production, and stimulates demand through the income channel. It is also argued by some MMTers that it raises the general price level, as it raises the term structure of the rates curve. I am also of the belief that raising rates when margin levels in the stock market is high forces leveraged traders (i.e. HFs) to de-gross their portfolios. And it makes it more expensive to take out a mortgage or an auto loan. It is a blunt tool that is intended to slow credit growth and therefore demand, although they ignore the impact that slowing growth has on the supply-side of the economy. One thing that was pointed out last week was Keynes’ idea that money demand = money supply; money is created when it gets voted into existence by Congress or when a bank makes a new loan, so there has to be both supply and demand for the “creditworthiness” of what that money is going to be used for.

One final point on this topic is that the Fed is supposed to be counter-cyclical, i.e. raising rates when the economy heats up and lowering them to stimulate when things slow. However, history has shown that for whatever reason, be it flawed economic models or institutional/political structure, they have proven to be pro-cyclical: lowering rates when the economy heats up and raising them into a slowdown. The Fed recently announced a surprise 75bp rate hike, and Chairman Powell anticipates more in the near future. If history is any guide, that is a bad sign for the US economy (more on that later).

To be continued...

Tuesday, June 7, 2022

Stop Blaming the Fed and QE for the Current Economic Inequality Problem

The narrative that the Fed, by virtue of lowering interest rates, has been a significant cause of today’s wealth inequality is pervasive, particularly on Wall St. I don’t know why but people love to find a bogeyman to blame all the problems in the world on; call it intellectual laziness. Despite being supposedly intelligent, thoughtful people, many in finance are guilty of this.

Wall St equated QE with “money printing” and believed it would result in high inflation. That inflation never materialized. I distinctly remember being an intern at Tudor Investment Corp, a renowned macro hedge fund, and a PM there was explaining to me that the Fed was purchasing bonds from banks, injecting dollars into the banks, and those dollars were bound to leak out into the economy and cause inflation. After over a decade of historically low inflation rates, this turned out to be spectacularly wrong. But this was consensus on Wall St at the time; people got paid millions of dollars for this “analysis.”

The consensus on Wall St has now shifted. People will say that they misinterpreted what was happening, and that the inflation showed up in asset prices rather than consumer prices. They weren’t “wrong,” just misjudged where the money would flow to i.e. the capitalist class. This has created and exacerbated wealth inequality and is therefore a moral catastrophe.

Here’s the problem with that analysis: it completely ignores the role that Congress and the Courts play in influencing economic outcomes. Take for example a Boomer refinancing their home(s). Doing so essentially enables them to monetize their home equity tax-free. The equity in a home grows over time as 1) the principal for the mortgage is paid off and 2) the inherent scarcity of land combined with strict zoning laws leads to home price appreciation. Said differently, the loan-to-value (LTV) goes down as the mortgage is paid off or the house appreciates in value. By refinancing, the owner is able to monetize the equity in their home: it gets re-appraised at a higher value. The inflated equity means that the bank won’t need to charge as much interest. Not only that, but if the Fed is holding rates down, then the owner has a real home run: their income is unchanged but now they get cheaper cost of financing. Essentially, they get to keep more of their gross income. And the best part is this is considered by law to be a non-taxable event! That is the real key: they leverage their home equity to reduce their monthly mortgage payment without paying taxes. This is essentially tax-free income for property owners. The same logic works with Private Equity/LBOs; the equity in the company grows as they pay down debt, and they can refinance, lowering their interest cost, without paying taxes.

The key in refi’s is the fact that they are a non-taxable event. If they were treated like a sale, then there would be a capital gains tax charged on the owner; perhaps this cost would be amortized and included in the new mortgage service cost.  This would negate much of the advantage of doing a refi, and wouldn’t be such a sweet deal for the owners. Thus, it is the laws on the books (as written by Congress and interpreted by the Courts) that create these economic outcomes. The Fed’s lowering of rates wouldn’t matter nearly as much if people either a) weren’t allowed to refinance (i.e. it’s banned outright) or b) had to pay taxes on such a transaction. The argument that the Fed’s policies “supported asset prices” and therefore “exacerbated inequality” isn’t correct. It’s the tax-free income to property owners while the federal government gutted other programs that supported lower income households that caused it, among other factors.

What’s important to emphasize too is that this benefit only accrues to the incumbents/property owners/capitalist class, who borrowed at a higher rate and can now refinance to a lower one. It does not stimulate new investment. The government sets the price for money, and all other prices in the economy adjust relative to that price. For someone who wants to launch a new business, it doesn’t help if interest rates are “low” by historical standards; for them, the cost of money is what it is. Generally speaking, it’s not the absolute level, but rather the change, in interest rates that influences economic decisions. If someone launches a business and they want to make a certain margin, they’ll look at their total cost structure - including interest cost on debt - to determine how much they should charge. This is part of the reason MMT argues that raising rates is a lousy antidote for inflation, because raising the cost of debt means borrowers need to raise prices in order to maintain their margins. This is part of the reason why new business starts hit a 40-year low pre-COVID; it wasn’t until people received stimulus checks that the economy saw a burst in launching new businesses. 

I’m not necessarily advocating for the Congress to pass laws to change with regards to refi’s. I believe the ability to refinance makes our economy more flexible and resilient. But it is important to recognize the source of problems if we want to solve them. The Fed’s monetary policies mean nothing without laws that enable property owners to utilize lower rates to create tax-free income for themselves. Combatting inequality requires fiscal support from the federal government, not monetary “support” from the Fed.

Wednesday, June 1, 2022

No, Biden’s American Rescue Plan Did Not Cause Inflation

US President Joe Biden deserves blame for many things that have not gone well. For example, we’ve written extensively about how his administration is determined to lower the budget deficit, which is causing financial stress across the country and, arguably, the world. His administration has so far failed to unite the country, and vaccine rates have been stubbornly low compared to other developed nations. He should have made at-home testing kits available for Americans sooner.

That all being said, Biden and his administration is getting far too much blame for the high rates of inflation we’ve experienced of late. This Twitter thread from Mark Zandi, Chief Economist at Moody’s, sums it up best. He writes:

What’s more to blame for the painfully high inflation, strong demand and thus government policies like the American Rescue Plan or scrambled global supply chains and labor markets and thus the pandemic?  It’s supply and the pandemic.

To be sure, demand was behind the resurgent inflation this time last year as the vaccines allowed the economy to quickly reopen and the ARP [American Rescue Plan] shored up pandemic-stricken households and small businesses. But that was more a feature than bug, as inflation had long been too low.

The problematic inflation surge happened later when the Delta wave of the pandemic hit. Delta was a huge surprise and did big damage, particularly to Asia where most supply chains begin. It also made lots of people sick and unable or fearful to work. Thus, the labor shortages.

Note that inflation is up a lot across the globe. Some places more than others, like here at home, but this is mostly due to differences in how inflation is measured. Hard to blame U.S. fiscal policy for the higher inflation in Europe, Latin America or Asia. Blame the pandemic.

Mainstream neoliberal economists like Larry Summers have been doing victory laps over their supposed prescient inflation calls, having argued the ARP was too big. This narrative is consistent with what Wall St, and probably most Americans, believe as well. In fact, Summers’ more nuanced views seem reasonable compared to most people on Wall St. But they’re all wrong. The EU and UK did not do anything close to the “money printing” the US did, and they are experienced record high price increases. Inflation is high because real costs have gone up. “Money printing” is a result of real cost increases, not a cause, as we’ve written about before.

There is also growing evidence that lax antitrust enforcement has led to increased market share concentration across industries, which gives dominant corporations better pricing power and has contributed to inflation. Corporate profit margins are near all-time highs, which is atypical for inflationary periods. The Boston Fed recently published a paper that acknowledges this problem.

These narratives are frustrating, because they are so intellectually intoxicating and spread so easily. It is generally accepted to be true that QE was the reason that asset prices in the US have gone relentlessly up since the GFC, despite the fact that other areas like the EU and Japan carried out more extreme programs and didn’t experience the same magnitude of asset price appreciation. This is first-level, lazy analysis that is pervasive on Wall St. And people get paid outrageous amounts of money to peddle these lies. It’s ridiculous. We can, and must, do better.

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...