Head of Macro Analysis, Saxo Bank Group
Summary: Modern Monetary Theory is gaining in prominence, particularly among political progressives. Despite the failures of the current orthodoxy, however, MMT poses significant dangers and its proponents have still not been able to provide a convincing response to its seemingly inherent inflation problem.
What is MMT?
MMT is often understood as a justification for public spending. Simply stated, one of the core ideas of MMT is that deficits don’t matter for countries (such as the US) that can borrow in their own currency and print more money when they need to pay off their debts.
It is called “Modern” Monetary Theory but this concept isn’t new. It is connected to the doctrine of “functional finance” that has been endorsed by the economist Abba Lerner in the 1940s. It states that governments should not subordinate their real-economy objectives – such as low unemployment, higher wages et cetera – to the quest for a balanced budget. This doctrine has never been popular since, after WWII, Keynesianism took over as dominant economic approach until the mid-1970s.
In the past 20 years, though, this theory has enjoyed some renewed interest in progressive circles, resulting in the emergence of MMT. Wray, Forstater, Mosle and Dantas have written some of the most important academic papers on the subject, but it was not until the collapse of moderates from the Democratic Party after the last US presidential election and the emergence of a new progressive left, led by young new politicians such as AOC, that MMT emerged at the heart of public debate.
How would it work?
Under an MMT regime, central bank independence would be abrogated and monetary policy would be completely coordinated between the central bank and the Treasury, as was the case in the immediate aftermath of World War Two in many developed economies. The central bank would finance public spending – eventually on a massive scale - for job guarantees or Green New Deal-type programmes and when it came time to pay off debts, it would print more money.
Monetary policy would be essentially accommodative as the central bank would keep interest rates below the growth of GDP and debt, which would stabilise the debt-to-GDP ratio and avoid – in theory – an excess of inflation. It seems simple. But what if central bank independence and inflation targeting were the keys to explaining why inflation has been held down over the past decades? Would a central bank dependent on the Treasury be able to contain inflation? History shows us that the answer is no.
MMT is very controversial. Most mainstream economists, including left-leaning figures like Paul Krugman, label MMT as the new “voodoo economics” of our time. They say it is ludicrous to believe that massive spending can be financed by central banks without any burden on the economy, warning that it could cause high inflation and even hyperinflation.
MMT diverges fundamentally from the dominant, Quantity Theory of Money when it comes to inflation. QTM states that there is a direct relationship between the quantity of money in circulation and the level of prices. In its simple mathematical form, what we call the Fisher equation is expressed as: MV = PT (M = money supply, V = velocity of money, which is the number of times money changes hands, P = average price level and T = volume of transactions of goods and services).
Concretely, when the quantity of money surpasses the growth of economic output – for instance, if the central bank needs to print a lot of money to pay off debts – the result is inflation. When the quantity of money falls behind the growth of economic output, we see deflation. Therefore, to curb hyperinflation in the 1970s, monetarists advised central banks to target money supply growth. The relationship between money supply growth and inflation is rather robust in the long run, but it is not rigid, which means prices can be distorted by numerous factors in the short and medium term – such as quantitative easing, as pointed out by many recent academic papers.
MMT also contradicts a more heterodox approach that emerged in the early 1990s and is popular among economists: The Fiscal Theory of the Price Level. FTLP can be seen as complementary to QTM, at least in the view of its proponents). It claims that monetary and fiscal interactions (not only monetary policy, as in QTM) jointly determine the economy's equilibrium and the price level. For the price to be stable and to control inflation, both monetary policy and fiscal policy are required. Monetary policy stabilises output at potential and sets the real interest rate while fiscal policy must aim to stabilise debt, as high deficits will affect the price level and push it up.
It would be inaccurate to claim MMT proponents consider there to be no risk at all of high/uncontrolled inflation due to endless money supply growth used to finance deficits, or massive fiscal stimulus increasing structural deficit. Stephanie Kelton, a key figure among the MMT economists, recognised in a recent discussion that there is a level (that needs to be defined) from which the deficit can cause a strong jump in inflation.
MMT economists propose various methods to manage inflationary risks: tax increases as key part of the budgeting process (to try managing inflationary pressures before they materialise), strengthening automatic fiscal stabilisers (savings policies or indexing tax brackets to an inflation target) or delegating day-to-day demand management – as excess demand can cause inflation – to an independent agency. However, none of them are convincing.
MMT has a completely different approach to monetary policy and inflation than conventional wisdom. Mainstream monetary policy has failed; QE has increased inequality and was unable to tackle the issue of prolonged low growth. However, MMT is the not the solution. It is, instead, a collection of mostly magical thinking that could have profoundly negative economic consequences. This kind of supply-side economics would eventually hit hard working and middle-class people as it may not be able to contain the spike in inflation caused by an excess of debt and money printing.