MMT: Modern Monetary Theory or Mad Macro Tosh?

John Maynard Keynes’ General Theory of Employment, Interest and Money came about as a direct response to the economic conditions of the Great Depression which he attributed to deficient demand. His work, and that of his followers, demonstrated that cyclical variations could be dampened by greater government intervention to smooth out movements in the economic cycle. But by the late-1970s, the world was growing weary of recessions, high inflation and rising unemployment and was looking for alternative policy options to the statist economic model that had produced them. Thus was the free market economic revolution born. Fast forward thirty years to the fallout from the crash of 2008 and questions have increasingly been raised about the role of free market economics in producing the biggest economic slump in 80 years and the perception that economic and social inequality has widened.

One of the candidates for a new economic theory for the 21^st century is Modern Monetary Theory (MMT) which has been around for a while but is now attracting a huge amount of attention in the US. As might be expected, the pendulum has swung completely, with the latest policy theory attempting to move from the fringes to the mainstream espousing a much bigger role for government. It has increasingly been adopted by those on the left of the political spectrum as a policy which could justify a big increase in government spending. The likes of Alexandria Ocasio-Cortez, the high-profile US politician who is making a name for herself in the Democratic Party, has argued that her proposed expansionary fiscal agenda can be justified by MMT in which a rising deficit does not impose major constraints on the US economy.

MMT’s big thing: The lack of a government budget constraint

So what exactly is MMT? It starts from the premise that the government is the sovereign supplier of money. Consequently, there is no such thing as a government budget constraint because governments can finance their deficits by creating additional liquidity at zero cost when the economy is running below full employment. Even when the economy is operating above full employment, although there are some inflationary consequences, the budget constraint is still not regarded as an issue.

In conventional economics, the intertemporal budget constraint implies that if a government has some existing debt, it must run surpluses in the future so that it can ultimately pay off that debt. In formal terms, current debt outstanding is equal to the discounted present value of future primary surpluses. MMT gets around this problem by arguing that since the government is the sovereign supplier of money, it will always be able to generate the liquidity to cover any debt obligations. This implies that a sovereign government that issues debt in its own currency can never go bust. There is nothing controversial in that proposition per se – indeed, it is one of the arguments I have long used to refute rating agencies’ concerns about UK fiscal solvency. However, there are some major reservations.

MMT makes a big thing about the government’s monopoly in monetary creation. But governments need not be the sole supplier of money, as the recent Bitcoin debate has illustrated. It just happens to be the most convenient form. Second, all students of economic history are aware of past experience when unlimited monetary creation resulted in hyperinflation. This in turn gives economic agents an incentive to find alternative forms of money that will maintain their value. Third, whilst it is true that governments will always be able to repay their local currency debt, it does not justify continually expanding the deficit without limit. In what can be thought of as the “when you’re in a hole, stop digging” theory, governments have to be aware of the extent to which there will always be willing buyers of debt. If one government expands its deficit without limit but another is more prudent, bond investors will always favour the more prudent debt issuer. 

It claims to offser insights that standard Keynesian analysis has missed 

Indeed, the more closely we look at MMT the more we realise that some of its key underpinnings do not stand up to scrutiny. One of the claims made by its proponents is that it offers new insights that standard Keynesian analysis has missed. This is an overstatement. MMT appears to claim that Keynesian analysis failed to recognise that governments could finance themselves by issuing money and that budget surpluses reduce private sector holdings of high-powered money (that which is issued by the monetary authority). Both of these claims are false as both can be inferred from standard Keynesian ISLM models. There is also nothing new in the claim that if the private sector wants to save more (less) than it invests, government must run a deficit (surplus). Again, this is standard national income identity stuff.

MMT claims to differ from standard Keynesian analysis in that it “does not rely on increasing aggregate demand in order to reach full employment; it disconnects full employment from economic growth[1].” It does so by engaging in “targeted spending that is designed to improve the structure of the labor market by developing a pool of employable labor while at the same time ensuring continuous employment of those ready and willing to work.” Critics such as Thomas Palley[2] point out that there are no theoretical underpinnings as how this might work which makes it hard to validate the intellectual argument. My reading of this approach is that it merely represents a choice by government as to how to use the resources at its disposal (which MMT proponents argue are unlimited).

But its treatment of inflation is hazy

What is new is the claim that it is possible to create higher employment without generating inflation. But MMT lacks a well-defined inflation process which makes it difficult to validate this claim. Labour markets operate on the basis of the supply-demand principle and if there are labour shortages in key areas there will be higher wage inflation, particularly where there are structural impediments such a high concentration of trade union membership. Some MMT proponents do not accept that this Phillips curve-type world exists but offer no alternative inflation-generation model. There are some who do allow for such a process but they then cannot therefore escape the fact that they have introduced a trade-off between wage inflation and unemployment, even in today’s flatter Phillips curve world. 

It seems to me that much of the analysis relies on the assumption that a wise government planner will be able to determine in advance where bottlenecks in the economy will arise and that offsetting action can be taken. But since I am not convinced that macroeconomists fully understand the inflation creation process (here) I rather suspect this may be a forlorn hope. 

Desperate times call for desperate measures by desperate governments 

I have long been an advocate of using fiscal policy as a tool of demand management, so an attempt to identify a coherent policy that ascribes a role for government should not be dismissed. I am just not convinced that MMT lives up to (m)any of the claims which are made for it. Palley argues that “it is a policy polemic for depressed times. A policy polemic that promises full employment and price stability at little cost will always garner some attention … such a policy polemic will be especially attractive in depressed times.” It is widely dismissed as being neither modern nor a theory. There again George H. W. Bush initially dismissed Ronald Reagan’s supply-side policies as “Voodoo Economics” before he signed up to them as Reagan’s running mate. Just because it is flawed may not prevent governments desperate for alternative policy measures from trying it out.

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[1] Tymoigne, L. and L. R. Wray (2014) ‘Modern Money Theory 101: A Reply to Critics’ Levy Economics Institute Working Paper 778

[2] Palley, T. (2014) ‘The critics of modern money theory (MMT) are right’ IMK Working Paper 132