Leverage and sticky prices — am I wrong?

RSJ, whose excellent blog is windyanabasis, takes issue with my claim that financial leverage is a source of sticky prices. Not only that, but he’s performed an impressive experiment to test and disprove the hypothesis. Check it out.

I am not persuaded that I am wrong, for reasons that I describe in a lengthy comment. But I am hardly an impartial reviewer. What do you think?

Update: RSJ has updated his experiment in response to some of my comments.

Update History:

  • 21-May-2011, 5:15 a.m. EDT: Added bold update with link to RSJ’s follow-on post.

Sticky prices, leverage, and Pascal’s wager

In Keynesian / quasi-monetarist of explanations of depression, sticky prices play an essential role. If prices were not sticky, a deficiency of expenditure would just lead to a reduction of the price level, and nothing very bad would happen. There are (at least) two channels by which sticky prices can harm production:

  1. Sticky relative prices distort patterns of economic activity, preventing the economy from achieving the optimal level of production. Following a sharp change in nominal expenditure, the sluggishness with which some prices adjust leaves activity badly distorted, and so observed real production falls relative to the expenditure-stabilized trend.
  2. Sticky absolute prices allow changes in nominal expenditure to affect levels of economic activity more directly. Suppose we set all relative prices correctly, and then fix them in stone. Now, if we scale up the willingness of all agents to part with money, we might not observe a decline in aggregate production, but markets would fail to clear and we would observe shortages. If we scale down aggregate expenditure, we would observe a glut of capacity and a fall in production (as measured by transactions).

I’m interested here in the second channel. [1] Except under politically imposed price controls, we rarely observe what absolute price-stickiness would predict in an expenditure boom — production at capacity but shortages at offered prices. The relevant case is asymmetrical. Absolute prices adjust upward easily, but they are “sticky downward”. They do not fall.

A while back I had a post that described the price of extinguishing old debt as “the stickiest price”. After a wonderful comment exchange with Nick Rowe and others, we came, I think, to some agreement that sticky nominal debt contracts were both like and unlike sticky goods prices in important ways. However, I’ve recently come to think that, besides the direct but distinct distortions associated with rigid nominal debt, indebtedness might be an important source of downward stickiness in the prices of goods and services.

The argument is a form of Pascal’s wager. Suppose that I own a firm which generally operates at capacity. The firm is leveraged in the expectation of achieving a certain level of nominal income, out of which my debt will be serviced. Should I fail to service my debt, I will face outcomes that are very dire. Perhaps my firm will be out of business, perhaps I will have to surrender the firm to creditors. Perhaps I’ll manage to squeak by after a very radical downsizing that allows me to service my debts but destroys the long-term value of the firm. Let’s refer to any of these catastrophes as “bankruptcy”.

Suppose there is a shock to nominal demand, and people become less willing to part with money. I have two choices. I can cut prices to maintain my expected volume of sales, or I can leave prices alone. In the first case, I condemn myself to bankruptcy with certainty. I was already operating at capacity, so there is no hope that an increase in volume will save my bacon if I reduce prices.

If I do not cut my prices, my expected level of sales will fall due to the recession. On average, I will still be bankrupt. But I could get lucky. In any economic environment, sales are a fickle random variable. It is possible, if I stick with my old prices, that sales will prove robust despite the dowturn. So the rational thing for me to do is to refuse to adjust my prices and hope for the best.

Now this is a perverse outcome, from an economic perspective. Considered without regard to financing, my firm fails to maximize expected profits by failing to adjust its pricing. It instead maximizes the value of the right tail of the profit distribution, because as the owner of a leveraged firm, the right tail of the distribution is all that I have claim to. Not reducing prices is a form of screwing creditors, but I don’t care. As the owner of a highly leveraged firm operating near capacity, I will be disinclined to reduce prices.

This tale of an overleveraged entrepreneur would be insignificant, if it were an idiosyncratic occurrence. One overextended entrepreneur might refuse, but her less leveraged competitors would cut prices, and observed market prices would fall. But suppose our entrepreneur is in an industry where intense leverage is the norm. As Hyman Minsky famously pointed out, if an industry is competitive and at least some players are not foresighted about risk, levering up in good times ceases to be optional. More levered firms gain a cost-of-capital advantage that permits them to undercut financially conservative rivals over what may be prolonged periods of tranquility. So we might expect to competitive forces to drive whole industries into similar capital structures. And empirically we do find this — firms in general choose wide varieties of capital structures, but within industries, capital structures are more alike.

In highly leveraged industries then, we’d expect downward price stickiness. Following a negative shock to nominal expenditures, we would observe production losses, but not in the form of evenly distributed cutbacks. Instead, some firms would seem to thrive despite the weather, while others are forced into bankruptcy. Perhaps the firms that survive would be the “best” firms, and certainly differences in quality and ex ante leverage would affect the distribution of outcomes. But even among perfectly identical firms, if the distribution of sales is stochastic, we’d expect “consolidation” to occur. Firms that are lucky early in a depression survive. It gets easier to stay lucky as time goes on. The failure of competitors eliminates supply, helping to support your sticky price (which becomes less sticky as you retain earnings to delever).

From a macroeconomic perspective, this account suggests that, even putting aside systemic fragilities introduced by cascading bankruptcies and financial accelerators running in reverse, financial leverage leaves an economy vulnerable to depression through a price rigidity channel. This strikes me as relevant to our current situation. Policymakers have effectively guaranteed the debt of highly interconnected borrowers and successfully eliminated the threat of cascading defaults. But if my account is correct, reducing leverage at “Main Street” firms may be at least as important as ensuring the stability of interconnected financials. Policymakers have put tremendous effort into ensuring the continuous availability of credit to firms that wish to expand. But promoting debt-financed expansion may be self-defeating, if it reduces the ability of the economy to adapt to fluctuations in nominal expenditure by making prices sticky. [2]


Notes:

  1. This will be an intramural point. Footnote 2 is more interesting.

    I think that explanations of the business cycle based on relative price stickiness ought not be classified as Keynesian or monetarist at all. Relative price stickiness is really a recalculation story of the sort favored by Arnold Kling (and to which I am also sympathetic). If you think of markets as calculators of equilibria, and that after a large shock computing a new equilibrium takes time, then there must be some sort of friction that prevents the computation from being instantaneous. Sticky prices offer one plausible source of friction.

    I won’t speak for Kling, but I think that some proponents of recalculation-ish theories would object to this characterization, because they view economic calculation as something deeper than a rejiggering of relative prices. They’d focus instead on inspired entrepreneurship, creative destruction, entirely new practices and products. I agree with all that, but when making up models we do have to reduce a variegated and multicolored world to symbols, and modeling recalculation as a laborious price vector computation is more expressive than it first appears. For example, we can imagine a space of potential new products whose prices begin at infinity and adjust downward with difficulty, as we learn by doing or as a stochastic function of entrepreneur effort.

    It might seem odd to expel relative-price-stickiness-based explanations from the Keynesian pantheon. After all, aren’t New Keynesian models almost defined by incorporation of relative price stickiness? Well yes, and they use relative price-stickiness to achieve monetary non-neutrality. However, at risk of stepping on toes (which is really not my intention), I think that by construction New Keynesian models are poorly suited to the analysis of extreme business cycles. New Keynesian models, like their Real Business Cycle progenitors, are usually characterized in log-linear approximation around a long-run equilibrium. Even if we believe the models to be perfectly correct, the conclusions we draw from log-linear approximations become less and less reliable as variables depart from equilibrium values. Log linearized models, if they are useful, are useful at describing near-equilibrium dynamics. If extreme business cycles involve severe departures from the presumed equilibria, or worse yet, if they involve multiple equilibria so that the economy might be durably drawn away from the presumed steady state, common New Keynesian models just aren’t helpful. To invoke Hyman Minsky again (via Steve Keen), if you want to answer questions about extreme business cycles

    it is necessary to have an economic theory which makes great depressions one of the possible states in which our… economy can find itself.
    Perhaps I am overharsh. I am certainly no expert on New Keynesian macro, and I’d be delighted to learn that I am wrong. But the New Keynesian models I have encountered simply don’t live up to Minsky’s very sensible criterion. Monetarist and Old Keynesian models, though hydraulic and not-microfounded they may be, incorporate in their design the possibility of durable and severe depressions. [ back ]

  2. The story I’ve told isn’t particularly novel. It complements commonplace accounts of why unemployment occurs in depressions. In theory, firms could simply cut employee hours and wages rather than fire people in response to a downturn. But they don’t. Employment adjusts on the “extensive” margin of layoffs much less than it adjusts on the “intensive” margin of reducing work or pay. This is often attributed to employee morale. It is better, the story goes, to have a small workforce of happy people than a big workforce of bitter people.

    But consider the same situation from employees’ perspective. Families are often highly leveraged. Even when they are not explicitly in debt, many families take on operating leverage. That is, for many families, the fixed costs of ordinary living (e.g. rent, day care, food) approach their total household income. With high leverage (whether explicit debt or operating leverage), a reduction of wages and hours translates quickly to financial and personal crisis, and ultimately to a disruptive reorganization of living arrangements. A cutback in wages and hours may leave families unable to afford their mortgage or their rent, and force a move to less desirable digs or “doubling up” with family, usually after a lot of confusion and juggling and bills and shame and collection agencies.

    Getting fired will do all that too, of course. But if firms hold wages steady and cut back by firing workers, then some workers will avoid the reorganization entirely. When firms cut wages or hours, all highly leveraged workers must reorganize. If the severity of crisis is not so different for those who are fired versus those who see pay cuts (a big if), then workers rationally prefer a layoff lottery to universal pay cuts. Their reasoning would be identical to that of leveraged firms who hold prices steady and take their chances.

    So firms find layoff lotteries to be better ex ante, because employees prefer them, and ex post because only the happy winners remain with the firm. A perennial suggestion among reformers is that we substitute some form of work-sharing for cyclical unemployment, so that the burden of downturns is evenly shared instead of falling disproportionately on an unlucky few. That sort of reform only makes sense when household leverage is generally modest. [ back ]

Update History:

  • 14-May-2011, 3:15 a.m. EDT: Fixed some typos and awkward sentences in Footnote 1. No substantive changes.

The quality of muddling

Ezra Klein, Karl Smith, and Ryan Avent today debate the merits and demerits of muddling though vs “grand bargains” and bold solutions. Here’s Smith, insightful as always:

The opportunity to muddle through is a gift. It allows one to make changes at the margin, to monitor their effects and to update accordingly. It allows us to avoid massive often useless sacrifice. It allows our knowledge, understanding and resources to race ahead opening up new ways to deal with our problems… We don’t always have that opportunity. Sometimes we are forced to deal with things in a big way. Indeed, this is much of what we mean by crisis. However, you don’t want to avoid an externally inflicted crisis by creating a self-inflicted one. If you have a chance to make your way with adjustments at the margin, take it.

I think this is right, and important. But even true words can lead us astray if we are not careful. To say that muddling through is a gift because it permits certain advantages can mutate into a case for incrementalism where there are clear disadvantages.

Further, which changes constitute “adjustment” and which would be disruptive are themselves contested. Consider Scott Sumner‘s view of the world. Sumner claims that the stance of monetary policy, when properly defined, turned sharply contractionary in 2008. However, what Sumner would have proposed in order to “stay the course” would have seemed bold and radical to status quo central bankers. Generally, what constitutes measured and incremental changes and what constitutes a sharp turn gets defined according the the conventions of dominant interests. Consider the TARP vs bank nationalization debate. The case against nationalization was often made on grounds of continuity and nondisruption, and that certainly reflects the perspectives of people inside the banking system and the Treasury department. And yet to me and many others like me, the no-accountability/no-more-Lehmans policy regime that was crystallized as TARP represents a wrenching and violent alteration of previously settled social arrangements.

Today’s conversation began with US fiscal policy. Klein tells us

The wish for a grand bargain that’ll take care of the deficit all at once is probably just that: a wish. The likelier outcome is a slew of deficit-reduction measures passed over the next decade or so. That’s even truer for health-care spending, which is both the biggest fiscal problem we face and the one that most requires a decades-long process of trial-and-error in which we test out new ways of delivering care, of paying for care, of separating useful treatments from useless ones and of modernizing the sector’s IT infrastructure.

Overall, this seems sensible. There is a problem, but we won’t hubristically predetermine a 30 year plan,. We’ll make small adjustments in real-time until the problem is solved. That sounds wise.

But is it true? Is that how US fiscal issues are likely to play out? I don’t think so. I’d bet on one of the following three scenarios:

  1. We will experience a boom and/or create technical efficiencies in health care delivery such that the US fiscal trajectory seems to stabilize on its own.
  2. The US fiscal situation will fail to durably stabilize at anywhere near the levels we now deem reasonable, but nothing catastrophic will happen. The MMT-ers will turn out to be right that any inflation or yield pressure associated with a growing stock of public debt will prove manageable in real time. It will feel like we are muddling through perpetually, but nothing bad will ever come of it.
  3. A crisis will force bold changes on the political system. This might take many forms — an inflation, a sharp spike in bond yields, a disruptive depreciation of the dollar, popular revolt against the distributional effects of fiscal largesse, etc.

At the moment, Klein’s scenario seems plausible. After all, despite elevated chronic unemployment — which in our society constitutes almost unthinkably severe human tragedy — we are making genuflections towards deficit reduction. Surely this means we are committed, and bit by bit we will adjust. Right?

No. For better or for worse, we are not adjusting. The small changes our political system proves capable of are promises of future chastity and cuts that disproportionately harm the disenfranchised. Historical experience suggests that even this degree of restraint depends upon an ephemeral configuration of political authority — a Democratic president, a Congress divided or Republican. There is little evidence that our government is capable of adjusting, incrementally but intelligently. It follows paths of least resistance and responds to crises. That might work out all right, or it might lead us to catastrophe.

So is it wise to muddle through? I think we all can agree that not all paths of least resistance end up in places one would wish to go. At the same time, Karl Smith is still wise. Sharp, bold changes are ipso facto crises, and there’s no sense creating pain willy-nilly to deal boldly with inexhaustible phantoms.

So what’s the right strategy? I’m not sure, but I’ll tell you what I used to think. I used to think that the right strategy was to muddle through in a context created by sophisticated financial markets. Human beings, as individuals and as policymakers, have limited information and are prone to flawed choices. Markets aggregate the information and foresight of millions, weighted by confidence expensively signaled via degrees of financial risk assumed. Such markets would always be current, would produces prices reflective of the best available information at any point in time, and would be forward looking. Markets would ensure that, on the path of least resistance, peoples’ incentives would be to make smart adjustments in real-time. Muddling through under these circumstances would leave us where Smith suggests: With “knowledge, understanding and resources…opening up new ways to deal with our problems…[we’d make our] way with adjustments at the margin.”

I think that this view, once my view, is now completely discredited. Financial markets, as they exist in the world we live in, have proven liable to catastrophic and foreseeable mistakes. The instruments we trade hide information and prevent adjustments as frequently as they reveal and promote them. Plausible mechanisms of self-correction have been weakened rather than strengthened during the crisis, so we can expect even poorer performance looking forward. Our financial institutions are best understood as means by which certain groups within our society protect and perpetuate themselves, and as mechanisms by which covert prerequisites of stability are maintained. Of course markets were never going to be perfect — no human institution is. But existing market institutions have fallen in my estimation from “good enough, the best we’ve got” to “incompetent and hopelessly corrupt”.

Absent some context that shapes incentives and links muddling through with intelligent adjustment, accepting muddling as a default position is unsatisfactory. It becomes a means of drifting towards hazards unknown and an excuse for attending to the interests of the powerful. The alternative of bold, flawed, improvisations is also unattractive. The choice between moldy bread and rancid stew is best made on a case-by-case basis, with a lot of unscientific sniffing.

The only way out is to recreate some context in which we’ve reason to expect our muddling will be smartly shaped. Our existing political and financial systems strike me as a poor place to start, but here we are. In the end, I’d like to agree with Karl Smith about the virtues of muddling through. But it all hangs on the quality of the muddling.

Update History:

  • 10-May-2011, 3:55 a.m. EDT: Fixed some typos and awkward sentence constructions. No substantive change.

Two deficits, two austerities, and quantities matter

The excellent Kindred Winecoff considers the troubled periphery of the Eurozone:

[A]usterity must occur. It’s only a matter of how it occurs. The alternative to an internal devaluation through wage cuts, tax increases, and reduction of social services is external devaluation (exit from euro) and default. Call it the Iceland Alternative (Iceland was never in the euro, but it did devalue/default, which is what we’re talking about). In that scenario, the new drachma and Irish pound will collapse in value and the government will be unable to borrow from international capital markets. This is austerity too. The government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years.

Moreover, small open economies like Greece and Ireland are heavily reliant on imports to maintain standards of living. Ireland imported about 40% of its GDP in 2009; Greece about 1/3. For comparison, the U.S. imported about 14% of its GDP. If the post-euro currencies drop 50% in those countries (as Iceland’s did, and it was never attached to the euro), then those imports become 100% more expensive. That’s a big price increase. True, there will be some substitution into domestically-produced goods, but such a large adjustment will take time and cause pain. These are not large, diversified economies and there’s a reason domestic production wasn’t being consumed before; overall standards of living will have to drop if there’s a currency devaluation. And while exporting industries may benefit from a cheaper currency, boosting employment in those sectors, the importing industries will suffer, contracting employment in those sectors. Even if overall employment goes up, it will be at much lower relative wages. This is why Iceland is applying for EU membership, including adoption of the currency, despite the sacrifice of policymaking autonomy that entails.

In other words, there will be austerity. The only question is how it’s distributed.

Winecoff makes an important point, but I think he needs to cut his analysis a bit more finely. Economies run two very different kinds of deficits, a government fiscal deficit and an international current account deficit. Although the two deficits are related, there is no mechanical connection between the two. They do not reliably move together.

A country that defaults on its international debt will find its paper shunned international capital markets for a while. In countries that have grown accustomed to running current account deficits — that is, countries whose citizens have grown used to consuming more imports than they pay for with exports — a forced return to international balance will undoubtedly be perceived as a form of austerity.

But Winecoff is wrong to claim that “[t]he government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years”. As long as the country, post-default, issues its own currency, and as long as the country’s citizenry is interested in accumulating domestic currency and debt, the government can run a budget deficit after the restructuring. The capacity of a country to run budget deficits post-crisis will depend largely on the citizenry’s confidence in domestic institutions after the fall. (Countries can also employ controls to prevent capital flight and support domestic currency. But in cosmopolitan, habitually integrated Europe, I suspect that won’t work unless people have some measure of confidence in the project. Wise governments would implement technocratically credible monetary institutions and simultaneously encourage patriotic enthusiasm for the country’s newly independent scrip.)

Winecoff’s example of Iceland is a great case in point. Following its collapse and quasi-default in 2008, the Iceland ran a budget deficit of 9.3% of GDP in 2009 (a primary deficit of 6.6%), and has continued to run deficits since, gently drifting towards balance. Iceland has also been able to sustain large current account deficits as well for a while after the crisis, which helps to cushion the adjustment. Iceland received loans from the IMF and several European countries, which partially financed its continuing international deficit. Also, private citizens of Iceland may have had foreign asset holdings which they could pledge or sell to finance imports while the economy shifted towards international balance.

Iceland’s circumstances were, perhaps, unusually benign. Other crises (Argentina in 2002, Russia in 1998) proceeded much as Winecoff describes, with sharp, simultaneous moves towards fiscal balance and current account surplus. But would crises in the Eurozone look more Argentina or like Iceland? I don’t know, but I can make a strong case for Iceland. Savers in the Eurozone periphery inhabit a world of open financial borders, and have already been diversifying out of home-country bank deposits. (Importantly, this forces governments and the ECB to cover financing gaps left by fleeing depositors.) Argentine savers perceived dedollarization as expropriation, which was corrosive to the legitimacy of domestic institutions. Citizens of the Eurozone periphery, on the other hand, might support their governments’ bid to escape impossible foreign debt. The drawn out, slow motion nature of the Euro crisis has made it easy for private citizens to prepare for Euro exit by sending funds abroad. This practice shifts the costs of default to governments, who in turn can shift costs to external creditors. If domestic publics support the move and believe Euro exit to be a one-off event rather than the start of recurrent devaluation cycles, governments may well be able to run deficits and use Keynesian fiscal policy to smooth the aftershocks of Euro exit.

There may be important differences of institutional credibility between Greece and, say, Ireland or Spain. An Irish exit might be more Icelandic, while a Greek exit might be more Argentine. (It’s worth pointing out that, a decade later, Argentina’s default seems to have worked out very well.) As in Iceland, the (growing) foreign savings of private citizens might cushion the shift from international deficit. (Euro drop-outs could not expect the post-crisis IMF support that Iceland enjoyed, though.) There is a hazard that the furious Eurozone core would try to hold the private wealth of citizens of the periphery as security against the defaulted debt of sovereigns. But that would be a stronger violation of current norms than sovereign default.

Suppose that it will be possible for a drop-out to run a fiscal deficit, but as Winecoff predicts, a sharp shift to international balance proves inescapable. Winecoff is absolutely right to point out that

small open economies… are heavily reliant on imports to maintain standards of living… If the post-euro currencies drop 50% in those countries (as Iceland’s did…), then those imports become 100% more expensive. That’s a big price increase… [S]uch a large adjustment will take time and cause pain. These are not large, diversified economies

Undoubtedly, ending an era of persistent current account deficits will prove painful to consumers accustomed to cheap imports. However, that is not ultimately an incremental cost of leaving the Euro. After all, the purpose of staying and suffering austerity would be to pay down indebtedness, which is more costly than a shift to balance. Contrite borrowers have to pay interest on past debt and run (primary) surpluses. Deadbeats just need to pay for what they buy now. Quantities matter. Staying within the Eurozone offers the palliative of stretching the pain out over time, but increases the ultimate burden of the adjustment. Exiting front-loads costs, but reduces their size, as much of the work is done by the act of default. Undoubtedly, jilted creditors would punish “Euro deadbeats”, and exact non-financial costs, so the benefits of debt write-offs would be counterbalanced, at least in part, by new costs. There’d have to be some cost-benefit analysis. But the options are not, as Winecoff suggests, a zero-sum shift in how countries take their lumps. Countries may find they have a lot fewer lumps to take if they repudiate their debt than if they don’t.

Losing the capacity to run a current account deficit and losing the capacity to run a fiscal deficit have very different implications. Shifting international accounts from deficit to balance harms citizens in their role of consumers, but serves them in their roles as workers and savers. If you view the current crisis as driven by the challenge of maintaining consumers’ standard of living measured in tradable goods, then losing the ability to run current account deficits seems harsh. But if you view the crisis as driven by frustration within countries over insufficient opportunity and employment, then shifting to international balance or even to surplus helps. Losing the capacity to run a fiscal deficit has the opposite effect. Where current account austerity increases labor demand, fiscal austerity reduces it. So if you think that underemployment is the pressing problem in the Europeriphery, current account austerity plus continued fiscal deficit is a golden combination.

Lots of countries, obviously emerging Asia but also Germany, seem to prefer the social goods that come with full employment and financial security to the consumer purchasing power gains that accompany current account deficits. The countries of the Eurozone periphery have so far “chosen” the path of excess consumption, but it’s not clear whether that represents a genuine preference or a historical accident. This isn’t to minimize the pain and disruption that would undoubtedly attend import scarcity. Changing human habits hurts. But, as Joni Mitchell might say, something’s lost but something’s gained. This would not be a novel sort of transition. It would be a reprise of the aftermath of the Asian financial crisis.

Leaving the Euro would not be all bows and flows of angel’s hair. But it would not necessarily be catastrophe, and there is no fixed quantity of austerity that Europeriphery countries have to face one way or some other. These countries have difficult choices before them, and should think carefully about the tradeoffs and just what sort of outcomes they hope to engineer.


Note: I have very mixed feelings about any break-up of the Eurozone. This piece was not intended as advocacy of that. I do think the European core is being foolish and shortsighted in its dealings with the periphery. In a better world, the core countries would equitize their claims against the periphery by, for example, adopting some variation of Warren Mosler’s frequent suggestion that the ECB issue per capita grants to all member states, that surplus nations would use as they see fit but debtor states would use to reduce indebtedness.

MMT stabilization policy — some comments & critiques

“The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound… The principal of judging fiscal measures by the way they work or function in the economy we may call Functional Finance
Abba Lerner (1943)

First, I want to make clear that the critiques I’ll offer below are not intended to discredit or dismiss MMT. As I’ve said before, I think MMT offers a coherent and important perspective on fiscal and monetary issues that ought to be understood, on its own terms rather than in dismissive caricature, by anyone serious about macroeconomics. MMT is not “true”, but then no theory is “true”. We ultimately judge theories by how useful they are, both in making sense of “the data” we already know and in offering guidance for policy going forward. In my opinion MMT is one of the most useful perspectives in thinking about fiscal and monetary questions.

However, it is still just a perspective. Enthusiasts sometimes present MMT in a manner that’s too complete and hermetically sealed. While some MMT theorizing is based on “double entry accounting” or “obvious, unarguable facts”, when MMT adherents offer non-trivial conclusions, they rely upon assumptions about human behavior that are in fact contestable. I continue to place non-zero weight on theories of government insolvency that MMT-ers have persuaded me are, in a sense, incoherent. Life is complicated, and even absurd prophesies can prove self-fulfilling.

This will be a long post. I’ll discuss each of the seven points I outlined in my summary of MMT stabilization policy. Then I’ll offer some general comments. Before you continue, you should understand the point of view being examined. Please read my previous post first. Or much better yet, read Chapter 1 (Tymoigne and Wray) and Chapter 5 (Tcherneva) of A handbook of alternative monetary economics (ed. Arestis & Sawyer). These essays offer a polished, concise introduction to the MMT perspective. Then spend some time with the “mandatory” or “101” readings on Warren Mosler and Bill Mitchell’s websites.

The summary points from my previous post are repeated below in bold. New comments then follow. I am critiquing my own distillation of MMT stabilization policy, so there is the danger I have set up straw men. If I have, I apologize and look forward to being set straight in the comments. As usual, almost nothing I say will be original. Many of the points I’ll make have been made better by others, for example, in the comments to the previous post, which are extraordinarily good. At a Kauffman Foundation blogger convention last week, I discussed MMT informally but at some length with David Beckworth, Megan McArdle, Mish, and Mark Thoma. My comments will undoubtedly be informed by those conversations.

  1. The central macroeconomic policy instrument available to governments is regulating the flow of “net financial assets” to and from the private sector. The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.

    While the flow of net private sector financial assets does strike me as an important and powerful tool for macroeconomic policy, it is not a uniquely effective tool. Changes in the relative price of financial assets (the object of conventional monetary policy) and in the distribution of financial assets can also powerfully affect behavior, and there are costs and benefits associated with each lever. What is the justification for focusing almost exclusively on managing the level of “net financial assets”?

  2. A government that borrows in its own currency cannot be insolvent in the same way as private businesses. That is, such a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.

    It is unassailably true that a government cannot be forced into insolvency for want of capacity to pay in its own currency. But a government might find itself politically or institutionally unable to meet an obligation despite access to the printing press, and there might be a sharp run on government obligations even without the focal point of formal insolvency that usually occasions private sector runs. It strikes me as an open question the degree to which protection from formal insolvency protects government obligations from disruptive races to redeem. Point #7 below strikes me as stronger protection.

  3. However, the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives (such as, especially, full employment).

    I think almost no one would argue with this point.

  4. The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows.Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.

    This is a place where MMT-ers, quite rightly, call out conventional economists on adherence to dogma ill-supported by the data. Empirically, the relationship between government balance sheet quantities and either the price level or private/foreign willingness to absorb government claims is weak. Conventional economists intone seriously about our growing debt-to-GDP, and discuss solvency criteria that no one believes as though they were real. (I don’t think any sensible person believes indebted governments will ever run surpluses of present value greater than the accumulated stock of public debt. Yet that is the party line solvency criterion. [Update: See below]) Theories of the public balance sheet that have proven unreliable continue to be endorsed to avoid inconsistency in the edifice of neoclassical finance. It is true, in extreme cases, that governments that experience hyperinflations go through periods of high indebtedness relative to GDP, but what is cause and what is effect there is murky.

    Macroeconomic theory is often stupid about debt. Common models impose a “no Ponzi condition” that is absurd not only for governments, but also for private firms. All firms and governments eventually end, and when they do, they usually leave substantial claims unsatisfied. Agents lend to corporations and governments not because they believe the debt will be paid down, but because they believe the almost certain eventual default or debasement of claims is unlikely to happen within their investment time horizon. In the real world, governments and corporations balance actual gains from the transfer component of increased borrowing against increased hazard that the end will come quickly and potential “distress costs”. Typically, governments and firms find these costs easy to manage as long as indebtedness grows no faster that “size” (whether measured in terms of revenue or asset values). While it is risky to “lever up” — to increase debt faster than size — many firms and governments do so successfully. We have no reliable criteria of maximum leverage even for firms, let alone for governments. Governments are special. Their core asset is their taxing power. Their liabilities, whether notionally bonds or money, are best understood as preferred equity rather than debt. They face very diffuse liquidity constraints.

    All of that said, I think MMT-ers sometimes err in the opposite direction. They are right that ultimately it is flows (actual or desired) between private agents in aggregate and governments that determine the value of government obligations. But the whole purpose of balance sheet analysis, in the private sector and the public sector, is to predict future flows. That conventional theories of public balance sheets are foundationally stupid and overstate the hazards associated with large stocks of outstanding debt doesn’t invalidate the intuition that flow volatility is likely to be proportional to the outstanding stock of government claims. Suppose, because of a sunspot, private holders of government claims get nervous and try to redeem them for current goods. If the net stock of claims in private sector hands is small, it takes very little taxation to offset that flow. If the net stock of government claims is large, than the desired flows might be massive, and governments might be faced with unappetizing choices between taxation or accommodating inflation. There is little evidence that increasing the stock of government obligations, by itself, increases the likelihood that the private sector will seek (impossibly but disruptively) to divest itself of those claims. But there are undoubtedly fluctuations in the private sector’s enthusiasm for holding money and government debt, and it strikes me as implausible that the difficulty of managing those fluctuations is entirely unrelated to outstanding stock of those claims.

    Also, although MMT-ers are typically regarded as “left” economists, I think they underplay the distributional costs that attend expanding the stock of government obligations. Government obligations, like all financial assets, are disproportionately held by the wealthy. If the government did not accommodate the private sector’s demand for net financial assets, preferring different policy levers to stabilize the economy, wealthy people might be forced to store wealth in the form of claims on real resources, and would have to oversee the organization of those resources into value-sustaining projects. A large stock of “risk-free” financial assets allows people wishing to carry wealth forward to shirk their duty to steward resources carefully and bear the consequences of investment failure. Thus, the availability of government obligations simultaneously degrades the quality of real investment (by disincentivizing supervision) and magnifies the distributional injustice that attends failures of aggregate investment by shifting the burden of those shocks onto risk investors and workers. In theory, governments can mitigate this injustice by careful transfers and expenditures ex post, and that might be the right policy, but in practice those who disproportionately hold existing government obligations disproportionately hold political power, and resist the issue of new obligations which might put dilute the value of existing claims. In practice, a large stock of government claims serves as the lifeboat through which prior wealth inequality carries itself into the future. Absent an accommodative stock of government obligations, recessions would be crucibles that separate the deserving from the undeserving rich, and would thin the ranks of the rich generally. Recessions should be periods that decrease inequality, but the availability of default-risk free claims whose purchasing power is politically protected inverts the dynamic.

    MMT-ers are right, I think, to argue that, for fiat-money issuers who borrow in their own currency, conventional government solvency criteria are false. They are right to argue that such governments have a great deal more latitude to issue money and debt than conventional theories suggest. But that shouldn’t be taken as license to defend carelessness in the distribution of new claims, or to treat expansions of money or debt as entirely cost-free. To be fair, this is a bit of a straw man. Serious MMT-ers think about distributional issues and quality of expenditure, and don’t claim that deficits should be “carelessly” expanded. But in the heat of current policy debates, rhetoric about “deficit terrorists” and money being nothing more than spreadsheet entries unhelpfully obscures that. At its best, a deep point of MMT is that the absence of short-term fiscal constraints creates space for government to craft policy that focuses on the productivity of the real economy. If the mobilization of real resources is wise, fiscal maneuvers will be rendered sustainable ex post. If the real economy will be mismanaged or let to languish and decay, no amount of “fiscal discipline” will save us. The version of MMT that I like best is, oddly, wedded to an almost Austrian sensibility about real investment.

  5. The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.

    I agree entirely. I think this is the best definition of government solvency.

    The MMT-sympathetic Traders Crucible objects, however, to my use of the word “solvency” here, even with the scare quotes. After all, what currency issuing governments must concern themselves with is not insolvency per its dictionary definition (an inability to pay debts), but something quite different, a decay in the value of its claims in terms of real goods and services. Here’s TC:

    [T]he impossibility of insolvency does not mean the fiat currency will have value. A government might be fully solvent even with a worthless currency… This distinction between insolvency and debasement is at the heart of MMT…

    Why is the Traders Crucible going nuts…about the difference between insolvency and debasement?

    Well, we can directly observe the debasement of a currency in an economy through the inflation rate. We can directly observe the process of debasement and loss of value of the currency through inflation. We cannot directly observe the risk of insolvency — it must be inferred from bond price action… the resulting process is one of guesswork, misstatements, boneheaded plans, wild specualtion, and dumbassery, because there is no way to observe the risk of insolvency directly even though it is one of the ideas that govern our spending. …[B]y removing the fear of insolvency, we can more directly observe the risk of debasement… [W]e don’t need to rely on the bond market to “give us signals” about the potential loss of access to their club to determine if we need to lower spending, or raise spending. We can just witness inflation and unemployment and make decisions on these two variables, instead of the three variables of unemployment, inflation, and insolvency… This is a much simpler task, and is perhaps the core strength of the MMT paradigm.

    This is an important point, but contestable. We know with some confidence that the threat of traditional insolvency can lead to powerful and unpredictable runs and a lot of turbulence in the value of private claims. I’m glad to concede that, at the margin, absence of a sharp solvency threshold reduces the likelihood of such events. But does the lack of a sharp solvency threshold eliminate the possibility of sudden stops, Wile E. Coyote moments, etc? Can we be confident that, absent the danger of outright default, any debasement of fiat claims would take the form of an observable spiral, which would start slowly and thereby offer time to apply a policy antidote? Would we in fact observe and recognize the signs, and would they be different than, for example, a 500% increase in the price of gold in the span of a few years and recurring bouts of commodity inflation? Are employment pressure and labor costs the sole true and perfectly reliable indicators of debasement hazard?

    One can make a strong case that increases in labor costs are in fact the sine qua non of uncontrollable inflation, that absent labor income to “ratify” price rises, inflation in inherently self-limiting. But you can make other cases too. Perhaps transfers and deficit spending can substitute for wage power, bidding up commodity prices and the capital share of income even while wages are held back by the reserve army of the unemployed. I’m not sure about any of these stories. But my experience as a trader in capital markets makes me wary of accounts that suggest sharp swoons in the price of any asset cannot happen, or would definitely be preceded by warning signs that would permit one to get out early.

    So, I’ll to acknowledge TC’s objection as important and potentially valid, but defend my positing of an MMT “solvency” constraint, at least with scare quotes in place. I don’t think it’s reasonable for MMT-ers or anybody else to write off the possibility of sharp and unexpected changes in the value of a fiat currency. The possibility is dangerous enough that it should focus the mind in a precautionary way. If MMT policy advice is to be taken seriously, it must offer a some assurance of safety against that scenario. The absence of formal default hazard provides some assurance, but without Point #7 as a backstop, not enough.

  6. Avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilization is slack, as evidenced especially by high unemployment. Avoiding net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed.

    I think this point is unobjectionable.

  7. However, a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes.

    On the one hand, I consider this point is one of MMT’s deepest insights, and its secret weapon. So long as a government’s taxing power is strong, so long as it is capable of persuading individuals to surrender highly valued real goods and services for the ability to escape liabilities imposed by fiat, exercise of that taxing power creates a floor beneath which the value of a currency, in real goods and services, cannot fall.

    However, relying too overtly on taxation to give value to a currency strikes me as dangerous and potentially counterproductive. A government’s taxing power is limited and socially costly. Governments must maintain a patina of legitimacy so that people pay taxes “voluntarily” or else they must intrusively or even brutally force compliance. In a decent society, it’s perfectly possible that governments will find it politically impossible to tax at the level consistent with price stability goals. A wise, MMT-savvy government would try very hard to regulate the issue of government obligations over time in a way that avoids the need for sharp fiscal shifts in order to stabilize the price level. Avoiding the need for sharp contractions later on might imply slower issue of obligations than would be short-term optimal during recessions. But once you acknowledge this kind of forward-looking dynamic, MMT starts to sound very conventional. We start having to trade off the short-term benefits of fiscal demand stimulation with long-term “exit costs”.

    Two other points are worth making here:

    • Even though, in principal, taxation could be used to regulate economic activity and put value underneath the currency, the institutions that would be necessary to do this successfully are simply not in place in existing democratic polities.

      Within the MMT community, smart people have given a great deal of thought to institutional forms under which which fiscal policy might be used to regulate activity. As far as I know, they have mostly converged upon the institution of a “job guarantee (JG)” or an “employer of last resort (ELR)”, whereunder the size and wage of a “buffer stock” of public labor would become the economic instrument of macro stabilization. This is an ambitious idea, both politically and technically. Not only must one develop appropriate policies for stabilizing the economy on the fiscal side (i.e. the equivalent of a Taylor Rule for ELR wage levels), but one must also plan and implement real-world projects for a variable-sized pool of (hopefully) transient workers. These projects should usefully employ and develop the productive capacity of ELR participants, while remaining distinct from and and not interfering with the ordinary private and public sector workforces. (As I understand the proposal, ELR employees would be distinct from other public employees, in that they’d be paid a standard, low but livable, package of wages and benefits. ELR employment would always be viewed as a backstop that individuals would be encouraged to transition out of, rather than as permanent employment.)

      I’m interested in and sympathetic to the project of designing a government-guaranteed full employment policy that would be complementary to a vibrant private sector and that would anchor rather than disrupt macroeconomic stability goals. But however richly MMT-ers have outlined such an institution in theory, we are very far from implementing such a thing in practice. MMT-ers participate actively in current fiscal policy debates, arguing that “sovereign” governments have sufficient space to let fiscal concerns be secondary to resource utilization goals given their power to tax. Yet the power to tax is next to worthless if we do not have well understood and broadly legitimate means of exercising it in a timely manner.

      Taking a page from status quo macro management — that is, from the world of central banks — the least costly way to meet macro stabilization goals is to maintain credible expectations among the general public that tax policy will in fact be managed with sufficient dexterity and force that those stabilization goals are rarely tested. Existing fiscal institutions are mostly quasidemocratic legislatures that act in sporadic and highly politicized bursts. Their policy ventures typically mix interventions on the liability side of the public balance sheet with ad hoc changes to programs on the asset side that are often difficult to reverse. These institutions seem poorly suited to the task of credibly managing expectations and ensuring, in high-frequency real time, an appropriate fiscal stance. Promoting fiscal license in actual policy while the institutions that would render such license sustainable do not exist strikes me as reckless. When participating in practical debates about fiscal policy, it would be better if MMT-ers would bundle their support for “fiscally loose” stabilization policy with advocacy of institutional changes that could be plausibly implemented in time to matter and that could ensure support of the value of government claims, should that become necessary.

      Some MMT-ers (Warren Mosler and Winterspeak come to mind) have proposed less ambitious institutions than an employer of last resort program, specifically using the level of existing payroll taxes as the instrument of discretionary macro policy. A government can stimulate by reducing the level of payroll taxes (and thereby increasing the flow of net financial assets to the public sector in a manner that directly encourages job formation), and could fight inflation by raising payroll taxes, rather directly reducing wages and putting pressure on employment. Macro policy by unemployment is detestable, despite its long, proud tradition at the Federal Reserve. If it can be made practical, I’d much rather we work out an effective ELR program. But ELR is not an achievable option in the time frame of the current business cycle. Delegating management of the level of the payroll tax to a “technocratic, independent” institution, whether the existing central bank or some new entity, is practically achievable on a short time frame (although the politics would be rough). Perhaps there are better easy-to-implement means of conducting credible, high-frequency macro policy. I’ve no special attachment to payroll taxes as an instrument. (I’d prefer that we use transfers as an instrument.) Whatever the specifics, relying on ad hoc interventions by Congress to thread the needle between inflation and underemployment strikes me as unlikely to work out.

    • This is a technical point that would usually apply mostly to small, open economies, but that arguably applies to the United States today. Taxation can support the value of government claims, when priced in domestically produced goods and services. Taxation cannot support the foreign exchange value of a fiat currency, except to the degree that foreigners desire to purchase domestically produced goods and require expensive domestic currency to do so. A country that runs a large current account deficit owing to decisions by foreign governments to accumulate its currency and that faces competitive export markets cannot rely on taxation to support its currency, should foreign governments revise their policy of accumulation. For a country like the United States which is structurally “short” tradables, one may view the possibility of a difficult-to-counter fall in the value of the currency as a good thing or a bad thing. People like Dean Baker and Paul Krugman argue that a weaker dollar is exactly what the US needs to eliminate the structural gap in tradables production and spur domestic demand. People like Warren Mosler argue that a very weak dollar would be a bad thing, an adverse terms-of-trade shock and a loss of opportunity to trade cheap nominal claims for valuable real resources. Regardless of how you view the event, the taxing power of the government will not be able to undo it.

  8. Therefore, a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses. A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes.

    I think this is true, a deep and powerful way to think about public finance. Note that a government’s “political capacity to levy and and enforce payment of taxes” depends first and foremost on the quality of the real economy it superintends. The value that a government is capable of taxing if necessary to sustain the value of its obligations increases with the value produced overall. A government that wishes to be solvent should first and foremost interact with the polity in a manner that promotes productivity. Secondly, the political capacity to levy taxes depends upon either the legitimacy of or the coercive power of the state. A government that wishes to sustain the value of its obligations must either gain the consent of those it would tax or maintain an infrastructure of compulsion. In theory, either choice could be effective, although along with the libertarians, I like to imagine excessively coercive regimes are inconsistent with overall productivity, so that legitimacy is a government’s best bet. The two strategies are not mutually exclusive — a government could be sufficiently legitimate as to be capable of taxing some fraction of the population without resistance and sufficiently coercive as to force the other fraction to pay up. That probably describes the best we can hope for in real governments.

I’ll end with a few miscellaneous comments:

  • I’d like to see more attention paid to quality-of-expenditure concerns. That is, if a stable economy requires continuing government deficits to accommodate growing private sector’s demand for financial surplus, then the government must actually make choices about how to spend or transfer money into the economy. These choices will undoubtedly shape the evolution of the real economy, for better or for worse. Should we rely on legislators to make direct public investment choices? Should we put funds in the hands of individuals and then allow consumer preferences and private capital markets to shape the economy? How? Via tax cuts? A job guarantee? Direct transfers? Perhaps the government should delegate management of public funds to financial intermediaries, and rely upon banking professionals to find high value investments? While MMT focuses mostly on the liability side of the public balance sheet, many critics fear that ever increasing public outlays imply increased centralization of economic decisionmaking that will lead to low quality choices. Whether that is true depends entirely on institutional and political choices. These concerns can be and should be specifically addressed.

  • MMT-ers sometimes blur the distinction between “private sector net savings”, which is necessarily backed by public sector deficits or an external surplus, and household savings, which need not be. In doing so, MMT-ers rhetorically attach the positive normative valence associated with “saving” to deficit spending by government. This is dirty pool, and counterproductive. The vast majority of household savings is and ought to be backed by claims on real investment, mediated by the liabilities (debt and equity) of firms. There is no need whatsoever for governments to run deficits to support household saving. When household savings increases, an offsetting negative financial position among firms represents increase in the amount or value of invested assets, and is usually a good thing. Household savings is mostly a proxy for real investment, while “private sector net financial assets” refers to a mutual insurance program arranged by the state. It is a category error to confuse the two. Yet in online debates, the confusion is frequent. Saving backed by new investment requires no accommodation by the state. It discredits MMT when enthusiasts claim otherwise, sometimes quite aggressively and inevitably punctuated by the phrase “to the penny”.

  • In general, the MMT community would be well served by adopting a more civil and patient tone when communicating its ideas. I’ve had several conversations with people who have proved quite open to the substance, but who cringe at the name MMT, having been attacked and ridiculed by MMT proponents after making some ordinary and conventional point. Much of what is great about MMT is that it persuasively challenges a lot of ordinary and conventional views. But people who cling to those views, even famous economists who perhaps “ought to” know better, are mostly smart people who simply have not yet been persuaded. Neither ridicule nor patronizing lectures are likely to help.

    My complaint is a bit unfair. The MMT community has been sinned against far more than it has sinned, especially within the economics profession. Whether you ultimately agree with them or not, the MMT-ers have developed a compelling perspective and have done a lot of quality work that has pretty much been ignored by the high-prestige mainstream. But a sense of grievance may be legitimate and still be counterproductive.

    The internet is a fractious place. Many MMT-ers are civil and patient, and devote enormous energy to carefully and respectfully explaining their views. There’s no way to police other peoples’ manners. Still, even by the standards of the blogosphere, MMT-ers have a reputation as an unusually prickly bunch. That might not be helpful in terms of gaining broader acceptance of the ideas.

Anyway, that was a lot. I hope that it’s not entirely useless. Despite my complaints and critiques, learning about MMT has added enormously to my thinking about economics. In practical terms, I think that MMT offers the most promising toolkit for crafting a desperately needed replacement of status quo central banking.

With that, I’ll shut up. Feel free to be as nasty as you wanna be in the comments.


Update: The always great Nick Rowe calls me out:

(I don’t think any sensible person believes indebted governments will ever run surpluses of present value greater than the accumulated stock of public debt. Yet that is the party line solvency criterion.)

No, that’s not the party line. In fact, the party line would say that is impossible. The party line says that the *expected* present value of *primary* surpluses (plus seigniorage, if that’s not included) is *equal to* the existing debt. That party line is perfectly consistent, in a growing economy, or in an economy with positive inflation, with perpetual deficits, as conventionally measured (i.e. non-primary, to include interest on debt). Basically, if Nominal GDP is growing at rate n%, then a government can run a conventional deficit of n% times the outstanding debt forever. (Because that means the debt will grow at the same rate as NGDP, so the debt/NGDP ratio stays constant over time.)

Rowe is right to call me out — my wording was sloppy. It was especially unforgivable that, in characterizing the conventional intertemporal goverment budget constraint, I omitted the modifier “primary” before surpluses.

But I was only sloppy, not mistaken. Rowe suggests that, when accurately characterized, the conventional intertemporal government budget constraint is something that sensible people actually believe. I cede no ground at all on this point. Rowe himself does not believe it. He gives himself a partial way out just in the part quoted above, when he writes “plus seigniorage, if that’s not included”. In most macro models, it is not included. There are two ways that you can incorporate seigniorage:

  1. You can treat seigniorage as a cost expected by borrowers and holders of money, in which case it is not disruptive to conventional models. It is equivalent to reducing the interest rate and taxing the value of real money balances, if those are in your model.

  2. You can treat seigniorage as a form of sporadic default. That is, you can claim that at some point the government will simply write down the real value of accumulated nominal debt, in practice by allowing debt or money growth without sufficient yield to prevent an increase in the price level.

The second view is disruptive of conventional models. Rowe may argue that we account for everything by the use of expectations rather than certain values in conventional models. That could be true, but broadly, it’s not. There are some models of default inspired by third-world debt crises, but outside of that, explosive growth in the price level and/or default are modeled are presumed or constrained not to occur. Monetary policy models are a partial exception, in that they derive conditions under which the constraint would hold, which then come to guide central bank policy. But in the limit, under standard equilibria in a decent country, it is assumed or derived that real primary surpluses will (in expectation) be generated in sufficient quantity to offset the real existing stock of debt. I view that as a very unlikely characterization for many existing governments.

Suppose that we do include the possibility of default. What happens? Rowe and I agree furiously on this:

Suppose there’s a 1% chance every year that a firm of government will disappear and default totally on its debt. The probability of default approaches 100% in the limit, going forward. But a risk-neutral investor will happily hold the debt with a 1% risk premium on the yield.

But what does this do to the intemporal government budget constraint? There is no constraint whatever in this characterization. Suppose that the government offers a 2% premium over investors’ cost of borrowing, and the probability of default is exogenously 1%. Then investors borrow and invest without limit! Obviously, we need to “close the model” somehow to make things realistic, but there are lots of ways to do so that violate any ordinary interpretation of the conventional intemporal government budget constraint.

I claim that realistic models, which incorporate consumers who face liquidity constraints and idiosyncratic risk in an economy subject to systematic risks of production shortfalls, do not conform to an intertemporal government budget constraint of remotely the conventional form. I’ve already described half of such a model here. I should add the other half, and write the math down in a way that economists can understand. The key insight is one that both quasimonetarists like Rowe and MMT-ers accept but rarely state explicitly — much of our motivation in “lending to the government” is not to capture growth, bit to self-insure against idiosyncratic risk. There is nothing novel about this — conventional treatments of the permanent income hypothesis characterize the conditions under which individuals will engage in precautionary saving. Redemption of precautionary savings in the form of money or government debt usually works not by government provision of goods and services when an individual faces shortfalls, but by virtue of transfers of real goods and services to those who face shortfalls from those experiencing surpluses. In other words, money and government debt are the medium by which we conduct a mutual insurance program. The stock of government debt then grows as a function of determinants of precautionary savings, which include income, but also risk preferences, the idiosyncratic risk that agents face, and the degree to which borrowing constraints bind. In all periods where the government does not default, participating in this insurance program is straightforwardly beneficial. The risk of rare government defaults, due to systematic shocks, may be insufficient to offset the benefits of participation in the mutual insurance program, and government debt need only be the least risky available medium, conditional on its use for insurance purposes, to rationally attract insurance-motivated lending. Under some circumstances (satiable preferences, steep reduction of incomes post-government-default combined with rationing based on prior savings, little relationship between the scale of insurance borrowing and the likelihood of default), I claim, it is reasonable to expect government debt to grow without bound. I consider these circumstances to be pretty realistic.

The MMT solvency constraint

It is good to see Paul Krugman prominently discussing “modern monetary theory”, although I don’t think his characterization is quite fair.

I am an MMT dilettante, so I’ll apologize in advance for my own mischaracterizations. But I think the MMT view of stabilization policy can be summed up pretty quickly:

  1. The central macroeconomic policy instrument available to governments is regulating the flow of “net financial assets” to and from the private sector. The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.

  2. A government that borrows in its own currency cannot be insolvent in the same way as private businesses. That is, such a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.

  3. However, the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives (such as, especially, full employment).

  4. The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows. Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.

  5. The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.

  6. Avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilization is slack, as evidenced especially by high unemployment. Avoiding net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed.

  7. However, a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes.

  8. Therefore, a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses. A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes.

I think this is a clever and coherent view of the world. I do not fully subscribe to it — in my next post, I’ll offer point-by-point critiques. But first, let’s see where I think Paul Krugman is a bit off in his characterization:

As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.

I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.

The real question here is why a deficit that would be inconsistent with price stability with “loose money” would be transformed into something sustainable with “tight money”. From an MMT-perspective, it is the flow of net financial assets from public sector to private, relative to the private sector’s willingness to absorb, that matters. Whether those net financial assets take the form of liquid cash or still very liquid Treasury securities is second order. As Krugman himself has pointed out, conventional monetary policy is just a shift in the maturity of government obligations. If the private sector is unwilling to hold the expanding stock of dollar-denominated obligations at prices (in terms of real goods and services) consistent with our definition of price stability, the private sector will be unwilling to hold those obligations whether they are bonds or money.

An obvious objection is that bonds pay yields that might induce private sector agents to hold government paper at current prices (again in terms of real goods and services), while money historically did not. Krugman’s sustainable “tight money, loose fiscal” scenario basically amounts to pointing out that the private sector can be induced to hold more paper if the public sector promises to make large ongoing transfers to holders of its paper. MMT-ers have mixed feelings about using interest payments to increase the willingness of the private sector to hold government paper. Regardless, since most central banks now pay interest on reserves, these payments no longer serve to demarcate “fiscal” obligations of the Treasury and “monetary” obligations of the central bank. Rather than being divided into “fiscal” and “monetary” policy, we end up with “flow” policy and “yield” policy. In order to stabilize the price level and real spending in the face of changes in private sector demand for government paper, the public sector can either modulate supply (by adjusting the size of the deficit / surplus), or modulate demand via the yield (by altering the interest paid on reserves or selling term bonds). As MMT-er Bill Mitchell puts it, “Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.”

MMT-ers view the size of the flow itself — that “6 percent deficit” — as the primary instrument of stabilization policy. By holding the deficit constant in his thought experiment, Krugman deprives MMT of the means by which it would manage demand. MMT-ers do not claim that fiscal policy can ignore private willingness to hold government assets. On the contrary, they take from Wynne Godley’s sectoral balance analysis that fiscal policy should do a jujitsu to accommodate the changing net demand of the private and external sectors. MMT-ers very much agree that it is important not to lose access to the bond market, broadly construed. But they suggest that the government’s power to tax is sufficient to maintain the private sector’s appetite to hold government paper, whether in the form of bonds or of money. Therefore, there is little need to fret about “confidence” and undead theories of government solvency. The government can issue paper — make transfers, deficit spend, whatever — when the private and external sectors are willing to buy, and reduce deficits or even run a surplus when those appetites have been sated.

Anyway, this is long enough. I’ll post critiques of the view I have summarized later.


Much of my understanding of MMT comes from conversations with the excellent Winterspeak. Obviously, any mischaracterizations are my own and any insights due him. I owe Winterspeak a contentious post highlighting our argument about whether it is detestable for wealthy people to maintain large holdings of money and government debt. I say, for the most part, that it is. If you want to read that argument in raw, unhighlighted form, see the comments here. I’ve also learned a lot from the mysterious JKH.

Some writers of note about MMT include Marshall Auerback, Scott Fullwiler, James Galbraith, Bill Mitchell, Warren Mosler, Rob Parenteau, Pavlina R. Tcherneva, Eric Tymoigne, and L. Randall Wray. You can find the writing of several of these authors in Levy Institute’s working paper series and at Economic Perspectives from Kansas City. Some blogs that occasionally offer an MMT perspective include Credit Writedowns, Naked Capitalism, New Deal 2.0, and Pragmatic Capitalism. See also the related links below.

Update History:

  • 27-March-2011, 7:30 p.m. EDT: Fixed misspelling of Marshall Auerback’s name (sorry!). Added lots of MMT resources and related links, many thanks to commenters Sennex and Tom Hickey as well as Winterspeak for some links. One change to the piece itself (pre-acknowledgements): Changed “modulate the yield” to “modulate demand via the yield”
  • 27-March-2011, 7:45 p.m. EDT: Changed “effects” to “impact” in Point #1, to avoid repetition of “effective” and “effects”…
  • 27-March-2011, 8:45 p.m. EDT: Obsessively removed the “i.e” before “conventional monetary policy”. Also changed “in the present and recent past” to “in the recent past”, just because the latter reads less awkwardly.

The meaning of “socialism” in American politics

So, call me a philistine, but I really think that the Tea Party types have gotten a bum rap over their whole “Keep Government Out Of My Medicare” slogan. Yes, Medicare is a government benefit. One’s Medicare card represents a claim on the government that can be redeemed for goods and services, usually delivered by private sector providers.

You know what else is a claim on government that can be surrendered for goods and services from private sector providers? Money. Yet there is no part of the political spectrum that considers it incoherent to say “Keep Government Out Of My Pocketbook”, even though the only relevant thing your pocketbook contains is government scrip. If the money analogy seems to forced, consider a retirement account chock-full of government bonds. The account contains nothing more or less than government promises to pay, but that doesn’t render it incoherent to object to the government’s altering the terms of the bundle of promises, whether by restructuring the debt or more aggressive taxation.

What the Tea Partiers are accurately if not artfully expressing is that Medicare feels a lot like a property right. Our most important property rights are often claims on people or institutions. This includes all financial wealth — dollar bills, stocks and bonds, pensions and 401-K plans, every form of insurance we buy for ourselves or others provide for us. Medicare and Social Security are, from users’ perspective, property, no different from a privately funded health or pension plan. Why should users think of them as “government benefits” any more than they think of interest payments on a Treasury bond that way? Human beings are notoriously territorial about property. All it takes to turn a human being into a urinating canine is the combination of 1) a readily comprehensible set of nonuniversal rights; and 2) some account that legitimizes differential claims to those rights. Medicare and Social Security have all that in spades. They provide rights to tangible, extraordinarily valuable, transfers and services. People endowed with those rights believe themselves to have earned them, by virtue of having contributed to the programs specifically and to society generally in a quasicontractual arrangement. People consider themselves “entitled” to their entitlements because they view them as property.

Matt Yglesias writes:

Any effort to reduce government spending on health care for the elderly is intolerable socialism, and any effort to increase government spending on health care for the non-elderly is also intolerable socialism. That’s cynical, but it also reflects the objective difference in the age structure between the parties.

I think it’s fair to point out that it’s cynically exploited, but I think the underlying feeling is not really so cynical. The meaning of socialism in American politics is government action to redistribute property rights. It is socialism in America to tax the rich and it is socialism in America to give to the poor. Similarly, it is socialism for the government to change the terms of the extraordinarily valuable set of rights that constitute property to Medicare incumbents, and it is socialism to extend those extraordinarily valuable rights to people who haven’t “earned” them. That may be objectively bizarre for a program that is universal after age 65. But the median Medicare recipient has worked and paid taxes most of those 65 years, views her benefits as earned, and takes herself as representative of Medicare recipients as a class.

Americans, for better and for worse, are unreasonably — almost limitlessly — respectful of what they understand to be property rights. That’s just a fact on the ground. Some interest groups get this: Consider the decades long project of recasting copyright, patent, trademark, and trade-secret protection into “intellectual property” that can be “stolen”, rather than narrow government dispensations intended to advance specific social purposes. People trying to design policy that will actually work in America have to keep this property fetish in mind. It creates both constraints and opportunities, but it is there.

The changing private value of oil in the ground

So oil prices are rising, and, inevitably, a debate is heating up about the role of speculation versus that of “fundamentals”. Ryan Avent makes a point that was commonplace last time our collective heads were on fire about oil prices and it was all the speculators’ fault:

[T]he easiest and most effective way to speculate on the price of oil is to leave the stuff in the ground, and there’s not a thing the American government can do about that.

I thought this was a good point in 2008, the best rejoinder to Paul Krugman’s recurring query that, if it’s speculation, where was the inventory build? But it strikes me as a less compelling point now.

Suppose you are the House of Saud. Like anyone with a position in a traded asset, you face a sell or hold decision. If you expect that the real value of your asset will rise faster than the real value of financial investments you could make at equivalent risk if you sold, then you should hold. Otherwise, you should sell.

But there’s a wrinkle. The House of Saud really must compare the private value of oil in the ground to the private value of alternative investments. Like a middle American muni investor maximizing after tax returns, the House is looking to maximize the value it can actually appropriate. Ordinary taxes aren’t that big a deal to the Saud’s, who after all run the state. But the House of Saud faces a different sort of “tax” on future oil: the possibility that by the time it is exhumed from the desert, it will no longer be theirs to sell. The expected private value of future oil to the House is proportional to the expected future oil price and inversely proportional to the probability of revolution. I’d guess that events of the last few months have significantly reduced their expected private value of oil in the ground, the current oil price spike notwithstanding.

One might even argue that current circumstances amount to a natural experiment by which we might test the question of whether Saudi Arabia in fact has 3.5M barrels a day of spare capacity they can easily bring on line, or whether they’ve basically been running full tilt already. As the probability of revolution — or else a permanent increase in wealth-sharing to forestall revolution — increases, the private value of oil in the ground falls. If flows don’t increase, that could be taken as evidence that the Saudi Arabia is pumping at capacity.

Of course, life is messy, and natural experiments are never perfect. Lots of caveats: The pump-or-store decision should be based on the relative private values of oil and financial investment. If the princes think that, after a revolution, their financial wealth would be frozen by fair-weather patrons in the West, that would tilt things in the opposite direction. The princes might believe that defending their claim to oil in the ground is a better bet than relying upon recently less than reliable Swiss bankers to protect the interests of unpopular clients. (A strange corollary of all this is that if the West wants to maximize current oil flow, it should credibly promise to recognize the House of Saud’s claims on private and sovereign wealth, come what may on the Peninsula. I do not advocate this — I think we should put longer-term interests before concerns about the moment’s oil price. But the logic is clear.)

Also, the princes would have to be mindful of potential backwards causality from pumping decisions to revolution. If it looks like the rulers are ramping production in a panic, that might signal fear and undermine the government’s legitimacy, aiding the revolutionaries’ cause. However, the current price spike and concerns of oil consumers would provide cover. There are lots of reasons besides fear of regime change why the Saudi government might choose to increase production now, if they can.

Obviously, all of this is, um, speculation. Interfluidity is not the The Oil Drum. I know little about the details of oil production or of Saudi politics. But from the perspective of several Middle Eastern regimes, I’d guess that “oil in the ground” seems less of a safe bet than it might have a few years ago.

The case for film subsidies (and other goodies)

Last week, Michael Kinsley published a jeremiad against film subsidies in the LA Times. Two of my fave Economist-oids, Ryan Avent and Will Wilkinson, follow up, Wilkinson with an endorsement of Kinsley’s piece, Avent with a more nuanced but ultimately very radical comment.

Film subsidies and other state and local programs intended to promote economic and cultural activity are sometimes smart policy and sometimes corrupt boondoggles. I certainly don’t wish to argue that they are always and everywhere good. But Kinsley argues that they are always and everywhere bad, via arguments that are as compelling as they are false. Let’s try to understand the economics a bit.

The most widely quoted, and most plainly wrong, bit of Kinsley’s piece is this:

New Mexico under [former Governor] Richardson was a pioneer in this field. In 2002, it began offering a credit of 15% — later raised to 25% — toward the cost of making a movie in New Mexico… Now, 42 states have followed its lead… In less than a decade, the absurd notion of welfare for movie producers has evolved from the kind of weird thing they do in France to an unshakable American tradition… Richardson says that the film and TV subsidy has brought “nearly $4 billion into our economy over eight years” and has created 10,000 jobs. By “our,” he means New Mexico. He says every state should emulate this success.

But of course every state cannot do that because it essentially is a “beggar thy neighbor” strategy.

Ryan Avent is not ultimately willing to endorse film subsidies. But he is too good an economist to let this go by. He writes

A subsidy allows a business to cut prices and artificially raise demand. Given generous enough subsidies, many more movies would be made, and each state could, potentially, have a thriving film industry.

To put the same point differently, film subsidies reduce the cost of production and thereby increase risk-adjusted expected returns to investors. In a world thick with aspiring directors and clever screenplays, there are always hundreds of potential films getting ranked, accepted, but mostly rejected by investors willing to support film production. At the margin, there are films — perhaps quite a lot of films, it’s an empirical question — that investors would deem almost but not quite worth funding in the absence of subsidies. These films get funded and produced when governments sweeten the pot.

Film subsidies are not entirely or even predominantly a “beggar thy neighbor” strategy. They are certainly not, as Wilkinson asserts, a zero-sum game. In many countries, a large fraction of production depends upon state subsidies, and many films would not have been produced without them. The elasticity of film production to subsidy is far from zero.

Still, this is “welfare for movie producers”, as Kinsley puts it, right? Avent describes the excess demand as “artificial”. To which I say, huh?

Kinsley’s “France” is not nearly communistic enough to discredit this pernicious practice. If we really want to drive home the idea that film subsidies are a booger floating in the soup of red-blooded capitalism, we should associate them with that most Bolshevik of all institutions, the, um, suburban American shopping mall.

The economics of a well-designed film subsidy and the economics of suburban shopping malls are identical. State governments offer film subsidies on the theory that film-making within the state will generate ancillary economic activity that will more than offset the cost of the subsidy. Suburban shopping mall developers offer what are effectively rent subsidies to stores they expect to generate extra traffic and sales for the shopping mall. Many of the “anchor stores” — the big, national-brand department stores — at your local mall pay no rent at all, despite occupying vast territories of prime space for which their specialty store neighbors pay dearly. This phenomenon has been carefully studied. Gould, Pashigian, and Prendergast write

[T]he differential contracts offered to the anchor and nonanchor stores appear to not only offset some of the externalities generated by the anchor, but do so in an efficient fashion, at least on the dimension of total sales and rent in the mall. If this were not the case, the result would likely be a misallocation of space: a failure to internalize the benefits of the anchor stores would imply too little space allocated to anchors, because anchors themselves would not consider the external benefits their presence has on the other stores when deciding how much space to lease.

The arrangement that has evolved among private parties via consensual, contractual negotiation is that shopping mall developers effectively tax non-anchor stores with high rents in order to subsidize anchor stores with mostly free rents. Far from “artificial”, if developers did not do this there would be a deadweight cost. If rents were held homogenous within shopping malls, there would be a lot fewer anchor stores, which would deprive smaller stores of the foot-traffic and sales those anchors generate, which would then deprive shopping malls of a lot of potential rent.

Still, the Macy’s, Sears, and Nieman Marcuses of the world have to live somewhere, right? And it’s got to rankle shopping mall developers — you know it does — that a substantial fraction of their hard-built space is given away for trivial or even zero rent. Suppose that all of America’s shopping mall magnates gathered in a smoke-filled room and decided to ban the practice of subsidizing rent to anchor stores. What would we call that? It turns out we have names: “price fixing”, “cartel”, “conspiracy in restraint of trade”.

If shopping mall developers could pull off such a scheme — or really if they could have pulled off such a scheme years ago — they might narrowly have benefited. There would have been fewer anchor stores and therefore fewer shopping malls, but the loss of scale might have been offset by developers ability to, um, extract rents from anchor chains, leading to increased profitability. But that extra profitability would have been an ordinary monopoly rent, of the sort we typically condemn and even criminalize, wherein higher prices are extracted by virtue of a monopolist’s power to enforce underprovision of goods. We’d have the FTC or the Department of Justice all over their asses if shopping mall developers tried to pull something like that.

Similarly, if it is true that film production generates positive externalities for local and state economies, it still might be true that having local governments band together and refuse to provide film subsidies would lead to greater overall tax receipts. The reduction of taxable economic activity due to cartelized subsidy refusal could be offset by the savings realized from withholding the subsidy. If this is so, then state and local governments (in aggregate) profit only by forcing a reduction of activity below the level economists would ordinarily call “efficient”. By not permitting filmmakers to recover some share of the value of the positive externalities they generate, we force a lot of them to take their ball and go home, leaving us all poorer in aggregate.

I don’t think it’s likely, either with respect to shopping malls or with respect to films, that “local governments” would in fact benefit by forming a cartel. In both industries, I think the externalities are real, and despite some “beggar thy neighbor” competition — between shopping malls as between states — these “governments” come out ahead by rebating some of the external benefit back to those who create it and getting a smaller piece of a bigger pie.

Kinsley, in his column, implicitly recognizes that he is calling for a cartel of state governments. “Government, in order to work, must be a monopoly,” he asserts, without explanation or justification. Governments do maintain certain monopolies within their territories, but must the fifty state governments band together and become an uber-monopoly as well? Isn’t much of the justification for federalism the notion that multiple governments experiment and compete, generating creativity and dynamism that wouldn’t exist in a monopoly public sector? How does the fact that “the landlord” is a government alter the economic logic of efficient contracting within competitive shopping malls, which is precisely the same logic that justifies film subsidy?

Distributional issues arise when subsidizing externalities. The local gag store is more sympathetic than a national chain, but the gag store ends up paying the anchor store’s rent. Local taxpayers are more sympathetic than Hollywood studios, yet local taxpayers end up funding Hollywood studio returns. With respect to private sector shopping malls, there’s little we can do about these distributional concerns. In the local government sector, however, it is perfectly legitimate to discriminate by, for example, offering the subsidies only to local filmmakers, however defined. That choice is full of trade-offs: Restricting subsidies to local filmmakers arguably implies that, from a global perspective, some less valuable films get produced in preference to more valuable films. The restriction also reduces the power of the subsidy to generate activity, both in absolute and bang-for-the-buck terms, as there are fewer films locally than globally. But local films may contribute to local culture in ways that taxpayers value, local subsidies go to people more likely to respend money in state (increasing tax recoveries), and distributional concerns are legitimate and serious. These are tradeoffs for taxpayers and their representatives to make based on particularities.

The most serious case against film subsidies, emphasized both by Kinsley and Wilkinson, is the public choice argument. Wilkinson claims that “the film and TV incentives racket is a hotbed of corruption.” That may or may not be a fair characterization, but the point is well taken. The economic logic behind subsidies is iron-clad, given activities that generate net positive externalities whose value is known to be more than the cost of the subsidy. But the externalities of future projects can only be estimated, and estimates by potential recipients of subsidies are rationally overoptimistic. If politicians, perhaps blinded by “personal friendships” with campaign contributors, fail to form independent and conservative estimates of public benefits, then they may offer excessive subsidies, which destroy value while transferring funds from taxpayers to the subsidized.

This is a very serious issue. But it needn’t be insurmountable. Subsidies can be and sometimes are attached to contractual obligations to generate promised activity. Localities do this routinely, and sometimes sue to recover the subsidies if public benefits fail to appear. There is always a lot of uncertainty surrounding indirect public benefits that may result from various activities. But, as Matt Yglesias reminds us:

Life is full of situations that demand you to make decisions under conditions of uncertainty. In almost all cases, the right thing to do is to try your best, not to simply give up.

It is conceivable that we are simply unable to organize governments capable of resisting corrupt inducements, and therefore our best option in a bad world is simply to forego all subsidies. I’m pretty cynical about government, but I don’t think we’re there yet. If that is your position, however, at least get the economics right. Don’t imagine that a blanket prohibition of subsidies, to film or any other activity with positive externalities, is “efficient”. On the contrary, a blanket prohibition is guaranteed to result in underprovision, and likely to result in lower total tax receipts than an optimal subsidy regime. You can argue that in a third-best world, we’re better off accepting very large deadweight costs than the corruption that attends differential taxation schemes. But there is nothing efficient in either of those choices.

In the real world, all successful governments subsidize activities with putative positive externalities. All unsuccessful governments do so as well. In the history of the world, I doubt there ever was a government which has not differentially taxed or subsidized in order to promote allegedly valuable activity. Under the circumstances, I think we should take Yglesias’ advice and try our best to do subsidy well. If we do it right, both theory and evidence suggest that subsidy can do a lot of good. If we do it poorly, we’ll destroy a lot of value and generate corruption. Not doing it at all, in a practical sense, is not an option. I think the case for positive externalities associated with film production is pretty strong. If so, then the right thing to do is to keep the subsidies but to administer them as wisely and as noncorruptly as we can. Distributional concerns matter a lot to me, so my preference as a taxpayer is to support subsidies that discriminate in favor of local and/or “independent” filmmaking (although that invites its own corruption in the form of “definition arbitrage”). More generally, a world without state subsidy is not a world to strive for. It would be as much a libertarian paradise as a ghost shopping mall.


FD: My wife is a film student, aspiring to become an aspiring filmmaker. Perhaps that colors my view of film subsidies.

Update History:

  • 5-March-2011, 11:15 a.m. EST: Changed “Kinsey” to “Kinsley” throughout. Thanks to Leigh Caldwell for pointing out the error, and my apologies to Michael Kinsley for making it.

The overpayers’ club

The overpayers’ club is a club I’d like to join. Somebody, please, help me pay too much. I want to overpay, but I insist on overpaying well.

Here is how the overpayers’ club would work. I’d enter a restaurant, and present my club card. The hostess would swipe the card (or perform whatever the newtech equivalent of a card-swipe is), and then either agree or apologetically refuse to accept my custom as an overpayer. If I am an overpayer, then my meal is on pay what you wish terms. At the end of the meal, an ordinary check would be tabulated and presented. But my payment of that check would be optional, and the amount I pay entirely at my discretion. After the meal, both the amount charged and the amount paid would attach to my permanent record with the club.

Service providers of many different kinds, not just restaurants, could participate in the program. The club would promote a norm, voluntary and nonbinding, that overpayers pay on average at least 10% more than amount billed at pre-agreed or ordinary prices. Providers would have instant access to members’ average overpayment (dollar-weighted), dispersion of overpayments, and any other information they contrive to mine from customers’ overpayment history, when deciding whether to offer price flexibility. The benefit for service providers in participating in the overpayers’ club is obvious. After refusing known cheapskates, they would expect to earn a substantial premium from overpayers. In exchange for that, they risk uncertainty and volatility of cash flows, which they can somewhat mitigate by delivering reliable quality.

Customers benefit from the ability to monitor and discipline relative quality among service providers, from increased agency and bargaining power within the context of isolated transactions, and, when quality is high, from the pleasure and mutual goodwill that comes from overpaying. When quality is low, customers can express that in a way that bites. At a restaurant, if I am unhappy with the quality of food or service, I can pay only half the check. Note that I cannot actually avoid the cost of my meal without putting my reputation in jeopardy. I’ll have to make up for stiffing the bad restaurant by overpaying other establishments unusually much in order to maintain my average overpayment. But I have the power to redirect funds from bad to good establishments without putting my overpayment record in jeopardy.

Besides restaurants, the overpayment club would obviously extend to businesses like hotels and salons. It could be useful for meat and produce purchases at grocery stores (whose bill would be payable after, say, a week, during which the food’s quality could be experienced). More ambitiously, a wide variety of professional services — consulting, programming, even doctoring, lawyering, and teaching — might benefit from the combination of discretionary payments disciplined by transparent and valuable customer reputations.

That’s the basic idea. There are lots of extensions and details to consider. Should merchants’ overpayment experience be accessible by club members or the general public? (Overprice transparency!) Should there be a mechanism by which members can augment past overpayments after some time has passed, both to allow a considered evaluation and in order to ensure that members who express dissatisfaction aren’t shut-out of opportunities to make up for the underpayment? Perhaps there should be a lottery that occasionally denies requests for price flexibility even by the very generous, in order to reduce the social stakes associated with refusals. How should tips and gratuities be dealt with? These are important details, but they are details.

In financial terms, this proposal can be described very simply. I want to give consumers the option to issue equity rather than debt in exchange for goods and services. You and the SEC may not have noticed, but when you sit down at a restaurant, order, and are served a meal, you issue debt. The restaurant extracts an unwritten but enforceable obligation that you pay a fixed sum of money. In exchange for that obligation, you receive an asset of uncertain consumption value. Canonically, the result of financing an asset with debt is to concentrate valuation uncertainty — risk — on the asset’s purchaser. Equity finance, on the other hand, diffuses risk, in exchange for sharing some of the upside if things works out.

Equity finance by vendors is particularly appropriate when the seller has better information than the buyer about the quality of the asset being sold. Vendors selling opaque but high quality assets can predict good realizations, and so are happy to take an equity position. Purchasers interpret sellers’ willingness to bear risk as a credible signal of quality that justifies extra cost. I think that we underutilize equity arrangements at every level of our society. We have made an error, from which we need to backtrack, that can be summed up by the word “commodification”. In the name of a false efficiency, we have struggled to cram everything from corn to cars to financial and legal relationships into the mold of widgets that can be competitively produced, objectively characterized, and then priced in fixed numeraire at arms-length by open markets. If only this could work, if things like financial services really were goods just like soda pop, the uncontroversial parts of microeconomics would vouchsafe easy, efficient commerce and we’d live happily ever after. But it can’t work. Pretending is killing us.

Commodification is a reasonable framework for managing trade in corn and manufactured goods, but is an inappropriate for any thing or practice whose quality is revealed over time. Commodities are appropriately priced in money and financed by debt. Goods and services that are not commodities require more complex forms of exchange than what’s imagined by an introductory economics textbook. What we must “buy and sell”, most of what matters, is relationships. Managing relationships is mysterious, a difficult problem. But we know more than nothing. Just as commodities are naturally exchanged for debt and money, relationship finance naturally takes the form of equity arrangements, in which cash flows are contingent upon variable outcomes. The trouble with equity is that, in most cases, the space of potential outcomes is too complex for the amount and timing of cash flows to be firmly contracted ex ante. Choices must be made, costs and benefits must be allocated, after events have unfolded. Ex post allocation implies discretion and requires trust. Trust outside of local social networks depends upon reputation. As economies have grown, we’ve gravitated to the commodity exchange model, because it is easy to scale with low information and transaction costs. We do not yet know how to reconcile large-scale open commerce with trade based on relationships, reputation, and equity. But in an IT-rich world, we should be able to make progress.

Equity arrangements, when they are successful, have positive social externalities. Fixed-price commodity exchange and ex ante contracting discourage both trust and what most of us would recognize as virtue. If a person receives poor value from a commodity purchase, the question to ask is whether she shopped well. Did she research the product or service she was buying? Did she look elsewhere for better pricing? Caveat emptor becomes a moral duty. Any hint that a transactor has not fulfilled her obligation to be energetically cynical disqualifies her from any claim to our sympathy. Sellers in a commodity world have no obligation but to maximize their advantage within bounds prescribed by law and formal contracts. After all, if buyers are informed, competitive shoppers who assume no beneficence on the part of counterparties, then anything that might go wrong after the sale must already have been priced into the contract.

Equity arrangements flip this logic 180 degrees. Equity relationships are based primarily on trust. Caveat emptor still has a role to play, in that extensions of trust should be merited. Not everyone is trustworthy or competent, so equity providers must be discriminating. But once the relationship is formed, an equity issuer who abuses her discretion and metes out an unfair distribution of risk and benefit, who seeks to maximize her own position to the disadvantage of collaborators, is justly condemned. In an equity world, well-placed trust, fair dealing, reputation, and character are rewarded, while in a debt/commodity world, shrewdness and informational advantage win the day. Designing and understanding our economic interactions more on equity rather than commodity terms would help to diminish some of what is parasitic about liberalism (ht Chris Mealy).

Both modes of commerce, debt/commodity and equity/collaboration, have their place. It’s nice that we can buy toothpaste and cereal without forming a relationship with the convenience store or much worrying about its reputation. Goods that can be standardized, that are easily understood and perform reliably, ought to trade as commodities. But most goods and services fall somewhere between toothpaste and astrology on the information spectrum. Real people in real economies have already invented hybrid schemes that mix the debt/commodity and equity/collaboration styles. Often when we buy complicated and expensive products, we trade them like commodities, but they come bundled with something called a “warranty” that shifts some of the uncertainty surrounding performance back to the seller. Most of us rely very little on the contractual fine print in these warranties, but depend instead on the reputation of the manufacturer or the retailer. We trust that these businesses will deal fairly with us ex post, even if we lack any formal assurance that they will. Without this kind of risk-sharing, a lot of markets would be severely handicapped. In restaurants, the American custom is to issue debt to the restaurant owner, but equity to the server, who is paid almost entirely from discretionary tips. This makes some sense, since we can gather information about restaurants from reputation and experience, but with each visit we patronize a server whom we do not know or choose. Still, even after wasting hours on Yelp, restaurant outcomes are highly variable. The arrangement is a rough on servers, who are at the mercy of generous clients and cheapskates alike, and who bear most of the consequences of errors made in the kitchen. The lack of any means to translate virtue on the part of clients into reputation is unfortunate.

Just as we’d be collectively poorer if no one had made workable the idea of a product warranty, we are poorer than we might be because we’ve not yet invented off-the-shelf tools to manage the information- and risk-sharing appropriate to variable-outcome services. These services resist commodification, but perhaps the infrastructure we use to manage them can be made more standard. The overpayers’ club, and its mirror image, equity finance of business by consumers and other stakeholders, amount to experiments in combining the risk-sharing of a relationship economy with the low costs, openness, and scale of a transactional economy. They are imperfect experiments, but they could be tried. Like always, we’ll stumble into the future. We might as well get started.