Although institutions have been manipulating interest rates and monetizing debt for the past decade, these policies have intensified over the past two years. Low interest rates have made debt servicing possible, while enormous purchases of government debt (monetization) by the United States Federal Reserve and the European Central Bank have ensured that the newly issued bonds have always found a willing buyer.
Abba Lerner’s legacy
In 1944, Russian-born economist Abba Lerner wrote “The Economics of Control,” an influential book on the irrelevance of fiscal deficits and public debt. He maintained that money printing would become the primary way to finance public expenditure, which could expand until full employment is obtained. Lerner’s theorizing, which went under the name of “functional finance” and is now known as “Modern Monetary Theory” (MMT), also posited that public expenditure and money printing can continue indefinitely if inflation stays low.
We are certainly not living in Abba Lerner’s world: public expenditure is financed by heavy taxation, not only debt securities issued by governments, and large amounts of these securities are being held and bought by creditors other than central bankers. Nonetheless, even economists who have never heard of Abba Lerner now fear that the Western world might soon approach Lerner’s inflationary limit. Although consumer price inflation is still moderate, stock prices have been rising rapidly, as have prices for real estate and intermediate goods.
Policymakers may soon face a dilemma. They can follow Lerner’s functional finance views, kick the can down the road, and then reverse course when consumer-price inflation approaches, say, 5 percent. Or, they can act before prices get out of control and trigger social unrest. If legislators worry that stagnation and inflation are a distinct possibility and decide for the latter, they have a limited range of options.
Regardless of Lerner’s and his disciples’ conjectures, policymakers must either cut budget deficits drastically or find new ways of persuading the private sector to buy the treasury securities that many individuals and institutional investors are unwilling to accept – or both. The most realistic outcome is that the authorities will try to target private wealth. This move, if successful, would have momentous consequences.
History shows that cutting public expenditure is an uphill battle. In Europe, the recent narrative holds that the only way out of the debt problem is an economic expansion and that greater public expenditure is key to enhanced growth. Simply put, European leaders believe that debt-financed public expenditure will grow the economy, reducing the debt-to-GDP ratio and creating enough tax revenue to service and pay back the debt incurred over the past decade and a half. They also believe that new, post-Covid debt is necessary to jump-start the system.
Lerner’s functional finance has morphed from “spend whatever it takes to reach full employment” into “spend whatever it takes to reach shared social goals.” If necessary, such goals may result from global initiatives, like transnational projects that require transnational financing. The 1990s advocates of “happy degrowth” (who called for economic shrinkage) have been replaced by those who say public expenditure on a global scale can produce substantial material growth, bring about a green revolution and reduce income inequality.
By resorting to public expenditure and their functional finance vision, the authorities stand ready to circumvent the inflationary threats by heeding Lerner’s MMT descendants in two ways. First, they are prepared to finance debt by tapping private income and assets. Second, they tend to explain inflationary outbursts as the result of supply bottlenecks, which are to be eased through government intervention – a mix of price regulation and nationalization. These possible solutions would lead to disturbing scenarios.
Bond-buying dead ends
As mentioned above, trouble materializes when consumer-price inflation hits a given threshold and persuades policymakers to stop monetizing. The traditional way out is issuing treasury securities and selling them to private investors: individuals, investment funds, banks and insurance companies. Of course, in the presence of high public debt and rising inflation, these potential buyers are willing to buy if they are rewarded with increased rates of interest, which in turn would further weaken the financial position of many indebted countries.
In short, plan A is bound to fail. Plan B consists of creating transnational bonds (like bonds jointly issued through the European Central Bank by the European Union’s 19 eurozone states) carrying an implicit guarantee by the central bank. However, plan B is also problematic. On one hand, a tongue-in-cheek assurance that the ultimate guarantee is monetization is perhaps acceptable when you have zero or negative inflation, but far from reassuring when inflation is significant and rising. On the other hand, asking relatively healthy countries like Germany to step in if relatively weak countries like Greece, Italy and France default is likely to meet significant resistance.
A third possibility would be to persuade institutional investors to buy government bonds at a high price and low rate of interest. The ECB did this by enforcing relatively harsh capital requirements for banks, and then pretending that all EU governmental bonds are risk-free assets. It is hard to say whether this strategy can be pursued much longer if inflation is present and, therefore, the cost of remaining liquid rises.
Suppose inflation encourages depositors to reduce their cash balances. In that case, banks can no longer collect the funds necessary to buy treasuries, and there is no guarantee that depositors switch from zero-yield bank deposits to very-low yield treasuries. In this case, individual investors would turn to corporate debt, and governments could no longer rely on their trusted accomplices – the banks – who would be short of cash.
Back to taxation
This mechanism explains why, if the traditional “technical” solutions mentioned above are not viable, governments must force individuals to finance public expenditure through taxation. This is what the advocates of MMT really want. Taxation makes expenditure possible with neither debt nor inflation and accomplishes political goals. After all, squeezing large corporations and the rich helps bring about “social inclusion,” a euphemism for income and wealth redistribution. Lerner would not have objected. In his view, taxation amounts to a transfer of income from one group of individuals to another, a zero-sum game from the social standpoint.
Yet, expropriating property and taxing the rich will not satisfy the government’s needs. There are not enough “rich” people, nor are they sufficiently wealthy. Bleeding the rich only makes sense if it helps the middle class forget that its wealth will soon be targeted.
The strategy might pay off in the short run, especially if new wealth taxes were introduced along with income tax cuts for low- and middle-income households. But it would be the kiss of death for many economies. The destruction of private wealth and the heavy penalties on private savings would annihilate entrepreneurial incentives and create an increasingly large public sector. Corruption, partial nationalizations and inefficiencies would follow, as individuals would strive to better their position by acquiring privileges within the government apparatus rather than by producing and competing to meet others’ needs.
The recent debates about Abba Lerner’s views are certainly more than idle academic discourse and open up the possibility for new scenarios to emerge. Make no mistake, though. What we are dealing with is an attempt to give academic respectability to a project that would entail the systematic destruction of the middle class and make what remains increasingly dependent on government benevolence.
Enrico Colombatto is a professor of economics at the University of Turin, Italy. He is also director of research at the Institut de Recherches Economiques et Fiscales (IREF) in Paris.