This is part 1 of 3 in a series which I have extracted from a long interview with Warren Mosler held in Mallorca on October 14, 2021. It will be published in both English and Spanish
Stuart Medina (SMM): A good starting point is your inflation and interest rates story. Let’s start with inflation. You frequently argue that inflation is not always driven by demand. Indeed you could argue that [demand driven inflation] is a rare event. After that we can talk about interest rates.
Warren Mosler (WM): Inflation academically is defined as the continuous increase in prices that is faced by agents today looking to purchase things for delivery in the future, whether it’s next week, next month, next year or five years forward. But they want to purchase it now for those dates. And they’re facing what, I like to call, a term structure of prices. The continuous increase of that term structure of prices is academically the rate of inflation. And, with floating exchange rates, it’s also a direct function of the central bank policy rate.
So if you have a permanent zero-rate policy, something like Japan has now, where [the Central Bank] controls up to ten years at zero, the term structure of prices is flat. And so the inflation rate under the academic definition —the way I read it— is zero, because agents are looking at flat prices relative to spot prices. So if I’m a gold manufacturer I can buy gold today for jewelry manufacturing at $1,800 an oz. But I have other choices: I could buy it a year from now for $ 1,800 or ten years from now for $ 1,800 plus some storage, insurance and other sundry charges. But effectively it’s the same thing.
Now, if the central bank raised rates, say to 1% from zero, the term structure of rates would now be locked at 1% instead of zero. Then the price of gold for every year forward I want to buy would go up. Prices would continuously go up at a 1% compounded rate, so the rate of inflation would be 1%. By the academic definition of inflation —as I read it— the central bank sets the policy rate, which is the rate of inflation, the structure of the policy rate.
By the academic definition of inflation the central bank sets the policy rate, which is the rate of inflation, the structure of the policy rate.
The Fed only sets overnight rates, as in the European Union, and allows the term structure to adjust to what market participants anticipate that the Fed is going to do. That’s their policy choice. So today, with a one and a half percent ten year note, you could say the forward structure of prices is increasing linearly at an average of one and a half percent a year for ten years. For people looking today to purchase things for delivery next year or the year after —and this could be somebody who wants to buy a house which is going to take a year to build or who wants to build a factory which is going to take three years to build— they have to look at the forward prices of those things. The term structure of prices, which is set by the policy rate, is the rate of inflation.
The term structure of prices, which is set by the policy rate, is the rate of inflation.
According to that definition, you would not see a headline today saying inflation is at 4%, right? Because that’s what the CPI did versus a year ago, which is a very different thing. What we have today is what’s called a price level. And if the rate of inflation is zero, as it is in Japanese yen, that’s not to say that the price level won’t change, go up, go down, go sideways for the next ten years. It is to say that, right now, if I want to buy something for one year delivery, the forward price is the same price as the spot price.
The next question is, what does determine the structure of prices? And one of the questions it brings up is why the central banks won’t even consider this or put any time or effort into trying to see what the relationship is between the term structure of prices and their policy rate. Because central banks think they’re in control by using the reference rate.
Well, they’re looking at changing the price level, not realizing that, when they raise rates, which presumably causes the price level to go down, they’re establishing a higher inflation rate. They haven’t looked at it from this point of view nor done the research on it. So it’s not that they’re right or wrong, it’s just that it doesn’t even occur to them to look at this.
Let’s look at the price level. Why are prices where they are? Why does this thing cost $10 or 9 Euro? Where does this price come from? The mainstream [economists] do not have a theory of the price level or a way of determining it independently from what it was yesterday. So they just say it’s historic, because they don’t have anything better and their math doesn’t work to determine the price level as they claim.
SMM: It’s an infinite regress story such as the Marxist labor theory value. Prices are determined by the amount of [socially useful productive] work that you need to get that gold out of a mine, yes, but how much was that hour of work worth in your first place?
The currency is a simple public monopoly
WM: They don’t understand the source of the price level. What I recognized with MMT, since inception, is that the currency is a simple public monopoly. The economy needs the government’s funds to pay taxes and the government is dictating the terms of exchange when it spends, —whether it knows it or not. So what markets can do, and that is what the mainstream recognizes, is set relative value. And all their models do is try to determine relative value. They can tell you why peaches cost twice as much as apples or 1 hour of labor earns enough for three pizzas or one pizza per hour of labor. Markets can determine relative value, but markets can’t determine absolute value. They can’t determine whether the hour of labor should be $10 or eleven and a half euros per hour.
Markets can determine relative value, but markets can’t determine absolute value.
SMM: It’s like saying I can tell that this distance is twice this other distance, but somebody has to define a measuring rod.
WM: That’s what I call absolute value. The only information the markets get on absolute value comes from the government through its institutional structure.
SMM:What we’re seeing with the electricity market in Europe right now, is that an institutional structure is determining the pricing in the market. It has nothing to do with production cost.
WM: Exactly. And the institutional structure has a large effect on relative value.
If the government needs to pay for soldiers and nobody else wants them then it’s setting their value. They get what we pay for them. These soldiers can say “We need the money to pay the tax” and we say, “This is what we will pay”. They’re kind of stuck with those terms right now. The government, of course, is setting some price in terms of currency supply and demand.
The demand comes from the tax liability, which then causes the private sector to need the government’s money. So nothing happens without the tax liability. The story begins there. The mainstream money story begins with the government collecting taxes and what they don’t collect, they have to borrow.
But we see it the other way around, the actual way it works, where the government spends first and then taxes are paid. But they can’t spend first without creating the tax liability. Once the tax liability is established then the government is in a position to dictate terms of exchange. So the price level is necessarily a function of prices paid by government when it spends. And, I used to add, also the collateral demanded when it lends because, if the government lent, open ended, with no collateral, anybody could borrow all the money they wanted and become the agent for government spending. If you’re getting it in exchange for nothing it has no value and you would just get hyper-inflation. Money would be worth nothing. You could borrow the money, pay the taxes, and nobody would care about it anymore.
However, if you look carefully, when a bank lends, the debtor signs a note and they give you a balance in their account. They give you a check; they’re buying a note. It’s a purchase of a signed note. So lending is a [financial] asset purchase by a bank. And any purchase by a bank is paid for by increasing the balance in someone’s account. That creates a new deposit or addition to an existing deposit. This is new money, so to speak, if you define bank balances as money, which everybody does.
Banks in the commercial banking system are agents for the state because they are chartered members. They have an account at the central bank. They’re fully regulated. Regulation includes who they can lend to, what collateral they have to provide, their management, how much they can pay their management, whether they can pay a dividend on their profits,… everything. The Regulators have an acronym, CAMELS[1], which explains what they regulate, which is everything. If the banks are agents of the state so I can now say that bank lending is a subset of government spending in the purchase of financial assets.
Then we can just stick with the simple statement. The price level is a function of prices paid by the government when it spends. We don’t have to qualify further with regard to lending. That’s the only source of absolute value. So the price level doesn’t change without some change in the absolute value information coming from the state.
The price level is a function of prices paid by the government when it spends.
SMM: How do you put into the equation the fact that the government buys an assortment of goods and not a single uniform homogeneous commodity?
WM: So it’s determined by what needs to be offered at the margin: what the population has to do to get that next dollar from the Government. But it’s not the same offer for everyone. For someone it could be one hour of labor and for someone else an additional mile of highway.
The government is not only influencing the absolute price level. It could also be influencing the relative price level. If they decide they want apples for everybody in the army then the price of apples goes up. If they want everybody in the Army to wear a Rolex watch, the price of Rolex watches goes up.
The government creates a notional demand but there isn’t any aggregate demand until the government spends first. It is the source of aggregate demand. I call it the ‘demand filter’. How do the dollars get from the government to the taxpayer? If they just hired everybody —let’s say they tax everybody’s house— then everybody would work for the government and it would give you a job. In this case the demand filter just has one layer. But if they took the whole $ 5 trillion [budget], or whatever it is, and gave it to one contractor and said: “here you go; run the economy” then you would get very different results. He might keep a bunch for himself and you get a whole different distribution.
SMM: Then this person would be the price setter instead of the Government.
WM: Exactly. Especially if he wasn’t given any instructions. Now, if you give him money without instructions, then he becomes an agent of government spending in terms of price level. If the Government pays you a Social Security cheque you can go out and tell people what they have to do to get his money. But if they say “here’s money to buy a car” or “here’s money for food only” then that’s a different story.
SMM: When you talked about banks you said they are buying those promissory notes from their borrowers. Presumably those borrowers will pay back their loans and the promissory note will be canceled, as well as the deposits that were created when the promissory note was first given out to them. What happens when a borrower goes bankrupt and is not able to pay back?
WM: So that deposit is still outstanding. The bank capital has been reduced and that’s a loss for the shareholders. So it all balances out in the end.
SMM: Recently the European Central Bank redefined their inflation target. They used to say less than, but close to, 2%. And now they say that they will allow inflation to overshoot that target a bit. However, do you expect the Fed or the European Central Bank will be raising interest rates [in response to the recent price increases]?
WM: They’ve got the interest rate thing backwards. So the answer to that question is, if they believe that inflation, the way they define or report —the CPI, the core, all these things— is somehow ahead of their targets, whatever that means, then their response will be to raise rates because they believe that the cause and effect sequence is “we raise rates; inflation comes down”. They don’t have any hard evidence nor supporting theory for that anymore, but they believe it. That’s their story and they’re sticking to it.
We can give them all the theory and evidence to the opposite. [However] they fear that if they got their money and interest rate stories backwards then the logical conclusion is that central banks really cannot do that much about inflation in the first place. They never have, indeed. That’s why they will never believe this story because they know they will be out of work.
In the meantime, MMT has pointed out several things that the economics profession totally got backwards to the detriment of the economy and the standard of living for a long time. One of them is the sequence of spending. They think that they have to take money in at the federal level to be able to spend. We pointed out that’s backwards. It’s the economy that needs the government’s money. Every mainstream economics model gets that backwards. And that’s a lot of models for many years that have won a lot of Nobel Prizes for having it backwards.
SMM: Their models were designed under the assumption of a gold standard [monetary system].
WM: Now they’re coming around on the realization that government at least prints the money or creates the money when it spends. They haven’t taken the next step: which means accepting that all their models are wrong but they do know that all their models are broken. And that includes their interest rate models because, when you look at all their forecasts which are based on their models, they’ve all been wrong. So they recognize their models are broken. So that’s a good start.
The second major thing that we’re saying is they got the interest rate thing backwards. They haven’t gotten anywhere near as close to seeing that our way —at least in public— as they have on the fiscal side. They’re no longer worried about default but they’re worried about inflation. And of course, the reason they worry about inflation is because it’ll cause the central banks to raise rates to fight it, which is backwards. So now it’s in their best interest to be able to do the counter cyclical spending without concern that central banks are going to raise rates because that’s only going to make matters worse.
Once they know it’s in their best interest to leave interest rates at zero they should just leave them there forever, which is what we’ve been saying for 35 years now and Japan has proven for 30 years.
Once they know it’s in their best interest to leave interest rates at zero they should just leave them there forever.
SM: There’s also a twisted logic in thinking that by raising interest rates and causing the economy to slow down, they’re actually decreasing capacity and increasing productivity. They’re actually making things worse by slowing down the economy.
WM: Let’s look at their thinking. Remember the situation with Greece. They were not right about the Greeks being lazy and not wanting to work. It was shown that Greeks actually work harder than anybody else. But let’s just concede that they were right. So here you have a population that’s lazy and doesn’t want to work. How do you punish them? Well, you impose austerity and put them out of work. What sense does that make? So even on their own terms, which are completely wrong, their whole internal logic has always been completely flawed since the beginning. But it’s always worked politically and only things that work politically actually happen. If it doesn’t work politically it doesn’t happen.
Unfortunately they’re not anywhere near as close to the idea that they’ve got the rate thing backwards.
[1] CAMELS is an international rating system used by regulatory banking authorities to rate financial institutions, according to the six factors represented by its acronym. The CAMELS acronym stands for “Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity.”
Rendez-vous in Majorca: a conversation with Warren Mosler. Part 2/3
