Modern monetary theory is too good to be true | World Today News

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Australian government plans to spend $ 190 billion AUD ($ 132 billion) to support economy in response to COVID-19, according to the latest estimates from the Parliamentary Budget Office.

The total impact of COVID-19 on the government’s net debt, including the impact on revenue (decreasing, due to lower activity) and the impact on spending (increasing due to spending to support the economy) is between 11 and 18% of gross domestic product, or 500 to 620 billion Australian dollars.

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The estimates are based on the three possible scenarios developed by the Reserve Bank : “downside”, “baseline” and “upside”. Each differs in the timing of the assumption that physical distancing and other restrictions will be relaxed, and in the length of time associated with uncertainty and declining confidence that will weigh on households and business activity.

With similar crises around the world, an opinion that is gaining importance, including among commentators like Alan Kohler, is to say that the public debt does not matter provided that the government owes the money to its central bank (in the case of Australia, the Reserve Bank) or that the bank is ready to buy the debt from the party from which the government borrowed the money.

This view is an application of so-called modern monetary theory:

  1. when the government runs a budget deficit, it borrows from the private sector (mainly financial institutions) by selling government bonds which are in fact IOUs offering to repay in a certain number of years and offering interest to a low bond rate
  2. the Reserve Bank (as well as other central banks) has bought bonds from the private sector with the money it creates, and says it is ready to buy as many as it will take to keep bond yields at a low level, so that if it looks like the bond rate will go up, much of the debt will ultimately be owed to the bank
  3. when the bonds mature and it is time to pay off the debt, the government can simply issue other bonds which the bank will eventually buy if necessary in order to keep the bond rate low
  4. if, ultimately, all the extra money in the banking system causes inflation, the process would be reversed, which would slow inflation.

It sounds too good to be true, because it is.

Deficits and debt are large for a number of reasons, even if the debt is actually owed to the central bank and even if it was created during a recession, or in anticipation of a recession as it is. for response from COVID-19.

Creating Money Has Risks

We know that heavily indebted governments face interest rate premiums from lenders. A study of the European Union revealed that a 10 percentage point increase in the public debt to GDP ratio increased the sovereign bond rate by 0.47 percentage points.

These higher risk premiums are passed on to private sector borrowers whose interest rates are set relative to sovereign interest rates, so that all households and businesses face higher rates. The result will be a decrease in investment and household spending.

An attempt by the central bank to cancel the risk premium by buying more bonds would allow the government to issue even more, which would increase the risk of inflation which, in turn, would put upward pressure on interest rates.

The experience of Latin American countries that have relied on their central banks to create money is frightening. TheArgentina and Venezuela, in particular, have experienced inflation rates of up to 50% and falling exchange rates.

The idea that, when inflation does happen, the Australian government could easily reverse its spending and tax drivers is fanciful. It is politically difficult to cut public spending and raise taxes, and it may be impossible to do so on a large scale.

Modern monetary theorists respond by pointing out that we have not yet seen inflation in Western countries that have inflated their money supply.

It is true, but as the government went into debt, we witnessed a kind of inflation in the form of sharp increases in asset prices on the housing and stock markets. It has made us more vulnerable to financial shocks.

The markets don’t forgive

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Even the anticipation of future inflation by the market, before it arrives, could lead to a depreciation of the Australian dollar which could itself create inflation which would make Australians poorer.

One final point: the Reserve Bank of Australia is independent of the government.

If confidence in this independence were eroded, we could see an increase in the perceived risk of holding Australian financial assets. This would cause interest rates to rise and the Australian dollar to fall.

In any case, the Reserve Bank could decide at some point that the risk of inflation or asset price inflation is unacceptable and refuse to buy more government bonds, or to resell to the private sector the bonds she bought.

This would mean that the public debt would again be due to the private sector. The financial markets could consider it more risky than debt to the bank, which would have negative consequences on interest rates and the exchange rate.

Martin Wolf of Financial Times said that during the crisis modern monetary theory was both right and wrong.

It was fair, because there is no simple budgetary constraint. This was a mistake, because it would prove impossible to manage the economy in a sensible way once the politicians felt that there was no simple budgetary constraint.

Ross Guest, Professor of Economics and National Lecturer, Griffith University

This article is republished from The conversation under a Creative Commons license. Read theoriginal article here.

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