A Really Simple EconomyLooking at real world national accounts data and the formal definitions used immediately raises a lot of complications. But we can understand the problem if we look at an imaginary, highly simplified economy,
Let's assume that we are discussing an economy on a small, isolated island that does not trade with the rest of the world (for simplicity). There is a government that issues a fiat currency, and the business sector consists of a single conglomerate -- "Acme Inc," -- as well as some family-run firms whose accounting I merge with the operating households.
The government issues paper money and Treasury bills. The amount of these instruments held by everyone else are what MMT refers to as their "Net Financial Assets." It is easily seen that the total (cash) government deficit over a year equals the increase in Net Financial Assets. (This is assuming that the government deficit does not include accrual accounting concepts; the deficit has to correspond to net cash outlays.)
This leads to the common statement within the MMT literature that the government needs to run deficits to accommodate net savings desires of the private sector. If the private sector ("Acme Inc." and households) wants to increase their holdings of government-issued financial instruments, the only way that can be allowed is if the government runs a deficit.
What about private debt?
- If Acme Inc. issues short-term debt (to households), the increase in household financial assets is matched by the increase in liabilities of Acme Inc.
- If households issue debt to Acme Inc., the corporation's increase in financial assets is matched by the increase in household liabilities.
In other words, in order for one part of the private sector to increase its holdings of privately issued debt instruments, it requires another part of the private sector to be willing to increase its debt issuance.
The usual state of affairs in modern economies is that most private entities have a rising nominal income, and they correspondingly wish to increase their liquid asset holdings in line with income. (This is known as a stock-flow norm.) In an economy with a single firm, this means that either the firm has to be a net issuer of short-term debt, or the household sector, One could easily see that this could create problems, In a real economy with many firms, there is usually some sector of the economy that is willing to take on short-term debt. However, in a crisis, it is difficult to find credible short-term borrowers, and so the government has to step in.
(At this point, many people would start to raise the issue of the banking system. Although the banking system creates private money in large quantities, it can only do so if there are credible borrowers. Since those borrowers disappear during a crisis, this only has a limited effect on the analysis above. The key advantage of the banking system is "maturity transformation," which reduces the problems created by the mismatch between the large desire to lend at short maturities versus the limited willingness of borrowers to rely on short-term funding,)
What About Equity?The confusing part of the analysis is the role of equity. In order for private financial assets to net to zero, the shares of Acme Inc. need to be netted out as well. We need to treat the equity as being like a debt. This is implicitly done by the MMT formulation. This is often justified in two ways.
- The national accounting treatment essentially treats equity as a form of debt in other contexts.
- Businesses do take into account the "cost of equity" in determining their cost of capital. It is treated in practice like any other liability.
Once we realise that equity is supposed to be netted out, the complications raised by Steve Roth regarding valuation changes disappears. An increase in the market value of Acme Inc. shares would increase the value of assets held by households, but it still nets out to zero for the private sector, since there is a corresponding increase in the "liability" for Acme Inc.
However, it appears reasonable to object to this netting out of equity. As someone with a background in the financial markets, I would not normally lump a corporation's equity with its other liabilities when analysing the firm. If we do not allow for netting of equity, the accounting for "net financial assets" would break down. For example, an increase in the value of Acme Inc. shares would increase the value of shares held by households, but there is no longer an increase in the "liabilities" for Acme Inc.
Since the choice of accounting treatment is somewhat arbitrary, you can take either side of MMT's view of net financial assets. Correspondingly, I have no desire to argue about the technical details.
The more important question is whether the MMT treatment is analytically useful. My opinion is that it is in fact useful. In practice, we see that net equity issuance is negative -- that is, more is spent on equity buybacks than is raised via Initial Public Offerings. In other words, the stock market is a net drain of funds, not a source of funds. Since funding is effectively provided by debt, which should be netted, the MMT treatment is closer to reality. Furthermore, although increases in equity valuation do drive balance sheet decisions, they do not have the same impact as cash income flows. For example, a $100 billion increase in wages is going to have a much more significant effect on behaviour than a $100 billion increase in the market value of equities that are ultimately held by households. (The practice of holding assets via insurance companies or pension funds limits the importance of equity market gains for households, as the gains are not visible or necessarily passed through to them.) Correspondingly, I have little objection to a framework that minimises the effect of equity valuation changes.
In summary, this is a debate that revolves around accounting definitions. Although an argument about definitions is of academic interest, the more significant questions revolve around how the private sector behaves. My feeling is that the MMT literature captures the standard patterns of behaviour well, but one must keep in mind the subtleties behind the analysis.
(c) Brian Romanchuk 2015