Posted by: Dirk | August 31, 2015

Zhi: A Critique of Modern Money Theory and the Disequilibrium Dynamics of Banking and Government Finance

Such is the title of Tianhao Zhi’s recent paper. Zhi sums up MMT like this:

core mmt

A quick read seems to show that Zhi is mostly fair to MMT. There are the usual claims about MMT as a theory would ignore the inflationary effects of government spending, but the claim is repeated once again without a source. Wray (2012) in his MMT Primer writes on page 194: “Lerner realized that this does not mean that government should spend as if “sky is the limit” – runaway spending would be inflationary (and, as discussed earlier, it does not presume that government spending won’t affect the exchange rate).” The book by Wray has the word “inflation” in the index, and it comes up 27 times. If I am not mistaken, there is no text passage that says that the inflationary effects of government should be ignored.

The second section of the paper discuss the “loans create deposits”-story, which has recently been backed up by the Bank of England. The third section deals with the central bank setting the interest rate by varying the amount of reserves, which is only one possibility, by the way (the other being arbitrage by banks themselves that guides them towards the target interest rate). It is assumed that the central bank is exchange rate targeting, which something that MMT explicitly does not assume.

Section four is on “crowding in” of government spending, that is, the the fall in the interest rate that would normally occur with an increase in government spending. That it does not happen in the real world is understood by MMT authors, since central banks are able to set (most often short-term) interest rates. Zhi assumes here that having more reserves, the banks can extend more credit. This rests on the reserve requirements fallacy which assumes that banks need reserves before they extend loans. In reality, banks need them afterwards and can get them from various sources. Since the author is from China, where reserve requirements are used as a policy tool, I can understand that it might sound crazy that reserve requirements do not have any effect on lending. However, most economists – both MMT and non-MMT – agree that there is no effect (see this book).

Section 5 is a scenario which applies the money multiplier denied by MMT to a purchase of a bond by government and hence comes to alternative conclusions which are based solely on the existence of a money multiplier and the idea that banks need reserves to make loans. Section 6 builds on the same framework and concludes that government should spend until inflation increases. This is something many MMT authors would probably not reject as a practical policy.

In his conclusion, Zhi says #1 that government deficits can lead to more demand for reserves if the fall of the interest rate triggers loan creation. This is not refuting MMT in any way, I assume most MMT authors would be in agreement. #2 will lead to disagreement, since for Zhi only fiscal deficits have a long-run influence on growth (that one is interesting!) and inflation. #3 is once again not a refutation, since Zhi want government spending to increase to the point of inflation (using marginal terminology). I guess that #1 and #3 would find him in agreement – more or less – with MMT, so only #2 would be an original point of disagreement.

Since the paper is well-written, I hope that it triggers some more debate on the claims of MMT.


Responses

  1. Hi Dirk

    Nice job. Your interpretation is about the same as mine–mostly RR/money multiplier stuff, or things we’d agree with already so not actually criticisms. On the other hand, yes, well written and doesn’t fall into the usual misrepresentations.

    On #1, agree that the money multiplier thing is wrong. Beyond that, a generous, non-money multiplier interpretation of the critique is that as credit is expanded, banks create deposits which adds to their RR and thus their demand for reserves, thereby offsetting the fall in interest rates. My response would be that RR would never come anywhere close to creating a demand for reserves high enough to offset the full national debt created as resreves, or even modest deficits. In the US, RR have never been even close to $100B, let alone $10T that the privately held national debt currently is. But, in theory, his point could work if RR were high enough. Of course, many countries don’t even have RR at all.

    I fail to see how his criticism 3 is anything other than misinterpretations of MMT–the author’s actually agreeing with us, as you state.

    I find criticism 2 weird (yes, “original” as you note), and overall based on a misinterpretation of a quote the author attributes to Randy. A generous interpretation here would be that again the author is agreeing with MMT, which is that aggregate demand occurs as a result of the size of the govt deficit relative to net saving desires of the pvt sector. In that sense, it’s about getting govt deficit “right” via functional finance. But I would disagree with the author that this suggests that somehow the demand from pvt credit creation can be less inflationary, per se, if that’s what is being suggested. That would certainly not be consistent with MMT.

    Hope you are well!

    Best,
    Scott

  2. Hi Scott,

    Thanks for your nice comments.

    Regarding your last point: “demand from pvt credit creation can be less inflationary”. Here what I’m trying to argue is that private sector leverage does not have a PERMANENT impact on inflation in the very long run (before we are all dead as Keynes might put it this way) since mathematically, the leverage ratio of private sector can not grow in exponential terms, although in the short run we can loosen the boundary through endogenous money expansion accompanied by various forms of financial innovations such as securitization, which will have short-to-medium run effect on inflation. Government deficit on the other hand, can grow really big assuming that the government will never go bankrupt. This is also to support Randy’s argument: private debt is debt, but government debt is (nominal) wealth to private sectors. As far as I can see it, deficit expansion is the only source of injecting UNBORROWED reserves in the financial system thus it plays a role in the determination long-run money growth. And I totally with the endogenous school theory. The constant leverage assumption in the paper is nothing but an assumption to simplify the analysis of private sector endogenous dynamics, since the normative claim I made here is more about the public sector. I am also aware that in many countries nowadays the reserve requirement is not officially set by the central bank. The term “reserve” is more of a euphemistic way of saying “something to back up credit expansion”.

    Please do correct me if there are any other misrepresentations of MMT arguments.

    Best,
    Tianhao

    • Hi Tianhao

      What evidence do you have that private debt is limited by a particular leverage ratio? Looking at the data, it appears to me that the trend over the past 60 years has been an increase, with a few temporary declines here and there.

      You have to be careful with your language here, too. It sounds to many like you are suggesting that pvt created money isn’t really money, which isn’t what you are saying.

      There is a sense in which I might agree with your point, though. The govt can always service debts that it owes in its own currency, no matter how high the debt service grows, to the point of hyperinflation if it so chooses. On the other hand, pvt sector households and firms may default long before that happens (though there could obviously be inflation and asset price bubbles on the way up). But we have to be careful here because the credit creation by the pvt sector has no limit; as long as creditors are willing to create credit for debtors to service their debts, in theory any size debt can still be services indefinitely by households and firms. In practice, clearly this hasn’t happened, as default and financial instability have followed this sort of buildup of financial fragility in the past. However, it hasn’t been related to a particular debt ratio that is at the heart of your argument as your paper reads, at least, as Minsky explained rather thoroughly.

      As you said, though, your argument doesn’t really rely on the debt ratio point–so you should delete it in my view, unless you are talking about banks, which could have leverage limits as a result of capital constraints (though this isn’t the same thing at all as reserve requirements or reserve constraints–you may be confusing the two, but I can’t be sure). At the same time, any basic bank management text will show you how the capital constraint isn’t really a hard constraint but rather a set of requirements on the sizes of the profit margin, turnover ratio, and/or the retention ratio to enable a particular rate of balance sheet growth.

      Best,
      Scott

      • The government borrowed $100 to build a candy shop by issuing paper to Bob. The bank spends the money to buy candy for him and he ate all the candy. The next day Bob went to the banks asking money to buy Candy. The money’s gone and Bob killed the bank. This is the first financial crisis in history – 5000000BC.

        “When everything is fine, profit is the only thing that matters. When everything turns nasty, reserve is the only thing that matters.”

      • The way you wrote that makes no sense. Government doesn’t borrow. Why did Bob borrow if he had the $ to buy the govt bond? How does a bank spend his money? You are being sloppy with your wording, which makes it difficult to believe you are able to critique the precise descriptions of accounting and operations of MMT and others in PKE. Not to mention that Bob’s not broke–he can sell the bond.

        Regardless of that, I have no idea what this example is supposed to be responding to. If you’re just going to be a smart ass, as your language in the example suggests, then you are wasting my time and yours. If you actually want to understand MMT, which I would assume is somewhat important to you since you’ve tried to write a paper on it, then I’m agreeing to be here to answer your questions and discuss further. Your choice.

  3. Also, I am working on a new version where I ditched the QTM argument in section 5 and refined section 6 using a different model. I’ll keep you posted on that.

    Cheers,
    Tianhao

  4. Another point that I’d like to clarify: “In the US, RR have never been even close to $100B, let alone $10T that the privately held national debt currently is. “. The effect I discussed in section 4 is the effect of one-off transaction (a flow), not the total debt stock. Another word i’d like to clarify is that I mentioned the additional reserves “enable” banks to make more loans. It is at the bank’s decision as what to do with that increment. Even in the case where they spend the additional reserves on other investment, as long as it doesn’t enter the interbank market it won’t have effect over interest rate (although in this case it won’t have the FMC effect as I discussed in this paper). The other way would occur if they’ve decided to buy heaps of private bonds from a secondary market, which would push down the bond price – thus bringing an upward pressure on interest rate. And this is exactly the point that I think the MMT argument regarding interest rate pressure is flawed. The ultimate driving force behind bank’s loan making decision is still the profitability as well as its animal spirits.

    • Hi Tianhao
      The problem here is that you’ve got reserve wrong. Reserves exist only as liabilities on the CBs balance sheet. They can’t be used for the things you’ve mentioned. They do 2 things only–(1) meet RR, (2) settle payments among banks/CB/govt. That’s it. This means that banks don’t use reserves to make loans in the first place, which is the opposite of what you are basing your argument upon. When you say “even in the case where they spend the additional reserves on other investment, as long as it doesn’t enter the interbank market it won’t have effect over interest rate,” this is completely wrong because reserves can’t be anywhere else BUT the interbank market because only banks (and a few other govt institutions) have reserve accounts in the first place.
      In other words, you have not at all understood the endogenous money argument in the first place that you are critiquing. Please read this literature further and feel free to ask questions before you critique it.
      Best,
      Scott

  5. Sorry, i mean “as long as it doesn’t enter the interbank market it won’t have effect over (interbank) money market rate”. I had a conversation with Bill Mitchell and Randy Wray this morning and there seems to be a bit of misunderstanding between us. So what I’d like to clarify is that I’m not saying that banks rely on reserves to make loans. My central thesis is, as long as the additional reserve doesn’t end up in interbank (money) market, it won’t affect money rate.

    • Here, again, you are making no sense. Where do you suppose the reserves are “going” if not into the interbank market or settling payments among banks/cb/govt?

  6. Sorry, forgive me for the last point I made regarding pushing up the bond price…It’s the other way around.

    • *pushing up interest rate…sorry for the typo again.

  7. Tianhao,

    What I’m seeing here is that you are building models of things you haven’t taken the time to research. There is a vast literature on endogenous money. There is a vast literature on central bank operations. These literatures encompass MMT, horizontalists, circuitistes, and many others within and without neoclassical economics. From a distance, it appears you have the process backwards–you are dreaming up models in your head before doing the research (note the lack of references to virtually any of these literatures in any detail in the paper). You need to do the opposite–do the research, understand, then build a model.

    Best,
    Scott

  8. Dear Scott,

    Hope you are keeping well. I think it is better to write you a proper post to clarify some misunderstandings between me and the MMT team.

    First of all, please forgive me of my illiteracy on further MMT literature apart from my basic familiarity with Randy Wray’s primer, since my formative years are mostly spent on reading nonlinear dynamic system and chaos theory, in addition to key works of PK literature and Minsky and Kindleberger that might not meet the bare minimum in your institution. I don’t think by any means I am in disagreement with MMT’s narrative framework. I am in the mid of rewriting part of the paper since our last rounds of discussions to make things a bit clearer (and please forgive me of my use of English as the second language if there is anything inappropriate expressed in this paper). Yet I’ve come to the realization that our main disagreement here is the conflict of languages: from an operational perspective you aim to explain and present the real world top-down as precise as possible yet from a modelling perspective I aim to develop models bottom-up that is simple and open-ended enough so it can be further extended later on to approximate reality. The set of models presented here, again, is a bare minimum and it is open-ended enough to be improved upon in the future – yes I have taken steps back to develop simple model so it can be extended later on. This is just one possible starting point. My main message in the critique is that I want to develop a mathematical framework that would enrich MMT’s static analysis by having a detailed quantitative consideration of the short-run and long-run economic implications of the MMT discussion, which is often prone to pointless debate (e.g. MMT guys are bad because they think deficit don’t matter). For example, how exactly does money market rate change due to the interaction within interbank market, and how much deficit is good enough to reach an optimal level of productivity with minimum inflation. I fret about the fact that nearly all hyperinflations in history are created by excess government spending, which justifies the need to have a quantitative model for the discussion of optimal fiscal policy from MMT perspective. As far as I am concerned I couldn’t find any other literature that discusses this quantitative and dynamic implications (correct me if I am wrong). At this stage I think it is pointless to use the operational details (limited by a few OECD countries) to attack a preliminary formation of a start-up model. The discussion I made in section 4 is purely hypothetical for the sake of arguing that an additional reserve could increase both ERd and ERs so the overall effect is balanced. This is not the main point really since the short-term interest rate is ultimately controlled by the central bank. I am fully aware that in the absence of a regulatory reserve constraint, a profit-maximizing bank with depositor’s money insured by FDIC, the prime objective of a bank is to profit and to maximize shareholder value rather than to protect depositor’s money (given that they can get it from central bank whenever they want through various means). Hence keeping reserve in a bank vault is the least thing the bank wants to do. I am also fully aware that reserve only functions as payment settlement and fulfilling reserve requirement (if there is any) rather than funding loans. Yet we have to be careful when we apply this argument to some other countries where deposit insurances are not properly established and cash still plays a big role in the economy (it is only very recently that Chinese banks start to talk about deposit insurance), then the reserve constraint is still a real constraint and my hypothetical story is not that far-fetched from the reality (for example China where I originally came from – changing reserve requirement ratio is still considered quite an effective monetary tool, sometimes more effective than OMO), and reserve still matters a lot (if you work for a Chinese bank as a junior bank clerk you still have the business target to absorb deposit from various source to make ends meet). I do wish this would clear the misunderstanding (if any) between us to have more fruitful and constructive conversations also to help me understand more about MMT’s key insight.

    Please also forgive me of my sarcastic humour and please don’t overreact to that, my friend – just to express my obsession with reserves (given my Chinese background). You know, we all need a bit of silly fun sometimes – and internet is the best place to get it.

    Cheers,
    Tianhao

  9. Here’s probably the end of our discussion there, fwiw. I’m responding to him/her. He/she is in quotes.

    “First of all, please forgive me of my illiteracy on further MMT literature apart from my basic familiarity with Randy Wray’s primer, since my formative years are mostly spent on reading nonlinear dynamic system and chaos theory, in addition to key works of PK literature and Minsky and Kindleberger that might not meet the bare minimum in your institution.”

    OK, but it’s not about whether or not it’s the bare minimum at “my institution.” It’s about the basic standards of scholarship. Would you think yourself able to write a critique of Keynes’s work after reading a “primer” on it? You don’t get to agree or disagree with someone’s work at the level of writing scholarly papers without having some expertise in the work of those that you are critiquing and other work that provides appropriate context. You simply aren’t at a level of competence in MMT to write a paper, and I haven’t seen you acknowledge this yet. It’s not about “forgiving” you, as I don’t hold any personal grudge whatsoever against you. It’s about your lack of professionalism in attempting to publish a critique of a body of work that you admit you haven’t even read beyond the “primer” stage, much less having much if any background in the much broader endogenous money literature. This is simply unacceptable in the world of academics, whatever institution one is talking about, and if your advisors aren’t telling you the same thing then you are being given bad advice that could potentially harm your career at some point.

    “I don’t think by any means I am in disagreement with MMT’s narrative framework. I am in the mid of rewriting part of the paper since our last rounds of discussions to make things a bit clearer (and please forgive me of my use of English as the second language if there is anything inappropriate expressed in this paper).”

    Well, your English is far better than my Chinese. And the paper was well written in terms of the writing itself, even if I didn’t find the content persuasive.

    “Yet I’ve come to the realization that our main disagreement here is the conflict of languages: from an operational perspective you aim to explain and present the real world top-down as precise as possible yet from a modelling perspective I aim to develop models bottom-up that is simple and open-ended enough so it can be further extended later on to approximate reality. The set of models presented here, again, is a bare minimum and it is open-ended enough to be improved upon in the future – yes I have taken steps back to develop simple model so it can be extended later on. This is just one possible starting point.”

    Again, you’re not understanding. First, MMT is as much bottom up as it is top down. Randy’s first book in 1990 was about how banks work. And there’s decades of endogenous money research far beyond what MMT has done. If you want to do a bottom-up model of banking and central banks, start with the payments system, not with reserve requirements. Reserve requirements may or may not exist depending on the country, but the need to settle payments is fundamental to any system of exchange with monetary settlement.

    “My main message in the critique is that I want to develop a mathematical framework that would enrich MMT’s static analysis by having a detailed quantitative consideration of the short-run and long-run economic implications of the MMT discussion, which is often prone to pointless debate (e.g. MMT guys are bad because they think deficit don’t matter).”

    That’s a very worthy goal, of course. But you can’t understand these things without understanding MMT beyond a primer level, obviously.

    “For example, how exactly does money market rate change due to the interaction within interbank market,”

    There are literally dozens of models of this published by researchers at central banks. They usually come to the same conclusions as MMT does.

    “and how much deficit is good enough to reach an optimal level of productivity with minimum inflation.”

    Ever heard of the job guarantee? Have you read any of Pavlina Tcherneva’s work?

    “I fret about the fact that nearly all hyperinflations in history are created by excess government spending, which justifies the need to have a quantitative model for the discussion of optimal fiscal policy from MMT perspective. As far as I am concerned I couldn’t find any other literature that discusses this quantitative and dynamic implications (correct me if I am wrong).”

    I completely agree with your goals. There’s quite a bit of quant work in MMT, particularly from those associated with the University of Newcastle–again, you need to familiarize yourself better before making such sweeping generalizations. Don’t forget that there are maybe 10 MMT economists. While I would argue our body of work is impressive, it’s also impossible for us to duplicate the breadth of the output of the thousands of neoclassical economists. So, have at it. Also, if you haven’t already, look at the work of Godley/Lavoie and the non-linear models people like Steve Keen are working with. Those are good starting points that generally get banking right.

    “At this stage I think it is pointless to use the operational details (limited by a few OECD countries) to attack a preliminary formation of a start-up model.”

    Again, here you’ve shown your lack of understanding of the endogenous money literature, as well as MMT more narrowly. This is a ridiculous, baseless, naïve criticism of the endogenous money and MMT research programs. The research is about the “nature” of banking, central banking, and deficits under different types of policy regimes as much as it is about specific countries. And there are numerous studies well beyond OECD countries, for that matter.

    “The discussion I made in section 4 is purely hypothetical for the sake of arguing that an additional reserve could increase both ERd and ERs so the overall effect is balanced. This is not the main point really since the short-term interest rate is ultimately controlled by the central bank. I am fully aware that in the absence of a regulatory reserve constraint, a profit-maximizing bank with depositor’s money insured by FDIC, the prime objective of a bank is to profit and to maximize shareholder value rather than to protect depositor’s money (given that they can get it from central bank whenever they want through various means).”

    Again, you’ve missed the point. With or without reserve requirements, the ER are not a reflection of a bank’s abilities to make a loan, in general terms. It is only in the very narrow sense of a top-down control system like in China where one could make that case, or also in a gold standard or currency board system (though the causation works a bit differently even there).

    “Hence keeping reserve in a bank vault is the least thing the bank wants to do. I am also fully aware that reserve only functions as payment settlement and fulfilling reserve requirement (if there is any) rather than funding loans. Yet we have to be careful when we apply this argument to some other countries where deposit insurances are not properly established and cash still plays a big role in the economy (it is only very recently that Chinese banks start to talk about deposit insurance), then the reserve constraint is still a real constraint and my hypothetical story is not that far-fetched from the reality (for example China where I originally came from – changing reserve requirement ratio is still considered quite an effective monetary tool, sometimes more effective than OMO), and reserve still matters a lot (if you work for a Chinese bank as a junior bank clerk you still have the business target to absorb deposit from various source to make ends meet).”

    It’s considered that way for very special reasons, as Dirk alluded to, that have nothing to do with a critique of MMT. We’re fully aware of the differences there; Randy’s wife is a Chinese macroeconomist with a tenured position in China. But you are being inconsistent—you critique MMT for being narrowly focused on OECD countries, but then you build a model that itself could apply in only a very small number of countries for very specific reasons (if it applies at all anywhere, about which I have serious reservations; the way reserve requirements work in China isn’t necessarily the same as the traditional story you are telling in your model).

    “I do wish this would clear the misunderstanding (if any) between us to have more fruitful and constructive conversations also to help me understand more about MMT’s key insight.”

    Me, too. Please feel free to ask questions whenever you have them, via email if you prefer.

  10. Hi Scott,

    Nice shot : ) But could you please be more specific regarding your reference of literature? (I understand that internet might not be the perfect place for serious academic communications so let’s correspond via email from now on after this one) – do I indicate in any instance to argue that ER DETERMINES banks ability to make a loan? Please note that in section 3 I didn’t really go beyond the discussion of interest rate determination in a deterministic, endogenous manner.

    I’m aware of the body of work of SFC and Extended-Goodwin model with banking sector. Actually they inspired me to write some of my other papers regarding endogenous money. You might find them interesting to read if we just drop our prejudice on reserves for a little while.

    Anyway I’m not trying to insist being right. I believe that at end of the day we are all wrong but some are more right than others – and having a constructive debate is the only way to reach an approximated truth. I’m open to any criticisms toward my critique in the ongoing development of our future works.

    Have a lovely day mate!

    Cheers,
    Tianhao

  11. “…I’m responding to him/her. He/she is in quotes.”

    It is “him/he” btw.

    Cheers,
    Tianhao

  12. For those who think reserve doesn’t matter, here’s some statistics why it matters in a severe financial crisis. It might not be officially required when everything is high and people get themselves indulging in the debt jubilee. But when everything turns nasty to the point that people demand hard currency, it does matter. I am a bubble scientist, not a preacher for money and debt.

    History might be distant, people might have already forgotten scary words such as John Law, the Mississippi bubble, the french revolution, and etc. As french proverb goes: “plus ça change, plus c’est la même chose (the more things change, the more it stays the same.)”.

    • Dear Tianhao, modern central banks were invented to not allow currency (reserves and cash) to be scarce in moments of crisis. Nobody here thinks reserve doesn’t matter. Please give a source if you have someone specific in mind. Otherwise, you are reinventing Bagehot.

      best,
      Dirk

      • I see. Sorry for being a bit impulsive recently…Anyway let’s continue this discussion via email along with Scott. I’m working toward a better version of the paper now and I’m sure you’ll like it better and less offensive to MMTers.

  13. Thanks for this summary. I’m starting to follow this debate more closely now.

  14. “While criticisms and counter-criticisms are healthy in a scientific setting, neo-chartalists occasionally seem to over-react to criticisms, blasting away even people that are essentially on their side.” – Marc Lavoie


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