Randall Wray: Currency Sovereignty and Policy Independence

Randall Wray Cofounder of MMT; Professor and Senior Scholar, Bard College and the Levy Economics Institute

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1、Conventional views vs Modern Money Theory

Thank you! And thank you for the invitation. I agree with much of what every guest said and I’m going to follow James K. Galbraith's line of attack on the Federal Reserve Bank’s austerity policy. That is bad for the world and that’s also bad for the USA. And what I want to do is to focus on the theoretical framework that underlines monetary policy but also on policy in general.

Let's go to the conventional views on central banking. The Central Bank determines the base interest rate that we call the Federal Funds rate in the United States. And the loanable funds market determines the other rates—a flexible interest rate equates savings and investment. Government competes for the scarce supply of savings, and so it was borrowing as it was pushing up the interest rates. Inflation raises nominal rates through the Fisher effect. So that is a theory of interest rates.

As for the theory of exchange rates, it is largely determined by the trade balance. According to the purchasing power parity theorem, as we go across borders, the price adjusted by the exchange rate remains the same. Floating rates reduce the trade imbalance. But also fixed rates reduce the trade imbalance through the specie-flow mechanism. Economists hold strong views on determination of exchange rates, but as Alan Greenspan said when he was chairing the Fed (The Federal Reserve System), none of the models work. Nobody really knows what determines the exchange rate. The mainstream also argues that there is no strong reason to link currencies to nations. So they support Mundell’s Optimal Currency Area approach (that delinks nations from their currency) that is supposed to increase policy independence. But giving up your currency and joining a currency union actually reduces domestic policy space—for both monetary policy and fiscal policy.

OK, what’s the Modern Money Theory alternative? Currency sovereignty is essential for the independence of Monetary and Fiscal policy. With its own currency, the central bank determines the base interest rate. It can set others if it wants to. It can set any interest rate that it wants to—by standing ready to buy and sell to peg the price of a financial asset. Investment equals saving by identity as Keynes said. The interest rate is irrelevant to the equality of saving and investment. A Budget Deficit adds to private saving. It doesn’t take away private saving from the economy it adds to private saving. There is a role for Keynes’s liquidity preference theory, as it determines the interest rates that the central bank does not determine. Budget Deficits actually place downward pressure on interest rates by creating excess reserves. That pressure can be released by monetary policy— through Open Market Sales (OMS) of government bonds that remove excess reserves.

At least for major currencies, capital markets dominate exchange rates. And Keynes’s interest rate parity theorem does not hold firmly but it is on the right track. There is a tendency to equalize total expected return across assets and currencies. This works better than the purchasing power theorem used by the mainstream economists.

2、 Current CPI Inflation and Policy Interest rates

This is what I’m showing in this table here. It’s already even mentioned. As the United States raises its interest rates, what we see is that other countries also raise their interest rates sort of in line with their rise of inflation. So countries with higher inflation have raised rates more than countries with lower inflation rates. However, there are some anomalies. Phe red points signal countries that have interest rates very much higher than their inflation rates. And maybe that’s the “developing country penalty”. They are worried about the impact on their exchange rates—so they have much higher interest rates relative to their inflation rate. And then we can see where the interest rates is not in line with the inflation rates—either very low with high inflation, or very high with low inflation. For example, China has very little inflation but high interest rates. So it is following developing countries’ strategy even with no inflation. And then we have Japan--the opposite with inflation but very low, even negative interest rates. We have Poland with inflation that’s reasonably high and interest rates that are relatively low. And then we have Turkey that’s also an anomaly: high inflation and lower interest rates.

If we look at the path of the policy interest rate over almost a quarter century, we do see the USA, the UK, the ECB all sort of following a very similar pattern. But we do see countries that decided to go it alone and do not follow what the United States is doing. So there is some possibility that you do not to do what the USA does. If you have your own currency, you can maybe buck the trend—and don’t follow the leader.

3、 The View from the Fed

How is the Fed formulating policy? What’s the thinking behind the policy? We used to have Friedman's Quantity Theory--the idea that the money causes inflation. We abandoned that when inflation fell in the mid-1980s even though the money supply grew quickly. And also because Central Banks (the Fed and the Bank of England) could not hit their money targets. So Central Banks embraced the New Monetary Consensus and Taylor Rule.

The thinking is that expectations of inflation cause inflation. There is no clear guide to how that is exposed to happen. How thing works is supposedly by controlling expectations. But how can a central bank control those expectations? The Central bank is exposed to move the Fed funds rate in the United States, to push the “real rate”, which is inflation expectations adjusted, to some unknown “natural rate”. Tarullo (from the Fed) says, the Fed has no theory of inflation. Papadimitriou and Wray have argued since 1994 in a series of Levy Institute briefs that the Federal Reserve Bank is flying blind. They are focusing on triple unobservables:  They do not observe inflation expectations. They do not know what the real rates are because we don’t know expected inflation. And they don’t know what the natural rate actually is. They admit it, and they say the natural rate changes over time, too. So policy really is reduced to Psy-Ops: Psychological gamesmanship. Quoting researchers at the Fed again, “to influence emotions, motives, and objective reasoning”. That is what central bank policy is coming down to.

We have had low inflation since Volcker. And the Fed is happy to take credit for that. I argue that the reality is the low inflation is due to globalized supply chains with cheap labor, low costs of regulations, and low taxes abroad. The move to “Just-in-time” production was formed to get either low or no inventories, which is major cause of cost reductions. Austerity/stagnating demand and wages in the United States helps keep inflation low. Every recovery since 1990 has been a jobless recovery with the notable exception of the COVID recovery—when we had a $5 trillion rescue package. These same factors that tamed inflation have come back to bite during COVID. So Powell still follows Volcker who is given credit for stopping inflation in the 1980s, but he raised rates above 20% causing a deep recession in United States, a series of financial crises in the USA—with most of the big banks insolvent by 1990, and a lost decade of development in Latin America. A full recovery from Volcker’s policy took 25 years.

In spite of all that, Lawrence H. Summers said, “I’m aware of no major example in which the Central Bank reacted with excessive speed to inflation and a large cost was paid.” Apparently he wasn’t paing attention during that 25 years period. And when inflation picked up in USA after COVID, he predicted, “Killing inflation requires 5 years of unemployment rate at 6%, 2 years at 7.5%, or 1 year at 10% inflation.” As Galbraith says, “The Fed wants unemployment.”

The Fed expected unemployment to rise to at least 4.4% this year. Powell said: “we need to have” a sharp slowdown in growth—Fed officials are willing to accept a lot of economic “pain”. Now that pain will be borne by others—not by Powell. That “pain” spread around the world. Others think they must follow Fed rate hikes to minimize pressure on exchange rates which can lead to inflation and their countries.

4、 But Central Banks Have to Take-Way the Punch Bowl, Right?

Central Banks have come to believe that they have to take-way the Punch Bowl when the economy grows to fast, and the right way to do that is to raise interest rates. The line of thinking since early 1970s when the analogy was a first made—when inflation first spiked up. The thinking is that inflation is caused when government spends too much. So when government runs a deficit, the Central Bank is to reduce demand by raising rates.

But if you look at all the evidence, when does the Fed raise interest rates? They always raise rates as we are going into the recession! They always raise rates as the budget deficit is falling! Not when the deficit is rising. And it actually is the falling budget deficit that is putting the headwinds in place—tight fiscal policy was already causing the recessionary pressures. That is when the Fed raises rates. Finally, the Fed raises rates even when there is no inflation! And I agree with Galbraith. The Fed raises rates when the unemployment rate is down. That is when they raise the rates—when employment reaches its peak and we are poised for a recession.

Interest rates are determined by monetary policy, not by deficits! The government deficit or debt need not cause inflation! Inflation has been low as the deficits and debt have been rising over the past three decades. (Note I’m talking about the United States and I will not make this claim for all other countries). Our high inflation periods since WWII are always driven by the supply side, never by the demand side. (I have the data to show this in charts that were originally in the powerpoint, but to save time I took them out. I can support all these points with data.)  

5、How does Monetary Policy really work?

So how does Monetary Policy really work? Orthodoxy says policy should focus on expectations management. Well, all the evidence is that was a complete failure!  

How does raising interest rates actually work? Supposedly by reducing interest-sensitive spending. But we know from the evidence that spending is not interest-sensitive with the possible exception of housing. Raising rates today in the United States is very counter-productive because we have a severe housing shortage. And while shelter is the main driver of our Consumer Price Index measure of inflation, it is mostly an imputed price—not a market price that anyone really pays. So it is highly unlikely that raising rates actually reduces pressures on inflation by reducing spending.

Then there is the cost-channel: raising interest rates increases business costs, that raises prices. So the effect is the opposite of what the Central Bank wants; firms raise prices to cover higher interest costs.

There is also the income-channel. Raising interest rates redistributes income from debtors to creditors as Galbraith also mentioned. And that depresses spending, because the marginal propensity to consume of high income individuals that are the creditors is lower.

Finally, higher interest rates increases the risk of financial crisis—I believe this is how monetary policy works, by causing a financial crisis. Debtors default on their debts, that rise because of higher interest rates. Defaults spread through the economy and lead to bank failures, too. But that is a very costly approach to fighting inflation in terms of the economic fall-out.

There is also the impact on government interest spending on government debts. As interest rates go up, that increases private sector income. This will have a positive high impact on private spending when the economy has a high public debt but very low private debt ratio. Japan is a good example of that. The United States is not. This works best when the debt is held domestically, or if it’s foreign-held, it is held by importers of domestic output. In that case it can stimulate demand and spending by individuals or firms. This would make raising rates likely to increase spending—precisely the opposite outcome that the central bank desires. As interest rates rise now, it is we are getting an impact like that in the United States. In the USA, the federal government for this fiscal year 2023, spent $659 billion on net interest. That’s up by $200 billion.

So what I would conclude from all of these is when the Fed is raising the interest rate, you cannot be sure if the CB is stepping on the  brakes or the gas pedal—it depends on the conditions of the economy.

6、Lessons for the USA

We did have a tremendous relief impact of about 5 trillion dollars by two 2 presidents--Trump and Biden. Five trillion dollars--that was labeled as MMT policy. That was not MMT policy. We’re actually argued against to doing that, because it was not targeted at all. Then when inflation hit, it was supposed to be MMT’s fault. The claim is that MMT is always ignored inflation. They claim MMT says to just printut up the money and expand it. Well, that’s never been true. We emphasize the real resource constraints.

The first round of relief spending did not induce spending-- because people didn’t’t  spend it, they paid down bills and increased saving. The second round of relief may have had inflationary consequences—because as we recovered from COVID people did start to spend. And the supply side had not recovered yet.

But the current residual inflation is not demand driven. The government “stimulus” is long finished except for the inefficient interest spending. This is not well-targeted. The Fed can’t do much about inflation, anyway, as inflation is not a monetary phenomenon. We need to drive a stake through the heart of this belief. Money is always innocent. Money never causes inflation. Let’s just try a mental experiment. Let’s print up a quadrillion dollars. Put it in a spaceship and fly it to the moon. How much inflation do we get? None. Now we it back to earth and start spendingthe money like crazy. We can get inflation. Spending can cause inflation, money can not.

The impact of rate hikes is uncertain. And so I don’t believe that focusing on interest rates is easier, is going to work to lower inflation. Fiscal policy is more appropriate. We should address bottlenecks, we should promote investment in particular sectors in the USA such as housing, and sustainable energy. And we should punish price gougers which played a big role in our current inflation. And then finally we should create a job guarantee program to act as bufferstock to help stabilize wages and prices and to give full employment.

7、 Lessons for the Rest of World

If you have your own sovereign currency and you float your exchange rate, you can maximize domestic policy space. You can fully mobilize all your domestic resources. Most importantly, your labor resources--you can operate at full employment.

Inflation is not caused by money nor by expectations of inflation. The culprit is often on the supply side, but too much spending can be inflationary. So you want countercyclical fiscal policy and you want to rely mostly on the automatic stabilizers. That can help minimize the danger from government spending. Fiscal policy can also tackle supply side problems.

Avoiding foreign currency debt helps promote policy independence. So don’t get yourself in dollar debt. Low domestic interest rates reduce costs, and reduce the incentive for borrowing in foreign currency. If you are a low income country, if you are highly dependent on imports for food, energy and other essential inputs that can expose your domestic economy to inflation and exchange rate risks. So I’m not insisting that every country in the world should follow the advice of floating exchange rates.

8、Conclusion

Ok, I want conclude the very quick answer to the list of questions.

Will the U.S. economy fall into recession in 2024? I’m more pessimistic than some previous commentators. I think it’s likely. However, the lesson we learned back in 1998 when Wynne Godley and I predicted the US economy would crash into a global financial crisis is that the United States economy is huge. Once it’s going in one direction, it can continue in that direction for longer than one expects. So I won’t be surprised if it takes longer. It may come in 2025.

Will the Chinese economy be able to return to a strong growth path? Yes, if China focuses on job creation and sustainable shared prosperity.

How can developing countries and emerging economics (including China) balance financial openness and financial stability? I agree with Galbraith. For most, floating exchange rates and capital controls provide domestic policy space. Avoid foreign currency debt. Highly indebted low income nations have to avoid debt as they need debt relief and aid.

Wise people agree that we should cooperate. Absolutely. Humans face the biggest challenge since they came out of Africa, which was the very beginning of Homo sapiens. We must share science and technology with each other and with all other nations to tackle the challenges.

Specific policy suggestions for both countries. Avoid Mercantilism. Remember that exports are a cost and imports are a benefit. Fully utilize domestic resources to tackle the multiple pandemics that we face and avoid extinction of the human race. 

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