Countries than run continuous deficits do not seem to endure accelerating inflation or currency crises

There was a conference in Berlin recently (25th FMM Conference: Macroeconomics of Socio-Ecological Transition run by the Hans-Böckler-Stiftung), which sponsored a session on “The Relevance of Hajo Riese’s Monetary Keynesianism to Current Issues”. One of the papers at that session provided what the authors believed is a damning critique of Modern Monetary Theory (MMT). Unfortunately, the critique falls short like most of them. I normally don’t respond to these increasing attacks on our work, but given this was a more academic critique and I was in an earlier period of my career interested in the work of Hajo Riese, I think the critique highlights some general issues that many readers still struggle to work through.

Who was Hajo Riese, you might ask?

He was an German economist who died earlier this year (born 1933) and was considered to be the founder of the so-called “Berlin School of Monetary Keynesian”.

What was that?

I have written before about the way that the work of John Maynard Keynes was quickly hijacked by the dominant neoclassical orthodoxy of the 1930s and became, especially in the US and the main macroeconomic textbooks, the ‘neoclassical synthesis’, which treated Keynes as a special case of orthodox theory that applied if wages were rigid downwards.

So, macroeconomics failed to jettison a lot of the neoclassical baggage about real wage cutting to cure unemployment, crowding out consequences of using deficits, inflationary consequences of using overt monetary financing and more, which, ultimately led to Monetarism and then the current New Keynesian orthodoxy, which is little of Keynes left in it.

Hajo Riese spent his academic career working on strengthening the insights of John Maynard Keynes to avoid the conclusions of the ‘neoclassical synthesis’ and in that respect his work was admirable.

But the critique unveiled at the conference recently doesn’t really deal with any of that.

It starts by arguing that:

Economists of the MMT persuasion polarize with the claims that … a state with its own currency has ‘no budget constraint’

The authority for this assessment is that characters like “Fed chair Yellen”, “ECB President Lagarde”, Larry Summers, Mr Dodgy Spreadsheet Rogoff and others don’t like MMT so we are polarising.

Go figure that one.

The authors present a reasonable rendition of the basis MMT propositions that they consider to be ‘strengths’ although it is not how I would have written it.

They then turn to the “Weaknesses of MMT”.

The first attack is on a comment that they draw from Randall Wray’s 2015 Primer (Palgrave) that “households need the government to spend before they can pay taxes!”

They claim this is “astonishing” given that MMT also “emphasizes the endogeneity of money which is based on banks borrowing money from the central bank ” and thus means that “there is no intrinsic linkage between the volume of central bank money and government spending”.

But, of course, this criticism reflects a misunderstanding of the way in which we order the pedagogy which introduces our work to the general public.

In some cases, we use simple conceptual vehicles (heuristics) to begin a discussion with those interested in MMT who have no prior background.

Representative of these heuristics are these blog posts:

1. A simple personal calling card economy (March 31, 2009).

2. Barnaby, better to walk before we run (February 8, 2010).

3. Some neighbours arrive (February 15, 2010).

There is no sense that these ‘models’ can represent reality as we know it. Reality is much more complex and multilayered.

But these heuristics allow us to explore some intrinsic characteristics of the monetary system, the capacity of the currency issuer and the options that such a government might have to advance its policy agenda.

As an example, in a highly simplistic, logical model, we might show how a new currency achieves its status by requiring all people to pay their taxes in that currency and then we show that that capacity doesn’t exist in the non-government sector until the government spends that currency into existence.

For introductory audiences, I often present a small accounting model (in the MOOC we even had a game show format), to illustrate this point.

It allows us to establish a clear causality that taxes cannot intrinsically fund government spending. In that simplistic world, it is the other way around.

Government spending provides the currency in which the non-government sector can pay its taxes and any outstanding debt that such a government might issue just represents previous fiscal deficits, which haven’t been taxed away yet.

As it stands, that simplistic model serves a purpose.

But it should never be the end of the story. The academic MMT economists certainly don’t hold this sort of reasoning as the definitive MMT statement, even if others might.

The point is that once we layer that simple heuristic with real world institutional insights and reality then the simple heuristic quickly becomes inadequate for analysis.

For example, to say that MMT says that taxes cannot be paid before spending is obviously an incorrect statement on two counts.

First, MMT doesn’t say that beyond our simple heuristic models, which are highly stylised and the assumptions used are transparent and deliberate abstractions of reality.

Second, in the real world, I can walk into a bank and borrow funds to pay my tax obligations without having built up any prior financial assets. Abstract from the financial record I might have had to demonstrate in order to access the loan from the bank.

But it is clear, in that instances, taxes can be paid without government’s spending the money into existence first. That is because there are real world institutions such as commercial banks that create deposits when they make loans, and which are absent from the simple heuristic models.

The latter insight forms the basis of the endogenous money idea.

This doesn’t invalidate the insights in the simple models. It just adds layers of complexity that have to be augmented with deeper insights.

In a pedagogical sense, we need to walk before we run. So the simple heuristic models allow us to start thinking in terms of MMT concepts – currency-issuance, government/non-government, flows and stocks, income and wealth, etc – which then allow us to make the next steps as we layer the analysis with more real world complexity.

But hanging onto the simple logic and denying the real world complexity is a dangerous strategy and not one that the academic MMT economists adopt.

In this specific tax payments case, how we extend the complexity of understanding is to note that while it is obvious that banks can create deposits (and liqudity) everytime they create a loan, the transactions associated with that loan (in this case, me paying my taxes) have to ‘clear’. The funds have to come from somewhere.

And that then takes us into a deeper analysis of the role of bank reserves and central bank funds. We then note that ultimately, claims on that deposit at my bank, must be backed by reserves, which is a different to saying that the loan was made possible by the prior existence of reserves.

But clearly, when I tell the government I am paying my taxes and transfer funds from the deposit the bank has created as part of my loan, the government instructs the central bank to debit the reserve accounts of the bank in question and credit its own account with the amount of the tax payment.

If the bank in question has insufficient reserves or there are insufficient reserves within the banking system at that time, then the only place those reserves can come from is the central bank (which in MMT is considered to be part of the consolidated government sector).

In that sense, the correct statement is not that taxation requires prior spending but that the solvency of the non-government financial system ultimately rests on government making loans to the non-government sector in the currency that the government issues and that these loans allow the banks to always meet the demands on them for bank reserves.

Now, it is clear that not everyone who uses (and demands) the currency pays taxes.

But, the tax-driven currency argument that underpins MMT reasoning does not require everyone to be ‘taxpayers’. Once a currency is established then their are many reasons why it becomes broadly acceptable to the population, not the least being that transaction costs are lower if everyone uses the same currency.

The way in which MMT represents taxation is also rather simplistic. In our simple heuristics, it appears as a lump sum that everyone has to pay (although we represent it as a total non-government sum to simplify matters).

We can clearly introduce complexity into the tax system, with progression in the income tax structure, an array of non-income taxes (such as GST or VAT), and other complexities (death duties, wealth taxes, expenditure taxes, etc).

That has never been a necessity in my view, although I acknowledge that a government has to contend with those complexities when it is operating the tax system in the real world.

But introducing such complexity will not alter the fundamental insight that if you require a significant proportion of the population to extinguish their tax liabilities in the currency that only the government issues then that will elicit a demand for that currency, irrespective of whether you can get that currency by working for the government, working on contracts paid for by the government, or borrowing that ‘currency’ from commercial banks who have reserve accounts at the central bank denominated in that currency, or from other financial institutions that ultimately have to work through banks that have such reserve accounts.

So it is, in fact, ‘astonishing’ that these German MMT critics didn’t understand that complexity in our work.

Quoting from an ‘airport book’, designed to provide simple heuristics is not a legitimate academic exercise.

The next criticism is that it is an:

… untenable thesis that a sovereign state whose liabilities are denominated in the national currency cannot become insolvent as it can always print enough money to service its debt.

Note, we never use terms such as ‘printing money’, which is a mainstream concept built on a flawed understanding of how governments spend (every day) and monetary operations that might accompany that spending.

All government spending enters the economy in the same way – digital entries to banking systems – irrespective of how central banks might operate to maintain a target rate of interest or target a maturity yield (QE).

The mainstream idea that governments either spend tax revenue or spend bond issuing revenue or turn on a printer has no application to the real world.

That is a stylised version of the government based on a flawed household budget analogy.

But aside from terminology, what is the criticsm based on?

They say that:

MMT goes one step further and views fiscal policies aimed at high employment and output as expedient and risk-free in general … What MMT tends to neglect are the economic consequences of such monetary financing …

They recognise that MMT economists “do acknowledge the link between monetized budget deficits and inflation” but we fail to “appreciate inflation as a cumulative process with price-wage spirals and currency depreciation that erodes the quality of the currency.”

Apparently, we fail to understand that money is a “store of value” – “an asset that competes with domestic securities and stocks as well as foreign assets” and there is no certainty that people who receive money “will want to keep the cash in their portfolio at given valuations”.

Sure enough.

But they always have to have enough government currency to meet their tax and other liabilities that are denominated in that currency.

But the critics jump to the conclusion that an “increase in the supply of money or domestic securities creates a higher demand for foreign assets”, which leads to a depreciation in the domestic currency.

The critics conclude that “if the government continuously uses newly created money to service its debt service” then “continuous depreciation” is inevitable.

Which, in turn, creates accelerating inflation.

And if “investors anticipate the money expansion” then they will shift out of domestic currency, which exacerbates the situation.

This asserted causality then forces investors to demand higher yields on government debt, which leads to “Higher interest rates”, which “negatively affect the government’s fiscal position and depress investment”.

They then argue that if the government tries to control yields using QE, the investors will abandon the currency as per the previous assertion.

Then the workers retaliate and there is a wage-price spiral and a “further increase in inflation”.

So all of this is standard mainstream reasoning, which has floundered in the real world.

First, governments all around the world have run continuous fiscal deficits for decades, which inject net financial assets, initially denominated in the government’s currency, into the non-government sector.

Where is the systematic depreciation and inflationary impacts via import price rises evident for these nations?

Why is the demand for Australian government bonds so strong always and continuously held in Australian dollars, when there has been an external deficit mostly since the 1970s and governments have run fiscal deficits regularly, of varying magnitudes?

Why has the Japanese public largely held government bonds in yen and why hasn’t the yen collapsed in the face of massive fiscal deficits, significant government bond issues, and very large-scale QE programs?

Why has Japan fought deflationary rather than inflationary pressures since the 1990s given its fiscal and monetary policy settings?

Why has the Bank of Japan been able to control short-term interest rates and yields on government debt despite the massive QE programs, while simultaneously observing deflationary rather than inflationary pressures?

Second, there are notable instances of currency-issuing government facing currency pressures as investors shift their portfolios into foreign assets.

The experience of Britain in the 1990s is one example.

But that arose because Britain had pegged its currency and thus had lost its sovereignty.

Speculators knew that if Britain insisted on maintaining its membership of the ERM, then it could be targetted with short trades.

Ultimately, the ‘currency crisis’ came to a head on September 16, 1992, when the government finally abandoned its ERM membership and floated the pound.

MMT always considers nations that compromise their currencies with any pegged-typed arrangements will face ‘investor pressure’.

Third, there are also cases where a floating exchange rate can be targetted.

The GFC-example of Iceland is important to understand.

They had a very large banking collapse during the early days of the GFC and they prevented a currency-collapse and inflation by imposing capital controls.

I have regularly written about the need for capital controls in some circumstances.

MMT economists clearly understand that large private capital holders can cause trouble for a small nation through speculative ventures that can be thwarted by the imposition of capital control, which are clearly the remit of the legislative authority, as the Icelandic experience shows.

Fourth, the idea that recipients of a nation’s currency, acquired in the course of government spending on contracts to produce infrastructure, provide services, procure private activity, employ people, have the choice on how to store their wealth portfolio.

In a growing economy, which high levels of employment and wealth generation, it is implausible to assume that recipients of government currency, in the normal course of events, will seek to transfer those holdings into foreign assets.

The fear of these conversions was also raised in the context of Chinese purchases of US government bonds and there were many erroneous claims that the Chinese were funding US government spending.

The reality is that the holdings of US dollar-denominated assets were only able to be accumulated because the Chinese economy ran export surpluses and deprived their citizens of the use of the resources embodied in those exports.

But the value of those foreign currency denominated assets will be sensitive to what the holders do with them.

It would be very odd behaviour to build up these assets in one’s wealth portfolio and then undermine their value by selling them off via foreign exchange transactions.

The point is that there is no inevitability in which currency people choose to hold their wealth portfolios.

But the lack of evidence that ties fiscal deficits to currency fluctuations tells me that the critics who believe it is inevitable that deficits will create inflation, higher interest rates and depreciating currencies are wrong.


One of the strengths of MMT is that it maintains empirical credibility, something that cannot be said for the views expressed in the paper discussed.

The possibilities that the German authors raise are theoretical and derived from a macroeconomic framework that is flawed.

The real world does not accord with the theoretical linkages declared inevitable by the authors.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

Countries than run continuous deficits do not seem to endure accelerating inflation or currency crises