Senior Chinese finance official: Modern Monetary Theory exacerbates inequality

SAFE deputy head LU Lei on MMT

Reflecting the wide interest of your Pekingnologist and the dire need to bring more quality China content to the English-language part of the world, this is a newsletter that covers a lot of subjects. Today, it is a translation of an article about MMT, or Modern Monetary Theory.

It was published in the beginning of 2022 on 中国金融 China Finance, a bi-weekly magazine under the People’s Bank of China, China’s central bank. The author is 陆磊 LU Lei, Deputy Administrator of the State Administration of Foreign Exchange (SAFE) since June 2017. Prior to that, Lu served as the head of the Financial Stability Bureau (August 2016 to June 2017) and head of the Research Bureau (March 2014 to August 2016) of the central bank.

There have been numerous discussions on MMT in the English-language press in the recent several years, and it appears to your Pekingnologist that there haven’t been many Chinese voices, so the view from a current senior financial official in the second-largest economy should be a contribution.

What’s also interesting is that Lu apparently believes MMT - or at least the essence of it - has already been incorporated in the policies of the United States and Japan, despite MMT being more often described as “a niche theory endorsed by only a small but vocal group of far-left economists” and shunned by “mainstream but left-leaning economists” such as Lawrence Summers and Paul Krugman, who dismissed it as “just obviously indefensible”.

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《发达经济体现代货币理论实践及分配效应》

The Practice and Effects on Distribution of Modern Monetary Theory in Developed Economies

Since the 18th National Congress of the Communist Party of China, the Central Committee of the CPC has given greater importance to gradually achieving common prosperity in view of the new changes in China’s development stage. Looking abroad, the world’s leading developed economies, represented by Japan and the United States, have adopted a “dual expansion” policy that combines loose monetary policy and expansionary fiscal policy in recent years. Indeed, the combination has restrained a rapid economic downturn but has also had a significant effect on distribution.

The widening gap between the rich and the poor has ignited extensive discussions. That Modern Monetary Theory (MMT) and Capital in the Twenty-First Century have attracted great attention shows that theories actually mirror the reality on the ground. The practice in major developed economies demonstrates that the redistributive effects of changes in the price structure should be considered.

The reintroduction of MMT is due to mainstream theory's failure to explain current economic and financial phenomenon

Since the 1990s, post-Keynesian economists have developed the traditional state theory of money and put forward the concept of MMT. MMT has long been an obscure, niche theory, but after the 2008 global financial crisis, it became a hot topic discussed by people from many circles in developed economies, mainly attributable to the two following reasons.

First, the mainstream theory is incapable of explaining the current economic phenomenon of “easy money and low interest rate”. Reflections on the Great Depression fueled the rise of the Keynesian school in the 1930s, and government intervention in the economy through monetary and fiscal policy became the mainstream.

In the 1970s, the stagflation in major economies put the Keynesian policies in a dilemma over inflation and unemployment. The monetarist theory argued that the government should refrain from intervening, emphasizing that fluctuations in money supply were the fundamental cause of price changes. Since the global financial crisis in 2008, major developed economies have adopted ultra-loose monetary policies and expansionary fiscal policies, with rising government debts and persistently low interest rates. The stubborn phenomenon of “easy monetary policy, low interest rates, and low inflation” makes an explanation by the mainstream theory difficult.

Second, MMT to some extent explains the facts such as rising government debt and low inflation in developed economies. One of MMT’s pillars is functional finance, which attempts to achieve full employment without inflation. As an extension of Keynesian ideas in the monetary realm, MMT proposes that the central bank should support expansionary fiscal policy through monetary policy, allowing the government to have a more flexible fiscal policy without being constrained by institutional fiscal limitations.

[MMT argues that] To address economic woes and achieve full employment, central banks can inject liquidity into the market by purchasing government bonds and at the same time reduce the costs of government debt financing to increase the government’s solvency. [MMT argues that] At the level of fiscal spending that achieves full employment, rising government debt and liquidity expansion will not trigger hyperinflation. From a theoretical standpoint, a low-interest rate influences employment and factors of production, helps increasing the proportion of primary distribution in the distribution of national income, and expansionary fiscal policies obviously have effects on redistribution.

The world’s major central banks' practice of MMT enables a transfer of debts from the private sector to the government sector.

The Bank of Japan implemented quantitative easing (QE) for the first time in the world, boosting the development of MMT by putting it into practice. Since the 1990s, the Japanese economy, from the burst of the asset bubble, began to descend into a long-term economic stagnation, and the Japanese policy rate approached the lower bound of zero from 1991 to 1999. Low-interest rates did not revitalize Japan’s economic growth. In March 2001, the Bank of Japan decided to implement QE when the interest rate approached zero. The Bank of Japan’s balance sheet expanded by 50 percent when it quited QE in the second quarter of 2006. 

Japan further put MMT into practice after the 2008 international financial crisis. At the end of 2008, the Bank of Japan launched the second round of QE, expanding the yearly purchase of government bonds from 14.4 trillion yen to 16.8 trillion yen, and including a wider range of bonds such as 30-year bonds and floating-rate bonds into its purchases.

In the QE3 since 2013, there was an obvious trend of simultaneous growth in the Bank of Japan’s total assets and the purchase of government bonds. The central bank’s balance sheet soared from 157.9 trillion yen in early 2013 to 573.1 trillion yen by the end of 2019, an increase of 2.7 times. Since the outbreak of COVID-19, the size of government bonds held by the Bank of Japan further swelled. As of November 30, 2021, the Bank of Japan held 529.5 trillion yen in government bonds, accounting for 73 percent of its total assets and about half of the total outstanding government bonds.

Following the global financial crisis in 2008 which stimulated heated discussion on MMT, the Federal Reserve initiated putting the MMT into practice. Since the Federal Reserve launched its QE in 2008, it has not only supported the expansion of government debt financing demand but also kept inflation at a low level. The rising debts did not lead to the “economic collapse” that some economists were worried about. Some U.S. politicians became proponents of MMT, further promoting the practice of the MMT.

In response to the impact of the COVID-19 pandemic, the Federal Reserve increased its purchase of government bonds on a large scale, pushing its balance sheet expansion to an unprecedented level. As of December 1, 2021, the size of the Fed’s balance sheet hit an all-time high of 8.6 trillion U.S. dollars, which includes 5.6 trillion U.S. dollars in Treasuries, accounting for 65 percent of the total assets.

The European Central Bank also put into practice the MMT after the European debt crisis. The Eurozone began accelerated QE in 2014 across the board, and the balance sheet size of the European Central Bank rose from 2 trillion euros in September 2014 to 4.7 trillion euros in early 2019. Following the outbreak of COVID-19 in Europe in 2020, QE in the Eurozone picked up again. By November 2021, the balance sheet of the European Central Bank reached 8.4 trillion euros, up by 79 percent from the end of 2019.

Monetary policy in developed economies increases global inequality in  distribution through the price structure

Global wealth inequality hit new highs in recent years. According to the World Inequality Report 2022 released by the World Inequality Lab on December 7, 2021, about 2,750 billionaires control 3.5 percent of the world’s wealth, which is far higher than 1995 - just one percent in that year. The quickest growth rate happened after the outbreak of COVID-19. Inequality is caused by a host of reasons, and economic policies, including monetary policy, are important reasons.

Although the “dual expansion” of monetary and fiscal policies of developed economies have prevented economic collapse and worsening crises, they have brought in the rapid increase of financial asset prices and commodity prices. The difference between PPI and CPI has widened significantly. Changes in relative prices in the price structure have had significant effects on distribution for people at different stratas of society, exacerbating inequality. Specifically, there are three aspects:

First, rising financial asset prices brought more to the rich. Stimulated by unlimited QE, the three major indexes of the U.S. stock market have repeatedly hit record highs. After Federal Reserve Chairman Jerome Powell announced the plan to reduce the balance sheet in early November 2021, the U.S. stock market did not retract significantly but instead hit a new high for the year. Financial assets such as stocks account for a larger proportion of wealthy families’ assets, who are more dependent on income from capital. Rising financial asset price benefitted the rich more.

Second, the rapid rise of PPI is good news for upstream business oligarchs. In the meantime, a higher growth rate of PPI, compared to the CPI, further reduces the profitability of small and medium-sized enterprises (SMEs). Due to factors such as the pandemic and energy shortages, the prices of some commodities have been increasing.

According to the IMF Primary Commodity Prices, since May 2020, international commodity prices have risen by over 70 percent, with simultaneous increases for metals, food, and energy products. The U.S. Commodity Research Bureau Index grew by as high as 64.8 percent from the low point at the end of April 2020 to early November 2021, and it has remained high recently. Commodity prices pushed up the PPI as a whole. In October 2021, the PPI in the United States increased by 22.2 percent year-on-year, and the PPI in the Eurozone in October 2021 rose by 21.9 percent year-on-year. The profits generated by the rising prices of commodities such as raw materials are mostly reaped by the upstream oligarchs that control the resources. In comparison, SMEs have to bear the rising production costs. Moreover, the difference between PPI and CPI does not result in a simultaneous increase in the income of SMEs, so their profit was being eroded.

Third, the real income of residents decreases when the CPI continues to climb. Inflationary pressures were significant in major developed economies in 2021. The CPI in the United States increased by 6.2 percent year-on-year in October 2021, reaching a new high since November 1990. Germany’s CPI in November 2021 rose by 5.2 percent year-on-year, hitting a new high since 1992.

Inflation in the world’s major countries will peak at 5 percent, according to the OECD Economic Outlook released on December 1, 2021, before gradually falling to approximately 3 percent in 2023. High inflation raises the living cost of the general public and diminishes real purchasing power. Because nominal wage adjustment generally lags behind that of prices, high inflation has a greater impact on the lower-middle-income groups, who mainly rely on wages as income. According to the findings of a study released in late October 2021 by the Peterson Institute for International Economics, inflated-adjusted compensation - nominal compensation, wages and benefits - in the US was 0.6 percent lower than it was in December 2019.

Issac Newton wrote the Mathematical Principles of Natural Philosophy in 1687, in which the second, fifth, and seventh chapters of the second volume concern the law of viscosity of fluids, which was converted into differential equation by Daniel Bernoulli and Leonhard Euler in 1738. In 1822 and 1845, Claude-Louis Navier and George Gabriel Stokes put forward the nonlinear equations of “convective form” and “pressure gradient” at the molecular level. That could be an inspiration for us: the impact of monetary policy on various sectors is inconsistent, and there is a mutual viscous force between sectors.

This could help explain the relative movement of “monetary policy - reflection on asset prices - commodity market - PPI - CPI”. The monetary system on the gold standard can be understood as classical fluid mechanics. Contemporary monetary policy may need to be understood from the standpoint of turbulence theory.

The Sixth Plenary Session of the 19th CPC Central Committee emphasized deepening reform and opening up across the board and promoting common prosperity. Financial support for common prosperity is multi-dimensional, and inclusive finance, digitization, and differentiated reserve requirements are good practices. Essentially, the lessons from various countries indicate that the impact on income and wealth effect by monetary policy via “asset prices - commodity prices - consumer prices” must not be overlooked. Given the combined impacts of the changes unseen in a century and the pandemic, how to optimize distribution is a major theoretical and practical issue the world has to face. There is also room for further optimizing economic policies such as monetary and fiscal policies.

(This article is based on the keynote speech delivered by the author Lu Lei at the 2021中国金融学会学术年会 “2021 Annual Conference of China Society for Finance & Banking” held on December 11, 2021)

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