Modern Monetary Theory

Economics for the 21st Century

We may be on the cusp of a revolution in the field of economics. It seems that everything we thought we knew about public finance over the past 40 years has been wrong. A new economic theory has emerged that could rewrite our understanding of how governments create and spend money and what type of society we can afford to build. The theory is called Modern Monetary Theory (MMT) and it is challenging the neoliberal economic orthodoxy that has dominated policymaking in the United States, the United Kingdom and many other countries since the mid-1970s. The theory, in brief, argues that countries that issue their own currencies can never “run out of money” the way people or businesses can. But what was once an obscure “heterodox” branch of economics has now become a major topic of debate among Democrats and economists with astonishing speed.

A round the world, rich economies are facing a historically unprecedented set of problems, including aging populations, slow growth, low or negative interest rates, and deflation. This novel set of economic issues, which has emerged in country after country over the last few decades, demands novel policy solutions. Among the slate of possible options is so-called Modern Monetary Theory (MMT). This is an unorthodox – and highly controversial – approach, which once was confined to blogs and a handful of colleges, to government finances that allows for significantly expanded government spending. MMT challenges the traditional way we think about how the economy works: Government spending is financed through taxes and debt issued through government bonds and that we should work toward reducing the national deficit.

Introduction

Policy and business circles these days buzz about something called modern monetary theory. Many claim it explains why budget deficits do not matter and why monetary ease, “printing money,” can cover the difference between spending and taxes and never produce inflation.

Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that says monetarily sovereign countries which spend, tax, and borrow in a fiat currency (a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it) they fully control, are not operationally constrained by revenues when it comes to federal government spending. MMT challenges conventional beliefs about the way the government interacts with the economy, the nature of money, the use of taxes, and the significance of budget deficits.

The defining feature of MMT — and what distinguishes it from more established, mainstream economic theories — is its insistence that, so long as a government’s debt is denominated in its own currency, there is no upper limit on the state’s monetary borrowing. In other words, public debt is irrelevant; a country’s central bank can always avoid default by printing more money. Such printing, MMT proponents further argue, can go on without any inflationary consequences. They thus call for economists to shed their superstitious fear of debt and for policymakers to unleash the full power of unlimited, risk-free government spending.

Proponents

Modern Monetary Theory, also called MMT, is not a new concept though it is called modern –as it was proposed by noted American economist and theorist Warren Mosler in 1992, along with Bill Mitchell, a university professor based in Australia and a key developer of the theory. The theory behind it was first suggested by the Scottish economist John Law in 1705 in a book Money and Trade Considered: With a Proposal for Supplying the Nation with Money’ he published for use by Scottish Parliament.

Main Figures

Some of the main personalities include:

• Bill Mitchell, emeritus professor of economics at the University of Newcastle and Director of the Centre of Full Employment and Equity
• L Randall Wray, professor of economics at Bard College, United States, and senior scholar at the Levy Economics Institute
• Warren Mosler, economist and co-founder of the Centre for Full Employment and Price Stability at the University of Missouri-Kansas City
• Martin Watts, emeritus professor of economics at the University of Newcastle and a Research Associate at the Centre of Full Employment and Equity
• Stephanie Kelton, professor of economics at Stony Brook University and a former economics adviser to US Democratic senator Bernie Sanders
• Steven Hail, professor of economics at the University of Adelaide

Core Principles

The central idea of MMT is that governments with a fiat currency system under their control can and should print (or create with a few keystrokes in today’s digital age) as much money as they need to spend because they cannot go broke or be insolvent unless a political decision to do so is taken.

Some say such spending would be fiscally irresponsible as the debt would balloon and inflation would skyrocket. But according to MMT, large government debt isn’t the precursor to collapse we have been led to believe it is, countries like the U.S. can sustain much greater deficits without cause for concern, and a small deficit or surplus can be extremely harmful and cause a recession since deficit spending is what builds people’s savings.

MMT theorists explain that debt is simply money the government put into the economy and didn’t tax back. They also argue that comparing a government’s budgets to that of an average household is a mistake.

While supporters of the theory acknowledge that inflation is theoretically a possible outcome from such spending, they say it is highly unlikely and can be fought with policy decisions in the future if required. They often cite the example of Japan, which has much higher public debt than the U.S.

According to MMT, the only limit the government has when it comes to spending is the availability of real resources, like workers, construction supplies, etc. When government spending is too great with respect to the resources available, inflation can surge if decision-makers are not careful.

Taxes create an ongoing demand for currency and are a tool to take money out of an economy that is getting overheated, says MMT. This goes against the conventional idea that taxes are primarily meant to provide the government with money to spend to build infrastructure, fund social welfare programs, etc.

“What happens if you were to go to your local IRS office to pay your taxes with actual cash?,” wrote MMT pioneer Warren Mosler in his book The 7 Deadly Frauds of Economic Policy1. “First, you would hand over your pile of currency to the person on duty as payment. Next, they’d count it, give you a receipt and, hopefully, a thank you for helping to pay for social security, interest on the national debt, and the Iraq war. Then, after you, the taxpayer, left the room, they’d take that hard-earned cash you just forked over and throw it in a shredder.”

MMT says that a government doesn’t need to sell bonds to borrow money, since that is the money it can create on its own. The government sells bonds to drain excess reserves and hit its overnight interest rate target. Thus the existence of bonds, which Mosler calls “savings accounts at the Fed,” is not a requirement for the government but a policy choice.

Unemployment is the result of government spending too little while collecting taxes, according to MMT. It says those looking for work and unable to find a job in the private sector should be given minimum-wage, transition jobs funded by the government and managed by the local community. This labor would act as a buffer stock in order to help the government control inflation in the economy.

Weaknesses

These are the biggest weaknesses of modern monetary theory:

1. A flawed model of inflation

MMT argues that “slack,” the amount of resources not being used at a given time, is what determines inflation. This is partly based on an economic model called the Phillips Curve, which argued there is a tradeoff between inflation and unemployment (more of one will lead to less of the other). However, simultaneously high inflation and unemployment in the 1970s showed that this model was flawed. Rather, it is monetary policy, not slack, that determines the path of inflation.

2. Revenue can be earned from money creation

A government can earn revenue from printing money if the cost of printing is less than its value. For example, if a $100 bill costs roughly six cents to print, then it yields a $99.94 profit. However, assuming the government does not pay interest on that money, it will be quickly spent by the public. The result is high inflation for not much added revenue. In fact, one study found that the maximum sustainable amount of revenue from money creation is roughly four percent of GDP, which would generate annual inflation at 266 percent!

3. Overestimation of the potency of fiscal policy

MMT argues fiscal policy is more important than monetary policy in determining inflation, so raising taxes is the solution to high inflation. However, this is not the experience of the United States. In the 1960s, President Lyndon Johnson followed this logic by raising taxes and balancing the budget, but high inflation persisted. In fact, inflation only fell in the early 1980s when Fed Chair Paul Volcker reduced the growth of the money supply, despite high budget deficits under President Reagan during the same period.

The fiscal policy explanation for inflation is true in places like Venezuela and Zimbabwe, where the central bank’s monetary policy decisions are highly political. However, in these places, the government is so wasteful and irresponsible that monetary policy has to support fiscal policy.

4. Overestimation of the ability to control inflation

Politicians, who are charged with determining fiscal policy in most countries, adjust tax and expenditure policies in response to their constituents’ interests. How likely does it seem that Congress and the president would be likely to raise taxes during a period of high inflation when the public is already upset at rising prices? Not very likely, especially given the political gridlock in Washington, DC.

5. Few safeguards against excessive public debt

Debt that might look manageable in one economic environment may become unsustainable in another, as Greece learned during the Great Recession. While the United States is unlikely to default on its debt, high debt can cause other problems, including either higher taxation or higher inflation in the future. Either of these problems can stifle future growth and prosperity. Furthermore, while the US is not in danger of becoming like Greece in the near future, history tells us that circumstances change. If the US continues to accumulate massive amounts of debt, there is no guarantee we will always be able to easily pay it off.

Conclusion

MMT is not a debate set in finality: it is continually evolving as its scholarship grows and policymakers express interest in its applications. “Mainstream” economics, it should be added, is equally an evolving discipline (as it should be). What is of immediate concern for a general audience is to recognize the alternative explanations that MMT provides, and recognize that their concerns about government and money might be better encapsulated by this theory. Above all, this will set the currency-sovereign societies with the psychological breathing space to begin the ambitious projects of the 21st century that can revitalize their economies, put them on a path to sustainability, and put the fiction of money into the fact of prosperity.