Savings Glut or Investment Dearth: Rethinking Monetary Policy

REVIEW ESSAY
The Deficit Myth:
Modern Monetary Theory and the Birth of the People’s Economy
by Stephanie Kelton
Public Affairs, 2020, 293 pages

In the past, as governments have “funded” deficits (rather than monetizing them), much of their debt took the form of long- and medium-dated bonds. Since the yield curve usually slopes upward, this was an expensive policy and one that must be seen as foolish if the funding brought no discernible benefit. Beginning with the introduction of “quantitative easing” in 2008, however, the United States has reversed direction by having the Federal Reserve buy long-dated government bonds. “To fund or not to fund” is thus an im­portant and immediately relevant question, one which economists not only have no agreed answer to but seem reluctant to even ask.

Unasked questions are unanswered ones, and a virtue of Stephanie Kelton’s The Deficit Myth is that it forces attention on why governments ever go to the expense of issuing bonds in the first place. Her critique of the weaknesses of conventional economic policy should receive—and to some degree already has received—wide acceptance. Things become more complicated, however, when Kelton begins to propound solutions to the various problems that her critique has revealed. Dramatic changes in economic management, such as those Kelton proposes, must be based on relative risks, and the known risks in our current system will likely (and correctly) remain preferable to unknown ones. The Deficit Myth nonetheless raises important points about why our conventional economic policy approaches need to be improved and how this might be done.

Monetary Policy versus Fiscal Stabilizers

The book opens with an attack on the common analogy that likens government budgets to household spending, usually invoked to sup­port arguments against budget deficits. This thinking holds that if governments spend more than their income, then they, like households, will end up in bankruptcy. But as Kelton points out, the United States and most other countries today, with the exception of those in the eurozone, operate a system of fiat money under which bankruptcy cannot occur. Instead, the main risks are inflation and exchange rate depreciation. Kelton’s view is shared by many economists, but she argues that a persistent misunderstanding of these issues has consistently resulted in insufficient fiscal stimulus—either because the deficit spending has typically been too small or because it is often poorly designed, reducing its multiplier effect.

Deficit spending is desirable when it reduces unemployment, but only insofar as this does not result in increasing inflation. The Feder­al Reserve has the “dual mandate” of containing the levels of both infla­tion and unemployment. The optimal point occurs when unemployment has fallen to what is called the non‑accelerating inflation rate of unemployment (nairu). Since the nairu is unknown and varies over time, and since monetary policy does not immediately impact de­mand, the Fed is bound to make mistakes. A less fallible way to manage inflation and unemployment would certainly be desirable.

Governments could use fiscal policy to maintain unemployment at the nairu rather than relying on monetary policy to manage demand. The current preference for monetary policy reflects the view, which The Deficit Myth challenges, that fiscal policy cannot be varied quickly and precisely enough to provide the necessary fine-tuning of demand. Typically, government spending and taxation are decided by a lengthy process involving both houses of Congress and the presi­dent. But it might be possible to devise a system in which the fiscal balance adjusts automatically to the level needed to keep the economy at its optimal level of output while maintaining stable inflation. We already have such “automatic stabilizers” in the form of unemployment insurance and other programs that cause budget deficits to rise, without any action by Congress, as tax revenue falls in periods when the economy is weak. If the automatic stabilizers were stronger, Kelton argues, then the role of monetary policy in balancing the economy could become less important, and the inevitable errors in its application less damaging.

Kelton thus proposes to introduce such a stabilizer in the form of government-guaranteed full employment. In place of unemployment benefits, anyone wishing to work would be offered a job by the government if none were available in the private sector. This program’s practicality depends on two different types of problems: is it possible to invent enough government jobs, and can hiring for them be flexible enough to cope with the fluctuations in demand for labor from the private sector?

Critiques of Quantitative Easing

Before evaluating Kelton’s job guarantee proposal, it is helpful to examine the problems associated with the current paradigm of economic management. A key question is whether Kelton’s preferred automatic stabilizers would be likely to produce more or less collat­eral damage.

One problem with the current system is its vulnerability to errors of judgment by the Federal Reserve. Another lies in striking the right balance between fiscal and monetary policy. Central banks can­not determine fiscal policy, so if demand is too weak to ensure full employment, the Fed must act to stimulate the economy in order to comply with its dual mandate. If this cannot be achieved by cutting interest rates, it must be done by other means. The approach chosen by the United States and by other jurisdictions has been quantitative easing (QE).

QE involves buying long-dated bonds, an action that pushes up bond prices and flattens the yield curve. By triggering a fall in its cost, QE encourages debt, either to replace equity or to finance investment. Critics argue that QE encourages the buildup of private sector debt, pushes up asset prices to dangerous levels, and increases the risks of future policy mistakes.

Bond, property, and equity prices have all risen following QE. In the case of equity valuations, they are now at levels similar to the peaks of 1929 and nearing the historic highs seen in the tech boom of 2000.¹ This has discouraged savings and encouraged consumption, since the wealthier we think we are, the less we feel the need to save. But asset prices affect savings not only when they rise, but also when they fall. As we have seen after previous peaks, nasty recessions are a high risk when asset bubbles burst. This is amplified when, as today, there is a high level of private sector (and particularly corporate) debt, which, after falling briefly following the 2008 recession, has risen again to a record high level.

Moreover, although QE has served to inflate asset values, it has been much less effective in stimulating investment. Investment has recovered from the lows of the Great Recession, but it remains depressed compared with levels seen during past periods of full em­ployment. Some claim that companies have been discouraged from investing by a desire to improve their balance sheets, and that QE will eventually encourage more investment once balance sheets improve. Kathleen Kahle and René M. Stulz have shown that this is an untenable thesis, however: rather than repairing their balance sheets, companies have increased their debt to fund growing cash payouts through dividends and share buybacks.²

The financing of QE’s bond buying involved a massive increase in commercial banks’ deposits with the Fed. The question is whether this level needs to be brought down again. If it doesn’t, then the funding policy of the past has been an expensive folly. If it does, then the Fed will need to decide how fast to sell its holdings of government debt, as well as the appropriate level of short-term interest rates, and the opportunities for policy error will have shot up—especially since the Fed is now said to be in “uncharted territory” with no agreed upon theory governing its actions.

QE thus seems guilty as charged. It has increased the risk of another financial crisis by encouraging debt and boosting asset prices. It has also raised the risks of future Fed policy mistakes. In 2002, Stephen Wright and I argued that the Fed had become hubristic in its belief that asset prices did not matter, whether because financial bub­bles were considered impossible or because monetary policy was believed to be readily able to cope with asset price falls. The first error followed from faith in the Efficient Market Hypothesis (EMH) and the second from the “general consensus that monetary policy should be about controlling inflation and nothing else, which might be called the Efficient Central Banking Hypothesis (ECBH).”³ The hubris involved in these ideas was epitomized by Alan Blinder, a former vice‑chairman of the Fed, who remarked at the height of the tech bubble, “For the U.S. economy to go into significant recession, never mind a depression, important policy makers would have to take leave of their senses.” We added that “Time will tell whether Professor Blinder’s confidence proves to be admirable or foolhardy.”⁴

Time has duly told and, although it still has its adherents (and equivalent assumptions have not yet been eliminated from many models of the financial economy), it is now generally accepted that faith in the EMH was a disastrous mistake. And the widely accepted need to include financial stability in the responsibilities of central banks shows how the ECBH has also fallen into disrepute. Sadly, it took the Great Recession to change opinion, illustrating that events are more persuasive than debate.

Although QE seems guilty as charged, the Fed is not in the dock. Fiscal policy is something which it cannot control. Given its mandate, it clearly needed to boost demand during the Great Recession and the ongoing Covid-19 crisis, and buying more bonds (and other assets) seemed to be the only option. This has, however, increased the risks of another financial crisis, the avoidance of which is now generally accepted as being part of central banks’ responsibilities. Over the long term, QE is not a satisfactory solution, and structural change to stim­ulate demand becomes essential.

Fiscal Policy and Its Limits

When the ratio of national debt to GDP is low, deficits appear to boost demand without negative side effects. In favorable conditions, a rise in the budget deficit in dollar terms may increase output by even more, so that there is no increase in the ratio of the national debt to GDP. This scenario underscores the point that fiscal stimuli should be designed to produce the optimal demand response for any given rise in the budget deficit.

It is widely agreed, however, that there is a limit to the size of the deficit and that this limit depends on such factors as the level of the national debt, the growth of the economy, and the cost of borrowing. Of course, if the real rate of interest is negative, even a stagnant economy can rein in a massive debt ratio and run large budget defi­cits. But there comes a point when fiscal deficits will cause the debt-to‑GDP ratio to spiral out of control unless real interest rates are sufficiently negative, and sufficiently low rates may be impossible if central banks also seek to limit inflation. Some economists, therefore, favor raising the inflation target from the current preference of 2 percent. The objections to lifting the target are that it favors debtors over creditors and that it raises the nairu by way of increasing infla­tionary expectations, thereby leading to a sustained high level of un­employment as well as higher inflation.

The United States experienced the combined miseries of elevated inflation and high unemployment after the 1970s oil crisis. But other countries have reduced debt burdens through inflation without high unemployment. After World War II, the UK managed to achieve “financial repression”: inflation rose and the national debt ratio fell while the country avoided high unemployment. During this period, the UK brought down its debt-to-GDP ratio from 229 percent at the end of World War II to under 100 percent by the 1960s. The chancellor of the exchequer from 1945 to 1947, Hugh Dalton, issued irre­deemable debt with a 2.5 percent coupon at a time of rising inflation, thus earning him his sobriquet as “the man who put the ‘u’ in guilt-edged.” Inflationary expectations in this case, however, were kept in check by rationing, which continued well into the 1950s, and by limiting any falls in the international price of sterling through ex­change controls. Neither of these appear to be politically feasible options today. The problem disappears, however, if government debt is not funded, and the short-term nominal risk-free interest rate is kept at zero, as Kelton proposes.

The Prospect of Full Employment

With this history in mind, we can now return to Kelton’s main questions and proposals: Why do governments fund? Should we rely more on fiscal rather than monetary stimulus? Would stronger auto­matic stabilizers reduce the risk of policy misjudgment? If so, is the replacement of unemployment benefits by government employment a promising approach? These are all clearly important issues, even if largely avoided by economists.

I have listed the questions asked in the book as if they are separate, but in practice they relate to each other. We need to understand why governments fund in order to consider how fiscal and monetary stim­uli differ, and to determine whether we should put more emphasis on fiscal policy as Kelton argues.

Have governments been foolish to fund their debt? More likely, the considerable expense they have incurred has been well rewarded insofar as it has reduced the frequency of damaging levels of inflation. This is a significant benefit as inflation is expensive in terms of future lost output and tax revenue. Higher inflation does not just push up prices in the short term, it raises expectations about its future rate and with them the nairu. A higher nairu reduces the equilibrium level of output. Not only is it expensive so long as it persists, it requires the shock treatment of even higher unemployment to bring it down again.

Kelton, however, favors the exclusive use of fiscal policy. She assumes that if the government were to provide guaranteed jobs for everyone, cyclical fluctuations in private sector employment would be matched by the public sector so that the economy would have per­manent full employment without unacceptable levels of inflation.

Under this job guarantee proposal, government spending would fluctuate with changes in government employment, with both rising during downturns. Meanwhile, in more prosperous times, a shift from public to private employment would cause revenue to rise and vice versa. As wages would be higher in the private sector, labor incomes would rise when the private sector was hiring, and as some of this extra income would be spent, demand would also rise. Provided there was spare capacity, output would rise with it without generating inflation. The fiscal deficit would therefore rise and fall in a countercyclical way, and the automatic stabilizers would, in theory, balance the economy without the need for other changes in fiscal or monetary policy.

In Kelton’s plan, the risk-free short-term interest rate would be set permanently at zero, the government would not issue interest-bearing debt, and any expenditure incurred in excess of tax revenue would be financed by the Fed through changes in the balances held there by commercial banks. The long- and short-term interest rates paid by private sector borrowers would be set by negotiations, via bond mar­kets and the intermediation of banks, with private sector lenders. The average level of the fiscal deficit would control the growth of the monetary base, though additional adjustments could be made if manipulation of base to broad money ratios became necessary. In theory, the economy should be able to operate on autopilot with low inflation and low unemployment.

But what are the implications and consequences of such a policy of full employment? For private employment to rise when companies wish to employ more people, government jobs would have to pay less than the lowest private sector ones—and thus less than the minimum wage—which seems likely to pose a political problem. The greater the difference between public and private sector wages, the more move­ment there would be in employment between the two sectors. There would be no movement without a gap, and, at least in theory, every­one would move if the gap were very large.

R. H. Coase claimed that “in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximize wealth, and this irrespective of the initial assignment of rights.” Government and central bank decisions, both those currently required for fiscal and monetary policy and those that would be needed under a different system, arise because transaction costs are significant. It also remains true that, as Coase remarked in his Nobel Laureate acceptance speech in 1991, “the concept of transaction costs has not been incorporated into a general theory”⁵—which, he added, would be very difficult.

There is no reason to believe that transaction costs would be low enough under Kelton’s proposed system to dispense with the need for government decisions. We also have no basis to argue that errors in setting the average level of the fiscal deficit and the government wage would have only trifling consequences, or that they could somehow self-adjust to avoid regular decisions being called for. As such, Kel­ton’s automatic stabilizers may prove neither automatic nor stabilizing. Because our information is, to put it mildly, imperfect—and because we have experience of our past errors under existing arrangements but none for any alternative—the obstacles to the proposed change seem to me to be overwhelming. Until economic theory has taken a large jump, the devil we know must be preferred to the demon on offer.

Savings Surplus or Investment Dearth?

In the absence of a better alternative, we need to improve the current system rather than replace it, and Kelton’s criticisms remain valid. It is clear that both QE and conventional fiscal stimulus create long-term problems by encouraging debt in the private and public sectors, respectively. Even if sovereign bankruptcy is not a serious threat for countries like the United States, the record high debt levels indicate a deep economic imbalance. We should therefore address the cause of the problem, which is generally agreed to be the surplus of intentions to save over those to invest in the private sector. This is a structural and not a cyclical problem, and one that will not end with the arrival of full employment.

We have an ex ante savings surplus in the private sector. To cure this, we need structural changes in either private sector savings or investment. It would be better if the problem were called an “invest­ment dearth” rather than the conventionally preferred “savings surplus,” as the terminology has resulted in public discussion honing in on the need to reduce savings rather than on the need to boost investment. This is a defeatist approach that treats weak growth as the result of inevitable secular decline. The Deficit Myth takes a sharply contrary view and convincingly claims that “the typical working American has no money put away for retirement.” We need, therefore, to boost private sector investment rather than discourage sav­ings.

As I pointed out in a previous American Affairs article,⁶ the decline in business investment is a secular problem that does not result from a slowdown in the rate at which technology is advancing, the assumption preferred by those arguing for secular decline. It rather stems from the disincentive to invest that followed a dramatic change in how corporate management is paid. The “bonus culture” introduced in the 1990s raised the “hurdle rate,” or the minimum expected return on equity needed to justify new capital spending. This is the best place to start the work of addressing the present economy’s shortcomings. It is a major reason why QE has failed to produce more investment and overall growth. And unless it is addressed, programs such as Kelton’s are unlikely to succeed, either.

This article originally appeared in American Affairs Volume IV, Number 4 (Winter 2020): 36–45.

Notes