Monthly Archives: May 2011

Debt & Deficit in a Nutshell

A Summation of what we have learnt


Myth of Money Multiplier

This is one of probably many things I’ve forgot on introducing you all to Modern Monetary Theory.  The myth of the money multiplier or how private banks really operate.

One of the hard-core parts of mainstream macroeconomic theory that gets rammed into students early on in their studies, often to their eternal disadvantage, is the concept of the money multiplier. It is a highly damaging concept because it lingers on in the students’ memories forever, or so it seems. It is also not even a slightly accurate depiction of the way banks operate in a modern monetary economy characterised by a fiat currency and a flexible exchange rate. So lets see why!

Allegedly, the money multiplier m transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M). Students then labour through algebra of varying complexity depending on their level of study (they get bombarded with this nonsense several times throughout a typical economics degree) to derive the m, which is most simply expressed as the inverse of the required reserve ratio. So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR) would be 0.10 and m would equal 1/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.

The formula for the determination of the money supply is: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):

  • A person deposits say $100 in a bank.
  • To make money, the bank then loans the remaining $90 to a customer.
  • They spend the money and the recipient of the funds deposits it with their bank.
  • That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
  • And so on until the loans become so small that they dissolve to zero …

The following table and graphs shows you what the pattern involved is. They are self-explanatory. In this particular case, I have shown only 20 sequences. In fact, this example would resolve at around 94 iterations as you can see on the graphs where the successive loans, then fractional deposits get smaller and smaller and eventually become zero.

The conception of the money multiplier is really as simple as that. But while simple it is also wrong to the core! What it implies is that banks first of all take deposits to get funds which they can then on-lend. But prudential regulations require they keep a little in reserve. So we get this credit creation process ballooning out due to the fractional reserve requirements.

Well that is not at all like the real world. It is a stylised text-book model which isn’t even close to how things actually operate. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.

These loans are made independent of their reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

What about open market operations? These are allegedly how the central bank increases or decreases the money supply. So assume the central bank wants to increase the money supply it would purchase bonds in the markets and, accordingly, add reserves to the banking system. The banks in turn will try to lend those reserves out because they don’t want to be stuck with under-performing deposits and competition in the overnight markets will drive the interest rate down. Clearly, if the central bank wants to maintain control over the overnight interest rate it has to then drain the excess reserves which would require it offer the banks an interest-bearing asset commensurate with the overnight rate. That is, it would have to sell bonds in an open market operation. The reverse is true if it tried to reduce the money supply by selling bonds. This drains reserves from the cash system and would probably leave some banks short of required reserves. Given the only remedy for an overall shortage of reserves is intervention from the central bank the attempt to decrease the money supply fails.

It is clear that the central bank then is unable to control the volume of money in the system although it can control the price through its monetary policy settings. The money multiplier is a flawed conception of how things work. The monetary base does not drive the money supply. In fact, the reverse is true. So the reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions.

So when you consider this in the light of the current policy debate you have to wonder what half the commentators are on! For example, it makes no sense to say that the credit crunch is because banks have no money to lend and that Quantitative Easing will provide them with “printed money” that they can then lend. Banks will always lend when a credit-worthy customer walks through the door and the terms are to the bank’s favour.

Endogenous money or Wicksellian myths

Mainstream economists are not the only group who demonstrate a misconception of the way the monetary system operates. Among so-called progressive economists there are many, who while recognising that we use a fiat currency (manifest as worthless tokens) rather than a “commodity money” (where the actual unit has intrinsic value), still fail to consider how the currency gets its value and its role in the non-government sector transactions. So-called Circulation or Wicksellian models of the credit cycle which fail to include a government sector are examples of these flawed approaches. In general, these models reject the money multiplier myth but replace it with another – that you can understand capitalism without understanding the essential role that Government plays in the monetary system.

Accordingly, these models consider economies as being made up of households (who supply productive factors and consume); firms (who produce) and banks (who loan working capital to firms in advance of production). And they then analyse the “circuits of production” whereby firms borrow from banks to hire and pay workers to produce. The workers then use their wages to consume and the firms then are able to pay back the banks. At that point the “credit money” is destroyed (and corresponding and offsetting assets and liabilities). Any household saving is reflected in unpaid bank loans at the end of each circuit unless firms offer “bonds” to the households to soak up their saving.

The Wicksellian view then is that “money” is largely created by banks in response to the demand for credit from economic agents. It is clear that the revolving fund of credit finance can expand to accommodate growth in private sector activity, at a rate related proportionately to the product of provisioning rates for capital adequacy requirements and the percentage of retained earnings available for leveraged lending. For this very reason, the private sector can take up some of the slack created through government fiscal conservatism. However, and this is the crux of the modern monetary view, this growth will become unsustainable because net financial assets are either being destroyed or are not being created in insufficient quantity to meet the net saving needs of the private sector. Private sector debt levels will be rising while the stock of net financial assets declines. But back to the main story!

So the “elephant in the room” which is ignored by these analyses is the question of the currency unit. Why would these transactional circuits use the unit that the Government has legally sanctioned? Why would anyone accept the unit of account? You cannot answer these fundamental questions if you have excluded the Government sector from your analysis. Further models that exclude government clearly cannot say anything about the important fiscal effects on bank reserves?

MMTers consider the credit creation process to be the “leveraging of high powered money”. The only way you can understand why all this non-government “leveraging activity” (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory. Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.

HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant. The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed). Keep this in mind.

HPM enters the economy via so-called vertical transactions. Please refer back to Deficit spending 101 series (or check the INDEX)  for the details and supporting diagrams.

So HPM enters the system through government spending and exits via taxation. When the government is running a budget deficit, net financial assets (HPM) are entering the banking system. Fiscal policy therefore directly influences the supply of HPM. The central bank also creates and drains HPM through its dealings with the commercial banks which are designed to ensure the reserve positions are commensurate with the interest rate target the central bank desires. They also create and destroy HPM in other ways including foreign exchange transactions and gold sales.

We can think of the accumulated sum of the vertical transactions as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa. Budget surpluses force the private sector to “run down” the wealth they accumulated from previous deficits.

One we understand the transactions between the government and non-government then we can consider the non-government credit creation process. The important point though is that all transactions at the non-government level balance out – they “net to zero”. For every asset that is created so there is a corresponding liability – $-for-$. So credit expansion always nets to zero! In previous blogs I have called the credit creation process the “horizontal” level of analysis to distinguish it from the vertical transactions that mark the relationship between the government and non-government sectors.

The vertical transactions introduce the currency into the economy while the horizontal transactions “leverage” this vertical component. Private capitalist firms (including banks) try to profit from taking so-called asset positions through the creation of liabilities denominated in the unit of account that defines the HPM ($A for us). So for banks, these activities – the so-called credit creation – is leveraging the HPM created by the vertical transactions because when a bank issues a liability it can readily be exchanged on demand for HPM.

When a bank makes a $A-denominated loan it simultaneously creates an equal $A-denominated deposit. So it buys an asset (the borrower’s IOU) and creates a deposit (bank liability). For the borrower, the IOU is a liability and the deposit is an asset (money). The bank does this in the expectation that the borrower will demand HPM (withdraw the deposit) and spend it. The act of spending then shifts reserves between banks. These bank liabilities (deposits) become “money” within the non-government sector. But you can see that nothing net has been created.

Only vertical transactions create/destroy assets that do not have corresponding liabilities. My friend (Bill Mitchell’s friend) and sometime co-author Randy Wray puts it this way:

Credit money (say, a bank demand deposit) is an IOU of the issuer (the bank), offset by a loan that is held as an asset. The loan, in turn, represents an IOU of the borrower, while the credit money is held as an asset by a depositor. On this view, money is neither a commodity (such as coined gold), nor is it ‘fiat’ (an asset without a matching liability).

But what gives the unit of account chosen by the Government its primacy. Why do all the banks and customers demand it? The answer is that state money (in our case the $A) is demanded because the Government will only allow it to be used to extinguish tax liabilities. So the tax liability can only be met by getting hold of the Governments own IOU – the $A. Further, the only way that we can get hold of that unit of account is by offering to supply goods and services to the Government in return for their spending. The Government spending provides the funds that allow us to pay our taxes! That is the reverse of what most people think.

This process is how the Government ensures it can get private resources in sufficient quantities to conduct its own socio-economic policy mandate. It buys labour and other resources and creates public infrastructure and services. We are eager to supply our goods and services in return for the spending because we can get hold of $A.

So the private money creation activity that is central to many progressive models misses the essential point – that the credit creation activity is leveraging of the HPM – and is acceptable for clearing private liabilities (repaying loans) only because it is the only vehicle for extinguishing one’s tax liabilities to the state.


Graziani, A. (1990) ‘The Theory of the Monetary Circuit’, Economies et Societes.

Mosler, W.B. and Forstater, M. (2002) A General Analytical Framework for the Analysis of Currencies and Other Commodities.

Comment at Bill Mitchell’s place

The Natural Rate of Interest is Zero

This blog can be deemed to follow on from earlier blog, the role of the Central Bank (Federal Reserve).

Why the “natural” interest rate is zero

Modern monetary theorists consider monetary policy to be a poor tool for counter-stabilisation. It is indirect, blunt and relies on uncertain distributional behaviour. It works with a lag if at all and imposes penalties on regions and cohorts that may not be contributing to the price pressures (for example, when Sydney property prices were booming all of regional Australia which was not was forced to bear the higher interest rates). There is also no strong empirical research to tell us about the impact on debtors and creditors and their spending patterns. It is assumed implicitly that borrowers have higher consumption propensities than lenders but that hasn’t been definitively determined.

For a modern monetary theorist, fiscal policy is powerful because it is direct and can create or destroy net financial assets in the non-government sector with certainty. It also does not rely on any distributional assumptions being made.

Further, the natural economic state for a modern monetary theorist is full employment which means less than 2 per cent unemployment, zero hidden unemployment and zero underemployment. Deviations from full employment reflect failed fiscal policy settings – not a large enough budget deficit (other things equal).

The size of deficit has to be judged in terms of the desire of the non-government sector to save in the currency of issue. So if the deficit is inadequate and unemployment arises we know the net spending has not fully covered the spending gap.

We also know that budget deficits add to bank reserves and create system-wide reserve surpluses. The excess reserves then stimulate competition in the interbank market between banks who are seeking better returns than the support rate offered by the central bank. Up until recently this support rate in countries such as Japan and the USA was zero. In Australia it has been 25 basis points below the cash rate although there is no theoretical reason for that setting.

It makes much better sense not to offer a support rate at all. In that situation, net public spending will drive the overnight interest rate to zero because the interbank competition cannot eliminate the system-wide surplus (all their transactions net to zero – no net financial assets are destroyed).

So in pursuit of the “natural” policy goal of full employment, fiscal policy will have the side effect of driving short-term interest rates to zero. It is in that sense that modern monetary theorists conclude that a zero rate is natural. This article by Warren Mosler and Mathew Forstater is useful in this regard.

If the central bank wants a positive short-term interest rate for whatever reason (we do advocate against that) – then it has to either offer a return on excess reserves or drain them via bond sales.

Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.

Bill Mitchell

Job Guarantee and Inflation Control

In this vein we are suggesting that politicians should set a minimum acceptable living standard and ensure that a base level job is always available to allow all citizens to achieve that living standard independent of welfare payments. This is the essence of the JG. Analogous to the central bank’s function of lender of the last resort, the JG functions as a buffer which absorbs all potential employment, at the accepted minimum wage. Government then is also the employer of the last resort.

An additional advantage is that by creating an employment buffer stock government also facilitates inflation control.

Please read my blog – Full Employment with a Job Guarantee – for a detailed introduction to the JG concept.

While it is easy to characterise the JG as purely a public sector job creation strategy, it is important to appreciate that it is actually a macroeconomic policy framework designed to deliver full employment and price stability based on the principle of buffer stocks where job creation and destruction is but one component.

The idea came to me in 1978 when I was studying agricultural economics at the University of Melbourne. My earlier works discusses the link between the JG approach and the agricultural price support buffer stock schemes like the Wool Floor Price Scheme introduced by the Australian Government in 1970.

This was a system where the government desired to stabilised farm incomes and so agreed on a price for wool with the farmers. The government would then purchase excess wool supplied into the market to ensure the agreed price was maintained and in better times sell wool. They kept the wool in big stores spread all around the country.

So the government held buffer stocks of wool to manage the price. The JG is a buffer stock scheme too.

While generating full employment for wool production, there was an issue of what constituted a reasonable level of output in a time of declining demand.

The argument is not relevant when applied to unemployed labour. If there is a price guarantee below the prevailing market price and a buffer stock of working hours constructed to absorb the excess supply at the current market price, then a form of full employment can be generated without tinkering with the price structure.

The other problem with commodity buffer stock systems is that they encouraged over-production, which ultimately made matters worse when the scheme were discontinued and the product was dumped onto the market. These objections to do not apply to maintaining a labour buffer stock as no one is concerned that employed workers would have more children than unemployed workers.

Benjamin Graham wrote in the 1930s about the idea of stabilising prices and standards of living by surplus storage. He documents how a government might deal with surplus production in the economy. He said the:

State may deal with actual or threatened surplus in one of four ways: (a) by preventing it; (b) by destroying it; (c) by “dumping” it; or (d) by conserving it.

In the context of an excess supply of labour, governments now choose the dumping strategy via the NAIRU. It makes much better sense to use the conservation approach via a JG. Graham (1937: 34) noted:

The first conclusion is that wherever surplus has been conserved primarily for future use the plan has been sensible and successful, unless marred by glaring errors of administration. The second conclusion is that when the surplus has been acquired and held primarily for future sale the plan has been vulnerable to adverse developments …

The distinction is important in the JG model. The Australian Wool Scheme was an example of storage for future sale and was not motivated to help the consumer of wool but the producer.

The JG policy is an example of storage for use where the “reserve is established to meet a future need which experience has taught us is likely to develop” (Graham, 1937: 35).

Graham also proposed a solution to the problem of interfering with the relative price structure when the government built up the surplus. In the context of the JG policy, this means setting a JG wage below the private market wage structure. To avoid disturbing the private sector wage structure and to ensure the JG is consistent with price stability, the JG wage rate should probably be set at the current legal minimum wage, though an initially higher JG wage may be offered if the government sought to combine the JG policy with an industry policy designed to raise productivity.

Under the JG, the public sector offers a fixed wage job, which we consider to be price rule spending, to anyone willing and able to work, thereby establishing and maintaining a buffer stock of employed workers. This buffer stock expands (declines) when private sector activity declines (expands), much like today’s unemployed buffer stocks, but potentially with considerably more liquidity if properly maintained.

The JG thus fulfills an absorption function to minimise the real costs currently associated with the flux of the private sector. When private sector employment declines, public sector employment will automatically react and increase its payrolls.

The nation always remains fully employed, with only the mix between private and public sector employment fluctuating as it responds to the spending decisions of the private sector. Since the JG wage is open to everyone, it will functionally become the national minimum wage.

Inflation control under a Job Guarantee

The fixed JG wage provides an in-built inflation control mechanism. In an earlier published paper I called the ratio of JG employment to total employment the Buffer Employment Ratio (BER).

The BER conditions the overall rate of wage demands. When the BER is high, real wage demands will be correspondingly lower. If inflation exceeds the government’s announced target, tighter fiscal and monetary policy would be triggered to increase the BER, which entails workers transferring from the inflating sector to the fixed price JG sector.

Ultimately this attenuates the inflation spiral. So instead of a buffer stock of unemployed being used to discipline the distributional struggle, the JG policy achieves this via compositional shifts in employment. That is it can also deal with a supply-shock that generates distributional demands that ultimately cause inflation.

The BER that results in stable inflation is called the Non-Accelerating-Inflation-Buffer Employment Ratio (NAIBER). It is a full employment steady state JG level, which is dependent on a range of factors including the path of the economy.

A plausible story to show the dynamics of a JG economy compared to a NAIRU economy would begin with an economy with two labour sub-markets: A (primary) and B (secondary) which broadly correspond to the dual labour market depictions. Prices are set according to mark-ups on unit costs in each sector.

Wage setting in A is contractual and responds in an inverse and lagged fashion to relative wage growth (A/B) and to the wait unemployment level (displaced Sector A workers who think they will be re-employed soon in Sector A).

A government stimulus to this economy increases output and employment in both sectors immediately. Wages are relatively flexible upwards in Sector B and respond immediately.

The compression of the A/B relativity stimulates wage growth in Sector A after a time. Wait unemployment falls due to the rising employment in A but also rises due to the increased probability of getting a job in A. The net effect is unclear.

The total unemployment rate falls after participation effects are absorbed. The wage growth in both sectors may force firms to increase prices, although this will be attenuated somewhat by rising productivity as utilisation increases. A combination of wage-wage and wage-price mechanisms in a soft product market can then drive inflation. This is a Phillips curve world.

To stop inflation, the government has to repress demand. The higher unemployment brings the real income expectations of workers and firms into line with the available real income and the inflation stabilises – a typical NAIRU story.

Introducing the JG policy into the depressed economy puts pressure on Sector B employers to restructure their jobs in order to maintain a workforce. For given productivity levels, the JG wage constitutes a floor in the economy’s cost structure. The dynamics of this economy change significantly.

The elimination of all but wait unemployment in Sector A and frictional unemployment does not distort the relative wage structure so that the wage-wage pressures that were prominent previously are now reduced.

The wages of JG workers (and hence their spending) represents a modest increment to nominal demand given that the state is typically supporting them on unemployment benefits. It is possible that the rising aggregate demand softens the product market, and demand for labour rises in Sector A.

But there are no new problems faced by employers who wish to hire labour to meet the higher sales levels in this environment. They must pay the going rate, which is still preferable, to appropriately skilled workers, than the JG wage level. The rising demand per se does not invoke inflationary pressures if firms increase capacity utilisation to meet the higher sales volumes.

With respect to the behaviour of workers in Sector A, one might think that the provision of the JG will lead to workers quitting bad private employers. It is clear that with a JG, wage bargaining is freed from the general threat of unemployment.

However, it is unclear whether this will lead to higher wage demands than otherwise. In professional occupational markets, some wait unemployment will remain. Skilled workers who are laid off are likely to receive payouts that forestall their need to get immediate work.

They have a disincentive to immediately take a JG job, which is a low-wage and possibly stigmatised option. Wait unemployment disciplines wage demands in Sector A. However, demand pressures may eventually exhaust this stock, and wage-price pressures may develop.

A crucial point is that the JG does not rely on the government spending at market prices and then exploiting multipliers to achieve full employment which characterises traditional Keynesian pump-priming. Traditional Keynesian remedies fail to provide an integrated full employment-price anchor policy framework. In fact, a Keynesian policy agenda would impact more significantly on inflation if it was true that a JG was inflationary as a result of its impacts on demand in the product market.

Would the NAIBER will be higher than the NAIRU?

This last point invokes a fierce debate as to relative sizes of the NAIBER vis-à-vis the NAIRU. Some commentators argue that the NAIBER would have to be greater than the NAIRU for an equivalent amount of inflation control.

There are two strands to this argument. First, the intuitive but somewhat inexact view is that because JG workers will have higher incomes (than when they were unemployed) a switch to this policy would always see demand levels higher than under a NAIRU world.

As a matter of logic then, if the NAIRU achieved output levels commensurate with price stability then, other things equal, a higher demand level would have to generate inflationary impulses. So according to this view, the level of unemployment associated with the NAIRU is intrinsically tied to a unique level of demand at which inflation stabilises.

Second, and related, it is claimed that the introduction of the JG reduces the threat of unemployment which serves to discipline the wage setting process. The main principle of a buffer stock scheme like the JG is straightforward – it buys off the bottom (at zero bid) and cannot put pressure on prices that are above this floor. The choice of the floor may have once-off effects only.

It should be noted that while it is clear that JG workers will enjoy higher purchasing power under a JG compared to their outcomes under a NAIRU policy, it is not inevitable that aggregate demand overall would rise with the introduction of JG.

But assuming aggregate demand is higher when the JG is introduced than that which prevailed in the NAIRU economy, a traditional economist (and some Post Keynesians) might wonder why inflation is not inevitable as we replace unemployment with (higher paying) employment.

Rising demand per se does not necessarily invoke inflationary pressures because by definition, the extra liquidity is satisfying a net savings desire by the private sector.

Additionally, in today’s demand constrained economies, firms are likely to increase capacity utilisation to meet the higher sales volumes. Given that the demand impulse is less than required in the NAIRU economy, it is clear that if there were any demand-pull inflation it would be lower under the JG. So there are no new problems faced by employers who wish to hire labour to meet the higher sales levels.

Any initial rise in demand will stimulate private sector employment growth while reducing JG employment and spending.

The impact on the price level of the introduction of the JG will also depend on qualitative aspects of the JG pool relative to the NAIRU unemployment buffer. It is here that the so-called threat debate enters.

The JG buffer stock is a qualitatively superior inflation fighting pool than the unemployed stock under a NAIRU. Therefore the NAIBER will be lower than the NAIRU which means that employment can be higher before the inflation barrier is reached.

In the NAIRU logic workers may consider the JG to be a better option than unemployment. Without the threat of unemployment, wage bargaining workers then may have less incentive to moderate their wage demands notwithstanding the likely disciplining role of wait unemployment in skilled labour markets.

However, when wait unemployment is exhausted private firms would still be required to train new workers in job-specific skills in the same way they would in a non-JG economy.

Further, JG workers are far more likely to have retained higher levels of skill than those who are forced to succumb to lengthy spells of unemployment. It is thus reasonable to assume that an employer would consider a JG worker, who is already demonstrating commitment to working, a superior training prospect relative to an unemployed and/or hidden unemployed worker. This changes the bargaining environment rather significantly because the firms now have reduced hiring costs. Previously, the same firms would have lowered their hiring standards and provided on-the-job training and vestibule training in tight labour markets.

The functioning and effectiveness of the buffer employment stock is critical to its function as a price anchor. Condition and liquidity is the key. Just as soggy rotting wool is useless in a wool price stabilisation scheme, labour resources should be nurtured as human capital constitutes the essential investment in future growth and prosperity.

There is overwhelming evidence that long-term unemployment generates costs far in excess of the lost output that is sacrificed every day the economy is away from full employment. It is clear that the more employable are the unemployed the better the price anchor will function.

The JG policy thus would reduce the hysteretic inertia embodied in the long-term unemployed and allow for a smoother private sector expansion. Therefore JG workers would constitute a credible threat to the current private sector employees. When wage pressures mount, an employer would be more likely to exercise resistance if she could hire from the fixed-price JG pool.

As a consequence, longer term planning with cost control would be enhanced. So in this sense, the inflation restraint exerted via the NAIBER is likely to be more effective than using a NAIRU strategy.

Another associated factor relates to the behaviour of professional occupational markets. In those markets, while any wait unemployment will discipline wage demands, the demand pressures may eventually exhaust this stock and wage-price pressures may develop.

With a strong and responsive tertiary education sector combined with strong firm training processes skill bottlenecks can be avoided more readily under the JG than with an unemployed buffer stock in place. The JG workers would be already maintaining their general skills as a consequence of an on-going attachment to the employed workforce.

The qualitative aspects of the unemployed pool deteriorate with duration making the transition back in the labour force more problematic. As a consequence, the long-term unemployed exert very little downward pressure on wages growth because they are not a credible substitute.

Responsible fiscal practice in MMT

This is the macroeconomic sequence that defines responsible fiscal policy practice in MMT. This is basic macroeconomics and the debt-deficit-hyperinflation neo-liberals seem unable to grasp it:

1. The sovereign government, which is not revenue-constrained because it issues the currency, has a responsibility for seeing that the workforce is fully employed.

2. Full employment means less than 2 per cent unemployment, zero underemployment and zero hidden unemployment.

3. The sovereign government can purchase any real good or service that is available for sale in the market at any time. It never has to finance this spending unlike a household which uses the currency issued by the sovereign government. The household always has to finance its spending (as do state and local governments in a federal system).

4. The non-government sector typically decides (in aggregate) to save a proportion of the income that is flowing to it. This desire to save motivates spending decisions which result in the flow of spending being less than the income produced. If nothing else happened then firms would reduce output and income would fall (as would employment) and households would find they were unable to achieve their desired saving ratio.

5. The government sector must in this situation fill the spending gap left by the non-government sector’s decision to withdraw some spending (in relation to its income). If the government does increase its net contribution to spending (that is, run a budget deficit) up to the point that total spending now equals total income then firms will realise their planned output sales and retain current employment levels.

6. The government sector’s net position (spending minus revenue) is the mirror image of the non-government’s net position. So a government surplus is equal $-for-$, cent-for-cent to a non-government deficit and vice versa. So if the non-government sector is in surplus (a net saving position) then income adjustments will render the government sector in deficit whether it plans to be in that state or not. If income is falling in the face of rising saving behaviour of the non-government sector and that spending gap is not filled by government net spending then the budget deficit will rise (as income adjustments cause tax revenue to fall and welfare payments to rise). You end up with a deficit but the economy is at a much less satisfactory position than would have been the case if the government had have “financed” the non-government saving desire in the first place and kept employment levels high.

7. A fiscally-responsible government will attempt to maintain spending levels sufficient to fill any saving but not push nominal aggregate spending beyond the full capacity level of output.


Given the overwhelming central bank focus on price stability, and the critical roll of today’s unemployed buffer stocks of unemployed, we argue that functioning and effectiveness of the buffer stock is critical to its function as a price anchor.

Condition and liquidity are the keys. Just as soggy rotting wool is useless in a wool price stabilisation scheme, labour resources should be nurtured as human capital constitutes the essential investment in future growth and prosperity. There is overwhelming evidence that long-term unemployment generates costs far in excess of the lost output that is sacrificed every day the economy is away from full employment.

It is clear that the more employable are the unemployed the better the price anchor will function. The government has the power to ensure a high quality price anchor is in place and that continuous involvement in paid-work provides returns in the form of improved physical and mental health, more stable labour market behaviour, reduced burdens on the criminal justice system, more coherent family histories and useful output, if well managed.

It is also the case the training in a paid-work environment is more effective than contextually isolated training schemes, which have become the fashion under the active labour market programs pursued by governments in all countries over the last two decades.

Now don’t say MMT doesn’t integrate a concern for inflation at the level of first principles.

Bill Mitchell

Controlling Inflation

There are two broad ways to control inflation and buffer stocks are involved in each:

  • Unemployment buffer stocks: Under a mainstream NAIRU regime (the current orthodoxy), inflation is controlled using tight monetary and fiscal policy, which leads to a buffer stock of unemployment. This is a very costly and unreliable target for policy makers to pursue as a means for inflation proofing.
  • Employment buffer stocks: The government exploits the fiscal power embodied in a fiat-currency issuing national government to introduce full employment based on an employment buffer stock approach. The Job Guarantee (JG) model which is central to MMT is an example of an employment buffer stock policy approach.

Under a Job Guarantee, the inflation anchor is provided in the form of a fixed wage (price) employment guarantee.

Full employment requires that there are enough jobs created in the economy to absorb the available labour supply. Focusing on some politically acceptable (though perhaps high) unemployment rate is incompatible with sustained full employment.

Under the neo-liberal policy regime, central banks have, increasingly, been given the responsibility by government for managing the price level. In conducting monetary policy to fulfill their major economic objectives, central banks manipulate the interest rate and attempt to manage the state of inflation expectations.

These policy tools are employed to achieve an “optimal” level of price stability and capacity utilisation (typically assumed to be invariant in the long-run to nominal aggregates). Where negative real effects from the operation of inflation-first monetary policy are acknowledged they are theorised to be necessary for optimal long term growth and employment and small in magnitude.

These considerations suggest that the central bank, as part of the consolidated currency-issuing government sector, has another, somewhat similar yet far more effective buffer stock option which is in fact an alternative way of managing the unemployment program.

In MMT, a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.

The employment buffer stock approach (the JG) exploits the imperfect competition introduced by fiat (flexible exchange rate) currency which provides the issuing government with pricing power and frees it of nominal financial constraints.

The JG approach represents a break in paradigm from both traditional Keynesian policies and the NAIRU-buffer stock approach. The difference is a shift from what can be categorised as spending on a quantity rule to spending on a price rule.

For example, under current policy, the government generally budgets a quantity of dollars to be spent at prevailing market prices. In contrast, with the JG option, the government additionally offers a fixed wage to anyone willing and able to work, and thereby lets market forces determine the total quantity of government spending. This is what I call spending based on a price rule.

Under the JG scheme, the government continuously absorbs workers displaced from private sector employment. The JG workers thus constitute a buffer employment stock and would be paid the minimum wage.

Many economists who are sympathetic to the goals of full employment are sceptical of the JG approach because they fear it will make inflation impossible to control. To answer these claims, I once again outline the inflation control mechanisms inherent in the JG model. If the private sector is inflating, a tightening of fiscal and/or monetary policy shifts workers into the fixed-wage JG-sector to achieve inflation stability without unemployment.

Unemployment buffer stocks and price stability

There have been two striking developments in economics over the last thirty years. First, a major theoretical revolution has occurred in macroeconomics (from Keynesianism to Monetarism and beyond) since the mid 1970s. Second, unemployment rates have persisted at the highest levels known in the Post World War II period and in the current crisis have sky-rocketed upwards.

The concept of full employment as a genuine policy goal was abandoned with introduction of the natural rate of unemployment hypothesis (Friedman and Phelps) which has became a central plank of current mainstream thinking.

It asserts that there is only one unemployment rate consistent with stable inflation. In the natural rate hypothesis, there is no discretionary role for aggregate demand management and only microeconomic changes can reduce the natural rate of unemployment. Accordingly, the policy debate became increasingly concentrated on deregulation, privatisation, and reductions in the provisions of the Welfare State with tight monetary and fiscal regimes instituted.

The almost exclusive central bank focus on maintaining price stability on the back of an overwhelming faith in the NAIRU ideology has marked the final stages in the evolution of an abandonment of earlier full employment policies.

The modern policy framework is in contradistinction to the practice of governments in the Post World War II period to 1975 which sought to maintain levels of demand using a range of fiscal and monetary measures that were sufficient to ensure that full employment was achieved. Unemployment rates were usually below 2 per cent throughout this period.

Under inflation targeting (or inflation-first) monetary regimes, central banks shifted their policy emphasis. They now conduct monetary policy to meet an inflation target and, arguably, have abandoned any obligations they have to support a policy environment which achieves and maintains full employment. Unemployment since the mid-1970s has mostly persisted at high levels although in some economies low quality, casualised work has emerged in the face of persistently deficient demand for labour hours.

However, central bankers do not characterise their approach in this way and they avoid recognition of the empirical fact that contractionary monetary policy continues to generate output and employment losses which are permanent. Instead the dominant paradigm suggests that full employment is a natural derivative of the maintenance of price stability even though this approach to price stability requires the maintenance of an unemployed buffer stock.

The use of unemployment as a tool to suppress price pressures has, based on the OECD experience in the 1990s, been successful in that inflation is now no longer driven by its own expectations. One explanation is that unemployment temporarily balances the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital.

Similarly, low product market demand, the analogue of high unemployment, suppresses the ability of firms to pass on prices to protect real margins. Other explanations for the effectiveness of unemployment in controlling inflation are possible.

The empirical evidence is clear that most OECD economies have not provided enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. Central banks around the world have forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities in many cases have further worsened the situation with complementary austerity.

How useful is the NAIRU as a guide to policy? There is a growing literature that shows that the NAIRU is useless as a guide to policy.

Please read my blog – NAIRU is a myth! – for more discussion on this point.

While there may be some stability between inflation and unemployment for a period, experience from many OECD countries suggests that a sudden shock, especially from the supply side (as in 1974) can worsen the unemployment resulting from a deflationary strategy, which is attempting to exploit a given Phillips curve.

Evidence from the OECD experience since 1975 suggests that deflationary policies are effective in bringing inflation down but impose huge costs on the economy and certain demographic groups, which are rarely computed or addressed.

The overwhelming quandary that the NAIRU approach to inflation control faces is whether the economy, once deflated by restrictive aggregate demand management, can be restarted without inflation.

If the underlying causes of the inflation are not addressed a demand expansion will merely reignite the tensions and a wage-price outbreak is likely. As a basis for policy the NAIRU approach is thus severely restrictive and provides no firm basis for full employment and price stability.

Further, despite its centrality to policy, the NAIRU evades accurate estimation and the case for its uniqueness and cyclical invariance is weak. Given these vagaries, its use as a policy tool is highly contentious.

Employment buffer stocks and price stability

It is clear that central bankers are now using buffer stocks of unemployed to achieve a desirable price level outcome. While the real effects of such a policy have been contested, there is overwhelming evidence to suggest that the cumulative costs of this strategy in real terms have been substantial.

Several researchers have found that sacrifice ratios remain significant and persistent, meaning that GDP losses during disinflation episodes are substantial. Additionally, a major component of this monetary policy stance is the persistent pool of unemployed (and other forms of labour underutilisation, for example, underemployment) as a buffer stock for wage and thereby price stability.

In addition to lost output, other real costs are suffered by the nation, including the depreciation of human capital, family breakdowns, increasing crime, and increasing medical costs.

So the unemployment pool is thus widely recognised and monitored as a price anchor, a primary concern for price stability in general, and a prime object of monetary policy. However, the effectiveness of an unemployed buffer stock has been shown to deteriorate over time, with ever larger numbers of fresh unemployed or underemployed required to function as a price anchor that stabilises wages.

So in recognising that the effectiveness of unemployment per se as a price anchor is a further function of the terms, conditions, and administration of the unemployment program, MMT recommends management of the unemployment policy and programs be made a function of the agency responsible for said price stability – the central bank.

The question that arises is whether using a persistent pool of unemployed (or casualised underemployed) is the most cost effective way to achieve price stability?

An understanding of MMT principles suggest that a better alternative would be to utilise an employed buffer stock approach which is in fact an alternative way of managing the unemployment program.

MMT argues that a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.

Bill Mitchell