Review: The Magic Money Tree and Other Economic Tales
“What I shall argue”, writes Lorenzo Forni in The Magic Money Tree, “is that the main principles of economics remain unchanged; it is only the circumstances in which they operate that are currently different” (p. 3). Elaborating on these principles, he writes:
Economics, in fact, is characterized by the study of how to obtain the best possible
results from scarce resources, that is, how to maximize an objective function given
the constraints on what can be achieved. One point on which all economists would
agree, therefore, is the fact that constraints exist – we will call them budget constraints – that must be respected. Economists might disagree about everything else, but on the need to include budgetary constraints in economic reasoning there is consensus. (pp. 4–5)
Indeed, “the public budget constraint”, he writes, is “not substantially different from those we face in our everyday lives” (p. 28).
This idea has long been dismissed by many economists as an example of ‘the fallacy of composition’. In The Deficit Myth (John Murray Press, 2020), Stephanie Kelton, a leading proponent of Modern Monetary Theory (MMT), describes such thinking as “pernicious”:
… the federal government is nothing like a household or a private business …
because Uncle Sam has something the rest of us don’t – the power to issue the US dollar. Uncle Sam doesn’t need to come up with dollars before he can spend. The rest of us do. Uncle Sam can’t face mounting bills he can’t afford to pay. The rest of us might. Uncle Sam will never go broke. (p. 8)
The Deficit Myth quotes Paul Allen McCulley, another MMTer:
In a fiat currency world, the finances of we the people ain’t the same as a summing up of our individual budget constraints, because we the people can’t go broke, only deficit-spend our collective self into inflationary excesses. In the prevailing era of too-low inflation, the macro policy implication should be obvious: We the people presently have far more fiscal space than the deficit scold, pay-for crowd preaches.
Indeed, Forni notes, “In the last few years, inflation in advanced economies has been particularly low” even while monetary policies have been “extremely expansive” (pp. 114–16).
Then, in early 2020, COVID-19 hit. Economies across the developed world were shut down and government spending surged to stave off mass destitution. In 2020, the US federal government ran a deficit of 15 per cent of GDP, the highest since World War II, and British
government borrowing reached 13 per cent of GDP. As yields rose, central banks stepped in to buy government debt and cap borrowing costs. The Federal Reserve printed trillions of dollars and lent direct, for the first time,
…to the private sector through the Main Street Lending Program…In the UK, the
Bank of England opened up a direct line to the UK Treasury, disregarding concerns
over monetary financing of the government budget, actions historically perceived as very risky for central bank independence and, therefore, for the control of inflation. (p. 1)
Now, “as economies recover”, Forni warns, “politicians will find it difficult to dismantle this fiscal support. Central banks will come under considerable pressure to continue to ease monetary conditions and keep their printing presses subordinate to the needs of the public budget” (p. 8).
But dismantle it they must for that avalanche of new money killed the era of ‘too-low inflation’. In the year to June 2022, inflation in the United States was 9.0 per cent, the fastest year-over-year rate since October 1981. At 8.2 per cent, the rate of inflation in the United Kingdom in the year to June was the highest since March 1991. In the Eurozone, inflation of 8.6 per cent in the year to June was the highest rate on record. We have run out of fiscal space.
Policymakers now find themselves in an excruciatingly uncomfortable position. As central bankers raise interest rates to fight inflation, government borrowing costs are rising. In Britain and the European Union, they are rising just as governments implement vast new spending packages to protect voters from soaring energy prices; and as 2022 is Congressional election year in the United States, the Biden administration is buying votes. Borrowing and the costs of borrowing are rising together. If central bankers loosen monetary policy to accommodate fiscal expansion, they will fuel further inflation, which is already high. If they do not, fiscal policymakers will need to enact drastic austerity measures. The choice seems to be a stark one between an inflationary crisis and a debt crisis. Both are ways of satisfying the budget constraint and bring what governments have paid into line with what they’ve bought.
As much of a joke as MMT now is, it is only fair to say that MMTers acknowledged the existence of constraints. Kelton wrote in The Deficit Myth:
Just because there are no financial constraints on the federal budget doesn’t mean there aren’t real limits to what the government can (and should) do. Every economy has its own internal speed limit, regulated by the availability of our real productive resources – the state of technology and the quantity and quality of its land, workers, factories, machine, and other materials. If the government tries to spend too much into an economy that’s already running at full speed, inflation will accelerate. There are limits. (2020, pp. 3–4)
But the observation that a country that was willing and able to turn itself into Zimbabwe need not worry about turning into Greece was never the ‘Copernican shift’ Kelton claimed. Everybody knew it, but some chose to ignore it. The years of high debt, low interest rates, and low inflation convinced them that the main principles of economics had changed.
Forni is one of a group of fine Italian economists which includes Carlo Favero and Francesco Giavazzi, who – tempered by their country’s fiscal problems – have in recent years reminded us of truths that too many anglophone economists have been quick to dismiss. This short, readable, book is an indispensable guide to the economic environment we face now that the ‘era of too-low inflation’ is over.
This review originally appeared in Economic Affairs.