Does Macroeconomic Policy Offer a Free Lunch?

In “The Age of Magic Money: Can Endless Spending Prevent Economic Calamity?”, Sebastian Mallaby raises a variety of questions about the use of aggressive macroeconomic policy to achieve stable economic growth.  He begins his July/August 2020 Foreign Affairs paper with an interesting claim:

The Age of Magic Money

“Crises can drive change, but sometimes it takes two crises to cement a transformation.”

To support this claim, Mallaby provides numerous examples including:

  1. The New Deal and World War II led to a permanently increased role for the Federal government in the United States.
  2. The Vietnam War and Watergate break-in led to declining trust in that same government.
  3. The fall of the Soviet Union along with the global spread of technology led to enhanced U.S. economic strength in the 1990s.

Based on these examples, and others, he asks: will the Great Recession of 2008-2010 plus the current global pandemic generate another change in the character of politics related to economic policy in the U.S.?  Will this be the Age of Magic Money? Or will it end the relative economic hegemony of United States.

What characterizes the Age of Magic Money?

  1. Budget deficits financed by money creation that are not destabilizing.
  2. Inflation that is no longer a monetary phenomenon. Despite a five-fold increase in the monetary base in the U.S. since 2007, annual (CPI) inflation has topped 2.5% in only one year (2011 at 3.2%).
  3. Deficit finance and money creation can be used to meet employment, infrastructure and social goals set by governments without significant cost.
  4. Interest rates on long term debt can be driven to and kept at negligible levels.  Ten year treasuries currently yield less than 1% in the U.S. and have paid negative interest in Japan and Germany for much of the past decade. Such low interest rates are not just a pipe dream for real estate developers.

So what? Mallaby concludes that “don’t tax, just spend” has become the mantra of both political parties in the U.S. as well as central banks in high income economies.  Former ECB head Mario Draghi opined that he would do “whatever it takes” to support the Euro and the economy of the European Union.  In March 2020, Federal Reserve Board chair Jerome Powell sang from a similar hymnal by proclaiming that “when it comes to lending, we are not going to run out of ammunition.”

Based on such evidence Mallaby opines that “the iron law of scarcity need not apply to central bankers.”  The characteristics of “magic money” cited above are consistent with those such as Stephanie Kelton and other advocates of what has been labeled modern monetary theory (MMT.)

Some of you may recall that I have written on related topics previously (February 2017 ,   August 2019 September 2019 and January 2020.  

So, does Macroeconomics offer a free lunch? Does scarcity not exist at the aggregate national level? Has inflation been banished to the scrap heap of history?

As you probably guessed, I would answer “No” to all three questions. So, what’s going on?

  1. “Magic Money” only applies to a country that prints its own currency and as long as that currency is accepted globally in exchange for goods and services. It would not apply to countries such as Greece (which does not have its own currency) or Argentina (which has its own currency but few outside Argentina choose to hold its Pesos) or even China (which has its own currency but does not restricts trade involving the yuan.)
  2. Is the “exorbitant privilege” given the dollar an example of American exceptionalism?  Since almost 2/3rd of central bank reserves globally is held in dollars or dollar security forms, the answer might be “Yes.” Once upon a time, one might have said the same thing about the British Pound Sterling. Even if the dollar doesn’t have any strong competitors in the world of reserve currencies, that doesn’t mean that those outside the U.S. will want to put “all their eggs” in the dollar basket.
  3. If the afore described U.S. macroeconomic stabilization policies continue, then the rest of the world would be wise to heed the words of former Treasury Secretary John Connelly.  In 1971, as the US proclaimed that it was ending any pretense of tying the dollar to gold, he opined that “The dollar is our currency but your problem.”  Chinese and Japanese policy makers have reduced their U.S. dollar holdings, as well as share of, reserves over the six years and, thus, have heeded Connelly’s message.

Mallaby concludes by highlighting what the Federal Reserve should address. The FOMC’s  (Federal Open Market Committee) long-run goals and monetary policy strategy, as stated August 27,2020, provides a much different view than Mallaby’s expressed here:

“Nobody is sure why inflation disappeared or when it might return again. A supply disruption resulting from post-pandemic deglobalization could cause bottlenecks and a price surge; a rebound in the cost of energy, recently at absurd lows, is another plausible trigger. Honest observers will admit that there are too many unknowns to make forecasting dependable. Yet precisely because the future is uncertain and contingent, a different kind of prediction seems safe. If inflation does break out, the choices of a handful of individuals will determine whether finance goes over the precipice.”

As John Cochrane and others have argued, there are limits to how much we can borrow without raising taxes or paying higher interest rates.  We just don’t know when or what the implications will be.  But, similar to the impact of a pandemic, if we don’t prepare for it, the cost could be very high indeed.  I certainly am not ready to abolish the idea of scarcity at the macroeconomic level or that inflation will never again rear its ugly head.  We should seriously consider the prospective cost of pretending that  MMT holds or that we can continue to spend and print money until some idealized set of economic circumstances arises.

In the last decade in the U.S., despite low inflation (on average 1.6%) and abundant growth of both federal deficits (over $400 billion each year and over $3 trillion in 2020) and the accumulated debt as a share of GDP( from 60% to over 135%), real economic growth rate over the past decade (average of 2.1%) has not reached that projected by the Councils of Economic Advisors of either President Obama 2016 (2.3%) or President Trump 2020 (2.8% to 3.1%) nor do many economics expect it to. 

Perhaps stagnant real economic growth, as has been the case in Japan (0.2%) since the early 1990s or in Europe (1.6%) since 2010) will be a byproduct of MMT-like policies.  Furthermore, low or negative inflation-adjusted interest rates encourage borrowing for a variety of purposes both productive and unproductive. Such behavior, in contrast with spending based on household or business savings, makes our economy much more unstable than it otherwise would be.  Increased uncertainty and increased indebtedness are not a formula for either economic stability or sustained economic growth. Macroeconomic stability and growth, as well as the potential to reduce poverty and income inequality, depend upon more than just short-term demand stimuli.  We must understand the forces that affect productivity growth and stability, not just those that might counter short term economic turbulence.

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