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MMT and Austrian Econ: A (Wonky) Dialogue

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Photo: Johner | Johner Images | Getty Images
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Modern Monetary Theorist: Hey, my friend. Why do you look so glum?

Austrian Economist: I'm worried about the inevitable boom-bust cycle that will result from these artificially low interest rates.

MMT: I'm a bit confused about why you think that would happen.

AE: It's pretty simple, really.

In a market economy based on gold and 100 percent reserves at banks, low interest rates signal present savings are available for future consumption. Businesses expand in longer-term, more capital-intensive ways because they anticipate the demand created by the extra savings.

MMT: Right. I've got that. But you do realize that we're not on the gold standard and haven't had that kind of banking system in generations, right?

AE: Sure. That's the problem. You see, when interest rates are artificially lowered by a central bank or fractional reserve credit expansion, the interest rates are a false signal about present savings. Business expand but the future demand doesn't develop because the savings weren't there. The low interest rates created the illusion of savings.

MMT: I can totally see how this would be a problem if we had your free-market system in place and then a central bank intervened.

AE: So we agree. Do you want to borrow my copy of "Man, Economy and State?"

MMT: Thanks. I will. But I do not quite agree. I don't think you actually understand how far central bank intervention has gone.

AE: That seems implausible. I worry about central bank intervention almost every day, from dawn 'till lights-out.

MMT: Here's the thing. In our system — non-redeemable money, floating exchange rates, central bank — short-term interest rates don't reflect savings at all. Interest rates just do not reflect or signal real savings in the economy.

AE: That's what I was saying!

MMT: Take it a step further, though. Interest rates are now policy-based rates, not savings-based rates. The Fed targets rates and meets its target, when necessary, by paying interest on reserves, supplying new reserves or draining reserves. It's completely irrational to do any business planning that attempts to read savings from interest rates.

AE: It sure sounds like you are agreeing with me.

MMT: I am agreeing with you. But I don't think you have understood the full scope of our departure from the gold standard. In our current system, banks do not lend out deposits.

Their loans create deposits. The banks are not just "fractional reserve" lenders — they are "reserve independent lenders." They lend without regard to their reserves, and then borrow the reserves later to meet government requirements or make interbank transfers. If the banking system as a whole is short of reserves, the Fed notices this because interest rates go above the target rate. So the Fed injects more reserves in order to keep rates at its target.

AE: It's a giant illusion.

MMT: Sure. But it's not an illusion of savings, in particular. It's a credit system built on central banking plus banks which are semi-public institutions that are licensed by the government, to create new deposits by making loans "out of thin" air and backed by the government in the form of the central bank's role as a lender of last resort.

AE: Holy crap! This is the unlimited credit expansion that Murray Rothbard was warning about in "The Mystery of Banking."

MMT: Even Rothbard didn't quite understand that things were much "worse" than he thought. Banks are even less constrained than he believed.

AE: This is going to lead to disaster. Bubbles, unsustainable expansions, banks lending willy-nilly.

MMT: Yes. We've been warning that this financial system leads to fragility for a long time.

AE: We're screwed.

MMT: Well, we're screwed unless we put in place prudential regulations and have bank regulators that can shut down banks that exceed prudent limits.

AE: What guarantee do we have that regulators can effectively set prudential limits? Weren't Lehman Brothers and AIG within the limits set by regulators when they blew up?

MMT: But that was because of irresponsible deregulation.

AE: What makes you think that regulators can get it right? Won't the powerful businesses and banks dominate the regulators?

MMT: This is a policy question, not an economic question. We think that well-meaning, informed regulators can set the right rules of the road.

AE: The last decade doesn't shake your confidence in this proposition?

MMT: The last decade teaches us the need for more regulatory vigilance.

AE: You seem to have a double-standard here. You think that financial markets are prone to instability but that regulators can escape this tendency and stick to policies that embrace stability.

MMT: That's the policy we're urging.

AE: Good luck with that. I'm going to buy some gold.

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