The Joe Walker Podcast - The Rise And Fall Of Monetary Policy - Ian Macfarlane

Episode Date: October 4, 2020

Ian Macfarlane was Governor of the Reserve Bank of Australia from 1996 to 2006.Show notesSelected links •Follow Ian: Website •The Deficit Myth, by Stephanie Kelton •Macroeconomics, by William Mitchell, L. Randall Ray and Martin Watts •'Indebted Demand', paper by Atif Mian, Ludwig Straub and Amir SufiTopics discussed •Monetary policy. 4:44 •Modern Monetary Theory. 42:07 •Secular Stagnation and Indebted Demand. 1:11:10See omnystudio.com/listener for privacy information.

Ladies and gentlemen, welcome back to the show. This episode of the podcast is brought to you by none other than the Dollar Shave Club. There's nothing worse than waking up in the morning, stepping into your bathroom, opening up the cabinet, picking up your razor, and then realizing that it's blunt and rusty. The Dollar Shave Club is designed to solve the problem of poor quality shaving equipment and expensive shaving equipment because let's face it when you do need to eventually go and make that trip to the shop specifically to pick up the razor those things are bloody expensive. What the Door Shave Club does is send you out a shaving

box on a periodic basis. Here's how it works you sign up for their starter set which includes a weighty executive handle, 4 six blade cartridges and a tube of their shaved butter. The blades are the best I've ever used. They are luxurious. You will look forward to shaving. Then you tell the Dollar Shave Club how often you want regular shipments, whether that's every month or three times a year. There aren't any long term commitments so you can cancel your membership at any time. So here is the deal. For a limited time, listeners of this podcast, i.e. Swagmen and

Swaggets, who join the Dollar Shave Club will get the starter set for just $15 and $10 off your second order. And on top of that, the Dollar Shave Club will throw in a free tube of minty fresh, superba fluoride toothpaste. So to get your starter set for just $15 and $10 off your second order and a free tube of minty fresh, superba fluoride toothpaste, which is great, go to the dollar... Sorry, let me start that again. Go to dollarshaveclub.com slash swagman. That's dollarshaveclub.com slash swagman. That's dollarshaveclub.com slash swagman.

You're listening to the Jolly Swagman Podcast. Here's your host, Joe Walker. Ladies and gentlemen, boys and girls, swagmen and swagettes, welcome back to the show. It is great to have you here. Before I introduce the guest for this episode, a couple of housekeeping items. Firstly, I realize the length of ad reads at the beginning of the show isn't consistent between episodes and many listeners would like that to be consistent. I certainly hear you on that. We're locking in a couple more sponsorship arrangements.

And once that is done, we'll be in a position to make sure the ad reads are more consistent. Secondly, we are releasing episodes on a weekly basis every Monday morning at 6.30am Australian Eastern Standard Time. Sometimes I'll release content more regularly if it's too important to hold back for the regular Monday morning slot. But when I do, I'll do my best not to overwhelm you with long-form podcast content. If you're new to the show, make sure you subscribe or follow, depending on the app you use, in order to get updated when new episodes are released so that you don't miss them.

Thirdly and finally, our listener survey for 2020 is now out and available on my website, josephnoelwalker.com. I'd really appreciate you taking the time to complete the survey. Based on what people have been doing so far, it seems to take about five minutes to complete. Your feedback is very, very valuable to me. This is a special episode. I had the opportunity to catch up with Ian McFarlane again at his place in Sydney. Ian was Governor of the Reserve Bank of Australia from 1996 to 2006. For a good introduction to Ian, his career and his time as Head of Australia's Central Bank, I recommend our conversation from

January, which is episode 83. In this conversation, you're going to get unique insight into an issue Ian has been thinking about for decades, an issue that was previously treated as axiomatic by many economists, but which may in fact now be false. That is, can central banks always set inflation rates through monetary policy? Ian's thoughts around this question coming from a former chief central banker, a pretty cutting edge, ladies and gentlemen, the sort of insight you'll only find here on the Jolly Swagman podcast. Ian and I also discussed two more recent topics, modern monetary theory or MMT and secular stagnation. You'll get to hear how a first-rate economic mind like Ian's processes more recent economic issues such as these in real time. So without much further ado, please enjoy this chat with the great Ian McFarlane. Ian McFarlane, welcome back to the show. Thanks. Great to have you back on the show. This conversation began about a month ago when you got in touch, you'd listened to my podcast with Russ Roberts,

where I mentioned that a lot of people contact me about modern monetary theory. And you said to get in touch if I ever decided to broach the topic. And I said, why don't we record another conversation? But inevitably, there are so many other things we wanted to discuss. So, we're going to talk not only about modern monetary theory, but also about monetary policy. And then finally, about something known as indebted demand, which might not be familiar to many of our listeners, but which we'll eventually explain. Last time we caught up, you explained the two great lessons that you'd learned

across your career in macroeconomics. The first was that the financial system had become the source of shocks, not the shock absorber. And the second was that macroeconomic forecasting was not so much difficult as impossible. But there was a third big lesson you learned during your career, and this is going to lead us into talking about monetary policy. And what was that lesson? Well, it was the fact that there are some very powerful slow-acting forces that we always tend to underestimate because their effect stretches across decades and

it's difficult to incorporate them into your normal work stream which is based around monthly board meetings or quarterly national accounts or even annual budgets. It's not as though we weren't aware of them, it's just we really didn't quite know how to take them into account. And the other observation really I have to confess is that I really have only become fully aware of it in retrospect, I think it's when you stand back and look back over the decades and reflect that you realise how powerful these things were and how you tended to underestimate them. Yeah. So maybe before we jump into specifically what broader historic forces have impacted inflation, we should talk about a few basic concepts around inflation to make sure

everyone's on the same page. So firstly, what is inflation and how do we measure it? Well, inflation is the rate of increase in prices, and it's measured by surveys, the most famous of which is, of course, the Consumer Price Index. It's goods and services prices. It's not share prices or house prices. It's goods and services prices, the things you use every day. Yeah. Are there any problems with how we measure inflation? Well, yes, there is. There's problems with how you measure anything. And I don't really want to go into them all now, but I actually think that the CPI is one of the more reliable economic statistics.

You can find fault with it, but it's far more reliable than most economic statistics. I think the thing you're alluding to is it's difficult to take into account quality changes when you measure the price. What's the price? What happened to the price of a laptop, which is 2,000 times more powerful than it was 15 years ago? There were little issues like that.

Right. But I don't think they're a big issue. I think the public accept that inflation can be measured by a CPI, and it's only the purists who want to argue about the little decimal points. So Milton Friedman's famous phrase was that inflation is always and everywhere a monetary phenomenon. What did he mean by that, and what's the standard sort of theory of inflation when it comes to monetary policy?

Well, this is one of the things which is rather central to what I'm going to be talking about. That statement, inflation is always and everywhere a monetary phenomenon, that's probably the only statement that a lot of people have ever heard of about monetary policy or inflation. Well, to put it bluntly, it's not true. It was based on... Whenly, it's not true. It's based on... When I say it's not true, it's true in the extreme.

It's very good at explaining why inflation went up after the Napoleonic Wars or why inflation went up in Spain after they discovered all this gold in South America. It's very good at explaining the extremes, but it's not all that good at explaining sort of what's happening in the here and now. And the basis of it was this thing called the quantity theory of money, which said essentially if money supply went up by X, then inflation would go up by X, some variation

on that. And that this relationship between money supply and inflation was what you should use to conduct monetary policy. Well, it turns out that that relationship is extremely loose, and it hasn't been used for a long time as a means of conducting monetary policy. So you're going to say, well, what have we replaced it with? Maybe before we get to that,

should we just take a long view of the story of inflation in the post-war era? Do you want the story of what's happened or do you want a story of how we try to explain it? Yeah, good point. Let's start with the story of what's happened. Righto. That's the interesting bit.

I think that is very interesting. And that brings us back to this idea that there are very powerful, slow-acting things that are happening and that can explain very major moves in economic variables. And if you want to look at inflation over the post-war period, it's not too great an oversimplification to say that there's really only been two phases. There was a period where inflation went up. Then there's a turning point, different for different countries, but the turning point

was either sort of mid-70s or early 80s. And since that time, inflation has been going down. Now, if we go back to monetary theories of inflation, to me it's hard to explain two such really long-run developments purely in terms of a monetary theory of inflation. Now, I'm not trying to say that... Certainly, I'll be the last person to say that monetary policy is unimportant in inflation.

Yes, it is important. And it was particularly important at that turning point. The most celebrated example of that was in the US where it's called the Volcker disinflation. So there's no doubt that even though no one uses the old quantity theory of money slash Milton Friedman approach anymore, monetary policy still is very important. And but the point that I'm going to make is that other things are also very important. And the best way of doing that is to look at the economic and institutional structure of economies during the period where inflation was going up.

And then look again at the factors that were at work during the period that inflation was going down. And this is a global phenomenon, so we should be looking for global causes. That's right. Exactly right. That's exactly right. I mean, each country, there's a different story for each country, but it follows the same general pattern. The timing's slightly different, but you can generalise, really, that this happened everywhere,

even in what are thought to be the low inflation countries like Germany or Switzerland or the high inflation countries like Italy or the UK. They've still got the same pattern of going up in the first phase and going down in the second phase. Well, in my childhood and teenage years, inflation was hardly increasing at all. Right.

Really, the real action occurred really from about mid-1960 through to the 70s. And that's the period that's interesting to look back on and say, what was so different about that period compared to now? And there's a whole series of things that were different, some of which would strike you as probably very surprising. Now, the first one was, obviously, it was a period of very strong economic growth

and the economy was actually overstretched. There wasn't any slack left in the economy. Secondly, there was very different wage-setting processes. There was centralised wage-setting, and there was also wide use of indexation, wage indexation. Have you ever come across that? No. Well, it was really strange. For example, in the 70s, there used to be quarterly wage indexation. Have you ever come across that? No. Well, it was really strange. For example,

in the 70s, there used to be quarterly wage indexation. So every quarter, the government or the arbitration commission, which was actually a court, would look at the CPI, how much it's gone up by, 2%, 3%, 4%. And then there will be a national wage case. And then they decide how much of that they would pass through into the national wage case. Mostly they pass the whole lot through. So inflation went up by 2%, everyone in the country's wage went up by 2%.

And as I said, it was a quasi-court, and I think they were called judges, and the unions used to present their case to these people, and the government presented its case. The government actually hired a QC to present the case. It was not an economist. It was a QC. It was the legal proceedings.

Anyhow, that's another characteristic of that period. A third one, which is very important, was high levels of trade protection through tariffs and quotas, and more importantly, little or no competition from developing countries. Different structure altogether. There was a strong trade union movement who were confident in pushing for wage increases that it wouldn't lead to unemployment. And then I think the other one that I think is important is business attitudes.

In those days, you could characterize business as having a cost plus approach. If a cost went up, so wages or an imported component, you just passed it through into the final price, confident that your competitors would do the same thing. That's what we now would call pricing power. And then I think the final thing I would have to say is very important, but very slow acting. By the time we got to the late 60s and definitely during the 70s, inflationary expectations

had really picked up. People just expected that inflation would be in double digits. So it was a different world, really, a very different world. In fact, the piece I gave you, I titled it Two Different Worlds. That was the world that we got to in the 70s. And, of course, it was... It sort of lost credibility altogether because we ended up with both double-digit inflation and nearly double-digit unemployment at the same time. Stagflation?

Yeah, stagflation, yeah. What's it like? What is double-digit inflation like on the ground? I mean, you buy a coffee for $4 and then the next year it's $4.40 and then it's $4.84. Yeah, it didn't feel that different. I mean, it wasn't hyperinflation. It's not like people with wheelbarrows full of banknotes

as you had in the Weimar period. But a lot of business decision-making and household decision-making was based on the idea that it was going to be this continuing inflation. Yeah. And it was one of the things that gave rise to the belief, well, you might as well take on more debt because the real value of that debt will dwindle over time. And you should buy assets

because they're probably going to go up with inflation. So it definitely affected expectations in that way. Yeah. And this is an obvious economic point, but just elucidate the connection between wage increases and inflation. Well, they're very closely related. People could argue, did the wage increase cause the price increase or did the price increase cause the wage increase? It's a chicken and the egg problem, but they're very closely related.

Yeah. So you listed about six different factors that caused inflation to rise and stay at a reasonably high level during that period. And it's probably impossible to precisely quantify each of those factors, but which of them do you think was the most important? Well, hang on, I haven't got, I've still got a step to go. Okay. I think that institutional framework gave you an economy which was very vulnerable to an inflationary shock. And the inflationary shock came along as a result of policy mistakes. There was a big expansion of fiscal policy in 1971 because the unemployment rate had gone up from 1.7% to 2.1%. But at the same time, the rate of inflation was 7%. So policymakers ignored that 7% inflation and just concentrated on trying to achieve, actually,

an impossibly low unemployment rate. And during that whole period, monetary policy also did play a role. Interest rates were suppressed. There were all sorts of restrictions that suppressed interest rates. So once inflation started to rise, we had a long period where real interest rates were negative. Interest rates were lower than the rate of inflation. So policy errors did also play a big role, and including monetary policy definitely. But monetary policy can work at all times. I don't

dispute that. It definitely can work at all times. Yeah. I don't dispute that. It definitely can work at all times. All I'm trying to say is other things also work. Yeah. And sometimes the other things can be stronger than the monetary policy impulse. Okay. So if some of those other things were underpinning inflation during that first period the first world as you call it what changed in terms of the broader historical forces in the second period when inflation began to trend

downwards yeah that's that's very interesting question um i would say um that virtually all those features I described disappeared. They were replaced. And then the other thing I'd say really is that in the latter period, in the long battle between capital and labour, capital started to win and labour started to lose. And I think of this as the collapse in the bargaining power of Labor. And the evidence for this is that in most countries, the Labor share of GDP has declined. Wage growth has been very modest. In fact, in the US, it's almost been nil for decades, in real terms. Trade union membership has declined.

And income inequality has increased. So it's a different world in that sense. Now you could say, well why has that happened? How did we switch from world one to world two? I'm going to mention three factors and I think the second and the third are the more important. I think the one that most people concentrate on is a lot of people say, oh, it was a political, intellectual change.

And there was. I mean, for a start, the one that influenced me and most of the economists I know was simply that the old system wasn't working. It didn't work. It delivered stagflation. We had to turn over a new leaf and do something different.

Secondly, I think a lot of people were heavily influenced by the intellectual efforts of two well-known figures Hayek and Friedman who had been saying throughout the 50s and 60s this is going to lead to inflation and so their credibility rose and the other factor that a lot of people

emphasised was the public reaction which led to the election of both the Thatcher and the Reagan governments so all those things were happening at that time but I would emphasize the fact the old system wasn't working was the main thing that caused things to turn around Now, there's two other factors which are actually even more important, because they continue to operate right through the last three decades. And they're familiar. I mean, everyone knows about them.

The first one is globalization. The rise of the developing countries, particularly China, flooded the world's markets with cheap manufactured goods. It wasn't just the final goods. There's all sorts of other people, other manufacturers around the world were able to take advantage of lower-cost supply chains. I think the biggest influence of globalisation was that for a lot of firms and for a lot of workers, the realisation that your job or your business wasn't safe where it

was, it could always be moved to a cheaper part of the world if the cost structure suggested that possibility. And so you're always aware that that could happen. And, of course, that robbed the businesses of pricing power completely. They had to sort of do everything they could to stay competitive, otherwise they could be moved. And it influenced Labor too. Obviously they knew they could be moved and it influenced labor too obviously they knew they could lose their jobs and so labor became more and more concerned with

maintaining his jobs rather than putting up it wages so I don't think that's at all controversial I think everyone understands that and it had to have an influence on inflation. And the second one, big structural change, which I think is more important now than globalisation, was labour-saving technical progress, where in manufacturing robots replace people, in the biggest part of the economy, which is the service sector. Whole layers of management just disappeared. State managers, regional managers, all sorts of middle management were no longer needed because a small number of people in headquarters could run everything because the communication system was so much better.

That also explains globalisation as well. Techn. That also explains globalization as well. Technological change allowed globalization as well. All the things we're familiar with now, you don't need... Call India are cheaper than having people here and they're cheaper than having branches. People can buy goods on the internet. They don't need salespeople. I don't really need to elaborate on that. I think everyone understands those.

Yeah. And so that's why I contrast it I think you heard my description of the first era and my description the second year and they are totally different hmm so now we come to today and for the last six years, inflation's been under 2%, when the central bank's target is for inflation to be 2 point something. In other words, between 2% and 3%. And yet that's despite extremely easy monetary policy. So what's going on? Yeah, well, that's really the centrepiece of the whole thing. I've really come to this

sort of view that I'm expressing at the moment only really in the last five years. Now, the fact that inflation is lower than the target is not a big deal. I mean, 1.6% is not all that different than 2.5% or 3%. It doesn't feel different to people. The thing that is different is that it's happened despite the easiest monetary policy ever. And it's happened in every country, by and large, despite the easiest monetary policy ever. So in Australia, we've got, you know, the cash rate's negligible.

It's 0.25%, lowest it's ever been. All the monetary aggregates, money base, M1, M3, broad money, any of those things are growing quite strongly. The banks are awash with cash. And the Reserve Bank is now buying bonds, buying three-year bonds. So this is a far, far easier stance on monetary policy than I have ever experienced, and yet inflation resolutely refuses to go up.

So to me, it should shake in the faith of anyone who thinks that inflation is basically a function of monetary policy. Something else is happening. They're the things I've described. But I think that central bankers and monetary economists have been reluctant to admit this. I think the default position of the world's central bankers and monetary economists is still a monetary theory of inflation. And so the default position is, oh, inflation is lower than it should be,

monetary policy must be too tight. And someone like me comes along and says, no, it's lower than it should be. Monetary policy must be too tight. And someone like me comes along and says, no, it's not. It's very, very easy for the reasons I've just listed. And they say, no, it must be. No, it's too tight. Well, how do you know it's too tight? It'd be inflation's too low. So to me, that becomes a tautology.

It's something that is, once you accept the assumption, you have to accept the conclusion. It's not an empirically verifiable or falsifiable position. But it's not a good tautology like evolution by natural selection. It's a bad tautology because it implies that inflation is wholly or mostly a result of monetary policy. Well, that's right. I think it is.

I think people have been reluctant to give up the monetary theory. They've varied it. It's a very different monetary theory of inflation now. It's not based on the quantity theory of money anymore. It's based on central banks' capacity to set the short-term interest rate. It's based on central bank independence. It's based on inflation target. It's based on people's inflationary expectations going down and staying down.

And it worked. It worked very well. It worked very well during my period. And it continued to work very well during my period. And it continued to work very well. It's really, I think, only in the last five or six years that you've got to come to the conclusion that there are other bigger things at work than an incorrect setting of monetary policy. Why do you think central banks have been reluctant

to let that idea go? Well, I think they want to be seen to be playing their part and helping because economies are also quite sluggish and growth is quite weak. So they want to be seen to be helping. And I think it would be very difficult if you were a governor of a central bank to say look I've done everything I can

monetary policy has gone as far as it can go can't go any further I'll just sit here drawing my salary but you're on your own I think the feeling is you have to be in there doing your bit

even if you yourself privately think that monetary policy has already gone to the extreme and there's nothing more you can do. You have to be seen to be doing something, would be my guess. Very similar to going to a doctor with a problem and the doctor feels compelled to give you a prescription. There's sort of a bias towards action, isn't there?

Reminds me as well of that old Keynes quote that worldly wisdom teaches that it's better to fail conventionally than to succeed unconventionally. It'd be very hard to take a contrary position. It would be very, very hard. I mean, I've been disappointed with the recent cuts in interest rates, really all of them since about 2015. I thought, well, you didn't need to do that.

But then I don't think there's any way my successors could have stood there and said to the world, we're not going to do that. We're going to do it our way. You couldn't. You know what it reminds me of slightly is the sometimes people can, very rarely, in the COVID pandemic, the Swedes have actually stuck to a different line and under intense pressure.

But the equivalent, I don't think you could do, you couldn't do the equivalent with monetary policy. And one of the reasons you couldn't do the equivalent is if you still had those interest rates, which you thought in the medium term made sense, you'd be inundated with money and your exchange rate would go through the roof. So in a sense, you're forced to move with the majority,

particularly with the US. It's a collective action problem. Right, a collective action problem. Yeah. So cutting rates has been folly in the last few years? Well, the jury's out. The jury's out on that. It's one of those things, it's a bit like the Swedish guy saying

the jury's out for another two or three years. I think the jury's out on monetary policy for another decade or more because there are very big costs to having almost zero interest rates. I mean, the whole retirement incomes industry, all the pension funds and superannuation funds, including a lot of insurance companies and businesses like that, really don't quite know how to operate with interest rates that are negligible because they've never had to do it before.

So the jury is really out on that. Yeah. But certainly you seem to think that it's not advisable to be in this position i suppose i yeah i suppose i i uh i think that the latest round of cutting interest rates and quantitative easing and what have you um i don't myself think they've done any good. Although, as I said, once the majority do it, you really have no choice but to be part of that majority. Yeah.

And if we accept your two worlds thesis, and as a consequence we also accept that monetary policy doesn't have as strong of an influence over inflation as was conventionally thought, then, in a sense, central bankers who are continuing to try to push rates down are kind of like the Japanese generals who kept fighting in the wilderness after World War II was officially declared over. It's your words, Joe, not mine.

No, I think what it's done, though, what it's done is it's brought fiscal policy back onto the centre stage. And I think that's legitimate. I think we tend to put far too much weight on monetary policy and not enough on fiscal policy. And I think really on average in that post-GFC period, in a number of countries, I think they were probably more restrictive on fiscal policy than they should have been and believed that somehow or other by being very,

very expansionary on monetary policy, everything would work out. And now people of impeccable economic credentials have been, over the last two or three years, some of them have been saying, well, we ought to put more weight on fiscal policy. If we think the economy is... If inflation is too low, the economies are too sluggish. People have been talking about things like secular stagnation, which is an old idea which has been revived by Larry Summers, which is a way of saying that there's a tendency...

There's something in the system that means that private demand is not as strong as it should be. Others have come forward from a different perspective and they've come forward from the perspective that monetary policy, like me, would say that monetary policy has just lost all its... It hasn't lost all its power. It's used up all its power.

It is expansionary, but there isn't any more room. And if something needs to be done, then there's a role for fiscal policy. Now, two of the people who I was alluding to were Stanley Fisher, who's probably the doyenne of macroeconomists in the world, very nice man, who's done just about everything you can do in economics. And another one is Adair Turner, the English policymaker and advisor. And they have stepped out and said, yes, use fiscal policy rather than just monetary policy.

And they've also gone a little step further, and this is what we're going to talk about as we go ahead. They've said use unfunded fiscal policy. Now, unfunded fiscal policy means where the spending initially comes from the central bank rather than by borrowing from the public. Now, we're going to keep coming back to this. And it's got various names, and the most common is the very pejorative name of printing money. Now, it doesn't involve the printing press,

and it doesn't involve banknotes, but it is equivalent in a way to that. And so that idea has started to rise in public discussion. Anyhow, before we go on to say any more about that, the other thing that we've got to get out of the way is there's another big actor on the scene, and that's COVID-19. Yeah.

And everything I've said to date is pre-covid 19 but covid comes along and number one it uh means because of the social distancing and the lockdowns that have been associated with uh the with the disease uhies have contracted very sharply and we're all in the situation of a big budget deficit. Australia's going to have a budget deficit of 10% of GDP. Nearly everyone's going to have something like that. So whether you like it or not, you've got a big budget deficit, which means that the size of that deficit

plus the means of financing it have come back onto centre stage. That's number one. Number two, when people first started talking about expansionary fiscal policy, the people I've mentioned, plus we should also add the modern monetary

theory people in there as well, when they first started talking about it, they were talking about an economy which was already growing, sluggishly but growing, and the fiscal expansion would speed it up. But now we're in a totally different world where the economies are contracting, and so the fiscal expansion is softening the fall, but it's not actually speeding things up to any great degree. And so there's no likelihood of economies overheating or, in my view, inflation arising in the foreseeable future.

And anyhow, before we get on to modern monetary theory, the other thing I should say is that there's nothing wrong with having budget deficits in the circumstances that need them. It's not a controversial statement. There are circumstances, for example, a recession or a big fall in private demand, where a budget deficit is the correct response. Discretionary decisions to increase the budget deficit is the correct response.

That's got bipartisan support in Australia. Governments of both persuasions have at times moved to implement very expansive fiscal policy through budget deficits. So anything I say about this subject should not be interpreted as me arguing against budget deficits. It's simply me trying to explain to you the implications of how you finance a budget deficit. Yep. So that brings us to modern monetary theory. trying to explain to you the implications of how you finance a budget deficit. Yeah. So that brings us to modern monetary theory.

Maybe we should just begin by unpacking that term, modern monetary theory. What about it is modern monetary or a theory? Yeah, well, the first thing is it's mainly about fiscal policy and then to some extent about debt financing, but only very peripherally about monetary policy. Its centrepiece is the view that the government should provide a job for anyone who seeks one. A full-time job, if they want it, with full annual leave, sick leave,

all the sort of things that you would expect in a full-time job. Now, that, of course, would be be very expensive that would involve a huge increase in government spending and as a result it is subject to the usual riposte where is the money going to come from and modern monetary theory sets out to say that's a non-problem. Don't worry about that. I've got a couple of quotes here from Stephanie Kelton, and she says, modern monetary theory demonstrates that the federal government is not dependent on revenue

from taxes or borrowing to finance its spending money is the one resource the u.s government cannot run out of she also says we can pay off the national debt immediately with a simple keystroke now when you hear things like that, most people will regard that as sort of very radical, very revolutionary. And it makes it sound as though it's a real paradigm shift, a totally new approach. In fact, she even modestly compares it to Copernicus, who had to tell the world, the world thought that the sun went around the earth, and Copernicus

had to tell them it was the other way a government that issues its own currency can never run out of money and can never be insolvent Yeah, well, in fact, that is correct Even though that sounds extremely revolutionary that is correct So you don't disagree with that? Yeah, but before we get onto that, I'll get onto that in a moment extremely revolutionary, that is correct. So you don't disagree with that? Yeah. But before we get onto that, I'll get onto that in a moment.

Yeah. But the thing I want to go back to is this idea of it being revolutionary, as though it superseded the earlier approach to monetary policy or budget. Because it is called modern monetary theory. Yeah, I know. And I have to say that that was a marketing masterstroke, calling it modern monetary theory, because it's not. It's actually very old.

It's a revival of an approach that, for example, we had in Australia back in the 15s and 60s and even the 70s. And it's really based on the writings of quite an influential economist called Abba P. Lerner, who wrote two very influential articles in the 1940s and a book in 1950 called The Economics of Control. And Lerner's approach was really the same as modern monetary theory. He said that the job of the government was to ensure full employment and just put up with whatever debt came out as a result of that,

which is very much the same as modern monetary theory. You mentioned that book, Macroeconomics, the sort of textbook. Which I left on your doorstep late one night a few weeks ago. Yeah. Well, one of the interesting things about it, and parts of it are quite good, by the way, the interesting thing about it is that if you look at the authors who are being cited apart or cited favorably

apart from the uh members of the modern monetary theory club most of them are um old authors um the um most often one cited of course is Keynes now that's fair enough if it's a book on economics but Marx is the second Veblen Lerner and Minsky now I finished my economic studies in 1970 now all of those people who recited before my time apart Minsky. Minsky's the only one who's more recent. So I don't mind the fact that they're interested in the alter economists. I think that's good. But on the other hand, it does show you that the idea of calling it modern monetary theory is really just a marketing ploy.

First of all, let's start with the comment that the governments can spend as much as they like. Yeah. That's the centrepiece. Yeah. And that's what I said is true. Even if it's unwise to do so, they can. Robert Mugabe is still spending in Zimbabwe,

even though the rate of inflation is 10,000% or 100,000%, I can't remember one of those two. Now, not that I want to say that modern monetary theory is going to take you down that path. They say, no, they won't. They'll stop the expansion once inflation takes off. But it just is an illustration that the central point is you can keep spending.

And the other thing that they say, which is also true, is that you spend, you can spend, before you've worked out how much taxes you've raised or how much borrowing you've undertaken. You can just spend if you want to. And that used to happen in Australia. As I said, until for quite a while, actually, right through the 70s, the government just spent. And then after that, you worked out how much you had to borrow.

But the spending came first. And so that part is correct. Although a lot of people are surprised when they hear that, but that has always been the case but even though you can spend as much as you like it's not free it's not free it always implies or gives rise to a borrowing

and that's the bit that we have to go through now this may become a little technical for about three or four minutes, but bear with me. If you divide the economy into two halves, the government, which is the central bank and the government, and the other half, which is the banks and their customers, if one half has a deficit, which is the government, then the other half has to have a surplus. They have to add up to zero.

This is an identity. It's true by definition. It's true. It's an accounting identity. It has to hold all the time. Yeah. Now, there's all sorts of behavioural relations that might be consistent with it, but it has

to hold all the time. And I'm trying to find the best way of explaining this. So I think since it has to hold, then even though you can say the government has unlimited ability to spend, each time it does so in excess of its tax receipts, i.e. each time it runs a deficit, it creates a debt to the private sector. Now, the MMT people don't deny that. It's in the textbook that you were referring to. So I'm not arguing with them on that, and they're not arguing with me.

We both recognise that's true. But that sounds like an identity. Most people aren't really convinced by an identity. So the alternative way of looking at it is to follow the money from the treasury to the central bank to the bank to the bank customer. So let's take an example where the government decides to spend a billion dollars. Now the first step, the crucial step in that is the government,

i.e. the central bank, has to transfer that billion dollars to the banks of whoever the money is intended for. It goes to their bank, it doesn't go directly to them. Or if I want to be more precise, the central bank has to debit the government's account at the central bank by a billion dollars and credit the bank's account at the central bank by a billion dollars. So the banks have got a billion dollars more as an asset, but they've also got to credit it to their customers, so they've got a liability of a billion dollars. But the crucial point is that the banks have got this billion dollars extra on deposit at the Reserve Bank. That's a loan to the Reserve Bank. And that's the bit that a lot of people leave out when they're trying to understand how this spending occurs. But the spending, dollar for dollar, each bit of that deficit spending has to show up as a borrowing from the private sector. And initially, it shows up

as a loan from the banks to the central bank. So this is where advocates of modern monetary theory would disagree. And they would say that the commercial banks' reserves at the central bank are not in fact a loan. But we are going to talk about the implications of that and address that idea. I thought maybe before we get there, I was hoping, because you have sort of a unique insight into the plumbing of the banking system, having been governor of the RBA for a decade, what does that actually look like? And when you were, you know, during your time at the bank,

what does the flow of funds look like? Were you sitting in front of computer screens, you see the money coming in, the money going out out did you used to write it on bits of paper or how was it done well um well it's all done on computer streams now yeah screens and it's all real time it's instantaneous but uh when i before i was governor when i was in the bowels the reserve bank i used to get involved in this. For example, every fortnight the government would pay pensions to all the pensioners in Australia. And so what would happen is in those days they had a magnetic tape would come up from Canberra. And on that magnetic tape, it had the list of everyone who was going to receive this money. And most importantly, the BSB number and account number of their bank account and so this tape would come up it would go to the Reserve Bank and it would go

through a computer and we'd channel it off into each of the banks so Westpac would get 250 million and ANZ would get 200200 million, et cetera. And so the money would go into the bank accounts of the banks at the Reserve Bank. And then those individual banks would do the same thing and they would channel it through to the individual pensioners. So that's how the system works. It comes from Treasury first, central bank, central bank to banks, banks to customers.

But at the end of the day, the bit that is still there is the bank's loan to deposit at the central bank. The issue is, is it a loan or isn't it a loan? Well, it is a loan because if the central bank were to renege and say, oh, we don't recognise this anymore, it would instantly bankrupt the banking system and their customers. It has to be recognised that it's still there.

And the other interesting aspect of it is the banks can't get rid of it unless they do a particular thing. They can't just spend it away. It stays there unless the bank or its customers buys a government bond. In other words, by buying a government bond, you're drawing down the bank's deposit at the Reserve Bank and crediting the government's deposit at the Reserve Bank.

So unless the bank or its customers actually buy a newly created government bond, that loan to the central bank stays there. And when they buy the bond, it draws down the reserve at the central bank because they take cash out of their commercial bank to buy the bond. Yes, exactly. Exactly. That's right. To buy the bond. Yes, exactly, exactly. And so now we're getting close to the next identity. And the next identity, the first identity was that if the government's in deficit, the private sector has to be in surplus.

In other words, they have to lend to the government, which has to borrow. And the second identity, which we've virtually come to, is that the form of borrowing that the government does can take two forms. If it issues the debt to the public, that's the first form, or if it doesn't issue debt to the public, then the banks lend to the central bank. So it's either borrowed, so the consolidated government sector is either borrowed from the public or it's borrowed from the banks. And again, in that textbook, they recognise

that. So there's a lot that you and MMT agree on. Yeah, yeah, yeah. There's that bit, everything I've said so far, we agree on. That's because it's not revolutionary in any way. It's not even new. It's old. It's been around forever. So we agree on that.

So where is the disagreement? Well, the disagreement comes on how the deficit is financed. Is it an unfunded deficit, which is what I've been describing, or is it a funded deficit? I haven't really said much aboutunded deficit, which is what I've been describing, or is it a funded deficit? I haven't really said much about a funded deficit, but a funded deficit is what we've been doing for the last 30 years, which is when you have a deficit, the government issues bonds by auction. We call it by tender. And so the market determines the interest rate,

and so the deficit is financed one for one by the public lending to the government. Now, when I say the public, it's not predominantly the household sector. It's predominantly the banks, the big insurance companies, the super funds, other managed funds lending to the government. And so that's the conventional way of doing it. It has been the conventional way in Australia since the mid-'80s.

Before the mid-'80s, we did it the unfunded way. And so, to me, the difference between, say, my view and the MMT view is they want to go back to the old way of the unfunded deficit, and I'm more comfortable with the new way, which is a funded deficit. Why is a funded deficit more favourable? Or another way of asking that question is, why is an unfunded deficit unfavourable? Right, well, let's start with why is a funded one more favorable. Well, the first thing is that you don't suppress the interest rate.

You go to the market and you sell the bonds at the market rate. And so you haven't sort of held that down. You haven't suppressed that. You allow that to rise if it needs to. That's number one. Number two is at the moment interest rates, bond yields are so low that it's never been easier to fund a budget deficit. It's incredibly easy to fund a budget deficit.

R is less than G on government debt? Yeah, R is way, way less. So governments can borrow at virtually no cost. I mean, the Austrians recently issued a 100-year bond at 1 point something percent. Who buys that? Anyway. I don't know percent. Who buys that? Well. Anyway. I don't know. We talk about that.

But the third reason for preferring a funded deficit is the disadvantages of an unfunded budget deficit, particularly if it's a big one. If it's a small one, it probably doesn't matter that much, but if it's a big one, and of course with MMT it would be a big one, there are serious problems with an unfunded deficit, which I'll go on to. Well, the first issue is does the government pay interest on the loan that it has received from the banks now traditionally we didn't pay interest but there's a whole lot of reasons why it was very different then whereas now we do and americans do we do um so if you paid interest and you paid the interest that was somewhat similar to what the bond would be then you're not going to introduce much of a

distortion in the system at all but on the other hand it's quite clear that it's almost the same as issuing the bonds in other words, you're paying interest on your borrowing and you're going to have to continue to pay that interest every year you've got a deficit. So it's almost the same as a funded deficit. Now, if you wanted to go back to having an unfunded deficit without paying any interest, which is what the MMT people, I think, want to do, certainly what Kelton says, then you get some really big distortions. And we know a bit about this because we actually have been through that experience. The first thing that happens is if you saddle the banks with a great big lump of assets, i.e. their loans to the central bank,

they're earning zero, that really damages the profitability of banking. Now, some people might think that's a good thing, but if you think about it, it's not really a good thing. First, because the banks will try and restore their profitability. And the way they do that would be to put up their lending interest rates and put down their borrowing interest rates. And so as they did that, that would just shift the burden back on to their customers. They'd end up having to pay higher interest rates and receive lower interest rates.

But that's not the end of the story because as they did that, the banks would lose competitiveness against the non-bank rivals. And so what you would end up doing would be crimping the growth of the regulated financial sector and encouraging the growth of the unregulated financial sector, the competitors to banks. And that's called financial disintermediation. And that's really the main reason why we stopped the old system.

Is that not just an argument for more or better regulation of the shadow banking sector? We went through that too. We had, before we went through that too we had uh before we go get onto that um in in that period i'm referring to the shadow banking sector or non-bank sector were building societies credit unions merchant banks and finance companies and in the mid 7070s, as was clear, that they were growing much faster than banks, there was a proposal to put all of the regulations

that were on banks, try and apply those to those other competitors. In fact, there was a lot of work put into it. In fact, I think there was some legislation drawn up but was never enacted because in the end, people just thought then there were another group will grow up outside them. So you're playing whack-a-mole.

Yeah, whack-a-mole, yeah. Yeah. You're bound to lose. Now, the same thing would happen now, but there'd be a different, probably a different group of shadow banks, including very modern ones like fintechs would all grow at the expense of the bank sector. So that's why, that's the first reason why it was a real problem. Now, as a result, the government then took the pressure off banks by issuing some bonds. But once again, they were keen to suppress the interest rate,

and so they issued the bonds at interest rates which were very unattractive. So then you had to have another set of regulations called the captive arrangements to force banks, pension funds, insurance companies etc to hold a certain amount of government bonds. They didn't want to but they were forced to by legislation. So you ended up with a really elaborate set of rules and regulations. And when you look back on it, the main purpose of all these things was to suppress the market interest rate. And then when inflationary pressures did arise, you had this long period

where your interest rates were actually lower than the inflation rate, which did contribute to the rise in inflation. So I think if you work your way through all those steps, you can see why. Well, first of all, modern monetary theory is not new, it's old. And B, it's really taking us back to a period which we've been through and we found serious problems with it and then we discarded them and then moved to the situation we're now in. So that's the way I would summarise situation it's not as though

monetary theory is revolutionary nor does it have technical errors in it it just proposes a policy which I think is inferior to the policy we have now. And it proposes something which some of us with long memories

have already experienced and know why we stopped doing it that way. Could MMT work temporarily? It could work if it was, well, unfunded deficits can work if they're on a smallish scale and in an environment where interest rates are incredibly low, like now. So they can work in exceptional circumstances. And in fact, that is what's happening to some extent, because the Reserve Bank is buying bonds. And as it buys bonds, that's a form of unfunded deficit. It can work in those circumstances, but it wouldn't work if you had really big deficits as proposed by MMT. And it wouldn't work in normal periods where you have normal interest rates.

The difference is, it clearly is a form of debt. I don't think you can deny that. It's whether you can get away with funding your deficit that way and whether you can get away with it without paying interest on those reserves. Yeah. And as I said, in some circumstances you could. If the deficit was small and you're in a very low inflation environment, you could probably get away with it for a while. But if you want to have a policy that works in normal times, as well as working in exceptional times, and that works with large numbers, not just small numbers,

the conventional approach is much better. Why do you think MMT has become so popular recently? I don't know that it has. It got a lot of coverage in the press, but I think internationally, there's very few people who are adherents to it. Even in Australia, there's only, I don't know, a tiny handful. And in the US, I think there's only two universities really where most of the stuff comes from. It certainly has a lot of adherence among the general public. I think the constituency has been growing there. It's based on my anecdotal observations. Yeah, well, I think it does seem as though you're getting something for nothing.

And I think that attracts some people. Or the other way of looking at it is you removed a constraint and it allows you to do something that you'd like to do but formerly you weren't because you felt constrained by the fact that you were borrowing. My reading of it is it's not had much impact on the economics profession. It's zero effect on central banking and treasuries. In Australia, there are a couple of financial journalists

who have pushed it hard. But I think the more they look at it, the more you realise that it's not revolutionary and that it's in fact a revival of an old system that loses a lot of its charm. I think its popularity is probably also born out of broader frustrations with the economy's performance in recent decades. Yeah.

People are searching for a way out. Yeah, yeah. The feeling that this sort of secular stagnation idea, that there's something wrong out there and that we haven't managed to get the economy to sort of speed up much it's always been a little bit below what we hoped it would be but the other interesting aspect of that is um there's not a huge groundswell and the reason there isn't a huge groundswell is that unemployment has not been anywhere near as big a problem as it used to be

in fact in the US the unemployment rate went down uh immediately pre-covid went down to three and a half percent which is exceptionally low for the US now ours was five uh and that's not great but if you've already been through two peaks when it was over 10 or 11 and it's sort of drifted down towards five, it's not ringing alarm bells. I'm looking forward to the fan mail from MMT advocates. But thanks for stepping through the plumbing of the system so carefully. I think it was important that you went through it in technical detail.

When we caught up a couple of weeks ago, you said something to me which I found quite at once arresting and disturbing, and that was that the economy is anti-growth. What did you mean by that? Did I say that yeah well i think it was in the context of secular stagnation that's that's uh it's probably not a good choice of words but that's all i was trying to uh talk about that there is a disappointment that um that it hasn't got, we haven't got rid of all the slack in the economy, although the US has probably got rid of most,

had got rid of most of the slack in its labour market. But I think the general feeling that its consumption was a bit restrained and certainly that investment was restrained. I don't think, myself, I don't think it's as big as a problem as the secular stagnation people do. I think it's a bit disappointing, but on the other hand, you've got to grow below average half the time.

But I think the other reason that the secular stagnation people are worried is that they're aware that you've thrown everything in the monetary policy armoury at it and it hasn't worked. And that's why they're interested in fiscal policy and I think that's legitimate. Yeah. And as you said, you're not against deficits in the appropriate circumstances. Yeah.

We've mentioned secular stagnation several times. Why don't we just give like a technical definition for people? So the idea was first advanced by Alvin Hansen in 1938 in his presidential address to the American Economic Association. But the phrase had entered the lexicon a few years earlier. And Hansen was commenting on the fact that the US, which was still struggling to emerge from the Great Depression, had had a period of population expansion and a period of very vigorous use

and putting to use of arable land and that progress had started to slow after the end of that period. But he wasn't so much wrong as premature because then obviously World War II erupted and rearranged the whole economic landscape. Then Larry Summers revived the idea in an address to the IMF at the end of 2013.

And secular stagnation is the idea that the natural real rate of interest is negative. That is the rate at which saving and rates, combined with the presence of low inflation, conspire to make reaching full employment far less likely. And Larry thinks that that's what we've been struggling with, not just since the Great Recession, but really for the past couple of decades or more. Because if you think about growth in the u.s it's really only been satisfactory in the presence of unsustainable

speculative bubbles first the dot-com bubble and then the biggest housing bubble in a century but if you subtracted out those two bubbles, the economic performance would have been, it would have left a lot to be desired. And that is kind of the specter of secular stagnation. Well, I think you've said two things there that are almost mutually contradictory. The first definition, you say, of secular stagnation is that the neutral real interest rate

has got to be lower than what it is now for savings and investment to be equal and for the economy to grow. Now, that's very much like a pure monetary theory of inflation. And then the second bit you said is we've only really been able to grow because we've created these bubbles. Well, if we had had lower interest rates to satisfy the first requirement, we would have had even bigger bubbles.

If our problem, if the slow growth is because interest rates aren't low enough, then you'll be arguing for lower interest rates. But if you're worried about the fact that the economy produces bubbles, you wouldn't be. The last thing you'd be doing would be arguing or asking for lower interest rates. what higher interest rates so so that that is Larry's point that it might be impossible to simultaneously achieve full employment satisfactory growth and financial stability and that's where fiscal policy

comes in obviously to me that's a very strong argument for using for too much you put too much weight on monetary policy, you want to put it back on fiscal policy, which I think we've already established in an earlier discussion. So, Ian, in the 80s, you started collecting a file on inequality and you shared the Manila folder with me, which I found very interesting, of old newspaper clippings and magazine articles on inequality and you shared the Manila folder with me, which I found very interesting, of all newspaper clippings and magazine articles on inequality.

And that piqued my interest because it seems like you think inequality is not just a question for sort of moral philosophy, but it actually has positive importance for economics and the economy. Take me through the evolution of your views on inequality. Well, the first thing that you're alluding to is that a lot of economists' view was, particularly very much a Chicago view, that economics is about maximising satisfaction, essentially income per head, income distribution, although that's not economics, that's politics.

I don't think that's right. I think inequality or changes, not the level but so much as the changes or the direction in which it's trending can have a very important effect on economics. That's my view now. The other thing you were alluding to is that file. I started that file in the mid-'80s because just looking around, I could see what was happening.

A lot of it was to do with executive salaries and I started putting stuff in there. But a turning point in my thinking was when we started having these annual lists of the richest people in Australia, I thought that was a really backward step. I thought they were pretty vulgar. They were still going strong, and obviously people are sort of interested in it.

But you could see a move towards a more mercenary society developing, and that's the reason I started the file. I wasn't very serious about it it's uh it's very haphazard i never did anything with it but i think in that same period where we switched in our two worlds that was a switch in thinking and a world which was directed much more it uh became much more mercenary world. So we've just been speaking about secular stagnation and some of the broader frustration with the economy's performance in recent decades.

Let's try and connect that with inequality. And we've both read a recent paper by a former guest of the podcast, Amir Sufi, which he co-authored with Atif Mann, his regular collaborator, and another economist, Ludwig Straub. The paper's titled Indebted Demand. What is your take on the paper? Give us an overview of their argument first. Well, my take on it is it's only a first impression. I didn't know about the paper. You showed it to me. And I'm not really up to date

in modern economics. But my first impression was that they're onto something very big. I like the paper and I like their approach. and I find it genuinely modern. They've got a different, come out from a different direction than most of the economics I'm familiar with. I mean, I classify them as younger economists, certainly younger than me, who are trying to make sense out of how the world has developed over the last 40 years. And I think they've made a big contribution already. But I also note, which interests me and pleases me,

is these guys are from very... They're really very, in a sense, technically orthodox economists. They come from impeccable institutions of impeccable conventional excellence, Harvard, Princeton, and Chicago. And they're looking at things from what is, to me, an interesting perspective. As I said, it sounds genuinely modern. They're trying to make sense of what the big trends have been over the last 40 years.

Yeah. And they try to explain two trends. One is the fall in real interest rates. The other is the big run-up in both household and government debt that we've seen in the industrialized world. And in explaining those trends, they point to two further trends, which are financial liberalization, which is an ugly term. That's okay. It's financialization. That's the ugly term. That's okay. It's financialization. That's the ugly term.

Financialization. That's, yeah. Financial liberalization is a bit more melodious. No, financialization is not just liberalization. Yeah. It's saying that it's grown faster than the rest of the economy. It's not just freed up. It's actually growing.

It's becoming a bigger part of the economy. Gotcha. They point to that. Yeah, that's what they're pointing at. So it's not – financialization is not the same as financial liberalization. Yeah. Gotcha. So that's the first trend.

And then the second one is inequality. Connect all those dots for us. Well, I mean, the first one is some people would find it hard to believe that you could get lenders to lend so much money without actually having to pay them more. And in fact, what's happened is exactly the opposite. The lenders have lent all this money and real and normal interest rates have gone down very sharply.

And that's what they set out to answer. And they construct a model which, as you say, is inspired by the fact that they're very conscious of the increase in inequality and they're very conscious of the increase in financial ization, i.e. a lot more borrowing and lending going on, a lot more debt. And what they do, which conventional economists would not have dreamt of doing, I think, until recently, is they've divided the economy into two groups. The first the first group are the rich, the people who have benefited from the increase in inequality, the people whose income has grown faster than the average.

Now, sometimes they refer to it as the 1%, top 1%, sometimes it's the top 10%. And these people are people who have a lot more financial assets than they have financial debts. And the other group, which we'll call the rest, are the spenders. They have a lot more debt than they have financial assets. They spend a lot. They have a high propensity to spend. And in fact, once again, we've got to go back to an identity. If you divide the economy into two bits and

one's got a surplus, the other has to have a deficit. If the rich have got a surplus, which they have, their income's much higher than their spending, then the other group have to have a deficit. They have to spend more than their income. And the only way you can do that really is taking on debt. And the workhorse in their argument is non-homothetic preferences. But basically it's just the idea that the rich have a lower marginal propensity to consume out of permanent income and the poor have a higher marginal propensity to consume and that's a pretty straightforward observation you know a lot of people on lower incomes are living hand to mouth whereas people who are exceptionally wealthy i mean there are only so many lattes you can buy there are many only so many homes you can

live in or cars you can own until you've fulfilled your basic needs and then beyond that point you know you just it doesn't make sense to keep buying those things and marginal the marginal propensity to consume is often um defined as a number between zero and one um so if the marginal propensity to consume is for example 0.6 that means out of every additional dollar that you get you spend 60 cents and what they point out is that the increase in debt both on the part of households and governments, has on the part of the poor hasn't been fully offset by the increased income, the increased permanent income of the rich, i.e. the savers,

because they have a lower marginal propensity to spend. Yeah. And that puts a dampener on aggregate demand. Yeah, I think that's not radical to say that everyone, many people have said that, that one of the reasons that consumption has disappointed is the people who've got a high propensity to consume are not getting much of the income.

And the people who are getting the biggest share of the income are the ones who've got a low propensity to consume. That's not controversial. And I don't think anyone can dispute that. But the other thing, there's other things they say too. You can make up the gap by having a very big burst of business fixed investment. If consumption's not doing the job,

you can have a very big burst of business fixed investment. But for the countries they look at, that hasn't happened either. The business fixed investment as a proportion of income over the long period has trended down. And so what's filling up the gap? One of the things that's filling up the gap is government deficits. Somebody's got to fill up the gap. Now, I'm not surprised that they've gone down this path.

And I'm sort of, as I said, it's very modern. It's very modern. And I'm not surprised you're interested in it. I think someone of your age, in fact, anyone under 40, has basically spent all of their life in a world of falling inflation, falling interest rates, growing debt, all of their life in a world of falling inflation, falling interest rates, growing debt, rising house prices, increasing globalization,

and increasing labor saving technical progress. So your view of the world should be very different to someone's view of the world like me and the economics profession should be reflecting that I think and these guys are and I think there are a lot of others that I'm only vaguely aware of because I went through their bibliography and I could see that obviously there are a number of other articles that are appearing now which are sort of asking some of the same questions

or they are actually introducing the concept of increasing inequality into their macroeconomic explanations of how the world is evolving. Yeah. Sufi actually calls it the saving glut of the rich, which is an allusion to Ben Bernanke's global saving glut, and he thinks it's roughly equal to the global saving government and household debt has been coming from foreigners or from the rich. So in the US, it's roughly equal. In the UK, it's mostly from foreigners. I don't actually know what the data are for Australia, but I suspect me recently by email was that if you treat the

global economy as a closed system the global side falls out and the current account surplus countries like germany and china which cause the global saving glut our current account surplus countries in large part because of inequality within those countries as well so so ultimately it boils down to um a question of inequality yeah if i think that's right i think if instead of breaking the world up into countries we had the the data to break the world up into rich people and poor people, then it would be true that the deficit of the poor people has to be matched by the surplus of the rich people. And if the rich people's income is growing faster

than the income of, let's call them the poor people, which it is, well, then these imbalances are getting bigger and bigger year by year. So there's been this big saving glut driven by the fact that fewer and fewer people have more and more wealth and they're not spending it because they don't need to spend all of it. They have a lower marginal propensity to consume. And that's been pushing down the natural real rate of interest it has possibly created what sufi mean and strab called debt trap

which is an analogy to keynes's idea of a liquidity trap and possibly explains secular stagnation but it leads me to a kind of pessimistic conclusion where we have growing inequality monetary policy is ineffectual modern monetary theory doesn't seem to offer the panacea that many believe it promises. And many governments are reluctant to commit the adequate fiscal spending that would be needed to push our economies out of this kind of period of stagnation. So what do you think the solution is? Is it wealth redistribution? Is it better fiscal policy?

Well, I mean, they've got a conclusion. They've got a very definite, well, it's not a definite conclusion. It's as though they put forward their conclusion very diffidently. They don't really want to make a big song and dance about their conclusion. But they do conclude that, first of all, monetary policy can't get you out of it. We all know that. But fiscal policy can't either. And so how do you get out of this?

The only policies that will get you out of this long-term secular stagnation are policies that address the widening inequality of income. And that's their conclusion. And that is actually quite a radical conclusion. And as I say, it's one they put forward very sort of hesitantly. But that's the outcome of their model. It definitely comes to that is the outcome of their model. And so really what they haven't used these words, but what they would be talking about would be wealth taxes, higher marginal tax rates on very high incomes,

inheritance taxes, things like that. And that may be the future. That's why I say that my reading of this paper is that it's very modern and it is actually genuinely radical. How have your views evolved in recent years and are you overall more optimistic or pessimistic about the economy? I'm normally an optimist but at the moment I'm sort of slightly pessimistic and maybe it's just to do with age that all sorts of things that you used to take for granted no longer happen. I can't see, or very far ahead obviously, I can't see very far ahead. I have

trouble imagining a situation where the world economy is growing too fast. We've had that in the past. It's very hard to imagine it at present. I also have trouble imagining a significant pickup in inflation. I think a lot of people are saying there will be, and they're basing it essentially on the very easy, significant pickup in inflation. I think a lot of people are saying there will be, and they're basing it essentially on the very easy long period of very easy money supply and monetary policy. I have trouble in seeing that. And if I did foresee it, it would probably make me more cheerful. Because I think the only way that inflation would return is if, in fact, the economy speeded up and got rid of the

economic slack and started to produce a few bottlenecks, then maybe inflation would return. And as long as it didn't go too far, that would be good news. But that's not my central assumption. My central assumption is that we're still in for a period of average, of below average growth rate, low inflation and low interest rates. So is the economy broken? No, I don't think it's broken no it's not broken i mean even um we i think we do tend to uh take a short historical period and say oh this is bad or that's bad but i mean most of the post second world war economy is the best it's ever been it's not just the best

it's ever been it's best it's ever been by orders of magnitude. And so the fact that we're not doing as well as we were in the 50s or 60s, historically doesn't mean we're doing badly. We just think we could do better. Do you think we've run out of ideas or innovation somehow got harder? I don't know how to answer that one. You've spent a lot more time thinking about innovations than I do. I don't think a big technical innovation is going to solve the problem.

I don't think we're going to invent the automobile or the steam engine or the aeroplane or something like that. I have trouble conceiving of that. Although, of course, if I could conceive conceive of it or would already have done it um yeah so do you think this is more of a demand side issue yeah yeah at the moment it is yeah at the moment it is you know i was hoping we could finish by reflecting on the third big lesson that you learned in your career, which we opened the discussion with, from a different angle. And that is non-stationarity. What is non-stationarity and why is it important for economists to understand? Well, my characterization of two different worlds it's classic example of

non-stationarity hmm that the characteristics of one is very different to the characters ristics of the second half so if you just worked out the average over that whole 70 years for a lot of things it wouldn't help you because the two halves are so different. I don't know if there's any more I can say. That's why you have to look at these big long-standing, sorry, not long-standing, these big slow-acting forces. And it's so difficult to get them into an econometric model or even any sort of informal model that you have to apply every day or every week or every month. It's so hard

to get them in but they should be there. So many of these econometric models are based on shifting sands when the underlying relationships in the economy are constantly changing. Yeah. Does that mean the whole economics profession is bogus? No, no. What are the good parts? Well, part of the good part is, as I said, we look at the economy around the world and we say oh it's not very good it's doing very badly but it's actually doing brilliantly compared

to which is historical past even the worst periods in the post second world war era the era that i've lived through are better than really almost the best periods that happened before. I'm all mean. What are the good parts of the economic methodology more broadly? Well, a lot of the microeconomics based on incentives makes a lot of sense. It's the only way you can design policies to understand that. Even on macroeconomics, I think there has been a lot of progress made. I mean, the 70s was the worst period.

We were way, way better than the 70s. But you have to be my age, firstly, to have lived through the 70s and remember what it was like. I remember someone, did I mention this to you in our earlier talk? Someone was saying, oh, you know, it's really bad now. Not like the good old days, the 50s, 60s and 70s. I thought I'd say, hey, hang on, the 70s. How did you get the 70s in there? Yeah, that was a nightmarish decade.

Yeah, it was someone who was much younger than me and so you know even though it's sort of disappointing in terms of compared to our best periods it's still it's still a lot better than most of human history by a huge margin. Hmm. Ian McFarlane thank you so much for sharing your insights with me and for giving me a glimpse into your evolving thoughts on the economy and your continuing search for understanding. Thank you very much, Joe. Thank you so much for listening. I hope you enjoyed that conversation as much as I did.

For links and show notes for everything discussed, you will find those on my website, josephnoelwalker.com. My middle name is Noel, N-O-E-L. Also, please don't forget we have our listener survey, which you can also find on the website. I'd really appreciate you taking the time to complete that. Only takes about five minutes. And finally, thank you so much for your time. Until next week ciao