Home > Main > Chapter 3: In which Mr. Rowe proves his worth

Chapter 3: In which Mr. Rowe proves his worth

May 5, 2011

Did you know that we live in a fantasy world where we can get stuff for free?  I didn’t either.  But apparently, we do.  There is a free lunch.

I turn it over to Mr. Rowe.

“There is something economists have known since 1958 that we don’t talk about much, except in private, like in economics journals that nobody else reads. It’s a bit too weird.

There are two sorts of world. In a normal world, the equilibrium rate of interest is above the growth rate of the economy. In a weird world, the equilibrium rate of interest is below the growth rate of the economy. What’s weird about a weird world is that it needs a bubble, a Ponzi scheme, a chain-letter swindle, for the economy to work well.

Maybe the world we live in is a weird world. And it needs a bubble to work well. And the economy keeps trying to create a bubble. And when it succeeds the economy does work well. But bubbles are unstable and eventually burst. Then it works badly again. Until the next bubble.

Ok – stop right there, Mr. Rowe.  You’re telling me if the real rate of interest, r, is less then the real growth rate, g, then we live in a fantasy bubble world where we get stuff for free?  That happens all the time!  In fact, the last 20 years have been like that!  What does this mean?

“Governments can create the bubble, with a national debt they never pay the interest on, but just rollover from one year to the next. A Ponzi scheme. If spending and tax revenues grow at the growth rate of the economy, and that growth rate is above the rate of interest, they can do this forever. The long run government budget constraint just doesn’t add up, literally.

Come on!  We don’t live in a world like that!  It goes against what we see in…wait.  This is exactly what we see in the real world.  The budget constraint does not add up, just like Scott Fullwiler says, and it does not matter anyway!  We veer from Bubble to Bubble, first stocks, then real estate, now commodities and emerging markets like China.  Why?  The economy demands it when g is greater than r.

We want our free lunch!  We want our free lunch!

It is really a demand for a free lunch.  He draws this neat picture to show what he means more clearly:

As long as the real growth rate is higher than the real interest rate, the economy will demand bubbles.  If they are not accomidated, the economy will find something to make into a bubble.  It does this through using things that are not money as money. Like stocks being used to purchase real world goods, or using the paper value of real estate as collateral to purchase real world goods.

This is not very controversial in on main street USA. We see people going nuts to borrow money so they can satisfy this demand for a bubble.  If the government just supplied the money to close this gap a bit, the public would not be constantly trying to blow bubbles.

There is much much more to this model that Nick doesn’t talk about.  For example, what happens when g is less than r?  instead of drawing that line above the equilibrium point, draw it below.  Anti-bubble time.  The economy searches out and destroys leverage.  Think Japan, where the real rate of return has been relatively high, but low growth.

Also, since r and g are kinda sorta related to inflation, the zero bound in interest rates causes all sorts of huge problems. Deflation pushes up real rates to high levels. Current monetary practice has problems in solving this problem because it doesn’t address quantity, and the zero bound prohibits it from setting the price!  Warren is big on what monetary policy does – sets price, not quantity.  r becomes greater than g, and we live in Ebenezer Scrooge land.

And I won’t talk about the Anti-Democratic Conspiracy in Economics in light of “something economists have known since 1958 that we don’t talk about much, except in private, like in economics journals that nobody else reads.”  It is too depressing to realize we’ve been strangling ourselves for 50+ years because economists are afraid of good things happening.  Read that post again, and the one about Economists grabbing power, and you’ll cry.  We’ve thrown away my dads productive life over misguided, harmful ideas we cannot know ex ante.

[Update: Nick Rowe is a good person to even bring the Samuelson model out to the public. Then, his "demand for bubbles" explanation is brilliant.]

But the really, really cool part comes in now.   MMT plus monetary policy allows us to control r on the short end of the curve.  We can always create or destroy inflation through spending and taxation.  We can always peg the 3 month t-bill rate to nearly whatever we want.

We control r.  

We can make r go to whatever value we like through a combination of spending and monetary policy.  There is no hard constraint, just that pesky soft constraint of inflation.  How much inflation is worth it to get to very high levels of growth?

I think this is what Warrens intuition was telling him when he says things like “We could have 15% real growth if we had policy right.”  And this is the method on which to find that growth – the combination of fiscal and monetary policy to control r so that we live in bubble land.

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  1. May 5, 2011 at 10:06 am

    Great post. Consider, though, that with g greater than r during 1980 though 2000, we had two of our biggest post war bubbles–the banking/S and L bubble in the 1980s, and the stock mkt bubble in the 1990s. On the the hand, with g less than r the entire period, there were virtually no bubbles during 1945 to 1965; but as financial innovations increased and regulation turned to deregulation, they became common place, whatever g vs. r was. Innovation and deregulation enable greater spending out of current incomes–leveraging. Setting r less than g can encourage this, too (though not right now, for instance), but can be checked via appropriate oversight, regulation, and fiscal policy.

    • TC
      May 5, 2011 at 2:01 pm

      Hi Scott,

      Great catch. Bubbles are largely preventable in a world where banking is kept on a leash. Leverage is dangerous, but that doesn’t mean it shouldn’t be used, just used with caution.

  2. beowulf
    May 5, 2011 at 1:17 pm

    Agreed, great post TC. As for economists not wanting to talk about this or other inconvenient facts (you could make a list of economic truism that only apply “AT FULL EMPLOYMENT” and/or with zero trade balance), I’m sure Church Inquisitors were a little sheepish when they discovered (but didn’t talk about much, except in private) that witches were not (ha ha oops) the proximate cause of the Black Death. :o)

    Don’t forget that we can also affect (if not control) the rate of growth. Robert Pollin & Dean Baker paper puts average growth rate of GDP and public investment spending (e.g. infrastructure, education, R&D) over last 30 years at 3.1% and 2.3% respectively. They estimate every 1% of GDP ($150 billion or so this year) permanent increase in public spending would increase average GDP growth by 0.6%. So increasing public investment by 3 points (to 5.3%) would increase GDP growth rate 1.8 points (to 4.9%). Presumably, the bigger the r – g gap, the bigger the free lunch. :o)

    You know, even as I say that, unless we expanded growth rate in that way, what we’re talking about isn’t so much a free lunch as its simply cutting off rent seekers from their risk-free interest checks from Tsy. Consider that the average interest rate on public debt is approx 3% (about where Pollin and Baker peg GDP growth rate, though not sure if that’s ex inflation).

    The Fed already refunds its own interest income back to Tsy. Cutting risk-free interest rates to zero would mean, as old debt expires and new debt is issued, effectively EVERY bondholder will be refunding their interest payments to Tsy.

    • TC
      May 5, 2011 at 2:12 pm

      Exactly. We have lots of control over where we fit into this model. We are anything but helpless to control our destiny. Of course we need to watch inflation. It comes down to how much we punish savers through inflation vs. how much we reward the rest of the world. I am sketching out some sort of Laffer curve based thinking on the tradeoff. Too little inflation, and growth is in constant danger of getting swamped by r defined by the zero bound on nominal. Too much inflation, and r outstrips g as people demand high real rates as options on future inflation.

      I am having a tough time getting real GDP out of FRED. Any ideas? I can get Treasury rates back to 1962, but I suspect that in the 1970’s, high inflation pushed up r to be close to g and stagflation resulted. Its like we can hit ebenezer scroogeland at on the high side too….

  3. Clonal Antibody
    May 5, 2011 at 4:11 pm


    You said:

    I think this is what Warrens intuition was telling him when he says things like “We could have 15% real growth if we had policy right.” And this is the method on which to find that growth – the combination of fiscal and monetary policy to control ‘r’ so that we live in bubble land.

    This is the part where I think the problems come. If anybody thinks 15% growth is sustainable, or feasible, is smoking something, or is basing the statement purely on a theoretical model. For us to have “real growth” meaning – larger and larger quantities of “physical, tangible, material objects” – is an impossibility, a mirage. One just has to read and understand William Catton’s books “Overshoot” and “Bottleneck” and listen to Dr. Albert Bartlett’s groundbreaking lecture “The Most IMPORTANT Video You’ll Ever See (in 9 parts)” to come to a reality.

    To me, MMT offers an integral element in the path to a stable sustainable economy, with a reasonable, equitable distribution of wealth. To me the revolution of MMT, is the fact that it looks at the economy in terms of monetary flows, and not in terms of equilibrium models – the fact of using fiat money is ancillary to MMT, though the MMT thinkers are the first ones to see the inherent advantage of such a system! The other flows that have to be added into the system are those of material, and energy — then and only then do you get a model from which you can work at managing the global economy.

    • beowulf
      May 5, 2011 at 5:26 pm

      Check out Randy Wray’s discussion of the book Leakages:

      In his book, Leakages, Treval Powers makes the outrageous claim that without leakages, the US economy could grow at a sustained rate of 13% annually. According to his calculations (based on empirical evidence), normal leakages of 7.4% reduce the rate of growth to 5.6%, leaving the economy operating at only 92.6% of its capacity. Periodic restrictive policy by the Federal Reserve adds another layer of leakages, which can reduce growth to zero, causing the economy to operate at only 87% of potential.

      As for TC’s question about real GDP info, sorry I don’t have any insight where to track it down (well, other than the per capita GDP chart at the above cfeps link).

      • Clonal Antibody
        May 5, 2011 at 6:20 pm

        Beowulf you wrote:

        Check out Randy Wray’s discussion of the book Leakages:

        From Wray’s Review

        If demand were to grow at 7% or even 10% on a sustained basis, I see no reason to believe that supply could not keep pace.

        Let us do some simple arithmetic.

        US energy use 3815 million MWh
        75% from oil, gas and coal
        US oil use 19.6 mbd

        at 7% “real” growth for 20 years,
        multiplier = 3.87
        at 10% “real” growth for 20 years,
        multiplier = 6.73

        so at 7% growth US would be consuming
        14750 million MWh or 76 mbd of oil

        at 10% growth US would be consuming
        25700 million MWh or 132 mbd of oil

        So, pray where is this level of energy going to come from?

        Please see Bartlett and Catton’s work above.

        I am sure Wray is unfamiliar with that line of thinking. Otherwise he would never have made a statement like that.

        • Tom Hickey
          May 5, 2011 at 6:45 pm

          MMT asserts that the fundamental constraint is not financial but rather availability of (sustainable) real resources.

          Here are few more things to check out:

          Steady-state economics

          Jeremy Grantham, Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever

          Mr. Soddy’s Ecological Economy

          Law of Accelerating Returns

        • beowulf
          May 5, 2011 at 6:58 pm

          So, pray where is this level of energy going to come from?

          The same place our ancestors went to when the inexorable demand for more energy ran up against the limited supply of whale oil– human ingenuity. And yet despite our energy usage growing by orders of magnitude, there actually more whales in the sea today than 150 years ago!

          Short term, we’ll utilize our natural gas and shale resources, further out, maybe we’ll use thorium reactors, zero point or solar, I dunno. I have no doubt we’ll jump over to our next whaling ship (so to speak) before our present one sinks. Having said that, I don’t think the invisible hand gets us there by itself, there does have to be some level of govt coordination if not outright planning.

        • TC
          May 5, 2011 at 7:21 pm

          I will throw some Gregor McDonald in here. We face real world constraints in energy.

          One of the things I see is that when we have huge debt to gdp in the worlds reserve currency, there is massive amounts of innovation. See this post:


          And think about the post war era in the U.S. It ruled. the middle class and cars are tough to top, plus transistors/computers as a side project.

          The internet grew out of programs that today are being defunded.

          When people are working, lots of extra stupid stuff gets tried. Due to the lottery effect, 1 in 1,000,000 of these are worth something, but when they are, they change the world in a profound way.

      • Clonal Antibody
        May 5, 2011 at 7:24 pm


        Please educate yourself — do not engage in “magical thinking” that is what you just did! It is not just an energy issue — It is the planetary rape that is going on currently — Do you think that will just stop — do some basic arithmetic — and then look at where you want to take this world. Growth is not a necessary part of economics. The time value of money, and the charging of interest is what makes it so. Look at Michael Hudson’s (a close and well regarded colleague of Wray at UMKC) work – The Mathematical Economics of Compound Rates of Interest: A Four-Thousand Year Overview (Part -I) – and (Part -II)

        MMT’s zero natural rate of interest plays very well into this — because in an unconstrained Fiat currency regime, a positive interest rate leads inevitably to exponential growth induced collapse.

  4. Clonal Antibody
    May 5, 2011 at 9:03 pm

    One has to always plan for the worst outcomes, and spend resources towards finding ways to avoid those outcomes. However “head in the sand” approaches will never lead anywhere.

    • Tom Hickey
      May 6, 2011 at 9:48 am

      It’s between Kruzweil’s law of accelerating returns (exponential innovation) and whether energy innovation will come before peak oil. Many people have pointed out that the present course apparently leaves a several decade gap between oil being insufficient to power the global economy and getting any technological innovation to replace it sufficiently scaled up and online. There are some promising innovations but the scale is daunting. The jury is still out on this as far as I can see.

      • Clonal Antibody
        May 6, 2011 at 10:10 am

        “Kurzweil’s law of accelerating returns” is balanced by Niven’s “Crazy Eddie effect”

        “We call him Crazy Eddie, if you like. He is a … he is like me, sometimes, and he is a Brown, an idiot savant tinker, sometimes. Always he does the wrong things for excellent reasons. He does the same things over and over, and they always bring disaster, and he never learns.”

        • Tom Hickey
          May 6, 2011 at 10:23 am

          Well, some are arguing that the age of great technological innovation is past and the rate is declining. But then, someone is always declaring that everything has been discovered already and then looking ridiculous.

        • TC
          May 6, 2011 at 11:56 am

          lol – finally some SiFi! Plus, one of my early faves…

  5. Oliver
    May 6, 2011 at 8:17 am

    In theory, growth could take place purely as an advancement in quality with stable or even diminishing energy and scarce resource consumption. In practice, this has never been the case. Economic growth has always meant more energy and more resources being consumed, in total and per capita, no matter by which measure one compares wood to coal to oil to atoms. Increased efficiency has always been used to expand resource consumption somewhere along the food chain. I think it is this link (as well as its evil cousin of increasingly unequal distribution of wealth and resources) that needs to be broken to put the world on a more ‘sustainable’ (for lack of a better word) path for all its inhabitants. Not an easy task by any measure, and certainly nothing economists could take care of by themselves.

  6. May 6, 2011 at 9:18 am

    Thanks TC ;)

    You haven’t quite fully understood the model though, when you say:

    “But the really, really cool part comes in now. MMT plus monetary policy allows us to control r on the short end of the curve. We can always create or destroy inflation through spending and taxation. We can always peg the 3 month t-bill rate to nearly whatever we want.

    We control r.”

    See that point in my picture where the red and green curves cross? I have labelled that interest rate “natural rate (no bubble)”. Let’s call it rnnb for short. now rnnb is defined (roughly) as what the *real* rate of interest *would* be, *if* aggregate demand were just right to keep inflation stable, and *if* there were no bubble created by either government or the private sector.

    This leads to 2 observations:

    1. The very fact that my model talks about a *natural* rate of interest *means* it is independent of monetary policy. So you can’t say that monetary policy could keep the natural rate below the growth rate in my model. That’s a logical contradiction.

    2. By using fiscal policy to create government bonds that are rolled over in perpetuity, the government is (in my model) satisfying the demand for a bubble, and is raising the natural rate of interest (rn) above rnnb. So you can’t say that fiscal policy can be used to keep rnnb down below the growth rate. rnnb is either above or below the growth rate. Fiscal policy can raise (or lower) rn relative to rnnb, but it can’t affect rnnb, by definition. So you can’t say that fiscal policy can make rnnb whatever you want it to be. That too is a logical contradiction.

    And there is a limit to the size of the bubble the government can create that keeps rn below g. And when you hit that limit, so rn=g, the LRGBC kicks in again.

    You have to be very wary about grafting MMT policies onto what is a very non-MMT model. (My model above doesn’t really even have money in it, and implicitly assumes output stays at full-employment regardless of fiscal policy).

    • Clonal Antibody
      May 6, 2011 at 11:36 am

      Here are three interesting charts for you to ponder over courtesy Arthur Shipman

      Fed Funds Rate
      Total Credit Market Debt Owed/GDP
      MZM Money Stock/GDP

      This reinforces the point made by the MMT economists, that under a Fiat currency regime, the natural rate of interest will stabilize at ZERO

    • TC
      May 6, 2011 at 11:39 am

      Hi Nick,

      I mean it when I think you should change the name of the blog from “worthwhile” to “essential”. :)

      You are correct. I completely misunderstood the “natural” vs. “real” nature of this model. My understanding was entirely predicated on it being real rates. When you say r here you mean the inflation adjusted “natural” rate, which is the rate of interest in without any influence by the monetary authority. I did not get that.

      On first blush, does this natural vs. real distinction matter? The r is “real” and the “natural” part is an additional little assumption that makes it nice, friendly society to live in during the thought experiment. But the bubble demand isn’t driven by it being natural, its being driven by the difference between r – the real rate of interest paid on government script – and g. The r is natural, but real too. The bubble is being driven by the fact that growth is higher than this rate, not by the manner by which this rate becomes “natural”.

      In other words, this model probably still works without it being natural, and only real. I’d have to think about it more! Monetary policy would just shift one of the curves, right?

      Also, as I think about it, this model is massively powerful. It’s huge. MMT says monetary policy doesn’t have any impact on inflation. But in this model, monetary policy defines the demand for bubbles even with the MMT assumption of no inflation from monetary policy. Monetary policy should then cause asset inflation – bubbles – because people know how to leverage collateral enough to supply the demand for the bubble. This will have some small impact on real world inflation due to wealth effects spilling over into the real world, but the swings in asset values will be huge. These bubbles are created with non-money – leveraged collateralization of real world assets – so they pop due to Minsky moments and natural business cycle impacts, with devastating consequences.

      So, this model plus MMT says: If the govt doesn’t fill the demand for the bubble through spending of some sort, we will see very little real world inflation or deflation, but truly massive swings in wealth as asset bubbles are demanded by the economy to make it run at full capacity. It sounds really, really familiar to me.

      This is what I see in it.

      • TC
        May 6, 2011 at 11:46 am

        And then, of course, Sean Connery shouts “The Grail!”

      • Tom Hickey
        May 6, 2011 at 12:29 pm

        The is the role of progressive taxation and taxing away economic rent — so wealth doesn’t accumulate at the top and asset bubbles don’t form.

        Minskyians point out that that under the current framework, money gets access to money first and leverages that money to create asset appreciation. Asset appreciation does not count as economic inflation, so inflation as a general continuous price rise does not appear until the top of the town has increased its wealth due to early assess to booms, and then the public at large gets stuck with the bust after smart money has distributed assets accumulated on the way up to retail investors and naive traders. This is Trading 101.

        Most of the MMT on the blogs has to do with monetary/fiscal stuff, but MMT’ers are basically Minskyians.

  7. May 6, 2011 at 4:12 pm

    TC: Here’s how I see it:

    Assume (for simplicity) the central bank adjusts monetary policy at all time to keep the economy operating exactly at “capacity” with constant low inflation. And fiscal policy does nothing (G=T).

    Lets start the economy with no bubble. r is where the two curves cross. Since r<g, someone starts a bubble. The bubble slowly grows, fills the gap between the two curves, and so r grows too. Until eventually r grows to r=g. Then the bubble pops. Then another bubble slowly starts. It does sound a bit Minsky-ish.

    Now, that "someone" who starts the bubble could be the government, violating the LRGBC and running a Ponzi scheme. Now, when the unfunded (by expected future taxes plus seigniorage) government debt gets big enough it gets to the r=g point, what happens next? Does the government suddenly switch to respecting the LRGBC? Can it do so? Maybe it can't, and does a Greece, and the bubble pops. (And don't say governments who can print money unlike Greece don't have to worry, because I have already included the present value of seigniorage in the LRGBC, though the pop might take the form of inflation, so we get Zimbabwe rather than Greece).

    I don't know.

    I call it a "model", but it isn't really one. It's just me drawing a couple of curves and waving my arms around. The Misky-esque dynamics aren't worked out formally — they are just me talking. I haven't actually worked out those dynamics, with rational expectations and stuff.

  8. Clonal Antibody
    May 6, 2011 at 4:52 pm

    TC :
    lol – finally some SiFi!

    I had to do it — after all Kurzweil’s law of accelerating return is also a lot of speculation! But “Crazy Eddie” is a good and reasonable metaphor — which was the intent of Larry Niven. I read “Mote in God’s Eye” that when it came out in 1974.

    • TC
      May 6, 2011 at 9:50 pm


      I am pretty sure I destroyed the LTBC in this post here:


      I’ll turn it over to Peter D for a concise explanation:

      “If I am understanding you correctly, you’re saying that the IGBC is an ex post condition and as such worrying about it ex ante should be done only insofar as there is an observable that tells us whether we’re violating it or not. If there isn’t one, then who cares, more or less. If there is one – such as inflation rate – then this is the only thing we should be concerned about, which bring us back to your posts about solvency vs. inflation.”

      There might be a LTBC, but it is ever obscured to us. We can only know what we know today. And if this is the case, I addressed the consequences:


      We can become Zimbabwe, but we cannot go broke. The road to Zimbabwe will have signs every mile.

      But anyway, I think there is way, way more to this first draft model than you think. Because the economy is aggregated in the model, but the aggregation hides the fact that the bubble will happen in one part of the economy. The economy as a whole demands a bubble, but individual parts of the economy – that all total up to the aggregate g – have different g.

      r is set at the aggregate level by the Fed.

      Some sectors are in Ebenezer Scrooge land. Other sectors are in mega bubble land. The entire economy in bubble land overall, but only some part of the economy even wants to bubble. So the entire economy wants to bubble because g is bigger than r. But only the sectors where g is larger than r will try and fill this demand.

      So you’ll get screaming – screaming huge – bubbles in these sectors as they try to fill the demand for bubbles for the entire economy within that sector. And because the fed is pegging r for the economy, that sector will continue to bubble beyond far beyond the what could concieveable be sustained. g slows down as competition sets in.

      Then the fed says “Whoa the entire economy is over heating a bit”. It raises r enough to push the entire economy into Ebenezer Scrooge land. Of course, according to MMT, this does nothing for inflation, so the Fed keeps doing it. At some point, the bubble in that “on fire” sector gets quashed.

      But since the entire economy’s demand for the bubble was concentrated in that one sector, when this part of the economy moves over to ES land, its horrible.

      There isn’t any slow rise in r and a nice Minsky pop. There is a thermo-nuclear explosion in the sectors of the economy where g is larger than r. The actions of the fed will be completely ineffective until it pops the bubble – and then in retrospect, will seem to be overkill, because the entire economy was concentrating its bubble into bubble-ready sectors.

      I don’t want to talk about the Greece/Euro – I’ll just say I would consider the case of Greece to be very, very different than the situation the U.S. faces. I study them in unhealthy detail. Let’s just say that Greece is borrowing in a really friendly foreign currency and leave it there – its an entirely different conversation.

      Always more work, eh?

    • TC
      May 6, 2011 at 10:04 pm

      I still barely get the Crazy eddie thing. I’ll have to read it again.

      Mote in Gods eye is a strange book, even more so now that I am older. I haven’t read it in 20 years. I read Iain Banks more now – you can see I have a link to him in my links page. I’ve read all the Iain M. Banks books at least 4 times (except the most recent), many of them 8 times. Excession and the player of games are incredible.

      I have a friend who knows Larry Niven.

  9. beowulf
    May 9, 2011 at 12:54 am

    Then the fed says “Whoa the entire economy is over heating a bit”. It raises r enough to push the entire economy into Ebenezer Scrooge land. Of course, according to MMT, this does nothing for inflation, so the Fed keeps doing it. At some point, the bubble in that “on fire” sector gets quashed

    So what if the Fed tried to pop the bubble with a rifle instead of a B-52 raid? That is, instead of that cratering the entire economy by raising interest rates, simply targeting the red hot sector with capital controls (e.g. increasing down payment or margin requirements) or revising its fee schedule with higher and higher levies on disfavored transactions.

    • beowulf
      May 9, 2011 at 10:04 am

      Chuck Schumer has the right idea:

      Fee Pitched for Fast Firms
      Senator: High-Speed Traders Should Bear Cost of Oversight
      Charging algorithm-powered traders who “cancel a disproportionately high percentage of their trades,” Mr. Schumer said, would both chip away at the tracking system’s cost and discourage firms that are seen jamming exchanges with orders that are quickly discarded.


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