2-Two Sources of Monetary Injections
As a brief recap of the previous post, Part 1 of a talk on Policy Implications of MMT for Pakistan, we note the key accounting identity that Business Profits + Household Savings = Government Injections (Deficits) + Foreign Injections. If firms are motivated by profits, and households seek to save, the only way for both to achieve their goals is if money is injected into the economy from the outside. If the quantity of money does not change, then firms can make profits only if consumers dis-save, and consumers can build savings only if the firms make losses. An export led strategy can sometime work, but only at expense of other countries, so MMT seeks to neutralize trade balance via floating exchange rates, and concentrate on deficits as the source of monetary injections required for profits and savings. This is further elaborated below:
Floating Exchange Rates
Foreign trade can be a source of money injections, which stimulate the economy, or of leakages caused by excess of imports over exports. Leakage of money to foreigners reduces domestic money, and depresses the local economy by reducing profits and savings. A key MMT strategy is Floating Exchange Rates, which insulate the economy from foreign shocks and actually keep the trade balanced: the exchange rate adjusts to balance supply and demand for exports and imports. This is required in order to have domestic control of money supply or sovereign money; see “The Trilemma of Monetary Policy” for more details.
Generally speaking, MMT based policies STIMULATE aggregate demand by creation of sovereign money. However, if foreign exchange is under-valued, the aggregate demand will leak into demand for imports, rendering policies ineffective. Furthermore, additional import demand would worsen BOP and can lead to foreign exchange crises. A counter-strategy, especially useful in the Pakistani context, is to use OVERVALUATION of dollars. And UNDERVALUATION of PK Rupees. To do this, SBP should buy $5 when public buys USD 100. This will bump up the value of dollars somewhat above the equilibrium. This creates a transparent tax on imports, in DOLLARS. In such a situation, excess demand for imports will STRENGTHEN Balance of Payments instead of worsening it.
Benefits of Overvalued Dollars, and Undervalued Rupees
In the Pakistani context, we have maintained an overvalued Rupee, and an undervalued dollar for decades. Why this is so, and how harmful this has been for our economy is discussed in posts on “Rupee Over-Valuation” as well as “Burning Billions“ and “Fear of Floating“. Here we provide a very brief re-cap of main points, because Pakistani economy is currently experiencing the effects of a structural change from a Rupee Over-Valuation regime to a freely floating exchange rate regime.
Maintaining undervaluation of dollars leads to creation of industries which are profitable only because imports are available at cheap prices. Such industries are negative value-added industries, which can run only because undervaluation provides implicit subsidies to such import-based industries. Correction of exchange rates, like the recent correction from PKR 110/USD to PKR !60/USD will lead to the collapse of these industries. This will be a Short Term Disaster: A whole category of industries based on CHEAP dollar imports must actually be DESTROYED. This will lead to job loss, infrastructure becoming worthless, and suffering for public and business. However, huge Long Term Benefits can be expected from a policy of correct valuation of the exchange rate. The most important of these would be the creation of a VIABLE import substitution industry, which is ALWAYS the first step on the path to industrialization. Import substitution cannot be done when imports are artificially cheap. In the case of Pakistan, dollars were so cheap that it was profitable to import oilseeds from Brazil and Malaysia, instead of growing our own sunflowers. Whereas overvaluation of PKR causes great harm to the economy, a policy of slight undervaluation of Rupees (and corresponding overvaluation of dollars) brings great benefits. It is a cheap form of industrial policy which protects our domestic industries from foreign competition, allowing them to learn and grow, to compete in the international markets.
Our main concern here is not with trade policy, but rather with an MMT-based strategy for Macroeconomic policy. The key relevant insight from MMT is that Fiscal Deficits do NOT create BOP threats, as long as they are in DOMESTIC currency, and the exchange rate is either floating or has undervaluation for the domestic currency. In the video-talk (linked later) I said that currently vast percentage of government debt is in PKR, very small % in USD. In fact, SBP experts, informed me that foreign debt is now about 33% of the total, which is rather high. This does require some attention to manage properly, but measures to do so are not within the scope of the present talk on MMT-based policies. As a parenthetical note on current High interest rate environment, it is worth noting a few points which are not well understood. High interest rates are a source of TRANSFERS to financial sector from real sector. This creates a problem in terms of mis-directing investment from the real sector to the financial sector, an issue we will discuss later. Contrary to common impression, high interest is NOT a BUDGETARY problem. One of the key assertions of MMT is that government budget constraints are SOFT, and not hard like those of households and firms. However, this topic cannot be discussed in detail in the present talk.
Role of DEFICITS: Injections of Money
With this much as background, we can now discuss some of the main ideas of MMT. The standard picture of the economy, widely believed and basis for current economic policies, is that the Government gathers taxes, borrows, and raises revenues from other sources, in order to spend. That is, the government faces a budget constraint, just like ordinary private households and firms. MMT strongly disputes this view. According to MMT, Government SPENDING creates money, creates business profits and creates consumer saving. Assuming trade balance or trade deficit (as in Pakistan), government deficits is equal to business profits plus consumer savings plus trade deficits. That is, government MUST do deficit spending to create profits and savings. It is these profits and savings which create the surplus that CAN be taxed. Instead of needing taxes to finance spending, the government must spend in order to create the money which firms and people need, in order to pay taxes.
Especially in Pakistan, with trade deficit, Government MUST run LARGE deficits (over and above the trade deficit) to create prosperity (meaning business profits and household savings)! This is contrary to standard prescriptions of balancing budgets, and IMF prescriptions of austerity, which recommend reduction of deficits as the path to prosperity. Next, we will look at HOW the government should run deficits – not all deficits are created equal. Some ways of running deficits can lead to disaster instead of prosperity.
TO BE CONTINUED in Part 3
POSTSCRIPT: A previous introductory talk on MMT was given on 2 May 2019 at the School of Economics, Quaide Azam Univ. Talk is about Key concepts of MMT; Lecture explains how deficits, taxes, inflation, unemployment – major macro concepts — do not operate as described in standard macro theories.