Can ‘Modern Monetary Theory’ Save the World?
In traditional national economics, the economy of a state is compared to the private economy of a family or company. There is an income and a set of ex- penses, and if expenses exceed the income, debt is accrued, which isn’t sustainable at length. In the case of a state, the income mainly derives from taxes, while the expenses are government spending. If the government spends more than it receives in taxes, the result is budget deficit and a growing national debt. To balance the books, governments must then increase taxes, reduce spending, or sell off state assets.
According to proponents of Modern Monetary Theory (or simply MMT), this view overlooks a very important difference between the private and the national economy. Given a constant amount of money in a nation, a large state deficit simply means that there is more money in the private sector, which enriches families and companies. In return, if a government
tries to reduce the national deficit through taxation or reduced spending (austerity), money is taken out of the private sector, which hurts families and companies. Fortunately, according to MMT, having a large state deficit is not a problem, since the state, unlike families and companies, can ask its national bank to issue more currency to reduce the deficit, thereby increasing the money supply.
Increasing the money supply — basically printing more money, though most money today solely exist as numbers in accounts — sounds like a recipe for inflation, but this need not be the case according to MMT, as long as it is done within limits. The main limit is employment. If the state issues new currency to pay for workers to build or repair public infrastructure and pays sector minimum wage to these workers, then the state does not compete with the private construction sector for workers while there still is a supply of unemployed construction workers. The same applies to resource spending: If the supply of a resource is greater than the demand, the state can purchase the difference without depriving the private sector of resources. Similarly, the government can issue currency to buy services from the private sector if this doesn’t deprive other parts of the private sector of these services. The challenge is to stop spend-ing money in this way before the overall demand for workers, resources, and services begins to exceed the supply — for example when full em- ployment is achieved. It isn’t until the state starts to compete with the private sector over a limited supply that inflation ensues. Should inflation occur, the state can stop issuing new currency while also increasing taxes, hence reducing the money supply in the private sector.
This dynamic fundamentally changes the role of taxes in a society. In MMT, the function of taxes is not to pay for government spending — this is done by growing the state deficit and/or issuing more currency. Instead, the function of taxes is to reduce inflation by increasing the value of money through reducing the supply.
Making Money
Growing the money supply sounds like a dangerous thing, but it is being done all the time, just not by the state. Whenever a bank issues a loan, it does not move the money from its reserves — it just creates a bank account with the money in it, simultaneously creating a debt for the lender. As private debt grows, so does the money supply since the money isn’t taken out of the circuit until the debt is paid back. In this manner, banks in the UK have increased the amount of money in the British economy by an average of 11.5 percent yearly over the last 40 years, with no matching inflation.
States are also known to create new money in this fashion when needed. When the US Federal Reserve bailed out banks during the 2008 financial crisis with trillions of dollars, the money wasn’t paid by taxpayers — instead, the accounts the banks had at the Federal Reserve were simply marked up. Since 2015, the European Central Bank (ECB) has spent roughly €3 trillion on ‘quantitative easing’, buying up debt and bonds with new money created for the purpose. Neither case led to any measurable inflation; in fact, interest rates in the EU are negative while the interest rate (policy rate) in the US is at a quarter percent. Hence, strong evidence shows that increasing the money supply will not necessarily lead to inflation.
Someone once remarked that we often see absurd situations like housing shortages, where people need a place to live while workers need jobs — but we lack that strange thing called ‘money’ to allow the workers to build the needed homes. In MMT, the state would simply create money (or increase the national deficit) to employ people, or hire construction companies that then would employ people, to build the needed homes.
We also often see public infrastructure like roads, bridges, and schools in dire need of repair or refurbishing because the state lacks the funds to maintain them. If the state chooses to increase the money supply and pay workers or companies to repair the infrastructure, the result would be better infrastruc- ture, reduced unemployment, and a boost to the economy — all without causing inflation, according to MMT, as long as the state doesn’t compete with the private sector for labour and resources. Similarly, a state can offer free healthcare and higher edu- cation, increase the supply of sustainable energy, and even build entirely new infrastructure like highspeed railways.
The Weaknesses of MMT
Does all this sound too good to be true? Well, maybe that’s because it is — maybe. MMT does have some weaknesses, as proponents as well as critics are quick to point out. For one thing, the theory as outlined above assumes a closed economy — that any increase in money supply remains within the nation’s economy. If citizens and companies choose to spend money abroad, or move it to tax havens, it will not stimulate the economy — but that is true even without MMT.
Worse, perhaps, is how other nations as well as international traders may react if a nation chooses to implement MMT. Outsiders may lose confidence in the future value of that nation’s currency and sell off their reserves of the currency and related bonds, and this could discourage foreign direct investment (FDI). The exchange value of the currency would plummet, making it more difficult to pay off debt in foreign currencies. The cost of imported goods and services would increase, reducing the purchasing power of citizens, effectively creating inflation.
This need not happen, though. Japan’s gross go- vernment debt at the end of 2019 was 230 percent of the nation’s GDP, which is far above what is recommended by the World Bank, yet Japan has not experienced runaway inflation — in fact, the inflation is close to zero. In general, though, high government debt is associated with low growth. However, this may be because much of the debt is in foreign currencies (which is not the case for Japan) or because the spending of public money exceeded the restraints set by MMT. In addition, an influential 2010 study entitled “Growth in a Time of Debt” by Harvard economists Reinhart and Rogoff, which found a strong correlation between high external debt and low growth, was later found to contain errors and exclusions of data that did not support the conclusion, casting doubts on the value of the study.
MMT may also be derailed by political populism. MMT states that in times of high inflation, it is necessary to raise taxes to reduce the money supply — but high taxes tend to be unpopular, and voters may vote out a government that raises taxes in favour of one that promises low taxes, despite the inflationary danger. If inflation then rises, citizens may choose to convert their savings to foreign currencies or crypto- currencies and do their exchanges in these or through barter, further reducing the value of the national currency. Politicians may also select to use the option of issuing more currency for other projects than reducing unemployment, which would derail the po- sitive effects of MMT. Still, incompetent and corrupt politicians are a danger no matter what monetary policy is pursued.
The idea of Modern Monetary Theory may well have merit, despite the weaknesses outlined above. It is important to note that traditional ways to handle national finances have weaknesses of their own, as the current situation with high unemployment and low growth in most Western countries shows.
This story was originally published in Scenario Digest.
