MMT's Godfather Warns: Higher Rates Fuel Inflation as US Spends Like "Drunken Sailors"

Warren Mosler, the originator of Modern Monetary Theory, argues that conventional monetary policy has it backwards—higher interest rates are now inflationary due to massive government debt levels.

Key Takeaways

• Higher interest rates create inflation through the "interest income channel" when debt-to-GDP ratios are high
• Current US deficit spending at 7% of GDP represents "drunken sailor" levels unprecedented during economic expansion
• Interest payments now exceed $1.2 trillion annually, comprising 4% of GDP and fueling aggregate demand
• Traditional monetary policy tools have become counterproductive due to fiscal dominance effects
• Federal Reserve rate hikes inject more stimulus than restraint into today's debt-laden economy
• Japan's experience validates the theory that rate cuts would be massively deflationary at current debt levels
• The economy shows signs of a tiered system where interest income recipients drive luxury spending
• Warren Mosler's automotive company produced race cars that still win competitions 20 years later

Timeline Overview

• 00:00–08:32 — The Interest Income Channel Introduction: Hosts discuss the counterintuitive theory that higher interest rates can contribute to inflation, setting up the conversation with Warren Mosler about this heterodox economic view
• 08:32–18:45 — Warren Mosler's MMT Origins: Introduction of Mosler as MMT's originator, his background as economist and former investment manager, plus his 1997 paper arguing the natural rate of interest is zero
• 18:45–32:17 — Historical Rate Cut Analysis: Detailed examination of how 2008 rate cuts removed $400 billion in interest income annually, creating deflationary pressure, and quantitative easing's unexpected economic slowdown effects
• 32:17–47:23 — Debt-to-GDP Impact Multiplication: Comparison of current 100% debt-to-GDP versus historical 30-35% levels, showing how rate changes now have three times the economic impact through interest payments
• 47:23–58:41 — The Andrew Card White House Meeting: Mosler recounts his 2002 meeting with Bush's Chief of Staff, recommending $700 billion in deficit spending and the subsequent successful economic turnaround
• 58:41–71:15 — Fiscal Dominance and Paul Krugman: Discussion of how high debt levels constrain monetary policy effectiveness, with Krugman's acknowledgment that rate hikes become inflationary at extreme debt levels
• 71:15–89:32 — Unprecedented Deficit Spending Analysis: Current 7% of GDP deficit during expansion with 4% being interest payments, representing "drunken sailor" levels never seen outside recessions or wartime
• 89:32–102:48 — Price Level Convergence Theory: Mosler's observation that inflation gravitates toward policy rates over time, comparing current 3.75% CPI to last year's 3.5% effective treasury rates
• 102:48–117:25 — Japan Case Study and Policy Implications: Analysis of Japan's zero-rate experience, current inflation dynamics, and what massive rate cuts would mean for the US economy
• 117:25–132:17 — Distributional Effects and Economic Transformation: How interest income creates a tiered economy with luxury goods demand surge while traditional rate-sensitive sectors decline
• 132:17–145:39 — Mosler Automotive and Art Laffer Stories: Warren's race car company history, collaboration with Art Laffer on economic writing, and personal anecdotes from decades in economics
• 145:39–152:14 — Policy Recommendations and Closing: Final thoughts on what central banks should do, rate cut implications, and wrap-up discussion of the paradigm shift in monetary policy

The Interest Income Channel Revolution

Warren Mosler's theory fundamentally challenges conventional monetary policy wisdom by examining how interest rate changes affect the broader economy through government debt payments. His analysis reveals a critical threshold where traditional tools become counterproductive.

• The interest income channel operates through direct payments to bondholders, pension funds, and financial institutions when rates rise, injecting income into the economy rather than removing it. These payments flow through various intermediaries but ultimately reach consumers who spend portions of this windfall.
• Mosler's 1997 paper "The Natural Rate of Interest is Zero" established early groundwork for understanding how interest rates themselves drive money supply growth and price level changes over time. The relationship between policy rates and monetary expansion became apparent through decades of observation.
• Historical data from the 1980s showed clear correlations between interest rate levels and M2 growth patterns, suggesting that conventional causality assumptions needed reexamination. This insight emerged from practical trading experience rather than academic modeling.
• The theory gained validation during multiple economic cycles where rate cuts failed to provide expected stimulus while rate hikes produced stronger-than-anticipated economic activity. Traditional transmission mechanisms consistently underperformed relative to the fiscal channel effects.
• Modern economies operate with such high debt-to-GDP ratios that interest payments have become a significant component of aggregate demand, fundamentally altering how monetary policy transmits through the system. The arithmetic of this relationship becomes unavoidable at current debt levels.
• Mosler emphasizes avoiding the term "inflation" due to its imprecise usage, preferring to discuss "price level changes" and specific market dynamics rather than broad generalizations about monetary phenomena.

Historical Precedents and Policy Lessons

Mosler's experience spans multiple economic cycles, providing crucial insights into how interest rate policies have evolved and why current conditions represent a fundamental shift from historical norms.

• During the 2008 financial crisis, Bernanke's rate cuts from 5.5% to zero removed approximately $400 billion annually in interest income from the economy, creating deflationary pressure that prolonged the recovery period. This massive fiscal contraction through the interest channel overwhelmed other stimulus measures.
• Quantitative easing programs paradoxically removed income from the private sector by exchanging high-yielding securities for low-yielding reserves, effectively transferring $90 billion annually from bondholders to the Federal Reserve. "I said you know they're effectively taking 90 billion a year of interest income out of the economy."
• The 2002 meeting with White House Chief of Staff Andrew Card demonstrated practical application of these principles when Mosler recommended $700 billion in annual deficit spending to combat recession. Card's response: "well we don't have much time do we... you better get started."
• Subsequently enacted policies included unprecedented retroactive tax cuts, Medicare prescription drug benefits, and aggressive spending programs that lifted the deficit to Mosler's target levels and successfully ended the recession. The economy responded exactly as the interest income theory predicted.
• Japan's experience with zero interest rates validates the theory's predictions about deflationary impacts of rate cuts, while recent Japanese inflation coinciding with global rate increases supports the inflationary thesis for rate hikes. Their current policy stance reflects understanding of these dynamics.
• Each cycle reinforces that conventional economic models systematically underestimate the fiscal impacts of monetary policy changes, leading to persistent forecasting errors and policy mistakes across multiple decades.

Unprecedented Fiscal Expansion During Economic Strength

Current government spending levels represent a dramatic departure from historical patterns, creating economic conditions unlike any previous expansion period in American history.

• The federal deficit now exceeds 7% of GDP during a period of 4% unemployment and record-low jobless claims, a combination never before observed in peacetime expansion. Historical deficits of this magnitude only occurred during severe recessions or wartime mobilization.
• Interest payments alone consume over $1.2 trillion annually, representing 4% of GDP and exceeding defense spending, Social Security payments, and most other major government programs. Monthly interest payments recently surpassed $100 billion for the first time.
• Without interest expense, the underlying deficit would trend toward 2-3% of GDP, still elevated but not at current "drunken sailor" levels that Mosler considers unsustainable from a price stability perspective. The interest component represents the truly unprecedented element.
• CBO projections show deficits remaining above 6% of GDP indefinitely, creating a permanent high-stimulus environment that traditional macroeconomic models cannot adequately analyze or predict. These projections assume no recession or major economic disruption.
• The effective interest rate on treasury debt continues rising toward the federal funds rate through normal rollover processes, meaning current stimulus levels will intensify even without further Fed action. Mathematical certainty drives this process regardless of policy decisions.
• Mosler characterizes this spending pattern as fundamentally different from counter-cyclical stimulus, representing pro-cyclical fiscal expansion that amplifies rather than moderates economic fluctuations.

Fiscal Dominance and Monetary Policy Constraints

The relationship between debt levels and monetary policy effectiveness has reached a critical threshold where traditional tools produce opposite effects from their intended purposes.

• When debt-to-GDP was 30-35% in previous cycles, a 1% rate change affected the economy by roughly 35 basis points of GDP through interest payments, but current 100% debt ratios create full 1% GDP impacts. This represents a threefold amplification of fiscal effects.
• Paul Krugman acknowledged this constraint years ago, arguing that excessive deficit spending could render Fed rate increases ineffective because "the interest expense will be so high that that itself would cause inflation." Mosler responded: "I think we're already there."
• New Keynesian models explicitly recognize fiscal dominance as a mathematical inevitability when debt levels become sufficiently large, making monetary policy counterproductive for inflation control. This represents mainstream economic theory, not heterodox thinking.
• Rate cuts to zero would represent approximately $1.2 trillion in reduced government spending annually, equivalent to the largest fiscal contraction in American history multiplied by ten. Such deflationary pressure would overwhelm any conventional recession.
• The Federal Reserve's institutional framework lacks adequate tools for current conditions, as rate increases intended to cool the economy instead inject massive stimulus through interest payments to bondholders and financial institutions.
• Japan's situation demonstrates even more extreme fiscal dominance with debt-to-GDP ratios twice US levels, making any substantial rate increases potentially catastrophic for price stability through explosive interest payment growth.

Price Level Convergence and Long-term Dynamics

Mosler's observation of price level behavior over extended periods reveals systematic relationships between interest rates and inflation that conventional models overlook or dismiss.

• Over 50 years of data shows inflation rates gravitating toward federal funds rates through a convergence process that operates like "a stock split" where expanding net financial assets through interest payments drives proportional price level increases. Current 5.38% rates suggest inflation settling near that level.
• The mechanism operates through continuous expansion of the monetary base via interest payments on government debt, creating sustained upward pressure on prices independent of supply and demand factors in specific markets. This represents pure monetary expansion without corresponding real sector growth.
• CPI has plateaued around 3.75% after initial COVID volatility, closely matching last year's effective treasury rates of approximately 3.5%, supporting the convergence theory with remarkable precision. This correlation appears too consistent for coincidence.
• PCE measures differ because they incorporate substitution effects when consumers switch from expensive to cheaper alternatives while maintaining constant expenditure levels, but this doesn't invalidate the underlying monetary dynamics driving nominal price increases.
• Long-term expectations should incorporate this systematic relationship rather than assuming inflation will return to 2% targets while maintaining 5%+ interest rates on a $30+ trillion debt stock. Mathematical relationships eventually overwhelm policy intentions.
• The convergence process allows for temporary deviations but operates as a gravitational force pulling inflation toward policy rates over multi-year periods, regardless of short-term supply shocks or demand fluctuations.

Distributional Effects and Economic Transformation

The current high-rate environment creates distinct winners and losers, fundamentally altering consumption patterns and economic structure in ways that reinforce inflationary pressures.

• Interest income recipients drive demand for luxury goods like Rolls-Royce vehicles, which reportedly maintain multi-year order backlogs, while rate-sensitive sectors like housing experience significant slowdowns. This creates a tiered economy with divergent performance across sectors.
• Pension funds, insurance companies, and wealthy bondholders benefit enormously from current rates while borrowers face increased costs, but the net effect favors spending because "their clients are getting flooded with interest income and buying their output at whatever price they need."
• Government tax policy amplifies distributional effects through programs like 40% solar tax credits that create open-ended spending commitments, with major accounting firms establishing specialized partnerships to capture these benefits for wealthy clients.
• Housing market dynamics reflect rate sensitivity with substantial slowdowns in construction and sales, but this primarily affects middle-class wealth accumulation rather than aggregate spending by high-income interest recipients who drive luxury consumption.
• Business pricing power has strengthened because customer income from interest payments allows companies to pass through higher borrowing costs without losing sales volume, creating self-reinforcing inflationary dynamics across multiple sectors.
• The composition of GDP shifts toward sectors serving interest income recipients while traditional rate-sensitive industries contract, but overall economic activity remains elevated due to the massive fiscal injection through bond payments.

Common Questions and Answers

Q: If higher rates cause inflation, why hasn't the Federal Reserve recognized this?

A: Mosler suggests the Fed's models assume "zero propensity to spend interest income" regardless of how much interest gets paid out. Traditional models focus on borrowing costs while ignoring the massive fiscal injection through interest payments to bondholders, pension funds, and financial institutions.

Q: Won't wealthy bondholders just save their interest income rather than spend it?

A: While individual propensities vary, the data shows substantial portions get spent either directly through luxury consumption (like Rolls-Royce's multi-year backlogs) or indirectly through institutional spending by pension funds and insurance companies serving middle-class beneficiaries.

Q: How can 7% deficit spending be sustainable if it's "drunken sailor" levels?

A: Mosler argues it's not sustainable from a price stability perspective—that's precisely his point. This level of spending during economic expansion is unprecedented and creates persistent inflationary pressure that monetary policy cannot effectively combat.

Q: What should the Federal Reserve do differently?

A: Mosler advocates for permanent zero interest rates combined with fiscal policy adjustments for economic management. Rate cuts to zero would represent the largest fiscal contraction in history, creating massive deflationary pressure that would require offsetting stimulus measures.

Q: Does this mean Modern Monetary Theory supports unlimited government spending?

A: No. Mosler emphasizes that all government spending has consequences and affects relative prices throughout the economy. The theory describes fiscal constraints through inflation rather than financial constraints, making spending decisions about resource allocation and price stability rather than budget arithmetic.

Q: How does this apply to other countries with different debt levels?

A: The interest income channel's strength depends on debt-to-GDP ratios and the currency's status. Countries with lower debt levels may still see traditional monetary policy transmission, while highly indebted nations like Japan face even more extreme fiscal dominance effects than the United States.

Conclusion

Warren Mosler's analysis reveals a profound shift in monetary policy effectiveness that challenges decades of economic orthodoxy. His "interest income channel" theory, validated by current economic data showing persistent strength despite aggressive rate hikes, suggests that conventional tools have become counterproductive at today's debt levels.

The combination of 7% deficit spending during expansion and $1.2 trillion in annual interest payments creates an unprecedented fiscal environment where rate increases fuel rather than fight inflation. This paradigm shift demands fundamental reconsideration of how central banks approach price stability in debt-laden modern economies.