Modern Monetary Theory (MMT) has moved front and center in the discussion over macroeconomic policy.  With a boost from Alexandria Ocasio-Cortez and Bernie Sanders, MMT is shifting the discussion from prevention of inflation through worker unemployment and balancing the federal budget by cutting social programs to tackling problems like climate change.  Not surprisingly, economists like Larry Summers, Ken Rogoff and Paul Krugman, who face being rendered irrelevant, are fighting back and trying to discredit MMT.  Their arguments against MMT highlight why they have trouble discrediting MMT.  MMT looks at how governments actually fund their spending and contrast this with the assumptions in the mainstream’s macroeconomic models.  The defenders are left arguing trust our models which missed the Great Financial Crisis rather than the facts.

Unfortunately, when it comes to preventing and ending financial crises, the leading MMT advocates don’t apply the same analytical rigor as they do when looking at how a government funds its spending.  This is disappointing as it results in a set of policy recommendations that are no better than what the mainstream economists have produced.

The MMT policy recommendations all take the form of more regulation with the need for strict regulatory enforcement.  The recommendations are made despite enormous amounts of evidence that relying on strict regulatory enforcement doesn’t work.  (The Nyberg Report on the Irish Financial Crisis highlights why financial regulators are not up to the task of strictly enforcing regulations and preventing a financial crisis.)

Warren Mosler, who the Huffington Post describes as a Founder of MMT, wrote up the MMT recommendations.  Before discussing the recommendations, he observed

The hard lesson of banking history is that the liability side of banking is not the place for market discipline. Therefore, with banks funded without limit by government insured deposits and loans from the central bank, discipline is entirely on the asset side. This includes being limited to assets deemed ‘legal’ by the regulators and minimum capital requirements also set by the regulators.

There are several problems with this observation.  First, market discipline doesn’t exist on the asset side.  How exactly does the purchase of a Treasury security or the making of a loan exert pressure on bankers not to take too much risk?  It doesn’t.

Second, the US Savings & Loans showed financial institutions can go bust while adhering to regulatory requirements for both assets owned and minimum capital requirements.  Is there any reason to think bank regulators will do a better job of assessing credit risk for each individual exposure and in the aggregate than bankers?  No.

Third and most importantly, the investors in a bank’s unsecured debt and equity have an incentive (the risk of losing their investment) to exert market discipline and restrain risk taking.  How come market discipline didn’t work in the run-up to the Great Financial Crisis?  Regular readers know the opacity of the banks prevented investors from being able to assess the risk of each bank.  This prevented investors from exerting market discipline on both bank management and the financial regulators.

MMT advocates appear to have never asked why market discipline never worked.  They accept the work of Bill Black as the definitive answer on the subject.  I like his idea of accounting control fraud (bank managers have the bank take on risk in an effort to drive up the price of the stock and the value they recognize on their options in the short run, only for the bank to fail later).

However, Professor Black misses opacity is the necessary ingredient for making accounting control fraud possible.  If investors can see a bank taking on greater risk, they don’t bid up its stock.  Investors understand with greater risk they need to be compensated with a higher level of return.  As a result, as risk at a bank increases, investors decrease their exposure to the bank.  Decreasing exposure means selling and selling drives down the bank’s stock price.  This takes away the incentive from engaging in accounting control fraud in the first place.

Not only does transparency effectively prevent accounting control fraud, it is the necessary ingredient for market discipline to work.  It is only when investors have the information they need to know what they own that they can adjust their exposure by purchases and sale of an investment to reflect changes in its risk level and exert discipline based on management’s actions.

Mr. Mosler’s first recommendation reflects not understanding the role transparency plays in the financial system.

Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets.

While I fully appreciate the damage caused by the opaque structured finance securities sold in the run-up to the Great Financial Crisis, this solution ignores a host of issues.

First,  capital requirements cap the total amount of loans an individual bank can originate.  For example, let’s have a simple requirement that sets the maximum loan to equity ratio at 10:1.  Once a bank has reached its balance sheet capacity of 10 times its equity for holding loans, it cannot make the next loan regardless of how low risk it might be.  Is this good for the borrower, the bank or the economy?

Second, why are we trapping the risk of the loans on the bank balance sheets where governments and hence taxpayers are guaranteeing deposits?  If a loan goes south, wouldn’t we prefer it was owned by investors?  Taken to the extreme of trying to minimize the risk taking by a bank, isn’t there a good case to be made we prefer banks hold no loans at all and instead sell all of them to investors?

Third, does this actually eliminate bad incentives for the bankers?  Bill Black’s accounting control fraud suggests bank management will find a way around the regulations.  If the regulators didn’t see the deterioration in bank balance sheets in the run-up to the acute phase of the Great Financial Crisis is in 2008, why are the regulators suddenly going to see the deterioration now?

At this point, I hope I have conveyed MMT’s current recommendations for reforming the banking system still have too much reliance on the regulators and not enough focus on how the global financial system is actually designed to work.

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Before I end what is an already overly long post, I do want to give Mr. Mosler and the MMT advocates credit for understanding the existence of deposit insurance meant the taxpayers become an insolvent bank’s silent equity partner.

Once a bank incurs losses in excess of its private capital, further losses are covered by the FDIC, an arm of the US government.

This has important implications.  It lets the Fed lend to an insolvent bank because the taxpayers insure the Fed will be repaid.  It lets an insolvent bank continue in operation indefinitely until the FDIC chooses to close it.  It lets banks protect the real economy by absorbing losses on excess debt.