What is Modern Monetary Theory?
Hedging and Capital Markets
Private Equity | London
SummaryWith government debt levels reaching new highs relative to GDP, and deficits ballooning, now seems an appropriate time to examine Modern Monetary Theory (MMT). This piece aims to provide a high-level overview of MMT and discusses some of its claims.
What is Modern Monetary Theory and how much water does it hold?
Firstly, a caveat: there is not one “Modern Monetary Theory” like there is one Theory of General Relativity. In fact, one critique frequently levelled at MMT is that it has little formalism or explicit modelling to support it. However, there are a few key ideas shared by proponents of MMT which form the basis of their policy recommendations.
What lies at the core of MMT?
It does not assert that “government debt and deficits do not matter.” Rather, it states that a government that issues its own currency, and borrows exclusively in this currency, can never go bankrupt and thus faces no nominal spending limits.
Admittedly, this may go against one's intuition, but it is self-evidently correct. In an economy based on fiat-money (i.e., money not backed by gold), currency is created through banks issuing loans. Ultimately, the bank of banks (the central bank) can always produce more money, and so it can always finance any borrowing by the government. The idea that there is a limited supply of savings that could fund borrowing activity, and that government borrowing would always “crowd out” private investment, is not true in an economic system where money is not backed by some underlying commodity, such as gold.
What to do with this supposedly unlimited spending power?
Proponents of MMT argue the government should issue a job guarantee, such that unemployment is eliminated. This is where challenges arise. Wouldn’t this lead to inflation, either through labour’s improved bargaining position (leading to wage and then price increases); or because there are supply side constraints such that government spending outpaces the economy’s productive capacity? While there might not be any nominal limits to government borrowing and spending, vicious levels of inflation might impose a real-world limit.
Here, the role of taxation comes into play. MMT views taxes as a means of draining purchasing power from the rest of the economy, reducing aggregate demand and keeping inflation in check. Taxes, according to proponents of MMT, are not necessary to fund state expenditure (it could do so exclusively through debt). Instead, they are a lever that can be pulled to manage demand (read: inflation) and are ultimately what gives value to the currency the government issues. Under this interpretation, the money issued by a government is worth something because the state accepts it as tender for tax payments.
To many, this proposition seems counterintuitive to the point of absurdity. Even for those who are prepared to entertain it, many questions may remain. For example, what kind of jobs would the government create as part of its jobs guarantee programme? How would the minimum wage for these jobs be set? Moreover, taxing parts of the economy to curb inflation while at the same time running job creation programmes is, in effect, a redistribution of income. How can this be done without limits? Wouldn’t there be a point where such taxation and income redistribution depresses the growth and the productive capacity of the economy? Imagine that unemployment is mainly supply-side driven. Would the policies prescribed by MMT be effective at all in such a situation? Moreover, is it even possible to fine-tune taxation so that inflation doesn’t get out of hand? Would politicians credibly commit to keeping inflation under control?
Even if these questions of domestic policy could be answered, it is not necessarily clear how MMT policies would cope with the flow of investments, capital, and labour. Perhaps it would need to go hand-in-hand with, for example, capital controls. After all, if a government is viewed as not credibly committing to keeping inflation under control, there might be an inflationary “run” on the country’s currency.
What does seem clear is that, under MMT, there would be no central bank independence (the central bank would effectively become another government department), and that the state would enlarge to play a very active role in the economy – even more so than it already does in most countries. While MMT may well offer an alternative approach, and work in theory, a fair objection is whether it would work in practice given the importance it assigns to the state as an economic actor.
Where does this leave us?
MMT highlights a very important fact about our monetary economy, namely that a government controlling its own printing press could practically borrow and spend without limits (though this idea isn’t unique to MMT). For an economy running below capacity, this shouldn’t lead to inflationary pressures.
There is a case to be made to reset the discussion on government finances and debt sustainability. Prior to the onset of the COVID-19 pandemic, the U.S. and UK governments had been continuously running deficits without causing inflation to spiral out of control or triggering a run on their currencies. At the same time, unemployment rates reached record lows. Japan is even more instructive as a case study. Due to continuous deficit spending, its gross public debt stands well above 200% of GDP. However, a lot of this sits on the Bank of Japan’s balance sheet so that if one accounts for debt held by the state itself, the net debt figure comes in below 100% of GDP. Japan may have been struggling with generating growth despite all of that deficit spending, but it certainly didn’t have an inflationary problem: in 2019 unemployment was as low as 2.3%.
Now, with the policy response to the pandemic, governments are running large deficits and central banks are engaging in quantitative easing on a massive scale, effectively monetising the additional government debt. Yet, there is no run on government bonds or out-of-control inflation. One may ask if this isn’t MMT in all but name. What is clear is that the discussion on debt and deficits is shifting. Distinguished economists like Olivier Blanchard (MIT and IMF) and Larry Summers (Harvard, former U.S. treasury secretary) have argued that we should be less concerned with deficit spending when interest rates are below the growth rate of the economy. However, this line of thinking is still a far cry from full MMT. It may very well be that the current loose fiscal and monetary policy is only possible because many countries are in the same boat with strong deflationary forces at work and a naturally high demand for savings. Whether governments can continuously run deficits with impunity, we may find out once inflation returns, economies reach full employment and private sector savings become scarce.
Want to learn more about Modern Monetary Theory?
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