Modern Monetary Theory
A brief introduction
Governments across the globe crave larger budgets to finance their extravagant and wishful spending plans. Schools, hospitals, and infrastructure are all too scarce, yet constructing more of these is too expensive. What if economies had endless spending power to achieve their objectives, and the only limit to how much they could spend is the finite factors of production?
Modern monetary theory (MMT) theorises that this utopia is, in fact, achievable. It asserts that sovereign governments with fiat currencies, such as the UK, US, and Japan, are unrestricted by revenues regarding government spending, meaning that they can spend as much as they like, regardless of how much they receive, by ‘printing’ money. Government budgets, unlike household budgets, should not fret rising debts as they are the monopolistic issuers of money and can therefore ‘print’ more money to repay their debts. Debt is money that is spent but not taxed back. They can only go broke or be insolvent if a political decision to do so is taken. Consequently, government spending is infinite.
Only two factors stand in the way of far-reaching government spending: inflation and finite resources. MMT states that inflation, a result of high government spending, can be monitored by implementing taxation to take the heat out of the economy. Resources, namely commodities, labour, and capital, are finite, but increased spending is likely to improve productivity, and therefore these resources can be used more efficiently.
Warren Mosler developed this heterodox macroeconomic theory, and he utilised this theory during the 1990s Italian debt crisis. With the perception that governments will not go insolvent unless they decide to, his hedge fund was the largest holder of Italian lira denominated bonds outside of Italy. Consequently, Italy did not default, and Mosler’s firm harvested $100 million.
Despite its encouraging prospects, MMT is criticised by economists to be naïve and reckless: Paul Krugman said it would “lead(s) to an infinite upward spiral of inflation,” and Thomas Palley said it is a “policy for depressed times.”
One of the most prominent critics of MMT is that it will undoubtedly lead to high inflation. The theory approaches inflation in a highly simplified way: an ‘on-off’ model. When an economy is below full employment, there will be no inflationary pressure, and expansions of AD generate pure output gains with no price level or inflation effects. When it reaches full employment, increases in AD produce pure price level increases with no output effects.
The ‘on-off’ model may be the case within individual sectors, but there is an extensive variation within an economy. Some sectors may be near full employment, while others may be below. The Philips curve implies this as it shows the relationship between inflation and unemployment in a whole economy. Thus, increased AD is likely to lead to inflation in some sectors at maximum employment, but not in others.
When at full employment, MMT suggests that governments use taxation to reduce the money supply in an economy and prevent high inflation. Though, this is controversial for a few reasons. Firstly, extracting a large sum of money from the money supply through taxation can put an economy in a recession. Reducing demand in the economy will result in less consumer spending, leading to higher levels of unemployment and reductions in economic activity.
Furthermore, recognition and implementation lag could mean the government acts too late. As a result, high inflation has already set in, and the spiral has begun. Once it starts, it is tough to stop. Finally, flexible taxation policies require highly autocratic government structures to pass new tax laws quickly and efficiently.
It also challenges their ability to monitor the economy meticulously and quickly implement new policies through the government. For governments such as America’s, this is a tough ask.
Beyond its fiscal policy challenges, MMT’s interest policy is flawed. MMT recommends that interest rates are set to zero and parked there. As sovereign money issuers, governments do not have to finance spending through borrowing and therefore do not need to pay interest as they can print money. Therefore, why pay interest at all? The result of parking interest rates at zero is that economies are managed purely by fiscal spending and taxation.
This, too, has several issues. Firstly, at full employment, inflation will undoubtedly be positive, and therefore real interest rates will be negative; this will spur investment in assets and the economy, pushing up the price level and causing asset price bubbles, creating instability. MMT neglects this as it assumes that inflation only switches ‘on’ beyond full employment.
Furthermore, as previously mentioned, relying solely on government spending and manipulation of taxation emphasises the importance of the ability of governments to act quickly. Friedman challenged these assumptions with his construct of inside and outside lags. Inside lags are the time taken to realise and enact policy change, and outside lags are the time taken for it to kick in. Thus, a counter-cyclical interest rate policy is essential to stabilise the economy quickly with shorter lag periods.
Parking interest rates at zero can also have substantial effects on open economies. Assuming that rates in other countries are positive, it could cause a significant depreciation in the currency’s exchange rate as demand for it falls, particularly in a small open economy, resulting in negative real income effects and high inflation as imports become costly.
Overall, Modern Monetary Theory is an encouraging concept that appeals to many hopeful, optimistic policymakers looking to fix global matters through unlimited fiscal budgets. During times of crises, it can prop up economies and incite demand into an economy. For this situation, it is excellent. Though beyond pandemics, wars, and financial crashes, a sound and steady money supply is necessary. The onset of hyperinflation is imminent as soon as the economy recovers, reversing the positive effects of increased spending. Therefore, MMT cannot flourish in this contemporary economic climate.
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Ted Jeffery