Modern Monetary Theory

MMT reinforces some valuable lessons, including that fears over government debt and deficits are often overblown – especially during major economic downturns.
But there are problems with this approach in terms of trusting government to not stoke inflation or crowd out the private sector in the face of the temptations of ever-expanding government.
These are big asks.

I can’t believe it, but Twitter actually taught me something new. It’s not just about fighting with strangers.

Recently I came across a ‘new’ idea in economics called ‘Modern Monetary Theory’ or MMT. As it turns out, it’s actually not particularly new. But it does offer some useful insights into the relationship between government debt, inflation and taxes.

Granted, I only really encountered the idea recently, so I’m sure I’ll be missing or overlooking certain aspects of it. But here is my understanding.

I suppose the main conclusion of MMT is that concerns about government debt and deficits are overblown. MMT asserts that for a country that has its own currency (e.g. Australia, US, UK, etc, but not countries like Greece), there is technically no limit to the amount of money a government can spend. Even if the rest of the world no longer wants to lend money to that government (or for some reason, they start charging a much higher interest rate on that country’s debt), the central bank can hold all the government’s debt – it’s their money, they create it, they can create and spend as much as they want.

Not only does this mean a government can always ensure their economy runs at full employment. Technically, it also means a government that has its own currency can never go broke.

I know, I know, I had the same reaction – “hang on, a government can’t just print whatever money it wants, it’ll spark inflation!”

Correct. That’s why MMT advocates taxes – not as a means for the government to *afford* what it spends, but as a way of shrinking the private sector enough to *accommodate* that government expenditure without sparking inflation[1].

And this reveals what I think is the critical insight of MMT – a government’s budget is not limited to how much it *taxes*. It is limited to how much the economy can *handle*. This still means tax revenue and government spending will approximately coincide. Generally, every dollar the government spends, it has to tax from the private sector so as to not spark inflation. But not always precisely equal.

During a recession for example, the private sector has already retreated. Government spending will not crowd out the private sector – in fact, by supporting economic activity and private sector confidence, government spending in this case will actually crowd *in* the private sector.

And it can do this simply by borrowing money (either from people, businesses, other countries or just their own central bank printing press) – no additional taxes needed to be raised in the short term.

Now, once the economy is back on a solid footing, this extra money in the system can cause problems. Once the private sector recovers, that extra money may be too much for the economy to handle. So … the government has to gradually withdraw it from the system in taxes to keep inflation down.

So there will be a long run close correlation between government spending and taxes – but it doesn’t have to be exact. Which means any debt that happens to be accumulated during this process is, by definition, not a problem. If it doesn’t spark inflation, and it doesn’t crowd out the private sector, it is perfectly acceptable.

So essentially, MMT advocates allowing governments to print whatever money they want/need to finance their expenditures, as long as they correspondingly shrink the private sector with taxes in order to manage inflation. And any money they happen to borrow in order to achieve this – especially if it’s from their own central bank – is irrelevant. It’s their money.

There are useful insights here. First, it destroys the analogy of the government budget being like a household budget – that governments need to ‘live within their means’ like any household. Households are currency-users, not currency-creators, so for that reason alone, it’s not a valid analogy. A government ‘living within its means’ relates not to how much money it ‘earns’ in taxes, but how much the economy can handle (even though the two roughly coincide).

Second, it reinforces the traditional Keynesian idea of government stimulus during an economic downturn. Not only does this kind of stimulus help prevent the kind of human costs and hardships we saw during recent European austerity, and back in the Great Depression. It also gets the economy back on a solid footing sooner, allowing government tax revenues to recover sooner, thereby managing government debt levels sooner. So even if your only concern is debt, stimulus, not austerity, during a downturn is the way to go.

And MMT adds another piece to this argument – the government won’t go broke if it has its own currency. Again, this doesn’t apply to countries like Greece, but it does to countries like the US, who also got caught up in ill-advised austerity following the GFC. Even ignoring MMT, government debt is always manageable if the interest rate on that debt is lower than the country’s economic growth rate – which has almost consistently been the case for the US, especially over the longer term.

There’s also almost no concern of inflation during a major downturn – so the government can just print and spend for much longer than usual without sparking inflation because the private sector has already retreated. No additional taxes required (at least in the short term).

Now for my concerns …

In the end, MMT is advocating for giving government, rather than an independent central bank, greater control over the printing press.

And it’s not as though we haven’t seen what happens when we’ve done this in the past. Governments always have an incentive to print and spend more. And they’ve often not correspondingly increased taxes sufficiently to avoid massive inflation.

Trusting a government to frequently review tax policy – and change it – in response to inflationary fears, is a much bigger ask than for a central bank. Not just because of their incentives to drop taxes and increase spending, but because the administrative logistics of changing taxes are far more onerous than changing interest rates.

But even if we assume a government can adjust taxes effectively enough in response to their own spending and consequent inflationary pressures, there is still the problem of a continually-expanding government.

If a government always has the incentive to spend more, and manages to tax more to keep inflation down, this means the private sector has to keep getting smaller and smaller to accommodate a larger and larger government.

This raises at least a couple of concerns.

One, government is generally less efficient than the private sector. So a government that crowds out private activity will make the economy as a whole less innovative, less productive/efficient and more prone to crises.

Second, there is simply the matter of personal liberty – the right for an individual to choose how to best spend their own money for their own personal benefit, rather than trusting a government to know what is best *for* them and spend accordingly. This doesn’t override the entire need for government, but it does put a limit on how much we should expect or allow governments to do. Personal liberty should not be *entirely* sacrificed under the guise of the greater good.

So can MMT inform current policy in a way that avoids the above concerns?

In short, don’t give additional power to the government. An independent central bank-type entity should still be in charge of managing the economy, and enforcing at least some fiscal prudence on the government.

I’ve written before about the potential value of an independent fiscal body that picks the best infrastructure projects to undertake, and decides when to undertake them. This way, politicians don’t end up picking politically-convenient projects with limited economic value. And their construction is timed consistent with the business cycle.

And the central bank should remain in charge of interest rate policy and (if not some other independent body like Australia’s APRA) financial system stability.

This way, during a boom, the central bank can cool the economy with higher interest rates and the independent fiscal body can slow down the infrastructure activity.

And during a downturn, if the central bank’s interest rate policy can’t provide enough stimulus (i.e. interest rates are at zero and the economy is still sluggish, as was the case in the US and EU following the GFC), then the independent fiscal body can borrow up big (either from their own people and businesses, the rest of the world, or just from their own central bank) and speed up their infrastructure investment activity.

Any debt that is accrued should not be a concern, as long as it doesn’t over-stoke inflation and crowd out the private sector (which are virtually non-issues during a major downturn). Even if your only concern is debt (which as we’ve discussed for a country with its own currency, it shouldn’t be), stimulus during a downturn is better than austerity.

This action of using fiscal policy to complement monetary policy (rather than replace it, as MMT seems to advocate) can help manage economic downturns with far greater effect, without risking the long-term problems of an ever-expanding government.

It also doesn’t risk a central bank’s credibility being undermined by the threat of political incentives – which can make their job much harder to undertake.

So MMT does seem to have something to offer. But we mustn’t forget the lessons of history. Political incentives are not always consistent with economic realities.

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[1] There are other mechanisms, such as interest rates, credit rationing, etc. that could shrink the private sector instead of (or in conjunction with) taxes. But for now, we’ll just focus on taxes doing the job, which is what many MMTers recommend.