What is Modern Monetary Theory? (II): A Critique

What is Modern Monetary Theory? (II): A Critique

What is Modern Monetary Theory? (II): A Critique

In the last months, the US political debate has revolved around a number of proposals (e.g., Bernie Sander’s Medicare for All or Alexandria Ocasio-Cortez’s Green New Deal) that, if materialized, would send government expenditures through the roof. Most economists would tell you that, in the long run, these new programs must be financed either by increasing taxes or by trimming other budget items.

Yet Modern Monetary Theory (MMT) proponents disagree. According to this fashionable macroeconomic theory, governments aren’t “operationally constrained by revenues”, to quote Warren Mosler, one of the leading MMT theorists. MMT also states that, as long as governments enjoy monetary autonomy, they can’t default on their debt.

In a previous piece, I summarized these and other ideas contained in the MMT corpus. In this and a following article, I aim to refute its main postulates, emphasizing the dangers that following MMT policy prescriptions would pose for the economy.

In fiat-money regimes, the MMT claim that money is a creature of law is correct. By means of legal tender laws as well as the taxing power of the state, governments make sure that taxpayers use government-issued money as a medium of exchange, store of value and as a unit of account. Yet this doesn’t mean that money has always been imposed in a top-down manner.  

Gold and silver started to be used as media of exchange in market transactions several millennia ago, not to facilitate the payment of taxes as suggested by MMT, but because they possessed certain properties that made them suitable instruments in the conduct of economic transactions. Therefore, in a historical sense, money is a creature of the market.[1]

However, we don’t have commodity money any more. We live under fiat-money regimes, so governments can impose their own currency on taxpayers whether they like it or not. Does this imply that, as argued by MMT proponents, governments face no constrain when it comes to spending? Or put differently, do taxes and debt represent effective limits to government spending?

Let’s assume two scenarios. In the first scenario, government doesn’t have the power to conduct monetary policy. Instead, there is an independent central bank that has the legal mandate to do so. In this case, government expenditure is clearly limited by tax revenues plus the amount of debt government can raise in the financial markets. In fact, government wouldn’t be very different from a household or a business: if it accumulates more debt that it can sustainably manage, it will go bankrupt.[2]

In the second scenario, government has the printing press, so it doesn’t depend any more on tax revenues or debt raising to spend. In addition, government can force its citizens to settle their tax liabilities in sovereign fiat money, creating an artificial demand for it. Can now government print and spend as much money as it wishes without consequences? Not really.

I said above that, by demanding the payment of taxes in government-issued currency, governments create a demand for it: economic agents will use fiat money, not just to pay off taxes, but also to purchase goods and services or to save up. But this isn’t entirely true. If economic agents perceive that government is irresponsibly printing money, its demand for it as a medium of exchange and store of value will decrease even though the government currency continues to be the only way to pay off taxes.[3] This is what happens during hyperinflation episodes: the demand for government money drops sharply due to a loss of confidence in the issuer.

According to MMTers, excessive inflation can be avoided by fine-tuning the tax burden: increasing taxes takes money out of circulation, putting downward pressure on inflation. Yet this reasoning has a flaw: it doesn’t take into account money demand. If the demand for sovereign fiat money decreases more than supply (something plausible when monetary authorities lose credibility), inflation will soar, depreciating the currency along the way.

Fiscal policy is thus not enough to maintain the purchasing power of money. Instead, a central bank that commits to undertaking a price-stability oriented monetary policy is necessary to anchor the expectations of economic agents regarding inflation and keep the demand for a currency stable in the long term. 

In the last article of this series, I’ll critically examine three further ideas held by MMT proponents.


What is Modern Monetary Theory? Part I

What is Modern Monetary Theory? Part III

[1] For an excellent critique of the idea that money is a creation of the state, see chapter 1 of Juan Ramón Rallo’s “Contra la Teoría Monetaria Moderna.”

[2] Although this is true, the ability of governments to borrow is higher than that of other economic agents. This has to do with the fact that, when borrowing, governments place the future tax revenues of the country as collateral. Since governments have the faculty to increase this collateral if needed (i.e. increase the tax burden), their capacity to raise funds in the financial markets is considerable.

[3] That taxpayers are compelled to demand sovereign fiat money to settle down their tax liabilities once a year doesn’t imply that they have to demand it in advance. Consider, for instance, the situation in Venezuela. The government still collects taxes in bolívares, but the currency has lost almost all of its value because people don’t want to use bolívares in their everyday lives.

Luis Pablo de la Horra

Luis Pablo de la Horra
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