In an interview last January, Democratic Party’s rising star Alexandria Ocasio-Cortez brought attention to so-called Modern Monetary Theory (MMT), a theory that challenges the foundations of mainstream economics regarding fiscal and monetary policy. Whereas its supporters see in MMT a solid theoretical framework with which to justify the expansion of public spending, its detractors argue that following MMT prescriptions would lead the country to the abyss. Who’s right?
In order to answer this question, we first need to know what’s behind the most in vogue economic theory of our days. MMT encompasses a set of ideas regarding the origins, nature and source of value of money as well as the role of government as the monopolist issuer of a currency in a given territory.
MMT states that money didn’t emerge to overcome the problems resulting from barter, as stated by most economics textbooks. Instead, money was created to facilitate the payment of taxes. To paraphrase German economist Friedrich Knapp, money is a creature of law: it’s the law (and thus the government, and not the market) that confers value to money by forcing people to pay their tax liabilities in government-issued currency.
According to MMTers, this has a straightforward implication. The fact that taxpayers will sooner or later have to demand sovereign fiat money to pay off their taxes gives governments with power to conduct monetary policy leeway to spend regardless of how much taxes they can collect or how much debt they can raise in the markets. This also implies that governments can never go bankrupt since they can always repay any debt issued in their own currency by printing new money. As put by American economist Warren Mosler,
Federal government spending is in no case operationally constrained by revenues, meaning that there is no “solvency risk.” In other words, the federal government can always make any and all payments in its own currency, no matter how large the deficit is, or how few taxes it collects.
We have seen that governments can print new money and spend it on goods and services without resorting to taxes or debt because taxpayers will demand it to discharge their tax liabilities. But is there a limit to this prerogative? Wouldn’t a reckless use of the printing press bring about inflation? Indeed. MMT proponents acknowledge that money printing can result in inflationary pressures via excessive spending: an excess supply of money overheats the economy, leading to higher prices.
However, this shouldn’t be a problem as long as governments can fine-tune the tax burden to control the price level. According to MMT, if the government wants to fight inflation, it just needs to raise taxes; and vice versa, governments can achieve a higher inflation rate by lowering the tax burden. Similarly, governments can issue sovereign bonds to put downward pressure on aggregate demand (money is taken out of the economy), pushing the inflation rate down. This is what economists call the Fiscal Theory of the Price Level, which states that the price level is also affected by fiscal policy, and not just by monetary policy.
In addition, as long as there are idle resources in the economy (i.e., the unemployment rate is above the natural rate), spending via money printing won’t cause inflation. In fact, if the economy is below full capacity, governments should print new money and pour it into the economy to reduce unemployment and close the output gap. How should this be done? Some MMT advocates propose government-funded, job-guarantee programs to be implemented when unemployment spikes.
Until now, we have assumed that fiscal authorities (i.e., governments) conduct both fiscal and monetary policy (in fact, MMT blurs the line between both). However, this isn’t realistic. In today’s world, central banks are responsible for monetary policy, whereas governments carry out fiscal policy. What is the role assigned to central banks by MMT?
Central banks must facilitate the spending process by holding government borrowing costs down indefinitely. This wouldn’t only help finance public spending, but it would also keep the ratio of debt to GDP under control, which would continue to decrease provided that economic growth be higher than the interest rate paid on public debt. Alternatively, monetary authorities could finance the government directly via money printing (i.e., creating reserves in an electronic bank account) when the latter deems it necessary.
These are some, though not all, of the most relevant ideas behind MMT. But does MMT rest on robust premises? And most importantly, should governments and central banks follow its prescriptions? I will address these questions in following articles.