Heterodox Economic Theories Unite?

A friend recently sent us a link to an article by the ‘Rogue Economist’ in which it is argued that ‘Austrians and MMTers should be on the same side‘. In this article, some of the commonalities and differences between the two schools of thought are listed, albeit without going into too much detail. The main thrust of it seems to be that since the ‘mainstream’ is arrayed against both theories, their proponents have good reason to get together and jointly battle the errors of modern-day mainstream economists instead of taking aim at each other.


Modern-day chartalist Warren Mosler: just let the government and the central bank mark up a few accounts and everything will be fine.

(Photo via: Norwich Bulletin)



However, this proposal suffers from a fatal flaw. The test of a good economic theory is not if it is opposed to the establishment, but if it is able to correctly explain economic phenomena (besides, MMT’s economic policy prescriptions differ from the actual policies that have been implemented by the government by an increment of roughly zero). There are in our opinion unbridgeable differences between the Austrian School and MMT.

We apologize in advance that the article that follows below at times meanders a bit off course, but we tried to approach the topic from several angles while trying to not necessarily repeat everything that has been written on it before.


Schools of Economic Thought And The ‘Methodenstreit’

The term Austrian School that is widely used today to describe subjectivist economics based on deductive reasoning is merely a convention with specific historical roots. There have been many fore-runners in the history of economic and political thought, such as the 16th century scholastics of the School of Salamanca, Turgot, Cantillon, Bastiat, Smith, Hume, Mills, Say and Jevons to name but a few, whose ideas preceded and are closely connected with those enunciated by the the Austrian School. Mises himself often tended to put the term ‘Austrian’ in quote marks. As he saw it, the proponents of what is now called the Austrian School simply laid out a valid theory of economics, which in turn, as he put it, represented the ‘hitherto best elaborated part of a more universal science, praxeology‘. There is nothing particularly ‘Austrian’ about it, except for the fact that several of its most important contributors indeed hailed from Austria. We would guess that Mises thought that the terminology distracted somewhat from the fact of the universal applicability of the theory. Moreover, Mises noted that progress in science always builds on the achievements of one’s forebears, whose insights can either be refuted or extended and elaborated by new ideas.

The term praxeology stands for the ‘science of human action’. A longer quote from the introduction to Human Action clarifies Mises’ point of view regarding praxeology and the science of economics:


„For a long time men failed to realize that the transition from the classical theory of value to the subjective theory of value was much more than the substitution of a more satisfactory theory of market exchange for a less satisfactory one. The general theory of choice and preference goes far beyond the horizon which encompassed the scope of economic problems as circumscribed by the economists from Cantillon, Hume, and Adam Smith down to John Stuart Mill. It is much more than merely a theory of the “economic side” of human endeavors and of man’s striving for commodities and an improvement in his material well-being. It is the science of every kind of human action. Choosing determines all human decisions. In making his choice man chooses not only between various material things and services. All human values are offered for option. All ends and all means, both material and ideal issues, the sublime and the base, the noble and the ignoble, are ranged in a single row and subjected to a decision which picks out one thing and sets aside another. Nothing that men aim at or want to avoid remains outside of this arrangement into a unique scale of gradation and preference. The modern theory of value widens the scientific horizon and enlarges the field of economic studies. Out of the political economy of the classical school emerges the general theory of human action, praxeology. The economic or catallactic problems are embedded in a more general science, and can no longer be severed from this connection. No treatment of economic problems proper can avoid starting from acts of choice; economics becomes a part, although the hitherto best elaborated part, of a more universal science, praxeology.”


(our emphasis)

As an aside to this, the term praxeology was coined in 1890 by Espinas in his essay ‘Les origines de la technologie’, while the term ‘Catallactis’ or ‘the science of exchange’ was introduced by Whately in his 1831 book ‘Introductory Lectures on Political Economy’.

The term ‘Austrian School’ was initially meant to somewhat derogatory. A proponent of German ‘Historical School’ coined it in the course of the so-called ‘Methodenstreit’ (translatable roughly as the ‘dispute over methods’) between Austrian subjectivist economists and German historicists in the late 19th century.

What was at issue in the dispute was epistemology, the nature and scope of knowledge itself, in the context of economics. The main proponent of the German Historical School, Gustav von Schmoller, introduced the term ‘Austrian School’ in one of his unfavorable reviews of a book by Carl Menger, the founder of the Austrian School. The term sought to contrast the two theoretical approaches by associating Menger with the ‘backward’ Hapsburg empire, while the Historical School was deemed to be representative of the more ‘modern’ Prussian state.

The debate over the epistemological foundation of economics between the Historical and the Austrian school was initiated by Menger in his 1883 book ‘Untersuchungen über die Methode der Sozialwissenschaften und der politischen Ökonomie insbesondere(Investigations into the method of social sciences and political economy specifically). In this book, Menger criticized the Historical School’s belief that economic theory could be substituted by the collation and interpretation of historical statistical data. One can not, so Menger, replace economic theory with economic history. It is impossible to adequately describe and explain complex dynamic market processes with the help of statistical data. It is even more impossible to deduce a viable ‘economic policy’ from the contemplation of such data (as an aside, the Federal Reserve and other central banks attempt to do just that).

The German Historical School was founded in reaction to the rise of dialectic materialism, whose main proponent Karl Marx was implacably opposed to the Prussian absolutist monarchy that the historicists –inter alia – tried to defend.

As Mises noted on the Methodenstreit and its deeper meaning:


“It is a complete misunderstanding of the meaning of the debates concerning the essence, scope, and logical character of economics to dismiss them as the scholastic quibbling of pedantic professors. It is a widespread misconception that while pedants squandered useless talk about the most appropriate method of procedure, economics itself, indifferent to these idle disputes, went quietly on its way. In the Methodenstreit between the Austrian economists and the Prussian Historical School, the self-styled “intellectual bodyguard of the House of Hohenzollern,” and in the discussions between the school of John Bates Clark and American Institutionalism much more was at stake than the question of what kind of procedure was the most fruitful one.

The real issue was the epistemological foundations of the science of human action and its logical legitimacy. Starting from an epistemological system to which praxeological thinking was strange and from a logic which acknowledged as scientific – besides logic and mathematics – only the empirical natural sciences and history, many authors tried to deny the value and usefulness of economic theory. Historicism aimed at replacing it by economic history; positivism recommended the substitution of an illusory social science which should adopt the logical structure and pattern of Newtonian mechanics. Both these schools agreed in a radical rejection of all the achievements of economic thought. It was impossible for the economists to keep silent in the face of all these attacks.

The radicalism of this wholesale condemnation of economics was very soon surpassed by a still more universal nihilism. From time immemorial men in thinking, speaking, and acting had taken the uniformity and immutability of the logical structure of the human mind as an unquestionable fact. All scientific inquiry was based on this assumption. In the discussions about the epistemological character of economics, writers, for the first time in human history, denied this proposition too. Marxism asserts that a man’s thinking is determined by his class affiliation. Every social class has a logic of its own. The product of thought cannot be anything else than an “ideological disguise” of the selfish class interests of the thinker. It is the task of a “sociology of knowledge” to unmask philosophies and scientific theories and to expose their “ideological” emptiness. Economics is a´”bourgeois” makeshift, the economists are “sycophants” of capital. Only the classless society of the socialist utopia will substitute truth for “ideological” lies.”


(our emphasis)

The differences between MMT and Austrian theory show some parallels to the epistemological issues discussed in the Methodenstreit. The chartalist obsession with ‘accounting identities’ is closely associated with the positivist mechanistic view of economic science, instead of the deductive reasoning based on the choices of means and ends on the part of individual economic actors that Austrian theory employs.

Carl Menger – he initiated the ‘Methodenstreit’ with the Prussian Historical School in 1883.

(Photo via: Wikimedia Commons)

Ludwig von Mises underscored the fundamental importance of the epistemological problems that were at the center of the Methodenstreit .

(Photo via: Wikimedia Commons)

Chartalism Becomes ‘Modern Monetary Theory’

The German statistician Georg Friedrich Knapp first formulated the idea of chartalism (described in his book ‘The State Theory of Money‘) which got him a favorable mention by JM Keynes in the introduction of the ‘Treatise on Money’ ten years later. The idea was taken up and supported by Abba P. Learner in the US and has lately been revived by Warren Mosler, Randall Wray and Bill Mitchell. Wray refers to this revival as ‘neo-chartalism’, while Mitchell reportedly coined the term ‘modern monetary theory’ (or ‘MMT’ for short).

Randall Wray, reportedly regards chartalism as an adjunct to or elaboration of post-Keynesianism (however, it is apparently far enough removed from the neo-Keynesian orthodoxy that Paul Krugman declares himself unhappy with it. According to Krugman, only when the special conditions of a ‘liquidity trap’ pertain are MMT’s tenets with regard to deficit spending applicable. This may actually be due to a misunderstanding on his part). As mentioned above, chartalists are evidently partial to the idea that the economy is akin to a machine subject to mechanistic laws, i.e. chartalists are clearly positivists. As a result of that, chartalists also are broadly supportive of deficit spending to ‘blunt the impact of economic recession’. In this they are just as Keynesian as other branches of Keynesianism, or perhaps even more so. As it were, their proposals for intervention differ (they range from ‘job guarantees’ to ‘tax holidays’), but clearly they are in favor of an interventionist state.

Robert Murphy has recently published an article at Mises.org, ‘The Upside-Down World of MMT‘ that we highly recommend for reading and to which we will occasionally refer back, while adding some additional thoughts. In fact it should probably be read beforehand. You will also find numerous links to the main MMT writings by its current crop of its supporters in Murphy’s article, so you can acquire an overview of the theory’s main tenets.

First off, the description of the workings of the fiat money system the chartalists use is broadly correct (although we will take issue with one specific point further below). For a good overview of said description the Wikipedia page on chartalism is actually quite useful. We would however add to the contention about how fiat money acquires its value that it does not only derive its value as a medium of exchange through the fact that it is the only money accepted for payment of taxes (although this is no doubt the major feature). Legal tender laws after all prescribe that it must be accepted for payment of all debts, public and private. Moreover, historically fiat money developed from receipts for real money, i.e. claims for deposited gold that were circulating as bank notes. In essence, governments usurped money step by step, until in the end it was decreed that the receipts alone, although henceforth irredeemable, were to be used as money. Money substitutes thus became money proper. Had such claims to money not circulated as money substitutes for a long time, it would likely have been impossible to force widespread acceptance of such a scheme.

It should be noted that chartalists support the fiat money system, which they regard as the only viable monetary system for a complex modern economy. This goes hand in hand with their support of government intervention in the economy, which fiat money obviously makes easier.

As far as we can tell, the chartalists do not take a position on the origin of money, instead preferring to focus on the situation ‘as is’, i.e. the current institutional setting. We have previously written about the Misesian regression theorem and Menger’s explications on the origin of money, which make clear that money is not a creature of the state. In the free market, the most marketable commodities are used as media of exchange. Once a commodity becomes widely used and accepted as a medium of exchange, monetary demand becomes the main driver of its value, while the preexisting ‘industrial’ demand for it becomes a distant secondary driver. In the case of gold – the commodity that the free market has historically chosen as its money – we can observe that in spite of its official ‘demonetization’ by governments, it still behaves as though it were money. This is to say, monetary demand continues to be the main determinant of its value.

The chartalists however focus on the modern fiat money world, with its state created legal tender token money. To us their approach to monetary theory is a bit like military music is to music.

As Robert Murphy points out, the chartalists are focusing on well-known accounting tautologies that economists use to describe the economy in terms of ‘aggregates’ to make the case that their tenets are based ‘merely on accounting facts’ and thus should be impregnable to critique. Among the ‘inescapable conclusions’ of their singular focus on these accounting tautologies is that a government that issues its own currency can ‘never become insolvent’. To this we would note that it really depends on one’s definition of insolvency and default. Certainly the central bank could buy up all existing government debt with money it creates from thin air and thereby keep the government ‘solvent’ forever. Alas, it is a good bet that long before it was finished with such an exchange, the money it issues would have have become worthless and ceased to function as a medium of exchange.


Default By Another Name

To name an example of a government that quite recently ‘proved’ the chartalist theory in its most extreme form, we only need to look at Zimbabwe. The backbone of Zimbabwe’s economy was destroyed by a presidential decree that nationalized privately owned farms that produced the bulk of the country’s exports in order to ‘distribute them to indigenous workers’ (in reality, the choicest farms were of course handed to the president’s friends and relatives). The government’s tax revenues consequently collapsed and foreign exchange inflows dried up. The latter meant that the country could no longer pay for circulating capital goods it did not produce itself, forcing the idling of many factories and virtually all of the mines. In the case of gold mines which we followed closely at the time, it had become impossible to pay even for the chemical reagents needed in gold production. The mines were forced to sell their gold directly to the central bank at a price way below the market price and denominated in Zimbabwe dollars, while their applications to obtain foreign exchange languished. Soon the mines could no longer cut corners and simply had to close down if they wanted to avoid banruptcy. Thus yet more tax and foreign exchange revenue disappeared and unemployment in the private sector soared ever higher. The government however still had to pay for its vast bureaucratic apparatus, including its instruments of coercion and compulsion, i.e., the military and police. Since Zimbabwe’s government most definitely did issue its own currency, there was no question of it suffering ‘insolvency’ in the sense of a direct default on its debts. Instead it began to issue said currency in ever more copious quantities to continue to pay its bills. Now we are not sure whether the holders of Zimbabwean government bonds were really happy over this lack of default, since their bonds became utterly worthless even without one. From the point of view of bondholders, it became a default by another name – hyperinflation.

Note here that we have tried to paint as realistic a picture as possible of Zimbabwe’s drift into hyperinflation – including the destruction of much of its productive economic base that preceded it. We acknowledge that this was an extreme situation and that it is of course not directly comparable to the situation of the US economy today. And yet, this extreme situation serves to make a point: the ‘solvency’ of a government issuing its own currency is a matter of perspective. Somehow Zimbabwe didn’t become famous for the vast excess savings of its private sector when the government issued ever more debt and printed truckloads of money to ‘remain solvent’.

We would also add to the above that while we think the US and other modern-day welfare/warfare nations are far away from experiencing the monetary meltdown of the crack-up boom and we also believe that officials would not let such a breakdown happen on purpose, this does not mean that it will never happen. The day may well come when a decision must be made which of two paths to choose from is politically more expedient: outright default on government debt, or the destruction of the currency. The former would of course pose a somewhat more imminent problem for the chartalist ideas about government’s solvency than the latter.


Can We Save Without Government?

Another favorite tenet of the chartalists is that the only way the private sector can save is if the government goes into deficit and thereby ‘creates the financial assets’ the private sector requires for its saving.

As Mr. Murphy points out, the idea that one can not accumulate savings without first positing the existence of government debt is essentially ludicrous. He uses a device Austrian economists have employed since Boehm-Bawerk to explain how saving, investment, production and consumption relate to each other – namely ‘Crusoenomics’ – to show that one need not even posit the existence of a government in order to be able to save. Saving is simply the excess of production over consumption. Anyone can do it, with or without a government and its debt securities.

As Murphy further notes, one can use the very same equations or accounting tautologies the chartalists use to support their theory to support the exact opposite conclusions as well. This is just saying: the accounting identities are not incorrect, but they are really meaningless.

As Murphy relates, one MMT supporting commenter on his blog had to clarify the chartalist statements about savings as follows:


So how in the world are we to interpret the MMTers’ proclamation that “net private saving” necessarily equals the government’s budget deficit (if we ignore international trade)?

“When I raised this question on my blog, Nick Rowe — who is a very sharp economist — defended the MMT statement in this way:

Robert [Murphy]: “In particular, I think it is crazy when people say that if the federal government runs a budget surplus, then by simple accounting the private sector can’t save.”

[Nick Rowe:] That’s perfectly correct, and standard, once you do the translation. Assume [an economy closed to international trade]. Define “private saving” as “private saving minus Investment” … which is how MMTers normally use the word “saving”, or sometimes “net saving”. Then it’s just standard National Income Accounting. Y=C+I+G, and S=Y-T-C, therefore S-I=G-T.

And there you have it: When MMTers speak of “net saving,” they don’t mean that people collectively save more than people collectively borrow. No, they mean people collectively save more than people collectively invest.”

I’m not trying to make fun of Nick Rowe; he is a professional economist who has written some very nuanced posts relating MMT to more orthodox mainstream economics. But look at what he was forced to type: “Define ‘private saving’ as ‘private saving minus investment.'” As I noted in my response to Rowe, if we define “private saving” as “private saving,” then my critique of MMT stands. (That’s supposed to be funny, by the way — at least insofar as economics can be funny.)

Now Nick Rowe and the MMTers are certainly correct when they observe that “private saving net of private investment” can’t grow without a government budget deficit (again if we disregard foreign trade). But so what? The whole benefit of private saving is that it allows for more private investment.

This is the fundamental problem with relying on macro-accounting tautologies; people often bring in causal arguments from economic theories without realizing they are doing so.”


Now, admittedly the chartalists do have a point that we all need to keep cash balances in the form of the government-issued fiat money in order to be able to pay tax (hence the idea that fiat money derives its value from government taxation, an idea that was also the basis for the English ‘tally stick’ system). In fact, the legal tender laws force everyone to keep some government scrip or deposit money denominated in it in order to be able to engage in indirect exchange. As it were, no-one is terribly likely to transact in a market-chosen money if his counterparts must accept irredeemable pieces of paper in exchange. Gresham’s law mitigates against it – good money isn’t in circulation, but is hoarded instead (which is why gold behaves precisely as one would expect it to if it were money, even though it is at present not widely used as a medium of exchange – although there are some exceptions to this, such as Vietnam, where real estate is quoted in gold instead of the official fiat currency, the dong).


Aggregates Obfuscate Rather Than Illuminate

As Patrick Barron has remarked in rather blunt fashion with regards to the accounting identities so beloved by the chartalists: ‘C+I+G = Baloney‘ (this equation describes ‘Gross National Product’ or GNP, i.e., GDP without the external balance of payments). He has a good point. While it is true that if we compare the money equivalent of sum of the sources of spending with the totality of spending they will amount to the same sum, this really doesn’t tell us anything worthwhile about the economy.

It is, as Robert Murphy noted in his essay, simply not possible to skirt economic theory by saying that one is relying on such equations. The problem as Barron observes is that contemplation of the equation as such could easily lead one to conclude that government spending is a good thing, since it ‘adds’ to total GNP/GDP. The fallacy is to believe that such spending actually ‘adds to economic health‘, as he puts it. In reality, government spending burdens the economy by furthering a misallocation of resources and hindering the liquidation of malinvested capital (the ‘first time buyer credit’ for homes is a good example for the latter – it delayed the necessary adjustment in the housing market by several months, to no good purpose anyone is currently aware of). The important fact to keep in mind is that the real resources that make up the economy – the stock of capital goods, final goods, land and labor – can not be increased or bettered by government spending (and/or money supply inflation). Their employment can merely be moved in a direction decreed by bureaucratic fiat instead of the voluntary decisions of economic actors. There is only one economy and all the wealth it generates is produced by the private sector. Whatever the government spends must by necessity be taken from the private sector, whether by borrowing, taxation or inflation. If there are any government activities that produce a profit, we have yet to hear about them. It follows that government spending wastes scarce resources, since otherwise it would produce profits (there is of course the ‘seignorage’ profit of the central bank, but the profits produced by what is essentially a legalized counterfeiting operation hardly seem to provide cause for celebration).

Popular aggregations of economic data and circular flow models of the economy tend to obscure economic reality rather than illuminate it. The circular flow models are misguided, as they ignore the economy’s complex capital structure. The nowadays widely accepted Keynesian view sees capital as a homogenous, self-replicating fund that springs into action if only someone – whether consumers or government – spends enough. However, capital is heterogenous and needs to be maintained if the economy is to merely tread water, and more of it needs to be accumulated if the economy is to grow. What is required for the maintenance of existing capital and the accumulation of additional capital that will lead to a greater output of consumer goods in the future is not spending, but its opposite: saving. As it happens, once one accepts the rather obvious fact that the factors of production are heterogenous, both the Keynesian deficit spending and monetarist money printing prescriptions can no longer be maintained as viable.

It is worth noting in this context that modern-day GDP accounting actually does not really provide us with the monetary equivalent of ‘gross’ economic output, but rather the ‘net’ output. This creates the false impression that ‘consumer spending is 70% of the economy’. GDP (leaving the trade deficit aside) only counts spending on final products (i.e. consumer goods), government spending and investment in fixed capital. This means that none of the economic activity involving intermediate circulating capital goods is included – the entire production structure is simply ignored. In order to get an idea how big a difference this makes, one must look at the bi-annual release of the ‘gross domestic output by industry accounts‘ published by the department of commerce. In 2008, the total amount of gross domestic industrial output was estimated at $26.5 trillion – almost twice the level of GDP. When viewed in this context, consumer spending represents only 35% of total spending in the economy, not 70%. Not only that, it also turns out that the manufacturing sector is responsible for the by far greatest portion of domestic spending. In other words, the biggest sector of the economy by gross output is really the manufacturing sector, in spite of the fact that manufacturing employment has shrunk dramatically in recent years.

Looking at the ‘vertical’ and ‘horizontal’ models by which the chartalists describe the operation of the fiat money system, there is not much wrong with them from a purely technical perspective. We would however take issue with the idea that ‘government deficits lower interest rates and government surpluses increase them’, by dint of ‘increasing or decreasing available reserves in the banking system’. This is in our opinion technically incorrect – since the money supply can only be changed by an increase or decrease in circulation credit by the banking sector or directly by the central bank. To the extent that government borrows from the private sector or pays debts back to its private sector lenders (without the central bank ‘accommodating’ the borrowing by acquiring government debt), no changes in the money supply will occur – only ownership of the money will change hands. As an aside to this, the treasury’s deposits with the central bank do form part of the true money supply, while bank reserves held at the Fed do not (we are aware that official money supply definitions fail to include treasury deposits with the Fed, but they clearly are perfect money substitutes).

Moreover, chartalists reject the ‘money multiplier’ model by noting that inflationary bank lending takes place regardless of reserves, as these can always be acquired later in the wholesale interbank funding market or by borrowing from the central bank. While modern banking practice is indeed hardly constrained by reserve requirements or the actual level of reserves (this is especially so since the creation of ‘sweeps’), newly created deposits nonetheless increase the banking system’s ability to pyramid more loans on top of them, creating more deposits in the process. The increased concentration of the banking system furthers this tendency, as interbank clearing operations are more likely to hinder the creation of additional fiduciary media in a system of many small banks than in one where a handful of big banks predominate (a single monopolistic bank would not be constrained at all, hence the proclivity for bank mergers in a fractionally reserved system, as observed by JH de Soto). The most important factor is however synchronicity. As long as credit expansion is happening in a coordinated fashion, a system of small banks can also become ‘fully lent up’ under a given level of reserve requirements. That banks act differently under ‘boom conditions’ than under ‘bust conditions’ with respect to their inflationary lending is of no particular importance in a fiat money system controlled by a central bank with unlimited money creation abilities. We have noticed that some supporters of chartalism are prone to believing that the fact that banks have acquired vast excess reserves and are reluctant to lend means that there can not be any appreciable inflation of the money supply. The Fed has proven them wrong, in spades:


US true money supply TMS-2 and TMS-1 plus M2, year-on-year rate of change. In spite of inflationary commercial bank lending grinding to a halt, the broad measure TMS-2 did not even once fall below a 10% annualized growth rate since the outbreak of the 2008 crisis. The Fed’s pumping in conjunction with massive government spending have not only managed to manufactured the biggest money supply expansion of the post WW2 era, they have also managed to reverse the decline in total credit market debt that the crisis appeared to set into motion. Charts via Michael Pollaro – new readers should review the rationale, definitions and source material to this money supply definition at Michael’s dedicated TMS web-page at Forbes.


Components of TMS-2. Note that at end of 2007, the total broad ‘Austrian’ US money supply TMS-2 stood at $5.3 trillion. At end of April 2011, it stood at $7.574 trillion, an increase of 43% in 3 years and 4 months. No inflation? On what planet?


The currency component of M1. As this chart shows, ‘money proper’ – which in the fiat money system consists of the irredeemable banknotes issued by the Federal Reserve – has also experienced a vast increase since the onset of the crisis, rising from about $760 billion to about $960 billion – an increase of over 26% in the space of 2 ½ years – click for higher resolution.


As an side to the above charts, the rate of growth of the money supply has lately begun to sprint higher again. As Michael Pollaro reports regarding the changes recorded in April (note also that TMS-2 has recorded a double-digit annual rate of growth in 28 out of the past 29 months):


“The U.S. money supply aggregates based on the Austrian definition of the money supply, what Austrians call the True Money Supply or TMS, saw robust growth in April, with narrow TMS1 posting an annualized rate of increase of 10.7% and broad TMS2 showing an annualized rate of increases of 16.5%. That brought the annualized three-month rate of growth on TMS1 and TMS2 to 8.0% and 13.7% respectively, up 270 and 390 basis points from the growth rates seen in March.”


Economic Effects of Deficit Spending and Inflation

Even though the chartalist description of the processes by which the central banks and the commercial banking system operate is largely correct, MMT does not give sufficient consideration to the real economic effects of these operations.

Most importantly from an Austrian point of view, the intertemporal coordination of the economy’s complex productive structure is dictated by the prevailing interest rate and thus distorted when the interest rate is manipulated. Note that it does not matter in principle if an interest rate distorting growth of fiduciary media is undertaken by a private banking system without a central bank or one accommodated by a central bank, but the presence of a central bank without a doubt greatly facilitates the process. Money is not neutral and hence produces distortions in the structure of relative prices, which leads to the the capital malinvestments that result in the harmful boom-bust cycle. When an economy enters a bust, these malinvestments are unmasked. Some investment projects can not be completed as the real resources needed for their completion are simply not available. The mix of capital goods in the economy is revealed as wrong (see our above comment on the heterogeneity of capital), and does not conform to the actual demands of consumers. As Ludwig von Mises noted, it makes no sense for the government attempt to combat the recession by doing all over again what created the problem in the first place. In his essay ‘Economic Depressions: Their Cause and Cure‘ Murray Rothbard summarized Mises’ position as follows:


“Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers’ goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, “laissez-faire” policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.

The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.”

(our emphasis)


Murray Rothbard on the Misesian prescription for dealing with recessions: do absolutely nothing.

(Photo via: Wikimedia Commons)


Evidently the government’s actions since the beginning of the economic crisis in 2008 have not been modeled after Mises. The last time a US recession was met with a ‘Misesian prescription’ of laissez faire was the sharp recession of 1921 under president Warren Harding. The only people who occasionally still talk about this recession today are free market oriented economists, as it provides empirical proof for the correctness of Mises’ view. Everybody else has forgotten this severe recession. Why? Because it was over so fast. It’s just not regarded as worth talking about, since no lasting calamity resulted from it. We would note that the government has implemented both the Keynesian prescriptions of massive deficit spending and the monetarist idea of massive monetary expansion in order to counter-act the alleged ‘liquidity trap’, ‘avert deflation’ and generally ‘help the economy’. It has certainly accommodated the demand of the chartalists of expanding its deficit spending to ‘counteract the bust’, while showing precious little worry about its solvency. As we noted above, the money supply measure TMS-2 has been increased by 42% since the end of 2007. In the same time span, the government deficit has grown to $14.3 trillion, an increase of roughly 45% since 2008. As at September of 2000, the gross national debt stood at a ‘mere’ $5.7 trillion. No-one can accuse the government of not having complied with the requests of interventionist economists. What is conspicuously absent so far is the economic success story this was supposedly going to produce, unless one thinks that an official U3 unemployment rate of 9% is anything to crow about. We would also ask with regards to the ‘shock absorber’ theories of government deficit spending, if deficit spending is a good idea during a bust, why is it not always a good idea? After all, the laws of economic are not mutable. If deficit spending and inflation can indeed create wealth, as their supporters must implicitly assume, then they should always create wealth. So why didn’t it work? The answer lies (inter alia) with the fact that people are not automatons. Individual actors in the economy do not look at a GDP equation and say to themselves ‘I should now act in the manner some central economic planner in Washington thinks I should’. They know very well that an increase in government debt will eventually have to be paid for by a commensurate increase in taxation. Robert J. Barro’s 1974 paper on Ricardian equivalence asked the pertinent question in this context: ‘are government bonds net wealth?‘ (pdf). As Barro notes in the conclusion to his paper:


“There is no persuasive theoretical case for treating government debt, at the margin, as a net component of perceived household wealth. The argument for a negative wealth effect seems, a priori, to be as convincing as that for a positive effect.”


Barro has subsequently successfully defended his work against critics and further buttressed it by empirical studies that confirmed his main conclusion: the so called ‘multiplier’ of Keynesian deficit spending frequently turns out to b actually be less than one – in other words, the net effect of government deficit spending on the economy is often negative.


Robert Barro – he first wrote about Ricardian equivalence in 1974, and so far has found no reason to doubt his paper’s conclusions.

(Photo credit: Harvard University)


In Robert Murphy’s essay this problem is highlighted in the final part. He brings the example of an exchange of present good against future goods between two private persons. As the contract ends, the borrower simply threatens the lender with force and tears up the IOU. This is in principle no different from the relationship between tax payers and the State.

As Murphy notes:


“The MMTers correctly tell us that the taxpayers can’t accumulate “net financial assets” — i.e., drawing on income streams that originate outside the group — unless Uncle Sam runs deficits and issues them bonds.

But what is the point of accumulating bonds that will only be redeemed when Uncle Sam coercively raises the necessary funds from the same group of Taxpayers in the future? Any individual taxpayer can justifiably look at a Treasury bond as a net asset, because his or her own tax contributions will not vary significantly based on his or her investment decisions regarding Treasuries. But the private sector as a whole surely shouldn’t naively assume that if the government runs a $1.6 trillion deficit this year, this foretells of a shower of new income flowing “into the private sector” down the road.”


(our emphasis)


The gross federal debt (at end 2010 in this chart), which as of today stands at $14.39 trillion, or roughly 98% of US GDP, which makes it the 12th highest government debt in the world relative to economic output – click for higher resolution.


A bar chart of the gross federal debt since 2000, along with the debt-GDP ratio. We would note that this ratio is per se not really very informative given that it compares a stock to a flow and given the debatable value of GDP statistics, but it is still a useful yardstick for comparison purposes – click for higher resolution.


Hyman Minsky’s Instability Hypothesis

According to Edward Harrison at ‘Creditwritedowns‘, chartalists were among the few economists who predicted the financial crisis (we’re not sure which ones, as he doesn’t name them) – along with the Austrians, who definitely were among those predicting the crisis. The so-called ‘mainstream’ economists almost to a man failed to see that a big problem for the economy was brewing during the housing boom. If the chartalists were more successful in this department, it is likely due to the influence of one of the ‘post Keynesians’, Hyman Minsky, who has recently been resurrected from obscurity as well.


Post-Keynesian Hyman Minsky thought capitalist economies inherently tend toward developing financial instability after lengthy periods of prosperity.

(Photo credit: Diana Minsky)


As an aside here, just in case you’re wondering why there are so many different Keynesians, i.e., neo-, post- and ‘new’ Keynesians, this is very likely in no small part due to the many contradictions and the sheer unintelligibility of Keynes major work, the ‘General Theory’. As Henry Hazlitt, one of the most incisive critics of Keynes once remarked, “How did it happen that a book so full of obscurities, contradictions, confusions, and misstatements was hailed as one of the great works of the Twentieth Century? As with the works of Hegel and Marx, the very mystification added to the book’s prestige. Unintelligibility was assumed to be a mark of profundity.” As it were, Hazlitt’s line-by-line critique of Keynes’ General Theory (‘The Failure of the New Economics’) certainly demystifies the book and shows convincingly that the work’s assumed profundity is really only the eyes of very confused beholders. As Clifford Thies relates in ‘The Paradox of Thrift, RIP‘ (note that although the ‘paradox of thrift’ has indeed been excised from Professor Samuelson’s ‘Economics’ tome, along with the ‘accelerator model’ which was quietly dropped some time earlier already, it is not quite dead yet. Krugman & Eggertson have not only recently revived it, but invented a few new, related ‘paradoxes’ to boot.Like the broken window fallacy, this nonsense just won’t die):


“There is,” according to Axel Leijonhufvud (1968: 35), “room…for differing interpretations of Keynes.” Indeed, Leijonhufvud argues that if his interpretation is not what Keynes meant to say, it’s “…what he should have said.” Samuelson (1964: 316) writes that “there is reason to believe that Keynes himself did not truly understand his own analysis.”


Mind, there are ongoing debates over a number of issues in every school of economic thought. However, if one reads Keynes’ General Theory, it quickly becomes obvious what the gentlemen quoted above are talking about. We think it’s best to read it in conjunction with Hazlitt’s critique, which has the great advantage of sharpening the reader’s radar for bad economic theory.

To come back to Minsky, his main claim to fame is the ‘financial instability hypothesis‘(pdf). Minsky’s hypothesis claims that capitalist economies have an inherent tendency to endogenously develop financial instability while accumulating ever more debt during periods of stability. In short, ‘stability breeds instability’ and that, according to Minsky, is an inherent feature of the capitalistic economy. Minsky distinguished between three types of borrowers: Firstly, what he termed ‘hedge borrowers’ , entities that are able to repay both interest and principal of their loans out of their cash flows. The second type are ‘speculative borrowers’, who are only able to pay interest on their loans out of cash flows, but need to constantly roll over the principal of their loans. The third type he referred to as ‘Ponzi borrowers’, entities that can neither pay interest nor principal out of their cash flows, but need to constantly increase their borrowings to pay both.

As Minsky saw it, the longer a period of prosperity and stability lasts, the more debt is accumulated by the latter two categories of borrowers, until the whole edifice collapses under the weight of this accumulated debt. Minsky also noted that financial intermediaries will introduce innovations (think CDO’s and the like) to market more and more debt to borrowers and acquire new assets themselves. The longer prosperity lasts, the more potential financial instability will lurk in the background, which is then unmasked as a bust begins and lenders begin to curtail their lending to these Ponzi and speculative borrower entities.

Now, as a description of the run-up to the financial crisis, this sounds quite correct. Alas, that is all it is – a description. It does not tell us anything about the processes that enable the instability to develop, nor does it tell us why the boom must perforce turn to bust. The important feature that is missing from Minsky’s approach is that he fails to differentiate between credit that is fully backed up by savings and credit that is based on the creation of fiduciary media by the fractionally reserved banking system and the central bank.

To this we must hearken back to our above mentioned definition of savings. Savings are the excess of production over consumption, or put differently, unconsumed production. While we all use money to channel our savings, the abstention from consumption in the present means that when someone saves, an equivalent to his money savings in the form of unconsumed goods exists as well – and these goods form the economy’s pool of real funding. When a saver lends money to a borrower, he is essentially transferring his claim to said real goods in exchange for being able to consume more goods in the future, i.e., an exchange of a claim to present goods against a claim to future goods takes place. No large scale instability can result from credit that is backed by real savings. Entrepreneurial error as such is of course still possible, but the economy’s price mechanism will see to it that savings and the credit they back are quickly channeled to their best uses.

In an economy that progresses on the basis of savings and investment, an extended period of prosperity can not by itself breed instability – it will do the exact opposite, since more and more capital will be accumulated, enabling more consumption and a higher standard of living over time. A different situation emerges when fiduciary media are created by the banking system, also known as ‘money from thin air’, via the device of fractional reserve banking. The appearance of such unbacked financial claims on the market means that their first receivers can lay claim to real goods without there being any contribution to the pool of real funding that offsets the exercise of these claims. The later receivers of new money will have to pay higher prices than they would have had to pay otherwise, as the price effects of the greater supply of money percolates through the economy. Since new money enters the economy at specific points, the so-called Cantillon effect begins to distort relative prices and with them the production structure. Another way of looking at this is by noting that additional fiduciary media will tend to temporarily depress the market interest rate below its natural level. This is in fact how the Federal Reserve and other central banks maintain their ‘interest rate target’. When strong credit demand threatens to raise the interest rate above it, they add fresh reserves to the banking system by buying securities with money created from thin air, thus accommodating the increase of deposit money via the creation of unbacked circulation credit by the commercial banks.

The natural interest rate meanwhile is simply an expression of society-wide time preferences. It is the ratio of the valuation of present goods vs. future goods. Lower time preferences indicate a propensity to save more and consume less – the natural interest rate will fall. The interest rate (we will leave aside here that in the loanable funds market there is of course always more than just one interest rate, as a price premium, a risk premium and a profit component must be added to it and risk premia will not be the same for all borrowers) is an important signal, as it indicates to entrepreneurs whether the amount of available savings has increased or decreased. It thus helps to coordinate the time schedules of production and consumption. Producers will always choose the shortest possible production time to produce a certain amount of goods. However, longer and more specialized production processes tend to increase productivity and hence future output. Since the discounted present value of future goods is higher the lower the interest rate used in its calculation, a larger amount of savings indicates that more time consuming (and hence more productive) production processes become feasible. In short, a larger amount of savings will tend to draw factors of production toward the higher order goods stages of production, i.e. the production of producer goods, which are temporally more distant to their final aim, the consumer goods they will help to produce. This is in accordance with the wishes of consumers, who have indicated by their higher savings that they wish to consume less in the present in order to be able to consume more in the future.

The central bank led fractionally reserved banking cartel throws a monkey wrench into this process, as the creation of additional fiduciary media (i.e., money substitutes created from thin air) artificially lowers the interest rate and consequently distorts all other price signals. A ‘price revolution’ takes place, as Mises put it. These periods of economic boom are generally associated with growing prosperity in people’s minds. However, if one thinks the whole process through, one realizes that ultimately, this seeming prosperity can not truly be financed by the expansion of unbacked credit. What really finances the boom in the final analysis is the consumption of previously accumulated capital. Since capitalist economies always create more wealth over time in spite of these central bank induced distortions (this is to say, even underneath a capital consuming boom, there are always also true wealth-generating activities taking place), this process can continue for some time. The continuation of the boom obviously requires that the credit expansion is kept up and even accelerated, but the longer this continues, the more it becomes evident that the insufficiently large pool of real savings is not able to support the completion of all the investment projects undertaken. Banks become worried about the accelerating credit demand and begin to raise their interest rates. In the central bank-led system it is usually the central bank that becomes worried and raises its target interest rate, usually when the ill-defined consumer price index begins to increase beyond its official or unofficial target. It should be noted to this that in the framework described above, it eventually becomes clear that consumers have not restricted their consumption, but since factors of production have been drawn toward higher order goods production and intermediate stages and lower order goods production stages have been neglected, a lower output of consumer goods eventually clashes with this unchanged or even rising consumer demand, putting upward pressure on final goods prices.

Minsky correctly described what is happening in the realm of lenders and borrowers during an easy money boom, but his ‘instability hypothesis’ presupposes the existence of the current monetary system. It is not capitalism itself that is unstable, but capitalism with a central bank that engages in central economic planning by means of mispricing capital. As it were, Minsky’s conclusions from this were entirely incorrect, since he ascribed the boom-bust characteristics of the modern economy to the operations of the free market. He consequently believed that the ‘government must control these cycles’ by intervening in the market economy. This is deeply ironic, as it is precisely because of government intervention via the central bank and the granting of the fractional reserve lending privilege that the manic-depressive boom-bust business cycle comes into existence. It is not ‘stability’ as such that is making the emergence of ‘Ponzi borrowers’ possible and thereby breeds instability. It is the artificial stability that is mainly maintained by the interventions of the ‘lender of last resort’ and government spending in the short term business cycles nested within the secular cycles (see also our ruminations on Short and Long Term Cycles). The eventual panic and bust follow on the heels of this illusion of stability (the famed ‘Great Moderation’ was in reality nothing but a continuous set of cycles of credit expansion and deficit spending).

Since Minsky, along with the already mentioned Abba Learner and Wynne Godley is among the ‘post-Keynesians’ that are today considered fore-runners of the modern version of MMT, it is a good bet that chartalists observed the evolution of Ponzi finance schemes as described by Minsky and thus had an inkling that the boom would end badly.

However, as we have noted further above, the Austrian approach to dealing with the bust is entirely different. The economy’s problem is not a ‘lack of aggregate demand’ as Keynesians of all stripes hold, but the fact that the production structure is in disarray. The best way of ensuring that malinvested capital is transferred, transformed or liquidated as quickly as possible is to let the market work unhindered. This process is admittedly not painless and requires some time. As a rule of thumb, the bigger the artificial credit-induced boom, the bigger the subsequent bust. Nonetheless the bust is actually the period during which the economy is engaged in a healing process. Anything that throws obstacles in the way of this process – such as renewed credit and money supply inflation and deficit spending – will only delay the necessary restructuring. To paraphrase Steve Saville on fiscal measures to combat the bust, ‘deficit spending is akin to pumping water from the deep end of the pool to the shallow end of the pool using a leaky hose’.



We have by and large no quibble with the description of the fiat money system forwarded by MMT. Its supporters are also correct that the present system forces people to accumulate fiat money (that they think this coercive system should be supported strikes us as rather odd. Surely the management of the fiat money system over the past century provides more than enough reasons to oppose it). However, the focus on accounting identities – even though these accounting identities exist and are correctly stated – is no substitute for economic theory. They do not per se prove the correctness of a theory or its prescriptions, since they are tautologies devoid of meaning. As with other adjuncts to Keynesian theory, the lack of a theory of capital mars the proposals of chartalists as to how to deal with recessions. Aggregations and circular flow models make it easier to mathematically ‘model’ the economy, but the picture they paint is much too crude representation of reality, in which millions of individual economic actors make their own decisions as to the ends they want to achieve and the means they want to employ in this endeavor. It is simply not possible to press the activities of millions of individuals into a few equations and claim that these equations really mean something. The idea that the government should spend freely to support the economy during a bust and not worry about the size of deficits because issuing its own currency ensures its ‘solvency’ meanwhile is liable to create a great many problems in the real world.

Here is a recent debate on CNBC with one of the most prominent MMT proponents today, Warren Mosler (below the video it is noted: ‘Warren Mosler, founding partner of AVM Securities, says the answer to Europe’s problems could be as simple as printing more money.’), where Mosler expertly relates his fixation on technicalities. You will notice that in all this talk about ‘marking up accounts. ‘keeping score’, etc., no human beings apparently exist. The ‘government’ , the ‘Fed’ , the ‘EU’, and ‘China’ are just some neutral entities levitating in the aether, and impartially marking up accounts here or there, activities we mere mortals should have no reason to worry about. In this mechanical worldview, there can not be any real human beings – they would surely conspire to disturb it somehow.


Charts by: Federal Reserve of St. Louis Resaerch, Michael Pollaro




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4 Responses to “The Revival of Chartalism”

  • vincecate:

    I like Austrian Economics but have written up an introduction to MMT. To me the biggest flaw most MMT people make is not realizing that when the government sells a 30 year bond it is, in MMT terms, delaying demand and controlling inflationary pressures. The MMT people count a bond and cash both as money and don’t think it matters if the government were to print money to pay off the bonds. Historically it really does matter if people stop buying bonds and the government prints money to pay off bonds, you get hyperinflation.


    • I have noticed this as well – I once read an aparently MMT inspired comment on QE at pragcap, and the man asserted ‘the Fed is merely doing an asset swap’, as though it didn’t matter that is actually creates money from thin air in these ‘asset swaps’. And it certainly does matter economically whether or not the money supply is increased.

  • Thanks, this was very interesting Pater, I was looking forward to your take on MMT.

    “We would also add to the above that while we think the US and other modern-day welfare/warfare nations are far away from experiencing the monetary meltdown of the crack-up boom and we also believe that officials would not let such a breakdown happen on purpose, this does not mean that it will never happen. The day may well come when a decision must be made which of two paths to choose from is politically more expedient: outright default on government debt, or the destruction of the currency. The former would of course pose a somewhat more imminent problem for the chartalist ideas about government’s solvency than the latter.”

    I think this is absolutely right, it’s so frustrating when the MMTers deny the very possibility of government default. The crazy thing thing about reading some of their commentary is that they even apply their mechanistic ways of thought to the notion of political willingness. It would seem that they cannot even conceive of a scenario where the government aren’t willing (rather than able) to pay their debts in dollars terms. Of course, defaults are – to a great extent – about willingness to pay as well as ability to pay..

    I recall that Bob Prechter said something interesting about this a while back. He said that the choice may eventually be between ‘breaking the bond market’ (via simply printing) or giving up a portion of the bond market (via default/restructuring) to ‘save’ another portion. That could easily end up being the most politically palatable option..

    The other thing about the MMT frame of mind is that they use the emotional connotations of the word ‘savings’ to expound their theories. For example, if you were to say that the government shouldn’t do anything at all, they would probably retort “So you’re against people saving, are you?”. It’s really quite silly/amusing..

    • Prechter may well have a point. Given that a large proportion of treasury debt is held by foreigners, a future administration may decide on a ‘selective default’ – leaving foreign creditors in the lurch, while keeping domestic creditors whole. This may well be seen as an alternative that is preferable to hyper-inflation. Of course it is also not too late to change course entirely and stop increasing the debt and the money supply by leaps and bounds – there is still hope that a sufficiently strong political backlash could force a return to sounder policies, as unlikely as it appears at the moment. The ‘point of no return’ has probably not yet been crossed.

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