Modern monetary theory (MMT) explained

Modern monetary theory is a heterodox economic theory which states governments should not worry about government borrowing but be willing to aim for full employment. Full employment should be achieved through expansionary fiscal policy and financed by creating money.

MMT argues the only limit of higher government borrowing is the effect on inflation. Thus if the economy is depressed with unused resources, the government should immediately create jobs through creating money to finance extra government spending.

As the economy gets close to full capacity and inflationary pressures start to rise, the government should increase taxes to take excess money out of the circular flow and thereby reduce the budget deficit.

MMT argues the traditional view of government borrowing is a mistake. It is not really ‘borrowing’ like a household but the government is ‘borrowing’ using its own debt instruments.

MMT is a controversial economic theory, criticised for ignoring effects of crowding out, inflationary pressures and unrealistic world view. It has become more significant since the financial crisis of 2008 and 2020 have necessited very high levels of government borrowing to deal with falls in economic output.

(When MMT talk about government – it includes government and Central Bank acting as one.)

 

MMT View on Monetary policy

MMT advocates argue that the conventional view of monetary policy is misplaced – especially in a liquidity trap. The conventional response to a recession is cutting interest rates. However, in a slump, the private sector may not want to borrow and cheaper loans have no effect in increasing investment. This is why fiscal policy is much more effective. If the government employ workers, the private sector economy will have more confidence to employ people.

If the government maintain zero interest rates, but no expansionary fiscal policy this can actually be quite contractionary.

MMT argues that raising interest rates can even be expansionary because the government pay higher dividends to private sector, causing injection into the economy. Cutting rates can be deflationary because interest dividends to the private sector (holding bonds) is reduced.

MMT View on government borrowing

A key aspect of MMT is that a government can never default on debt because it can always create money which is accepted by private sector. The only constraint to government borrowing is the effect on inflation.

A traditional view of government borrowing is that it is like a household – spending more than it receives in income. This becomes debt they owe to an external third party. However, MMT says this is mistaken. A household cannot print money which will be accepted in a shop. MMT argue that a government should borrow by creating money (not issuing debt) In effect the government is issuing its own liabilities to the private sector. It is ‘borrowing’ using its own debt instrument. MMT also observe that when the government issue bonds, this is a value to the private sector.

“Hence government issuance of debt results in net financial asset creation for the private sector. Private debt is debt, but government debt is financial wealth to the private sector.” Yeva Nersisyan L. Randall Wray, June 2010

MMT say the only limit to government borrowing is its effect on inflation. In a recession, a government can easily increase the money supply without inflationary pressure because there is spare capacity and falling velocity of circulation. If the government pursue expansionary fiscal policy when the economy is close to full capacity then this will cause inflation, and the government should respond by raising taxes to reduce demand.

Note: MMT make an exception to countries like Greece and Italy who are in the Euro – they may not be able to print money to finance debt because they rely on ECB. Countries like UK, US and Japan do control their currency fully.

Crowding out/Crowding in

A traditional critique of government borrowing is that if the government borrow, it deprives the private sector of funds for investment – therefore, government borrowing – crowds out the private sector. However, MMT say if the economy has spare capacity, then government borrowing is not reducing private sector spending, but the reverse can happen. Creating jobs and reducing unemployment gives the private sector more confidence to invest because they expect additional demand.

Policy implications of MMT

“Politicians need to reject the urge to ask “How are we going to pay for it?” … We must give up our obsession with trying to “pay for” everything with new revenue or spending cuts…”  [Kelton, Bernal, and Carlock 2018].

  • Don’t worry about deficits – only worry about inflation. As long as deficits are not inflationary, governments should borrow (through money creation) as much as needed to gain full employment.
  • ‘Free-lunches available‘. When resources are idle (recession), there is no trade off involved in increasing money supply and getting unemployed back to work. It is like a ‘free lunch’ you can increase output with no cost. Unemployment is an unnecessary burden and loss of resources.
  • Importance of fiscal policy. The government should use fiscal policy to target inflation and unemployment. Increasing spending when inflation is low, increasing taxes/cutting spending when inflation is increasing.
  • Jobs guarantee. Some MMT propose a jobs guarantee or NAIBER non-accelerating inflation buffer employment ratio – this means that if workers cannot find a job in the government sector, they should find a job via the government’s job guarantee (JG). The government’s job guarantee will be a fixed wage and so you can reduce unemployment without causing inflation.

Criticisms of MMT

  • The concept governments can just create money to fund spending is misleading – ultimately the ability to print money is not enough – the government relies on real output and income to gain the credibility and ability to finance spending.
  • View on inflation too simplistic.  MMT say if there is spare capacity, the government can create money, but inflation could already be a problem even at this stage. Inflation can be due to cost-push factors. Also measuring the amount of spare capacity is difficult.
  • Political issues of using tax. MMT argues tax rates should be changed to control inflation, but this can be politically difficult. Politicians may not want to raise tax just to reduce inflation.
  • Higher government borrowing can be inflationary. In the 1970s, the government’s did run budget deficits which were highly inflationary. In effect, the government did default on part of its debt. Investors who owned bonds in 1970, saw inflation erode the real value. Many developing countries have underestimated the potential for higher borrowing to cause runaway inflation.
  • The ‘evangelism of MMT’ Paul Krugman, amongst others, has criticised the evangelism and ‘revolutionary fervour of MMT arguing they are too quick to state MMT agenda is self-evident.

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