Explaining what is wrong with Magic Money Theory [MMT]

This was from Beachcomber in the comments:

Hi Steve, I just read a fascinating essay by Peter Smith at Quadrant: Money printing in the age of Covid

In the essay it states:

In the age of COVID-19, bonds sold to finance deficit spending are being largely or wholly bought up by respective central banks. This is manifest in banks’ holdings of deposits with their central bank and of treasury notes or bills.

In comments the question is asked as to from where the “central bank” garners the money to buy the bonds.

To which Peter Smith answers:

It creates it out of thin air cos it can.

The central bank simply issues a cheque or like instrument, drawn on the central bank, which allows the holder of the bond (assume it is a non-bank – the process is short-circuited if the holder is a bank) to lodge the cheque in its bank account. The bank correspondingly lodges the cheque with the central bank and sees its deposts with the central bank increase accordingly. The central bank now has an asset – the bond – and a corresponding liability – the bank’s deposit. It can go on doing this till the cows come home. Or, practically speaking, until inflation rears its ugly head.

Is this true? Can this continue forever? With shrinking incomes and the associated shortage of money supply, inflation seems unlikely. Peter Smith makes a distinction from Modern Monetary Theory without explaining how it is different. Can the creation of money from nothing by the Government continue forever? If so, then Andrews can reign forever!

First, if there is an authority on the banking system in Australia outside and beyond the reach of government, it is Peter Smith. He was, when I first met him, the economist for the Australian Bankers’ Association, then became the Chief Economist for the State Bank of Victoria and finally was the first Chief Executive for the Australian Payments Clearance Association. No one gets this stuff better than he does.

But let me buy into this because this is part of my expertise as well. And to follow this with any understanding you have to divide the economy into two halves. On one side is production, the actual goods and services produced, which also includes the production of inputs into the production process, such as iron ore and natural gas.

And on the other side there is the monetary side of the economy which is completely distinct. This comprises:

  • money as a medium of exchange, say a $100 note, but represents the value of goods and services so that we can sell what we produce to buy what others produce
  • money which we set aside as a store of value, such as bank accounts or superannuation savings, and
  • money which we use as a unit of account so that businesses can calculate how much things cost to produce so that they can determine what to charge so that they can calculate whether they are making a profit.

And it should be emphasised that only profit-making businesses create more value than they use up in production. Loss-making enterprises – which include virtually every activity run by governments – slow the economy, using up more value than they create. Loss-making enterprises cause the economy to contract. Only if there are other enterprises making profits – almost always private sector enterprises – can the economy expand. Without understanding that, you cannot understand the first thing about how an economy works.

Creating more money does NOT create productive resources. Giving more money to governments, or allowing them to print more money out of thin air, lets governments spend on non-productive activities which they inevitably do. Spending more on non-productive activities means less is spent on productive activities.

And adding to the problems, when the government expands the volume of money by just printing the stuff up, they undermine each of the uses money has: as a medium of exchange, as a store of value and as a unit of account. The economy can no longer be run as productively as it might have been and often even leads to a fall in real income across the entire community.

Virtually no politician I have ever met has understood this. Virtually no political leader I see in the news today understands this. All of the others are Keynesians now, who believe the mere spending of money creates jobs, growth and higher real earnings. On this they could not be more wrong.

We will be paying for this ignorance for a very long time to come.

A how-to guide to economic policy

For any single business, higher demand all other things being equal makes them more money and can often lead to an increase in the number of employees.

For an entire economy, higher demand has no bearing either on real incomes or on the level of employment.

This is straightforward and for me anyway, as obvious as the morning sun. It is the conclusion that comes from a proposition that now goes by the name Say’s Law.

There have been many examples in history where Say’s Law was shown to be an absolute truth in an economy. There have been even more where attempts to raise an economy from recession through increased public spending – through an increase in aggregate demand – have been abject failures. No stimulus in history has ever succeeded in pulling an economy out of recession, NOT A SINGLE ONE! The sad story since the GFC is the most recent, but there have been lots. Every single one made economic conditions worse.

On the other hand, we had the Peter Costello/John Howard years from 1996 to 2007 of the best economic management ever seen, possibly anywhere. Not only did we balance the budget for years on end, we ended up with zero national debt! Because of the idiocies of modern economic theory, even though this was done right there before our eyes, bad theory remains. Modern macro is economic poison, but it’s often lots of fun for both governments and the people who they spend the money on. And for everyone else, it looks sensible since higher demand must create higher levels of production. In reality, it is higher levels of production that allow for an increase in demand. That is why we are so much richer than a century ago. We produce more so that we can demand more.

We were reminded of all this here: John Howard and Peter Costello urge PM to keep building budget surplus.

John Howard and Peter Costello have urged the Morrison government not to squander the budget surplus on a short-term stimulus, while doubting whether monetary policy is still a useful economic instrument given the reduction in interest rates to historic lows.

“The government is absolutely right to be returning the budget to surplus and I think it’s right to anchor­ its fiscal policy to producing surpluses over the next four years,” Mr Costello, the nation’s longest-serving treasurer, told The Australian.

Treasury is filled with people who have no idea why this is the way to prosperity. Reserve Bank as well. A bit more here:

As forecasts for economic growth, household consumption and wages have been downgraded, and $21.6bn wiped from future surpluses, Mr Costello said he doubted whether monetary policy was still a useful economic lever.

“Monetary policy has run out of puff,” he said. “Once you get interes­t rates at near-zero levels, whether they’re at 0.75 per cent, 0.5 per cent, 0.25 per cent, it just doesn’t matter, it’s lost its power as an economic instrument and that is why when the Reserve Bank cut rates during the course of (last) year it had no discernible effect.”

Low interest rates are the other side of the Keynesian economic model, a disastrous shambles of a policy, which inevitably puts money into the hands of many more people who will not earn a productive return on investment relative to the proportion of borrowers who will do so if rates are higher. Interest rates are near zero everywhere and no economy has found low rates of any benefit. Only value-adding investment can raise living standards. High levels of public spending and low rates of interest will not do that, just as they never have.

The economic resistance speaks out

Peter Costello was Australia’s greatest Treasurer bar none. Today in The Oz there is a front page story that reminds me just how much this is so: RBA cuts won’t help the economy, says Peter Costello, with the subtitle, “Former Treasurer urges Coalition to Resist Infrastructure Splurge”. And it’s not just rate cuts that are useless.

Future Fund chairman Peter ­Costello has brushed off suggestions that further cuts in official interest rates will help the economy, while urging the government to resist calls to ratchet up infrastructure spending, saying it should tackle the “hard” issues of structural reform.

He ran the economy for eleven years, and among the best forecasts I ever made was to say that we will all live through it, see how well a policy of balanced budgets and zero debt actually works, and not learn a thing. Come the GFC, and that fiscal incompetent Kevin Rudd grabbed the stimulus tray with both hands and now, more than a decade later, we cannot get our economy untracked. And it’s not just balancing the budget that matters.

So let me bring you back to the economics of the classics and tell you what needs to be done: (1) leave growth to the private sector and (2) keep interest rates high enough to stop our resources being ploughed into unproductive projects (eg the NBN, desal plants, streetcars down George St, billion dollar train stations at places no one goes to).

The problem remains that Keynesian macro and every introductory text – except mine – pushes stimulus spending and low rates of interest, the perfect recipe for staying in the doldrums for a very long time.

And by structural reform, the proper meaning, which I assume is the same as Peter’s, is to let the economy adjust so that we are producing value-adding goods and services that will actually make a profit in the market. And if we do that, strangely enough, it will also add to the economy’s capacity to provide higher levels of public spending, even though it is a smaller proportion of total output.

Peter Costello for PM

With Kelly O’Dwyer about to vacate Peter Costello’s old seat of Higgins, the scenario writes itself. Peter Costello must become the leader of the Liberal Party and contest the next election on behalf of the Coalition.

He understands how to run an economy better than anyone in Australian history.

He will continue to stop the boats.

He will unite the party.

And as an added bonus, Malcolm has now gone, the miserable incompetent who would never let any partly leader alone until he was the leader himself has disappeared into his fully earned oblivion. There will be no instability among those who will recognise just how crucial stability must be.

I know that politics is a hard game, but there is no one I have ever seen dominate Parliament as he did. You don’t lose the touch. Your country needs you.

Peter must run for his old seat and the Libs must make him their leader to face Bill Shorten at the next election.

No such thing as “the level of demand” at an aggregate level

Through the whole of the Costello years as Treasurer, I would say that everyone would live through these exceptionally good economic times, but no one would learn a thing. And it’s not just that we had balanced budgets, but had ZERO DEBT. Only country ever to do this and we floated on air. So then we elected Labor and then we had the GFC, and then we had the advice from Treasury to go early and go hard, and so here we are today, in a crumbling economy with living standards heading south. Which is a preamble to this: Peter Costello and later treasurers right to stress benefit of surpluses. Not so sure about those later treasurers, but Peter was the legitimate article, Australia’s greatest Treasurer.

In his book on Australian treasurers, Bowen describes Costello as the country’s first post-Keynesian treasurer, rejecting the idea that taxes and spending should be used to manage the level of demand in the economy, with that task left to the Reserve Bank. The pursuit of a budget surplus was seen as evidence of good economic management and became an end in itself. Costello was able to distil his political message into a simple message: “Surpluses are good and Liberals deliver surpluses,” Bowen writes.

Half way there. There is no such thing as “the level of demand” at an aggregate level. You cannot manage it. You cannot cause it to go up and down. Aggregate demand has no separate existence apart from aggregate supply. It is Keynesian junk theory whether it is spending or adjusting rates. It will not work and never has, ever. Modern macro is false from end to end. As John Stuart Mill put it, and found in my Free Market Economics where it is explained at great length: “demand for commodities is not demand for labour”. That was written 170 years ago. The idea that there is progress in economic theory is just plain wrong.

PLUS THIS: From Max in the comments:

“Austrian theorist Henry Hazlitt argued that aggregate demand is ‘a meaningless concept’ in economic analysis. Friedrich Hayek , another Austrian, wrote that Keynes’ study of the aggregate relations in an economy is ‘fallacious’, arguing that recessions are caused by micro-economic factors.”

“The Keynesian is a collectivist methodologically. He looks at aggregates. He recommends government programs that affect aggregates.”

“Keynes argued, and his disciples still argue, that the cause of unemployment is insufficient aggregate demand. This is another way of saying that the cause of unemployment is excessive aggregate supply. The fact that Keynesians never put it this way does not affect the analytical truth of the argument.”

Absolutely dead on. Is this the source: Illegal Aliens and Unemployment: Causes and Effects by Gary North?

“I am a Keynesian,” Bowen declares proudly

These people don’t get it. They just don’t get it. I want to write, “such idiots they are”, but I am much too polite for that. From Paul Kelly’s column today on Keating and Swan loom large in Bowen’s thinking:

“I am a Keynesian,” Bowen declares proudly. “I would take a Keynesian approach to fiscal management. We can’t rule out the need for a government to stimulate domestic demand sometime over the next decade.” It is an unambiguous statement of belief.

Given Australia’s lower economic growth and doubts about economic recovery, Bowen as treasurer resorting to fiscal stimulus would be a live option. It reminds us that Bowen is a politician formed by the 2008-09 global financial crisis and is a champion of the huge fiscal stimulus put in place by Kevin Rudd and Wayne Swan at that time. . . .

In his book The Money Men, Bowen rejects the main criticisms of the Rudd-Swan stimulus. While admitting the outcome was “imperfect”, Bowen says Swan was tested like no treasurer since Labor’s Ted Theodore during the 1930s and concludes that Swan, in relation to the GFC, “got all of the big calls right”.

The evidence of cloth between the ears never gets more evident than dealing with someone who actually sat in Parliament first through the Costello years and then through the years of economic management under Wayne Swan and thinks that Swan got it right. Those Costello years, when everything was going so well because the world economy was so placid. Like through the Asian Financial Crisis and the Dot-Com bust, you mean. They went well here because, for a change, we didn’t have a Keynesian in charge. How really out of it do you have to be to say this:

As Bowen says, Labor’s $46 billion second stimulus package of February 2009 triggered a debate that dominated “at least the next five years of Australian politics”.

It dominates us now because the deficits and debt will remain a problem for years on end. And now this clown wants to come back into government and add to the problems in the same way that they did the last time we gave them the chance. And if you really want to start to worry, try this on for size:

For Bowen, economic growth is the mission. He wants a competitiveness strategy “sector by sector”, says it is “not the job of Canberra” to determine where the new jobs come from but identifies the sectors that he sees as a priority and the skills deemed to be ­essential.

Picking last year’s winners is a tried and true strategy of failure, but back it will come if we give these people the chance to turn the Australian economy into the same kind of wreck that Obama has managed in the United States.

Dealing with the red-green faction of the Liberal Party

In the poll showcased by Sinclair, this was the tally that mattered. So far as Coalition voters are concerned: Abbott 41% / Turnbull 21%. Among Coalition voters, the split thus is 66.1% Abbott and 33.9% Turnbull. And would you like to know why? From a few days ago:

Communications Minister Malcolm Turnbull added pressure by live-tweeting his morning journey by public transport from Melbourne to Geelong — the same journey for which Mrs ­Bishop notoriously claimed a $5227 helicopter bill in ­November. “One tram, one train, one car,” Mr Turnbull said.

My dim and distant memory is that Peter Costello refused the leadership in 2007 primarily because he was not prepared to put up with the continuous white anting from Turnbull. Life was to short so he gave it away, and we have missed out on a great potential Prime Minister. Instead we had Brendan Nelson, who was white anted instead. Then Turnbull, who white anted himself with his incompetence. And how he is doing the same with Abbott.

The red-green faction of the Liberal Party is a major problem, and I just wish they’d stop. The government would be in a much better position if there was less treachery. Abbott I think understands all too well what is happening around him. But you are forced to work with the materials you have. He remains the most conservative and free market Prime Minister we are likely to have any time soon. He’s not perfect. He’s only better than any and all of the rest.

Australia’s supply side revolution

I don’t mean to be pedantic – well I guess I do mean to be pedantic – but the problem with bracket creep has nothing to do with whether the economy will recover. The increases in personal taxes are the necessary requirement to pay for all of the expenditures loaded on the economy by Labor. As the story says, Employees lose $25bn to creep as Labor blamed for blocking savings. Everyone will have to chip in to pay for Labor’s waste, and so, those annual personal tax cuts that Peter Costello used to deliver, are for the future. But here is where I wish to differ:

Treasury secretary John Fraser­ warned last night that fiscal drag was “a worry” that needed to be addressed and higher taxes would hurt growth.

The one thing that won’t be hurt by a gently rising personal tax burden is growth. The pervasive Keynesian mindset where the economy is looked at from the demand side, and that it is consumer demand that drives 60% of the economy, and et cetera, is just plain wrong. Just keep reducing public service waste, get that budget back into surplus, do everything you can to make the private sector grow, and it will all take care of itself. And under no circumstances let “aggregate demand” enter into any part of the policy matrix. It is value

My book launch

There will be few moments in my life as exquisite as Wednesday when Peter Costello* came up to the University to launch the second edition of my Free Market Economics: an Introduction for the General Reader. It was a rare moment when the political side of my life, the academic side and my recognition of the importance of classical economic theory were brought together all at once, and was a moment I could share with my friends and family.

I may sometimes give the impression that the book is mostly about Keynesian economics and macro which is not the case at all. That is why I started it out, but the oddest thing for me was to find that as I wrote each chapter, that I harboured views that are far outside the standard textbook treatment. This starts even before we get to supply and demand, but I promise you this, by the time you finish with supply and demand you will know you are in a different economic world. Of course, there are demand-side market forces that limit the price that can be charged for a product, and forces on the supply side that put some kind of lower limit on the price. But the notion that there is a single equilibrium price for a product where two lines cross on a two-dimensional plane is unsupportable by even the most casual empiricism. As I point out to my classes, the price of a cup of coffee, starting from the $1 at the 7-11, to prices four and five times higher that are charged, all within a mile of the front door of our building, ought to make you appreciate that there is something else. I do teach the traditional S and D analysis, but my students also are made to understand that prices are not set by these two curves, but by entrepreneurs who are making decisions about their optimal pricing strategy, given all of the forces of the market that surround them. And most importantly, I do not let them forget that the information in a demand curve can never be known by anyone, ever. It is strictly for teaching purposes. Entrepreneurs in the real world have to work these things out for themselves in real time.

But if I have a villain on the microeconomic side, it is the MR=MC analysis and diagram. If economics had gone out of its way to find some means to cloud minds about what goes on in markets, I don’t think they could have come up with anything worse.

mc equals mr

I teach Keynesian economics, of course, but I won’t teach that. You can find it discussed in my book, but it’s in an appendix. Over the years of teaching this diagram and the explanations that surround it, I found that after going through markets and then supply and demand, you would come to this and stop a class cold. Eventually some could draw the diagram and some might have seen the point, but there would not have been many. I do, of course, teach marginal analysis, but not like this. If you would like to see how I do it, as just part of the way this book is different from any economics book you know, Quadrant Online put up a few pages of the book under the heading Margin of Success.

As I said at the end of my presentation, there are three features of the book that I stress over and again: the role of the entrepreneur, value added and the crucial importance of uncertainty. Each is part of what must truly be understood by marginal analysis: entrepreneurial decision making in the face of the unknown future. And the point I make about the entrepreneur, as I said on the night, is that we now talk about market forces and the invisible hand, but the reality is that there is only one force that matters in a market economy, and that is the entrepreneur. And I don’t mean entrepreneur as in someone who innovates and causes change. I mean entrepreneur as in the captain of a ship in the midst of a storm a thousand miles from land.


* For non-Australians, Peter Costello is the nearest equivalent we have to Ronald Reagan. He ran the economy for eleven of the best years economically this country ever had. Not only was the Asian Financial Crisis a non-event when every one of our major regional trading partners was in recession, but we ended up with 5-6% at the same time. And not only budget surpluses year after year, Australia was, until Labor took over, the only country in the world that had ZERO DEBT! The momentum given to the economy by Costello meant that we travelled through the GFC with hardly a ripple. Our problems have come since due to the debts and deficits Labor piled up. We will never see zero debt again in anyone’s lifetime, and will be lucky even to see our budget balanced any time this side of 2025.

It’s more than just a matter of words

I wrote this the other day but didn’t push the “publish” button. But with Andrew Bolt having put up a post today on The West attacked: killers to the right, ferals to the left, which begins with the sentence, “Islamists on the Right, anti-capitalists on the Left”, I will just have to buy in. The rest of this was written on Tuesday.

There are no two people in politics I agree with more consistently than Andrew Bolt and Peter Costello, so if I bring up one of Andrew Bolt’s posts in which both feature, it must be understood that I don’t disagree with a single point they make, only with the terms they use. Andrew’s post is titled, The Left now sounds just like the Islamist Right, in which Peter is quoted as saying:

Australia is one of the most successful, open, prosperous, accepting societies that the world has ever known. Being born here is one of the best things that could ever happen in a person’s life. That is worth explaining as part of immunising the young against the false political claims of extremists.

Andrew began the post with this where I will begin myself:

One of the most disturbing developments in public debates has been the Left giving cover to Islamists of the far Right.

There is, I must insist, no such thing as “Islamists of the far Right”. The right-left divide in politics is between those who value individual rights above collective rights and those who do not. The only person who ever correctly thought of Hitler as to his right politically was Joseph Stalin who introduced this notion into our political direction finder. To think of racists and extreme nationalists as part of the right is merely to defame those of us who see ourselves on the right, far or otherwise. It is we members of the right properly understood who almost alone have been willing to take the fight up to Nazis, fascists, communists and Islamists and have been able to do so without missing an ideological beat. To describe Islamists as “far right” wrongly aligns people such as ourselves with people such as themselves, and introduces a confusion of terms since the right-left divide then becomes less clear cut than it ought to be. No one on the right is ever described by those on the left as anything other than “far” right. To be on the right should be seen as a badge of honour.

Same with the word “conservative” who are people, again like ourselves, who find the open and tolerant society in which we live one we would like to see preserved, and therefore are very careful about the nature of change, and are never in any great hurry to see things radically altered. I am at one with Edmund Burke in believing in “the general bank and capital of nations and of ages”* as the great repository of common sense and social morality. It is being worn away as the left has continued its march through the institutions, but it has a powerful hold even still.

And then there is the quote from Peter, where he wrote, “the false political claims of extremists”. The word “extremists” is commonly used about Islamists. But calling Islamists “extremists” makes it seem that these views are well beyond some kind of norm, a thousand miles from the political centre. And so they are, if we restrict the frame of reference for other people’s political morality to our own view of things as found in our own culture, whose traditions travel back in time through to the British Isles and the values that have developed as part of our Judeo-Christian heritage. These are the great bequest we have inherited and we must do everything we can to defend this history from the ignorance of the fanatics in our midst. To call our enemies “extreme” is to misread how they think of themselves. They are perhaps on the more aggressive side of their own value set, but they seem to be far from “extreme” within the communities in which they live. The extremists in such communities are more likely to be the people who agree with us, the ones who would like to share in our own cultural tradition and make common cause with us. Even living here in a Western nation, it is still not easy for them, as the life of Ayaan Hirsi Ali has shown. The proper word to describe Islamists is “barbarians”. If the left chooses to side with them, that is what they are as well.


*”You see, Sir, that in this enlightened age I am bold enough to confess, that we are generally men of untaught feelings; that instead of casting away all our old prejudices, we cherish them to a very considerable degree, and, to take more shame to ourselves, we cherish them because they are prejudices; and the longer they have lasted, and the more generally they have prevailed, the more we cherish them. We are afraid to put men to live and trade each on his own private stock of reason; because we suspect that this stock in each man is small, and that the individuals would do better to avail themselves of the general bank and capital of nations and of ages.” From Edmund Burke, Reflections on the Revolution in France, p 145.