A lot has happened since I first looked at the subject three years ago: Kelton’s book The Deficit Myth has become a best seller whilst the pandemic has focused minds on the role of government deficits. This fascinating area is thus worth revisiting. However, the quip that Modern Monetary Theory is not modern, is not about money and is not a theory still holds true. It is not modern because it has its roots in Abba Lerner’s Functional Finance Theory which first saw the light of day in 1943 and which suggests that government should finance itself to meet explicit economic goals, such as smoothing the business cycle, achieving full employment and boosting growth. It is also more a fiscal theory than a monetary one. At heart it is based on the premise that since the government is the monopoly supplier of money, there is no such thing as a budget constraint because governments can finance their deficits by creating additional liquidity at zero cost (subject to an inflation constraint). It is most definitely not a theory about how the economy works. Instead it is closer to a doctrine to which its adherents passionately adhere whilst regarding non-believers as having not yet seen the light (or worse, economic heretics).
What particularly riles the mainstream community is that there is no formal model which can be written down and therefore no testable hypothesis. In the words of blogger Noah Smith, “MMT proponents almost always refuse to specify exactly how they think the economy works. They offer a package of policy prescriptions, but these prescriptions can only be learned by consulting the MMT proponents themselves.” This is particularly irksome because it allows MMT proponents to sidestep the criticisms of the doctrine, of which there are many.
Many of these criticisms centre around the role of money, upon which the fiscal analysis is founded. For example, it treats money as being primarily created by the state (defined as the government sector plus the central bank) and has little or nothing to say about the role of banks in the process. It also treats money as a public good which should be used to maximise social welfare rather than its more prosaic use as a medium of exchange. This in turn assumes there is only one form of money in the economy, but as I have pointed out before this is not the case. Domestic actors may choose to use foreign currency, for example, or opt for digital options. Thus, although governments can create money almost without limit, there is no guarantee that demand will match supply. Increasing supply way beyond demand will only lead to currency debasement. In an excellent paper by the Banque de France[1] (here) the authors do a good job of picking holes in the theoretical underpinnings of MMT, noting that none of its supporters acknowledge “the reason modern literature on money puts forward for what makes legal currency “acceptable” by the public, i.e. monetary policy credibility.”
Whilst MMT does rest on shaky theoretical foundations, it is not the only area in modern macroeconomics to suffer from such problems. The New Keynesian school, which is the predominant model used by central banks, assumes no role for the quantity of money. It also imposes perfect pass-through from the policy rate to all other rates in the economy, thus giving the central bank a powerful lever to affect intertemporal decisions, which is extremely questionable. Nobel Laureate Joseph Stiglitz published a paper in 2017 which argued that “the DSGE models that have come to dominate macroeconomics during the past quarter-century [apply] the wrong microfoundations, which failed to incorporate key aspects of economic behavior. Inadequate modelling of the financial sector meant they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality.”
It is thus perhaps a little unfair to single out MMT which has fallen victim to the fetish for quantification in economics. Current academic practice seems to believe that if something cannot be quantified it is not a valid explanation of how the economy works. It is instructive to remember that the ideas of Keynes, which came to dominate the agenda after 1945, were also subject to significant criticism following their publication in the 1930s. Nonetheless there is a lot wrong with MMT and I concur with the conclusion to the BdF paper: “Such a stark contrast with mainstream economics analysis and recommendations would be understandable if MMT economists engaged into a debate with their colleagues to explain and justify their positions, from both a theoretical and empirical point of view. However, they rather prefer to talk between themselves, repeating consistently the same ideas that others formulated in a distant past, disregarding facts and theories that do not fit into their approach, and accusing those who do not share their ideas of being incompetent.”
Yet despite all these reservations MMT has opened up a debate about the role of government both during and in the wake of the pandemic. One of the core ideas of MMT is that governments are not like households because they have an (almost) infinite life and therefore debt can be repaid over periods extending over many generations. There is thus no rush to impose significant fiscal tightening as the economy recovers from the Covid shock. This view is, of course, not unique to MMT: It is a standard element in fiscal dynamics but it is a lesson that governments should heed as the rush to take away support after the pandemic gathers momentum.
If it has opened the eyes of politicians to the uses of fiscal policy after decades in the doldrums, then maybe MMT has served a useful function. But a policy of near unlimited fiscal expansion is for the birds. It calls to mind the other acronym often applied to MMT: The Magic Money Tree.
The Magic Money Tree" is a captivating exploration of economic myths. Presented Physical Properties With clarity and depth, it dissects misconceptions about government spending and monetary policy.
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