MMT's Godfather Says the US Government Is Spending Like a Drunken Sailor

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1:35Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, you know, there's that theory, people say it from time to time about, in different contexts, different schools of thought, and kind of gets dismissed as a crankishness sometimes, that higher rates can be a contributor to inflation. Yes, yes. And actually, I'm hearing this more and more, interestingly enough. So you used to hear, you know little rumblings of it every once in a while but i swear in the past two or three months a lot of people have been talking about this and i guess the basic idea here is there's always been some question about the efficacy of interest rates in the current inflationary environment so if you think back to the 2020 period the idea that we had all these supply disruptions lots of snarls in transportation and logistics what are interest rate hikes really going to do in that context, right?

2:31And some people even argue that higher interest rates are detrimental for that kind of inflation because you make it harder for people to build out capacity. But what's happening more recently, and I think you're hearing more talk of this, is the idea that higher interest rates in and of themselves can contribute to the inflationary impulse through the interest income channel. Yeah, absolutely. So, right. There's a bunch of people that are on treasuries and then they get a payment, I guess, every month, and that is income into the economy. And when you're fighting inflation, that's the more, I think that's one of the arguments for how higher rates can be inflationary.

3:11But then there is this sort of like, there is the more agreed upon view that you mentioned, which is that higher rates can strain investment and contribute to less housing. And that has an inflationary impulse in a time of housing shortage, that seems to be a little less controversial. The connection is clear. But I think regardless, I think, okay, here we are in July 2024. Inflation has come down a lot. There's still many stories that could be told a lot about the last four years. And I don't think there are any really economists who have nailed this cycle with some theory or whatever that it's like, yep, they explained how it's all going to work.

3:49There are many, this period, whatever we've experienced over the last four years will be debated and argued about and what role did higher rates have in bringing down inflation or why did the will be debated by economists for like 100 years probably. I find this aspect of our life right now simultaneously exhilarating and terrifying. So it's great that we're learning about how the world works. It's also terrifying that we still aren't entirely sure how interest rates work and what impact they actually have on the economy. But I am very, very interested in digging into more of this argument, the interest income channel here and the actual like push and pull of higher interest rates on inflation.

4:29I think we should talk more about it. Totally. Well, I'm really excited. We do indeed have the perfect guest, someone we've never had on the show before, but he's someone who we get a lot of requests for on Twitter, on the Outlaws Discord, someone we probably should have had on a long time ago. We are going to be speaking to a Warren Mosler. He's an economist, former investment manager. He drives fast race cars in the Virgin Islands. Currently, he's on a bike trip in Croatia. A very cool life. He is also the originator of what has come to be known as modern monetary theory. So, Warren, thank you so much for coming on Outlaw.

5:09Good to be here and enjoyed listening to the introduction. How did we do? I think you said it all. Okay. We're done here. Why don't you give us your summary? So someone said, okay, higher rates cause inflation. I think there's a neo-fisherian school that I think the Turkish president subscribes to. How would you characterize what that means or what's going on? well i i look at what is okay look at the numbers i look at the data and i try and make sense of it just just like everyone else and uh my narrative has been different from everyone else's at least up until recently from listening to you and uh it's nothing more than that where to start i wrote my first paper on this and i think 1997 called the natural rate of interest is zero so it's not something new to me and myself and my partner Cliff Viner back in the 1980s we always used to muse about how the best indicator of what M2 growth would be is LIBOR because the interest rate itself determines the money supply growth as it was measured back then.

6:22You know there's been there've been institutional changes since then but this was back in the 80s. And so the idea that But, you know, the interest rate itself was instrumental in how the price level moves over time. Now, notice I'm going to avoid using the word inflation rate. Okay. I may say inflation indicators from time to time. But that is the whole word and term has gotten so confused by the way it's been used. You know, if tomatoes go up, that's tomato inflation or something, right? Instead of just the price of tomatoes going up. that I, it's not informative the way I'd like it to be. So excuse me for not using that word maybe as much as you all do.

7:06Yeah. So the interest rate itself has had this effect on a price level, you know, for a long time that I've observed. Okay. It's 1980. That's 45 years, right? Something interesting happened at this cycle compared to prior cycles. Now, in prior cycles, like in 2008, I was saying back then that the rate cuts, the Bernanke rate cuts, were probably not going to do much for the economy, if anything, because cutting the rates from five and a half to zero or whatever it was at the time removed something like$400 billion a year of interest income from the economy. It lowered the deficit by$400 billion from what it otherwise would have been.

7:46And all that income and those net financial assets were no longer being added. So I was looking at a very sluggish recovery. I didn't see the stimulus packages being large enough to cause a particular boom. It was plenty large enough for decent growth, but not any kind of a runaway inflationary boom or anything like that. And I can recall being at the Fed at a meeting, a private meeting with a guy named Dave Wilcox. who was talking about quantitative easing and how he didn't think would be inflationary. And I said, yeah, I'm not so much worried about not being inflationary. But with the Fed buying all these securities, okay, they were buying securities that had higher yields.

8:28They were paying for them with reserves, adding reserves, which is fine. It was changing the duration of the government holdings. But it went from, you know, the Fed was now earning the high interest rates, and the market was earning the 0 % or whatever they were paying on reserves at the time. It was very low. And I said, you know, they're effectively taking$90 billion a year of interest income out of the economy. That might have been half a percent, 1 % of GDP at the time. I thought for that reason, quantitative easing would probably slow down the economy at that point in time. Oh, that's interesting.

8:57And that's kind of what happened. So initially, you kind of looked at it from the opposite side of where we are today. So the idea that QE was sucking out income rather than higher interest rates adding to it. And that was based on the yield curve at the time and duration of government debt, you know, everything at the time. And the data seemed to play that. Now, I don't know if it's just confirmation bias on my part, but it looked to me like that's what happened. And we did have this sluggish economy. And that was partially the reason that the deficit wasn't large enough, partially because the interest.

9:29Now, I'm categorically against using a positive interest rate policy to increase deficit spending to support an economy because it's so obscenely regressive. When they raise rates, the only thing they do is pay interest to people who already have money in proportion to how much they already have. And you increase deficit spending that way. Just to be clear, you may say that lower rates or whatever, that they're not particularly stimulative. But that's very different than saying, oh, a good form of stimulus would be higher rates. Yeah, I'd rather have low rates and a tax cut than high rates and a tax increase.

10:10Sure. So let's bring it to now. But back then, here's the point. Back then, the debt to GDP held by the public was something like 30 or 35 percent. So a 1 percent rate hike, or in those cases rate cut, but a 1 percent change in rates, a rate hike would have added maybe 35 basis points of income to the percent of GDP to the economy because the debt to GDP was like 30 or 35 percent. This time around, it's 100 % roughly, you know, debt to GDP held by the public. So a 1 % increase in rates two and a half years ago ultimately increased interest payments by a full 1 % of GDP, three times the impact of the prior cycle.

10:50So here I am saying, look, if I thought this had an impact before, now it really has an impact. Okay, now it's three times larger than before. This is going to be far different than anybody can imagine. And raising rates this time around is going to have a strong supporting effect on aggregate demand, you know, keeping unemployment down, you know, total employment growing, that type of thing. And at the time they increased the rates, the Fed was reigned, you know, with criticism for engaging in policy that was going to cause unemployment to go up to fight inflation. Remember that? Yeah, of course.

11:24Well, I'm going, no, they've got it backwards. This is going to bring unemployment down. This is going to bring total employment up. this is going to cause strong, positive GDP growth, not a recession. Every forecast was for a recession for, what, years, right? They were just ignoring this fiscal impact of this increase in deficit spending. Now, the only thing I could rationalize where they're getting this from is that they must have had, deep in their model somewhere, a zero propensity to spend interest income, right? No matter how high you raise rates, no matter how much interest you pay there, nobody's going to spend a dime of it and so you don't have to worry about it and that's why they look at the primary deficit when they talk about emerging markets they don't even count the interest income expense right that that's all i could come up with as to why they would ignore that channel

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14:05Can we talk a little bit more about, I guess, the consumption avenue of the interest income channel? Because I will fully admit that it was very nice in circa 2022 to finally earn positive interest on my bank account. I'm an elder millennial, so that had basically never happened to me before. However, I wouldn't necessarily say that because I was earning 2 % to 5 % on my savings that I went out and bought a bunch of additional things. And of course, a lot of that was offset by the increased cost of living, increased price level, if we're not using the term inflation. So how do you see that aspect of it playing out?

14:50People are earning more income, but does that actually translate into more demand? Yeah, and that's a good question. And that's a micro question. You know, what you look at what all the individuals who are getting it do. Pension funds get treasury secured, you know, interest. How does that translate into aggregate demand? Foreigners get a lot of interest. You know, I hear all this that, look, none of this interest is going to get spent. And so it doesn't matter. You're wrong. We're going into recession. The interest rate facts on, you know, borrowers is going to dominate and that's going to take down the economy.

15:24And the answer is you can only look at the data and see what happens. We can both come up with a narrative of what we think the propensity is to consume out of interest income, but we're not going to know until after it happens. And I looked at in prior cycles, the data was telling me that it's not zero, that there's a substantial amount that directly or indirectly does get spent. But that's all it is. It's a view looking at the macro data, looking at what GDP did versus what it was expected to do, looking at how the rate cuts helped the economy or didn't help the economy, you know, based on what their models expected, right?

16:01In the same way those rate cuts didn't help the economy as expected back in 2009-ish, is telling me it was that$400 billion a year of income that was cut out was having a dampening effect on spending. It goes back to under Bush in 2000, 2001, when we hit that recession. They dropped interest rates to 1%, and nothing happened. It didn't help. And I was actually in a meeting with Andy Card, Andrew Card, who was chief of staff at the White House in 2002, February, March. And I got in that meeting because in my car company, two of the people on the board of directors were ex-engineers, one General Motors, one Ford.

16:44They knew Card personally. He was an engineer at GM. And when I talked to him about the interest income thing, the same way I'm talking about it to you, they said you got to talk to Andy and set up this meeting you know I went to the White House the meeting was in the West Wing and the first thing I did was just what I said to you and what look in the economy itself when when they lowered interest rates okay it helped borrowers but it hurt savers you know into the penny for every dollar saved there's a dollar borrowed in the economy banks have loans and deposits and they're equal or somebody made an arithmetic mistake you know assets and liabilities and so you know when you lower rates you're just shifting income from one entity to another and the only way that can have an effect is if there are differences in the propensities to spend interest income of those two but at the macro level because of the public debt when you lower rates you're cutting the size of the deficit you're cutting total interest income in the economy i said i think that effect dominates and looking at what happened in the last year in 2002 i you know i wouldn't expect rates to do anything the card looks at it he goes he says yeah why would anybody think that's going to work he says and he goes oh what does work then i explain the fiscal side where when you spend more than you tax that is a direct add of you know income and that financial assets and when you increase deficit spending proactively any economist who pays to be right is going to revise his forecast upward for the economy.

18:13And he says, well, how much do we need? I said, well, I think it's probably 700 billion annually back then, which was maybe about 5 % of GDP. And he says, well, we don't have much time, do we? I said, no. I said, well, you better get started. I got a nice note back from him. It's very nice. A week later, the president was asked about the deficit. And he said, look, I don't look at numbers on a piece of paper. I look at jobs, which came right out of our meeting. And after that, I don't know if you remember those days, but they passed every tax cut you could imagine, including retroactive tax cuts, something we never had before.

18:45People were getting tax refunds from taxes from previous years. And they passed every spending bill they could get through Congress trying to get this deficit off to save the economy. And that included prescription drugs for Medicare. So I'll take personal responsibility, even though that wasn't discussed in the meeting, for the government spending all that money on prescription drugs. The deficit got up to$200 billion by the third quarter, which was about my target number,$700 billion for the year. The economy turned around, and it didn't cost them the election. So I've been on this for a while.

19:21And it's all been from a narrative and then watching the data. Yeah. So mainstream macro economists have this concept that they call fiscal dominance. And yeah, that sounds like what you're describing where and a little bit. Yeah. Yeah. So basically, yeah, so close enough. So I actually like, maybe I'll try to get you in trouble with some of your MMT friends here. But it sounds to me that from a policy, like, look, if debt to GDP were currently at 10 % right now, very low. And you raise rates that you have some constraining effect on borrowers. And yes, you do have this interest increase in the interest income channel, but it's not that big of a deal because there just aren't many coupon payments at all that are going out.

20:11That's right. That's exactly right. But where we are right now, is it safe to say that the size of the debt is a problem, that we are in fiscal dominance, and that the size of the debt constrains the ability of monetary policy to be a balancing force in a time of inflation. More than that, I've made it backwards. It takes it away. Now, I had had a discussion with Paul Krugman a few years ago, and that's when he and Stephanie Kelton were going at it with back and dueling editorial. Remember that? Yeah, yeah, of course. And I said to him, I said, what's, you know what's wrong with the job guarantee you know and he says well if you deficit spend for the job guarantee the deficit could get so large that if the fed tried to raise you know if we get inflation the fed won't be able to use interest rates as a tool because the interest in you know expense will be so high that that itself would cause inflation now he was using that as an argument against the job guarantee and he made my argument and i said to him yeah i agree with you I said, but I think we're already there for all practical purposes.

21:15And the debt to GDP was lower then. But, you know, it was at least neutral that interest rates were a tool. And he disagreed with me, and that's fine. And I said, and in any case, you know, I support, as you know, a permanent zero rate, in which case it's moot. You know, you could definitely spend for job guarantee without worrying about whether raising rates is going to do anything or not, because you're not going to do it. You're going to just leave them at zero. But the point was, that was his New Keynesian position out of the New Keynesian model. And it was a standard New Keynesian position not that long ago.

21:46You remember them all talking about anti-deficit talk and how the interest payments are unsustainable and all this stuff. By unsustainable, they always mean inflationary, right? They don't say it in their first phrase, but if you drill down on them, that's what they get to. but in the last couple of years when i asked him again two years ago it's like no i don't think we're at that level i still think the fed can raise rates to fight inflation i said okay you know we'll see so this is this is in the new keynesian model you know it's just arithmetic that at some point the deficit gets high enough the public debt gets high enough so that when you raise rates and pay more interest you do cause the interest itself causes inflation now let's look at how high the deficit spending is cbo's latest number shows seven percent of gdp right yeah and i think that's just treasury i don't think that includes fed remittance so maybe it's seven and a half or something okay now have we ever had anything anywhere near a seven percent budget deficit during an expansion with unemployment it's like four percent you know kind of record low levels no the only time we've gotten anywhere near this high is counter cyclically when you have a collapse and then tax revenues fall off and transfer payments kick in because unemployment's high you know then we got to eight or nine percent in 2009 and we got to i don't know what the number was covid maybe 15 but normally if you look at 08 the budget deficit was down to something like one percent of gdp when and that was low enough to uh allow the high price of oil and the other catalysts to trigger a major collapse in the financial sector.

23:28Not a 7 % deficit. 7 % is like drunken sailor level of government spending. And out of that, 4 % is the interest expense. It's over$1.2 trillion, I think, annually. We just passed$100 billion for the month. Wait. So, yeah, go ahead. Oh, no, sorry, go on. Yeah, so look, right now the deficit is 7 % in GDP, 4 % of which is interest expense so without the interest expense if they left rates at zero it would have been trending towards zero and the deficit would have been down 2-3-4 % something still high but not like it is now and that to me is like it's unthinkable that that's not going to support a strong economy now what's interesting is in the last month there's been a little bit of a bump in the numbers right the Fed of Atlanta is down to 1.7 % GDP GDP growth, still not a recession or anything.

24:22And everybody's now looking for this collapse and Fed rate cuts and everything else. And I'm sitting here going, how can this be with a 7 % pro-cyclical budget deficit? It seems like an absurd assumption that we could have any kind of substantial weakness or really any kind of a sustained weakness in the price level. So, but, you know, for the last few weeks, maybe months, a couple of months, you know, it's certainly been plenty of indicators around the edges that things are weakening. And it may turn out, you know, I'm completely wrong. We have a total economic collapse with a 7 % deficit. And I can, I'm 75 this year.

25:03You'll never hear from me again, right? We'll see what happens. That's a good hedge, the age hedge. In the long run, we're all dead. Right, right. In the short run, I'll be dead before I have to answer for anything I say. Wait, wait, wait. I don't know what's going to happen, but I'll be the first one to tell you that I've just totally caught out by a recession with a 7 % deficit. You know, unless we get$150 oil or something like that. But absent some other shock, you know, I don't see how that much could be spent without GDP being strongly positive, unemployment being very low and price pressures.

25:42Now, the other interesting thing is this hundred billion a month only translates into about a three and a half percent of the Treasury debt as interest payment. whereas fed funds rates five and a half five and three ace which means and t-bills are somewhere around there five and a quarter five and three ace which means that as rollovers continue as time goes by the deficit expands that number is going up okay even if they just leave rates alone it will get to five and three ace you know asymptotically but it'll get there and so that we're getting more and more of this and the cbo's deficit forecasts are showing deficits higher than six percent out into the future like this is like going to be interesting that to me is at least six seven percent nominal growth and if you think you know price level is going to be i don't know what you want to use pc or something at two and a half that's that's four and a half real right that's pretty strong number more likely you will get two to three real and the rest will be you know price level changes, which is one of the channels where the interest rate normally, or over time, I've just noticed over 50 years, the change in the price level, the rate of inflation gravitates towards the Fed's policy rate over time.

26:59They converge. And so with a 5.5 % rate, 5.3 % rate, you'll see CPI gravitating towards that interest rate, you know, towards that number, 5, 5.5. Not in day one. you can go months without it but over a longer periods of time and you can think of that something like a stock split you know or a stock dividend where if you just pay out more shares you're getting you know all else equal the value of this of an individual share goes down by that amount right so if you have a two for one stock split the price of the stock falls in half if you're paying out five and a half percent a year on the public debt which is the net financial assets in the economy called the net money supply in the economy, you're expanding it at 5.5 % a year through payment of interest.

27:46There's nothing on the supply side. It's just a distribution. Then I've just observed that over time, the price level gravitates upward by about that amount, and there's plus or minus. So those are my expectations going forward. And if you notice, CPI has leveled off at about 3.25 % or something. it went up with COVID. It came down and then sort of leveled off. It's been going sideways here. And that's about at the interest rate. The effective rate on treasuries last year was about three and a half, whatever it was. So to me, that's not a coincidence. It's not a surprise. It doesn't have to happen.

28:23It could have been different, but it's kind of like the midpoint of my expectations as to what's going to happen with the price level. Now, PCE is a different thing, right? That includes substitution. If the price of steak goes up and so people eat chicken instead, but spend the same amount, you know, then there hasn't been any increase in the BCE.

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