Zhi: A Critique of Modern Money Theory and the Disequilibrium Dynamics of Banking and Government Finance

by Dirk Ehnts, Econoblog101

Such is the title of Tianhao Zhi’s recent paper.

Zhi sums up MMT like this:

A quick read seems to show that Zhi is mostly fair to MMT. There are the usual claims about MMT as a theory would ignore the inflationary effects of government spending, but the claim is repeated once again without a source. Wray (2012) in his MMT Primer writes on page 194:

“Lerner realized that this does not mean that government should spend as if “sky is the limit” – runaway spending would be inflationary (and, as discussed earlier, it does not presume that government spending won’t affect the exchange rate).”

The book by Wray has the word “inflation” in the index, and it comes up 27 times. If I am not mistaken, there is no text passage that says that the inflationary effects of government should be ignored.

The second section of the paper discuss the “loans create deposits”-story, which has recently been backed up by the Bank of England. The third section deals with the central bank setting the interest rate by varying the amount of reserves, which is only one possibility, by the way (the other being arbitrage by banks themselves that guides them towards the target interest rate). It is assumed that the central bank is exchange rate targeting, which something that MMT explicitly does not assume.

Section four is on “crowding in” of government spending, that is, the the fall in the interest rate that would normally occur with an increase in government spending. That it does not happen in the real world is understood by MMT authors, since central banks are able to set (most often short-term) interest rates. Zhi assumes here that having more reserves, the banks can extend more credit. This rests on the reserve requirements fallacy which assumes that banks need reserves before they extend loans. In reality, banks need them afterwards and can get them from various sources. Since the author is from China, where reserve requirements are used as a policy tool, I can understand that it might sound crazy that reserve requirements do not have any effect on lending. However, most economists – both MMT and non-MMT – agree that there is no effect (see this book).

Section 5 is a scenario which applies the money multiplier denied by MMT to a purchase of a bond by government and hence comes to alternative conclusions which are based solely on the existence of a money multiplier and the idea that banks need reserves to make loans. Section 6 builds on the same framework and concludes that government should spend until inflation increases. This is something many MMT authors would probably not reject as a practical policy.

In his conclusion, Zhi says #1 that government deficits can lead to more demand for reserves if the fall of the interest rate triggers loan creation. This is not refuting MMT in any way, I assume most MMT authors would be in agreement. #2 will lead to disagreement, since for Zhi only fiscal deficits have a long-run influence on growth (that one is interesting!) and inflation. #3 is once again not a refutation, since Zhi want government spending to increase to the point of inflation (using marginal terminology). I guess that #1 and #3 would find him in agreement – more or less – with MMT, so only #2 would be an original point of disagreement.

Since the paper is well-written, I hope that it triggers some more debate on the claims of MMT.