Paul McCulley does Modern Monetary Theory

This is just in from PIMCO’s Paul McCulley, who seems to have caught on to the Wynne Godley sectoral balances approach to viewing the macro economy (hat tip Scott).  He says:

Double-entry bookkeeping was a great invention. It is a shame that so many macroeconomists and political pundits – and therefore, politicians themselves – seem to have forgotten it. One who hasn’t is the Financial Times’ Martin Wolf. And to the delight of all friends of the Levy Economics Institute, Martin cited in a recent column the financial balances approach of the late Wynne Godley, who spent his last years as a Distinguished Scholar at Levy.

Godley’s analytical framework should be the workhorse of discussions of global rebalancing, in the context of a deficiency of global aggregate demand. So, it was wonderful to see Martin riding Godley’s horse. I’ll walk you through it, but first the punch line: Front-loaded fiscal austerity in countries with their own fiat currencies is unwarranted and is likely to have deleterious, deflationary effects on the global economy. How so?

Let’s start with a simple tautology for any individual country:

Household Financial Balance +
Business Financial Balance +
Government Financial Balance +
Foreign Financial Balance = 0

Again, double-entry bookkeeping: The only way that one of the four sectors can run a deficit or surplus is for one or more of the other three sectors to run the opposite. This assertion doesn’t, of course, tell us anything about causation. Nor does it tell us about the composition or the sustainability of the starting positions for global stocks of debt and assets. It’s simply the tyranny of arithmetic for the flow of funds.

Right now, the household and business sectors in the developed world are running huge financial surpluses, in contrast to the opposite three years ago. In contrast, developed country governments are running larger deficits. Meanwhile, the emerging world is running a still-large financial surplus with the developed world. The graph below tells the story for the United States.


Thus, any notion that fiscal austerity in the developed world will not be a cyclical drag on global aggregate demand growth, much less boost it, must rest on the presumption that (1) the household and business sectors in the developed world will reduce their surpluses and/or (2) that the emerging world will reduce its surpluses with the developed world.

This is exactly right. The private sector is deleveraging right now in countries like the US, the UK, Spain and Ireland. This deleveraging increases the private sector’s net savings position. All else equal, this increase in net savings reduces aggregate demand and trade deficits and increases budget deficits.

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I have presented this outcome in a number of different contexts, most notably from the US domestic perspective , from the Japanese perspective and from the intra-Eurozone perspective. Here McCulley is presenting it as a low-growth developed economy, higher-growth emerging economy split. He is saying that austerity works only if the Chinese, Brazilians and Indians pick up the slack in aggregate demand or if the developed economies stop saving and allow their bloated balance sheets to stay bloated.

I see two problems here: the emerging economies are all trying to slow overheating economies. Moreover, maintaining excess consumption and leverage in the west is kicking the can down the road. In sum, austerity from all sides in the west leads the global economy to stall speed very quickly.

McCulley continues his essay challenging Ricardian equivalence, something that I don’t buy into either. Marshall will discuss his views on Ricardian equivalence and tax cuts in an upcoming post. But, here McCulley makes my point that government deficits are not the cause of private sector surpluses but rather the reverse – private sector debt distress is causing deleveraging and driving up net savings – which causes greater government deficits. Thinking about the aggregate private sector debt distress as being like any company bankruptcy or workout the way Ray Dalio does helps you understand the forces at work in the D-Process. Dalio uses GM as his model. I prefer RJR Nabisco post-KKR leveraged buyout.

Reverse-Ricardian Austerians
Why do so many implicitly make that presumption? With regard to reducing private sector surpluses in the developed world, it’s called reverse-Ricardian Equivalence. Recall, Ricardian Equivalence is the notion that governmental deficits cause the private sector to increase its surpluses, so as to save for the future increase in taxes that inevitably will be required to reduce the government deficits. Thus, current evangelists of front-loaded fiscal austerity preach that if only governments would reduce their deficits, the private sector, freed from the fear of future tax increases, will spontaneously reduce their surpluses. Put differently, it is argued, if only governments would put their fiscal houses in order, the private sector would immaculately regain confidence in their own financial affairs, pull down their savings and borrow more, boosting aggregate demand. Really, that is the argument, made with a straight face.

But it conveniently ignores why the private sector in the developed world is running a financial surplus: deflated asset prices, which have undermined the debt that had been applied to inflated asset prices. The private sector in the developed world wants to get its financial house in order! This is a profound structural change, running in parallel with a permanent downsizing of the shadow banking system and de-risking of the conventional banking system. Simply put, both the demand and supply curves for private sector credit creation have shifted inward.

And the only way that can happen without increasing the risk of a deflationary depression is either for the developed country governments to continue to run large financial deficits and/or for the emerging countries to reduce their financial surpluses. Again, the tyranny of arithmetic.

The bottom line, McCulley asserts, is that the developed world is facing a "cyclical deficiency of aggregate demand." I see this as a secular deficiency, but let’s not quibble. the reality is then that the private sector in the west is in a higher savings and slower growth mode. The only way that the government can net save at the same time is via an increase in net exports to the emerging economies. The FT’s Geoff Dyer is right when he writes the "G20 looks to Beijing to drive global growth." For the global economy, it’s China or bust.

Source: Facts on the Ground, Paul McCulley, PIMCO

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  1. Professor Pinch says

    Interesting stuff. Edward, I have two questions for you:

    1) I agree with you about this being a secular change in aggregate demand instead of a cyclical change. So in your mind, will the MMT approach work? Maybe you said it already, but perhaps you could re-state.

    2) China taking on the consumer of last resort makes sense given their surpluses. Do you think the news regarding the Dagong’s rating of the US vis-a-vis China is about getting cheaper costs of funds to take this role on or is about capital inflows because credit and real estate are facing headwinds there now?

    Thanks as always.

    1. Edward Harrison says

      Yes, MMT works. But, remember MMT is just a framework -a lens – through which to view actual economic events. It is a very useful framework though because it forces one to look at all individual transactions or any aggregate shift as having two parties with balance sheet effects.

      If I reduce my purchases from you that has implications not just for me but for you too. A lot of politicians try to talk about the budget deficit in a unitary way without working through the numbers.

      This still doesn’t get away from the longer term problems regarding the (mis)allocation of real resources (monetary and physical). But it doesn’t allow people to cheat intellectually and act like austerity will be positive for the economy.

      I was actually in bed when I saw this via my friend Scott and got up just to write a quick blurb on it. So I am headed back there now! More in the morning.

    2. Marshall Auerback says

      MMT has worked! See this paper:


      In the paper, Chick and Pettifor elaborate:
      The public sector finances are not analogous to household finances. Given
      spare capacity, public expenditures are not only productive but also foster
      additional activity in the private sector. Productive activity generates
      revenue and economises on benefits (and then debt interest) expenditures.
      This was one of Keynes’s central conclusions: “For the proposition that
      supply creates its own demand, I shall substitute the proposition that
      expenditure creates its own income” (Collected Writings, Volume XXIX, p. 81).
      Conversely, reducing expenditure would reduce income. Equally, reducing
      public expenditure will increase income only if it is outweighed by expansions
      in private expenditure.

      In a message dated 7/14/2010 21:36:34 Mountain Daylight Time,

  2. airelon says

    Indeed. The Crux of the matter …

    “The private sector in the developed world wants to get its financial house in order! This is a profound structural change, running in parallel with a permanent downsizing of the shadow banking system and de-risking of the conventional banking system. Simply put, both the demand and supply curves for private sector credit creation have shifted inward.”

  3. David Merkel says

    My view has always been that there will be pain to get out of the crisis, and the longer we take, the greater the pain will be. I am not a fan of MMT. MMT does not seem to take account of:

    1) limits on the balance sheets of governments that print their own currencies.

    2) The ability of governments to overpromise in real terms, especially with pension programs.

    3) That the amount of debt in the economy, and the inflexibility that it engenders, is itself a component of the problems, and affects producer and consumer behavior.

    They seem to be Keynesians on steroids; the markets are far more complex than the simplistic aggregation that Keynes used to get his math to work for his General Theory.

    1. stevie b. says

      David – nicely put.

      1. Scott Fullwiler says

        Wrong. You and David don’t understand MMT. As Ed says, it’s a typical knee-jerk reaction against MMT, rather than something based on an actual understanding of MMT. Those types of misinterpretations with a “chip on the shoulder” against MMT are a dime a dozen.

    2. Edward Harrison says

      David, your objections seem to be more knee-jerk than based on the actual MMT framework. You have to distinguish between MMT as a framework and the policy solutions recommended by proponents. As a framework, MMT is good.As for aggregates, they don’t give one a sense of resource allocation and that is the shortcoming. I would still argue that a recession which re-allocates resources is preferable to a recovery which misallocates them. But I wouldn’t call it simplistic to get a macro view of aggregates because a lot of people don’t understand the maths of national accounting identities. For example, the twin deficit fallacy is a perfect example that the MMT framework helps unmask. Trade deficits are driven by changes in private sector savings NOT by government deficits – and the MMT framework makes this clear.see my post “Why Stimulus Is No Panacea”

      1. Scott Fullwiler says

        Right, Ed. David’s comments show a lack of understanding of MMT. All of his concerns are addressed by MMT. If he hasn’t seen them, that’s not our problem.

      2. Professor Pinch says

        Edward, thanks for posting this link. Very helpful.

  4. Scott says

    Sick. I got lucky and it feels good. My instincts are at least 51% good which gives me an edge. Thanks.

  5. jenniferleathers says

    I too don’t understand MMT. What if the government just prints money and gives it to people. Where does that fall in the equation. The Federal Reserve is like an off-balance sheet vehicle.
    It doesn’t really go on Government Balance Sheet does it?

    1. dansecrest says


      There is a lot that has already been written and that is readily available regarding MMT. Just do some “Googling” and you will find the answers.

      I don’t understand your questions regarding the balance sheets, so I won’t try to answer them. As Scott Fullwiler and Ed Harrison mentioned above, it’s best to do some reading and thinking about MMT as it is a bit counterintuitive. While it may seem to be common sense that the Federal government has to balance its budget just like a household, that’s wrong. Once you understand this, a lot of other stuff starts to make sense, such as why it is rare for a nation to balance its budget….

    2. Edward Harrison says

      Jennifer, I probably should let Scott, Marshall or Warren Mosler speak to the money-printing aspect but I will say a few words of my own.

      1. The Federal Reserve acts as an agent of the Treasury in conducting money market operations. It is an independent entity within the government which ostensibly allows it to act without political intervention – much as the Supreme Court is supposed to operate.

      2. Printing money in and of itself does not create consumer price inflation. Austrian types like myself will tell you that inflation really is just an increase in the money supply. So printing money is inflationary and it is manifest in consumer price or asset price inflation. But in practice the printed money doesn’t necessarily lead to consumer price inflation for a number of reasons.

      Just yesterday, Paul Krugman wrote:

      when the Fed conducts an open-market operation, buying short-term debt with newly printed money, this normally affects the short rate because bonds and money are imperfect substitutes: money yields less, but has the advantage of being something you can use directly to make payments, that is, it’s more liquid.

      But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.

      3. So printing money is not going to solve the problem. What could solve the problem is the so-called helicopter drop that Krugman also refers to. Marshall is working on something related to this right now. But this is a Warren Mosler idea, that the Fed simply deposit money in people’s checking accounts that they are required to spend. The effect of this is to a. create a one-time increase in the price level b. decrease the value of the currency c. increase aggregate demand d. decrease the real value of debts. It is interesting and will be discussed at some point. Politically, I see it as a non-starter but it is one of the ideas out there. Krugman for his part rejects it because of the economic term called Ricardian equivalence but that’s what Marshall will discuss so I won’t go into that in great detail here yet. Here’s a link to it:

      Also, visit all the posts tagged chartalism for more on MMT:

      1. Stevie b. says

        Ed – well you know me – I continually expose my ignorance, so here goes again. I find some of what you say odd:

        “But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds”

        Surely you jest? “…holding money as a store of value” ? When there’s potential deflation for a while, you don’t want to get out of money into something that will be cheaper next year. You don’t want bonds at these levels in case it’s seriously mis-timed.You don’t want to get out of money if your job is on the line. You don’t want to get out of money if you’re on a fixed pension and you’re worried about the reaction to any deflation leading to serious inflation when you’ll be on a fixed income. And by reaction, I mean this “one-time increase in the price level” business. C’mmon Ed. One-time increase? Guaranteed one-time? How much exactly? How much poorer are retirees going to be made? Why are THEY going to be shafted? Or is there some magic mechanism that will leave them ALL at their equivalent former level before this magic experiment is foisted on us?

        I know desperate times call for desperate measures, but this is desperation gone double-desperate. The West is over the hill. There will be eventual global wage equivalence. Let’s get used to it, because in our efforts to deny this reality, we could end up bottom of the global pile.

        1. Edward Harrison says

          Stevie, I can’t respond in full since i am in the middle of something at the moment but this is a quote from Krugman actually. See the link above. We can get into some of the specifics later.

        2. Stevie b. says

          When I talk about not wanting to get out of money because of potential deflation for a wee while, this may of course mean money does become a temporary store of value, but it’s only held as the least evil of the various evils waiting in the wings for the unwary.

        3. Marshall Auerback says

          Stevie B, I suggest you read the stuff we’ve written on MMT more closely. All of these things are dealt with extensively. I’ve discussed them with you numerous times (you know that), but it doesn’t appear that you’ve got through the caricature of our position yet. I suggest you start by reading randy Wray’s “Understanding Modern Money”, which explicitly addresses virtually all of the questions you raise here.

        4. Stevie b. says

          Marshall – I know I’ve tried your patience in the extreme. I’ll try and read what you suggest, if I’m up to it…

          1. Marshall Auerback says

            Stevie, it’s very readable, I promise you!

        5. Stevie b. says

          Ed – sorry – should’ve realised the comments weren’t yours. Meant to add this earlier but wild Welsh weather and a power-cut intervened.

  6. Tom Hickey says

    Economists are a strange lot. In my field it is considered unprofessional to comment on colleagues’ positions without having read their publications. Please explain to me why people who are ostensibly professionals comment on MMT without reading and understanding it? I really don’t get it.

    1. Marshall Auerback says

      Good question. Perhaps because MMT challenges so much conventional wisdom and they feel professionally threatened?

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