Sunday, August 04, 2019

The Fed and inflation

I want to single out a statement in Dean Baker's recent article, The Dangerously Irresponsible Arguments of the “Responsible” Budget Gang: " I have some differences [with MMT]. In particular, I am not willing to give up having the Fed as a check on inflation."

This statement is false in part and true in part. MMT does not ask us to "give up" the Fed's role in checking inflation; instead, MMT scholars present considerable evidence that under ordinary circumstances, the Fed (or any central bank) cannot control inflation. According to MMT (and other theories), bank money is endogenous. The quantity of money in an economy is determined not exogenously by the Fed but endogenously by profit-seeking banks and firms creating loans.

Moreover, firms' investment spending is inelastic with regard to interest rates: if a firm believes they can make a profit by expanding, they will borrow at the prevailing interest rate. As long as banks believe firms can invest productively, they will provide the loans that firms want, and why not? Banks are profit maximizing entities. The Fed has very little choice but to provide the reserves that banks need: the alternative is to allow some banks to simply fail. Having the Fed's thumb on banks' self-destruct buttons is a kind of control, but it is not the same as sitting behind the wheel.

Similarly, as we have seen in Japan since the 1990s and the rest of the developed world since the global financial crisis, central banks can do very little to increase inflation. The Fed can shovel reserves to the banks, but regardless of the amount of banks' reserves, they can't lend if firms don't want to borrow, i.e. if firms believe investment will not be profitable, and banks won't lend if they don't believe investment will be profitable.

The Fed can check inflation. However, the only tool they have is to abruptly raise the Fed Funds rate high enough to choke off investment spending and cause a recession; the resulting unemployment will eventually bring inflation down. But we should find ways other than massive unemployment and suffering to fix systemic economic problems such as inflation. It is not MMT per se but ordinary morality that asks us to give up this tool.

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