new money financed government expenditure

Sometimes I hear economists describe a nation as facing a soft budget constraint. It’s true, but  it’s a funny choice of phrase because the literature on soft budget constraints initially was exploring how this caused monumental moral hazard and inefficiencies for firms in the soviet union and other centrally planned economies. This may have some slightly unpleasant implications for if the government explicitly acted as if the constraint they care about is inflation, at least it might under certain types of government self-financing. There is also a more interesting criticism, Daniel Kuehn contends “as James Macdonald argues, public debt has historically been an essential element in restraining government. Hoarded treasure (aside from being macroeconomically inefficient) ensures that sovereigns are unaccountable to their citizens. Citizen creditors ensure that their government stays accountable. Cutting out this debt instrument gives a sovereign all the revenue-raising power of government bonds, without any of the risk of nervous creditors restraining policy. Perhaps a robust republic can be maintained in such an environment, but if the Macdonald point is right, the chance of abuses are very real.” This is why many shudder when some MMT types appear to advocate an abolition of borrowing with politicians simply creating new money themselves directly in case they need more funds.
One good thing about my proposal, which I shall subsequently refer to as Rules Based New Money Financing of Government – RBNMFG (working title), is that it reconciles the moral hazard criticisms towards the ‘deficit owls’ with the demand sucking private debt fuelling criticisms towards the long-run budget constraint types. The committee in charge of RBNMFG is an agent of the government ensuring new money is issued consistent with a rule ensuring no output gad/no deficient demand and/or stable sectoral balances, in the same way that the judiciary is an agent of the government ensuring new laws are implemented consistent with legal precedent or a constitution. In this case the moral hazard problem is greatly diminished because there is a separation between the ‘print financing decision’ makers and the voter appeasing expenditure decision makers.
In sum we have two very useful insights:

(1) Monetary policy needs to be independent to prevent moral hazard and other problems (mainstream)

(2) Deficits might be needed for the foreseeable future to prevent the private sector going into deficit (MMT)

The MMT solution as explained in the first paragraph appeases (2) by violating (1). Mainstream solutions on the other hand might violate (2) in order to appease (1). I proposed the policy of ‘RBNMFG’ to appease both (1) and (2).


In this post I am going to propose a counter-cyclical policy that I think should in principle find support from economists of many different schools, including post-Keynesian economists as well as market monetarists.

I believe that current monetary policy is convoluted and indirect, especially when interest rates are near zero. It operates through the banking sector, and the behaviour of banks is a highly nebulous and complex subject in which there is a lot of disagreement. It is also not understood well by the general public and some even find the current primary dealer system alarming. The transmission mechanism from unconventional policies like quantitative easing is contested, especially by those from the endogenous-money camp. While market monetarists have some highly complex inter-temporal hot potato, portfolio adjustment and signalling transmission mechanism, many have difficulty finding plausibility or potency in this story, and it goes far beyond conventional money quantity effects, hence my description of it as indirect.

What I propose is extremely simple and not especially novel (although almost as an unspoken rule very rarely discussed): monetary policy should bypass the banks. Instead, a fully independent and non-partisan committee (like the FOMC, perhaps even the exact same people) should decide on a specific quantity of government spending that is to be financed by brand new money rather than by debt or by taxes (before you tell me how insane, immoral, counterfeit or idiotic this is, please read my response to some of the criticisms at the bottom) in accordance with some rule or target. This would be done by adding new money to the treasury’s account at the central bank (for you ‘spend first’ or ‘keystrokes’ MMTists, see the criticism section below). This in principle should not find objection, I believe, from market monetarists; after-all, monetarist models do not depend on or have any specific role for bank behaviour (as people like Steve Keen like to point out), it is still at its core just adjusting the quantity of money.

On the other hand it is far more direct, there would no longer be endless debates about the transmission mechanism: government spending is widely dispersed and pays the salaries of people across the country and of all classes. This doesn’t inherently require or encourage statist or anti-market policies either, this new money could simply finance a reduction in sales tax for instance, which would have the added benefit of lowering supply side inflation to counter-act any demand side inflation created by quantity effects. It also does not relinquish traditional monetary policy, an increase in the quantity of new money supplied to the government would inherently decrease the amount of new bonds supplied, which in turn would lower their yield and vice versa for a reduction in new money: hence this new ‘expansionary’ or ‘contractionary’ monetary policy has the same effects as before on interest rates. And even if it doesn’t, I see no reason traditional open market operations could not be conducted in addition to this policy.

Another benefit of this policy is that an increase in the money supply isn’t inherently caused by an increase in credit, thus discussion about unsustainable credit booms or fiat ponzi schemes where credit must be extended forever to pay-off the interest of the old credit would be greatly diminished. This would also be enormously helpful to those who worry about high household debt, this new money could be used to finance principal reductions and all kinds of other policies aimed at reducing indebtedness.

This is also entirely consistent with the rules based proposals advocated by Scott Sumner; the aspect of market monetarism that has much more bipartisan support (Michael Sankowski of the Monetary Realist camp for instance has said he is in favour of NGDP targeting). The quantity of new money, as before, could be set in accordance with a path for the inflation level or nominal gross domestic product growth. This time however there would be no doubt as to whether the target could be met or not, which is why I really think its something market monetarists should support.

Of course, one criticism I would expect to see, especially from monetarists, is that this policy is too radical and unnecessary, ‘we don’t need to change the demand management system since the current system is fine for that’. On the contrary, as I explained before I think monetary policy is highly convoluted and I would argue not optimal; Occam’s razor, I believe, would favour my proposal instead, which is far more simple in not relying on bank behaviour or credit, in essence changing policy structure such that it actually behaves more closely to monetarist models.

Now let me explain what this isn’t. This is not ‘printing our way to prosperity’, this is purely increasing demand, it is not a supply side policy. I agree with people like Cullen Roche and really most economists in that long run growth relies entirely on productivity and innovation (I would add institutional quality to that as well), not the quantity of money. This policy is not aimed at making us all more productive, instead it is merely a policy aimed at stabilising fluctuations in demand.

Of course there are serious criticisms that could be levied at this proposal, it is not perfect, I will analyse a few here:

People have non-linear, unpredictable or volatile demand for money (hyperinflation): This argument, favoured by Austrians, is that a policy like this would remove any ambiguity about what modern money really is (i.e. ‘nothing’, ‘toilet paper’, ‘not backed by anything’), and thus people, rationally or irrationally, will reject the currency, leading to hyperinflation which cannot be controlled merely by adjusting the quantity of money. While I can sympathise with this argument, it’s really not clear that this is actually the case. According to Bill Mitchell, the demand for money is not as simple as conventional wisdom suggests, fiat money still has utility for people because it can, for instance, extinguish tax liabilities. Others, like John Kay or Cullen Roche emphasize money as a social convention, useful in as much as other people also find it useful. Furthermore, I don’t think it is unclear to people what modern money really is regardless. Any statistics of M2 or the monetary base will show you that money has increased massively without being backed by anything and without causing hyperinflation. Suffice to say, I find the idea of people spontaneously rejecting the dollar, or the pound, not very plausible.

Moral hazard: perhaps a stronger argument, also favoured by Austrians. The government could easily get addicted to this free money, and this soft budget constraint (of which there is a large and interesting literature, useful for analysing centrally planned economies and their failures) would cause the government to become progressively more inefficient due to the incentive to cut down on wasteful costs becoming more and more diminished. This argument is a persuasive and important one, however I’m not sure if my policy would actually change anything, as Cullen Roche shows: the way treasury auctions are set up with primary dealers in countries which are sovereign in their currency (as opposed to say Euro-zone countries) makes the idea that the government would ever have much trouble finding funds or would have to suffer high interest rates due to investor risk premiums nearly impossible. In this case, there is already moral hazard and I don’t see how my policy has changed anything. You could argue that high quantities of debt in themselves are simply scary, which might put off government spending too much money, but it seems pretty clear to me in the face of ever increasing public debt that governments, despite their rhetoric, don’t really care that much.

Unnecessary, government spending is just key-strokes, they don’t have to worry about how much money is in their account: this would be from MMTists. First, I agree that the only thing preventing the government behaving in this way is self-imposed legal constraints. On the other hand, procuring funds is how governments today actually work, as Cullen Roche, former MMTer who started his own school after finding MMT too detached from the real world (ironically) explains:

“More recently, MMTers have started using two conflicting descriptions of monetary options.  They now use a “general case” and a “specific” case to explain why the government “spends first” in their general case and actually procures funds first in the specific case.  This is an evolution in MMT ideas that obscures and hides the fact that MMT’s long-held positions on “operational realities” are in fact shifting and/or misleading….

…To argue that the government does not procure funds to spend is a semantic debate because the government must always procure funds to ensure that the private sector allows the government to deal in the social construct (money) of the people (government of course being a construct of the people inherently making money a creature of the people and not just the state as MMT says)…”

It is also in our interests to make sure new outside money is created by an impartial and non partisan or perhaps rules based process, rather than entirely subject to the whims of short term thinking politicians, I hope I can find some agreement with MMT there.

Demand is not deficient, we are always at full employment: used by some RBCists and Austrians. While I disagree, obviously, this simply suggests that we should never need to manage demand, it doesn’t suggest  that this would be a bad policy at doing so should we need to.

In sum, I believe this policy to be simple with very few complications (far less compared to current demand management policy), no doubts about its effectiveness at what it does (increasing/decreasing demand, with no pretense about it increasing productivity or long run potential growth), and that suffers from criticisms which I believe are not strong enough to shoot this policy down.

Update: one more issue I forgot to address

Infrequency of budget decisions: this is something market monetarists are also likely to raise as a criticism, pointing to the advantages central banks have in being able to react more immediately to changing conditions. The remedy is simple, every quarter the committee can announce a quantity of money it projects will need to be provided for public expenditure during the next fiscal year, until private sector forecasts of NGDP or inflation (for instance) for that year are on track, which in turn is likely to affect growth in the current year by altering expectations. As market monetarists say, much of monetary policy is essentially signalling and expectations.

Even then, it is possible that some tax decisions could be decided quarterly instead of annually, although depending on the tax this could create some uncertainty. You could also set up independently financed government institutions, such as public investment banks, that could receive government support decided on a quarterly basis. I’m sure we could find plenty of schemes with quarterly or semi-annual expenditure decisions should expectations not be enough, so I don’t find that criticism too worrisome.

Update 2:
Steve Randy Waldman, in an email, expressing support for the idea points out that this policy shares some similarities with his own and Haito Zhang’s policy proposals, in that  “they share with your proposal a preference for fiscal spending or “helicopter money” rather than bank-mediated leverage as a macro policy instrument.” Steve’s proposal is even more radical than mine, not only bypassing banks but the government too, directly depositing money to individual bank accounts (with perhaps some lottery mechanism to prevent moral hazard), while Haito’s is an interesting democratised fiscal expenditure/investment program combined with an NGDP target although is not too specific on the financing. Getting political support for a proposal like mine would be extremely hard, but I think Steve’s proposal would probably be even harder. I’d argue that Hatio’s & Steve’ s solution are unnecessary while my proposal is simpler and logistically easier to administer, but they are interesting and innovative approaches none the less.