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

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

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

A widespread idea among MMT proponents is that governments can never go bankrupt. And to some extent, this is true. If a government has the capacity to print money, it can’t strictly default on its debt. Put differently, a government with monetary autonomy will always be able to print money to repay its debt in nominal terms. But at what cost?

Imagine you buy a one-year government bond for 909 € with the promise of getting 1,000 € in a year (that is, a 10% return on your investment). However, during that year, government has carried out such a reckless monetary policy that prices have doubled (i.e., inflation has increased by 100%). It seems obvious that, as long as government has the capacity to print new money, you will get your 1,000 € back on time.

Yet your money will be worth much less in terms of the goods and services. If government continues to print money to meet its debt obligations, inflation will accelerate, with the subsequent depreciation of the currency. So yes, government can always pay off its debts in nominal terms, but at the expense of creating an inflationary spiral that ends up destroying the currency.

This leads us to another MMT idea I introduced in the first article of this series: the funding of government expenditure via money printing, especially during recessions. According to MMTers, if unemployment is high and the economy is below full capacity, money printing isn’t inflationary. Thus, it can be used to reduce unemployment through, for instance, job-guarantee programs.

Yet this reasoning overlooks the fact that there isn’t a trade-off between unemployment and inflation in the long run. We can find examples in history of high inflation combined with high unemployment (for instance, the 70s stagflation in the US). So fiscal stimuli via money printing could perfectly result in higher inflation without lowering the unemployment rate, even when the economy is working below full capacity.

When would this occur? For instance, when the currency issuer (i.e., the government) lacked credibility due to a poor track record on monetary policy. In this case, economic agents would decrease their demand for sovereign fiat money, which would inevitably result in inflation no matter how many idle resources there are in the economy.

But let’s go back to the real world where central banks, and not governments, have the power to conduct monetary policy. Stephanie Kelton, a leading MMT advocate, suggests that central banks should hold government borrowing costs down indefinitely to facilitate government spending. Alternatively, the monetary authority could also finance the government directly by creating new reserves in the treasury’s bank account.

Can a central bank hold market interest rates low permanently? In light of recent experience, the answer seems to be yes. When Mario Draghi announced in 2012 that he would do “whatever it takes” to save the euro, sovereign bond yields of Eurozone countries facing solvency risk decreased rapidly, remaining low since then. Yet the long-run influence of the ECB (and of central banks in general) over market rates has been overstated.

There are two factors that explain low bond yields in the Eurozone without resorting to monetary policy: the weak economic recovery and fiscal credibility. The latter helps explain, for instance, the large spread between Italy’s and Germany’s 10-year bond yield. Of course, a central bank can always monetize as much sovereign debt as it wishes, but this would most likely end up destroying the value of the currency (see, for instance, the situation in Venezuela).

Neither can central banks directly finance government spending without consequences. As pointed out by Krugman, money-financed deficits are more inflationary than debt-financed deficits: whereas the latter implies less spending tomorrow (debt needs to be repaid), the former doesn’t. Consequently, money-financed deficits tend to have a higher impact on  inflation expectations of businesses and consumers.

In both cases, central banks would lose their independence and autonomy, becoming mere appendices of political authorities. This in turn would have an impact on consumers’ and businesses’ expectations regarding the capacity of central banks to meet its price-stability objective. The demand for central-bank money would eventually decrease due to a lack of confidence in government-dependent monetary authorities, leading to the depreciation of the currency and triggering inflation.

MMT appealing among politicians is understandable. After all, it gives them leeway to increase public spending beyond rational limits. Yet MMT suffers from several serious flaws, as I have tried to show in this series of three articles. Following its policy prescriptions would thus bring no good to a country’s economy.


What is Modern Monetary Theory? Part I

What is Modern Monetary Theory? Part II


Luis Pablo de la Horra

Luis Pablo de la Horra
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