Modern Monetary Theory

By Sandra Ng, Brooklyn Han, Anna Clarey and Pedro Almas

What is Modern Monetary Theory?

Modern Monetary Theory (MMT) is a fringe macroeconomic theory which argues that government spending need not be paid for by taxes. It further posits that governments can run budget deficits as large as they wish without facing adverse consequences, as long as they issue and control their own currency. In this framework, governments, which in most developed economies are run by elected politicians, replace independent central banks as the monopoly issuers of currency.

MMT claims to be applicable to monetarily sovereign countries like the US, the UK, Japan, and Canada, which spend, tax, and borrow in a fiat currency they fully control. Because their budgets are not like a regular household’s, MMT argues that their policies should not be shaped by fears of rising national debt. The explosion in debt due to the COVID-19 pandemic has brought MMT into mainstream debate, as a theory that governments can print as much money as they need without relying on taxes or borrowing for spending.

MMT is not Quantitative Easing

The idea of increasing the money supply may seem related to quantitative easing (QE), but there is a key distinction. The money creation in QE is reversible, while that in MMT is not. QE involves creating money electronically for the purchase of financial assets, which can be reversed by their eventual sale. In contrast, MMT entails directly paying for public services or making transfer payments to households using newly created money. This means the expansion in the money supply is permanent, as the government does not have a mechanism for its reversal.

Moreover, the money creation in MMT is done by governments, while that in QE is by central banks. MMT places the power in the hands of politicians, as opposed to independent central banks which tend to have a better track record of following through on policy commitments. This has huge implications for how decisions are made and their overall economic impact.

Advocates of MMT and their objectives

Under MMT, governments that control their own currency can spend freely, as they can always create more money to pay off debts in their own currency. In that sense, it seeks to give intellectual respectability to the notion that governments do not need to pay for anything they do. Thus, MMT is used by some left-wing politicians (such as Alexandria Ocasio-Cortez and Bernie Sanders) in policy debates to resolve funding issues with progressive legislation such as universal healthcare, a Green New Deal, big middle-class tax cuts, free college tuition, and other big spending plans. Economist Stephanie Kelton, who is now arguably the face of the theory, served as chief economic adviser to Sanders during his 2016 presidential campaign.

MMT and the risk of hyperinflation

One of the biggest arguments against MMT is the risk of causing hyperinflation. According to the quantity theory of money, money supply and prices are related by the following equation:

MV = PQ,

where M is the stock of currency, V is the money velocity, P refers to prices, and Q refers to output.

Holding output (Q) and money velocity (V) constant, a sudden increase in the money supply (M) would cause prices (P) to skyrocket.

High inflation leads to expectations of high future inflation, inducing economic agents to increase current consumption to avoid the higher future prices, but this means even higher current demand, causing even more inflation. It is notoriously difficult for economies in the death spiral of hyperinflation to break out of it. The conventional economic view is that MMT should be avoided because of this risk.

There are two ambiguities worth debating in this argument. One is that MMT could lead to more real output, Q, being produced in the economy instead of hyperinflation. Another counterargument is that inflation might in fact be pinned down by something other than the quantity theory of money.

Argument 1: MMT increases output, not prices

The starting point of MMT theorists is that the economy is not at full employment. There is unused spare productive capacity. It is hoped that transferring money directly to economic agents leads to higher consumption and production, hence pushing the economy to full employment. With reference to the aforementioned equation (MV=PQ), if the increase in money supply M results in higher output Q, then prices P would not rise that much, suggesting that fears of hyperinflation are overblown.

Argument 2: Prices are driven by aggregate demand — raise taxes to mitigate inflation

According to standard Keynesian economics, demand-pull inflation comes from aggregate demand outstripping the availability of real goods and services in the economy. More straightforwardly, this happens when there is too much money chasing too few things to buy. Based on this thinking, proponents of MMT claim to have tools at their disposal to address inflationary risks.

The proposed solution is to use taxation to suppress aggregate demand, in contrast to the stance held by mainstream macroeconomics that the interest rate is the tool for this, as part of the Fed’s dual mandate of low inflation and unemployment. Proponents further back this up by citing record-low interest and inflation rates in the aftermath of the Global Financial Crisis, indicating that the risk of inflation is even more muted. However, it should be noted that raising taxes potentially has negative distributional and efficiency impacts on the economy.

Has MMT been attempted before?

There is little empirical evidence that MMT will work effectively, particularly in the long run. In attempts to demonstrate the application of the theory in practice, many have pointed to Japan as an example where high levels of government spending and debt have not led to higher inflation, in line with an MMT-esque argument. Economist Stephanie Kelton has argued that Japan demonstrates that fears about hyperinflation were overblown: while Japan has high public debt from the expansionary policy of Abenomics, the feared hyperinflation never happened; inflation in Japan has actually remained remarkably low. The economy remains strong with high standards of living.

The example of Japan does support the argument that high levels of government spending do not necessarily lead to hyperinflation, but this is not actually a case of MMT. While Japan’s gross debt-to-GDP ratio is the highest in the world at 240%, the net-debt-to-GDP ratio, which accounts for real assets, is lower, suggesting that Japan is not as heavily indebted as it initially seems. Japan’s leaders are themselves sceptical of this theory. Taro Aso, the finance minister, thinks it is “very dangerous”, while Haruhiko Kuroda, the Bank of Japan’s governor, emphasised the need for the economy to maintain a healthy fiscal stance and the importance of the government striving for this goal.

MMT has been attempted in many emerging countries in Latin America, although all of these attempts were during populist regimes ending with high inflation and currency devaluation, as noted by Chilean economist Sebastián Edwards. More empirical evidence is necessary to support MMT, especially before implementing it in a major economy such as the United States, and suggestions have been made that it should first be put into practice in a small country to work out how to attain high economic growth and living standards.

MMT only applies to very few countries.

MMT is not applicable to all countries, only to countries with monetary sovereignty. American economist Thomas Palley has criticised the theory for not providing guidance to countries which are not able to borrow in their own currency, like Mexico and Brazil. They would have to repay debt in foreign currencies, in which case the excessive ‘money printing’ suggested by MMT would cause a massive depreciation of their exchange rate, leading to inflation. Very few countries are monetarily sovereign. This heavily restricts the usefulness and applicability of MMT on a global scale.

MMT ­- who is in control?

Mainstream Keynesian economics is built upon free markets, and the interaction of private agents (firms, households), public agents (governments), and arguably independent agents (central banks). In particular, the central bank is given control over monetary policy, with the objective of stabilising prices and maximising employment. However, under MMT, the control of the economy is placed entirely on the government and fiscal policy substitutes monetary policy. Stephanie Kelton argues that unelected central bankers should not have so much control over the economy, and the responsibility for economic management should rest with elected representatives. However, critics defend that handing this type of responsibility to politicians could have negative consequences. A lot of faith would be put in elected officials to show a high degree of foresight in budgeting and a high degree of precision in managing inflation. Moreover, would politicians have the courage, namely during election years, to raise taxes to keep inflationary pressures down?

MMT can be viewed as a system somewhere between a planned economy and a free market economy. In fact, under MMT, if the government wants more of something produced, it just prints more money to get it produced. Therefore, at least regarding important decisions, the government is essentially completely in charge and no other agent in the country can really compete. In this sense, MMT does have some similarities with a command and control system. A major concern regarding MMT then emerges from this discussion: excessive concentration of power. Under MMT, the government gains power to control most of the economy. This enormous amount of power could eventually be misused.

MMT ignores vested interests

Further, MMT does not take into account political complications arising from vested interests; as the government strengthens its control over the money supply, it could influence the allocation of resources, potentially leading to efficiency losses. By shifting power from central bankers to politicians, MMT may also promote perverse incentives and corruption.

How would a transition to MMT affect financial markets?

MMT would represent a massive departure from the way monetary and fiscal policy are currently conducted, making it an interesting thought experiment to consider what would happen to financial markets if the US adopts MMT.

Whether or not a transition to MMT is carried out in gradual incremental phases or in a one-off policy shock, the mere expectation of the policy shift would drive market participants to react. An increase in government spending funded by newly issued currency would conventionally be expected to cause a depreciation. Moreover, fear that MMT might lead to domestic inflation could prompt market participants to move their capital abroad, putting further downward pressure on exchange rates.

Bill Mitchell, the ‘father’ of MMT, advocates for the use of capital controls on cross-border transactions in order to manage the transition costs of MMT. This is a recognition of the destabilising impact MMT would have on financial markets, and exemplifies the narrow, inward-looking perspective of MMT proponents. Huge amounts of US debt are held by international investors, who have traditionally relied on it as a safe asset that can reliably preserve capital. Should the continued free movement of capital be placed under threat, private investors and national governments around the world could very well be thrown into disarray.

One question that arises is the impact on existing government debt. The government could choose to maintain the existing stock of debt, or to start acting to reduce it by printing more money to monetise debt. The mechanism by which debt monetisation might be carried out is not too dissimilar from quantitative easing, which has been successfully carried out without leading to hyperinflation in the real economy. However, the irreversibility of MMT as compared to quantitative easing might lead market participants to view it differently.

Based on the analysis thus far, it seems reasonable to suppose that the impacts would be heavily influenced by market expectations, which would be shaped by communication about the specifics of the policy plan. It is also likely to cause significant instability in the short-term. The million-dollar question is whether instability would be one-off or persistent. Short of going on an excessively speculative tangent, it is difficult to answer this question without seeing a specific implementation plan from the progressive politicians who advocate for MMT. It is also crucial to evaluate the costs of transition, recognizing that a move towards MMT has to take place within the global economic order, which is still dominated by mainstream monetary economics.

Conclusion

MMT’s proposal is often thought to directly contravene mainstream macroeconomic thought. It suggests that monetary policy, the mainstay of central banks, lacks potency and fiscal policy would be more effective. The move to reserve satiation and ultra-low interest rates in the past decade has indeed pushed central banks to the limits of their conventional policy tools, and the huge interest in potential solutions for further economic stimulus has helped bring alternative theories such as MMT into public debate.

Before MMT can be seriously considered as a policy tool, much more work needs to be done to evaluate the risk of excessive inflation and its claim of higher growth. Given MMT theorists’ suggestion that raising taxes is a possible solution, it might be worth attempting to model the level and form of taxes required in this framework, and corresponding welfare impacts. In addition, more thought should be put into what might happen to both financial markets and real economies in the process of transitioning to MMT.

This article is written by: Sandra Ng (Head of US Monetary Policy Research), Brooklyn Han (Research Associate, US Monetary Policy Research), Anna Clarey (Research Associate, US Monetary Policy Research) and Pedro Almas (Research Associate, US Monetary Policy Research). This article is reviewed by Jason Jia (VP, Monetary Policy Research).