The Irreverent Economist

Modern Monetary Theory (MMT)

Modern monetary theory (aka MMT) is a hot topic in political and policy circles.  The basic idea is that budget deficits needn't be financed with debt issuance (or tax collections, for that matter).  Rather, the central bank issues currency to fund productive spending by the Treasury.  So long as the expenditures are worthwhile, there's hardly a limit on how much money can be created by sovereign central banks--that is, those that need not rely on the sufferance of other countries to underwrite their fiat currencies.

Here’s a primer.   This liberal prescription appears to be akin to what Ben Bernanke calls a money-financed-fiscal program (MFFP), his new-and-improved name for helicopter money.   Not that Bernanke’s insight is new; this development was anticipated by Tom Sargent and Neil Wallace’s famous article of nearly four decades ago:  Some Unpleasant Monetarist Arithmetic.   For those who aren’t interested in formulas, let me distill the message as this:  when the debt gets large enough, central banks cannot hold the line on monetization of debt and deficits--with inflation as the usual result.

Whether and how much inflation results from the strategy depends on the extent of spare capacity in the economy, and the use to which the funds are put.  To be sure, investing in infrastructure and education and the productive capacity of ordinary people is preferred over the "socialism for capitalists" that is Quantitative Easing.  Even so, it's no panacea for growth, as the Japanese experiment demonstrated.  Those who warn of hyperinflation are certainly being hyperbolic--but without structural changes in the way the fruits of our progress are distributed, even modestly higher inflation could end up hurting the very people MMT is meant to help.

I’m not old, but already feel like I’ve seen it all—or at least read the history.  The research that shaped me as an economist in the late 1980s was geared toward understanding  the great inflation of the 1970s and the policy actions that preceded (and responded to) it.  Paul Volcker isn’t dead yet, but may soon be turning in his grave.  Inflation then barely broke into the double digits, yet wreaked havoc with business plans, consumer confidence and, of course, financial markets.

When Democratic and Republican economists agree (and how likely is it that economists ever agree?) it means there’s a coalition building across the political spectrum.  We’ve anticipated it in Paladin's 3-5 year investment view, and have felt confident the experiment would be tried in response to the next recession.  Now it looks like MMT may be coming soon to a central bank near you...

It is almost certain that MMT will substitute real (goods/asset) inflation for financial asset inflation.  In the short run (especially if fiscal policy is used to retrain workers and/or fund infrastructure rehabilitation) that will be a good thing.  However, in the long run, it could be very bad.  I agree with Stephanie Kelton and Randall Wray that the only real obstacle is inflation--and that productive growth might be achieved with a wiser allocation of resources.  But those assumptions beg the question of how we got ourselves into this mess in the first place.  Given the massive expansion of debt over the past decade, it doesn't seem that financing is the binding constraint faced by businesses, households and government.  Rather, it is the allocation of resources that's the problem.  Printing more money does not address that challenge, which is essentially political, not technical.

The new Keynesians believe our weak growth is due to deficiency of demand.  It's true that if income and assets were distributed more evenly, aggregate demand would likely grow, since less affluent households have a higher propensity to spend.  Yet those who have studied the supply-side drivers of productivity growth, such as Bob Gordon, don't believe potential growth is much higher than actual at this point.  If anything, the massive accumulation of debt over the past decade, relative to the anemic growth it's created, suggests the opposite.  Technology and natural resource scarcity are creating stranded assets (of both human and physical capital) that cannot easily be redeployed, no matter what happens on the monetary policy front.  MMT suggests there's an obvious solution, but I fear there are no easy answers.

For MMT advocates, the question is this:  can monetary policy deliver only “good inflation” that raises wages but not prices?  Or raises wages and not asset prices?  My economics training started with a focus on poor countries, where inflation was viewed as extremely bad, because wages tended NOT to rise as fast as prices--and rising inflation typically led to political instability.  India, a very poor country, has been lauded as the most successful large democracy precisely because of the central bank’s commitment to keeping inflation in check.  China and Japan also advanced once they learned the lessons of their great inflations of the late 1930s and 1940s—a delayed and disastrous parallel with Europe.

What makes anyone think that our inegalitarian economy would produce a better result simply by printing money?  Without structural changes to address the declining labor share of GDP, MMT is likely to boost prices faster than wages.  That might help with debt resolution, but could aggravate the widening social divide.

Moreover, policymakers would have to maintain credibility in achieving just the right amount and kind of inflation, after spending decades trying to convince people that well-anchored inflation expectations are maintained by tight money.

Idealists believe they’ve arrived at a miracle cure in MMT.  'Cause if it’s modern, it must be good, right?  As if this has never been tried before!  The information age has eroded our knowledge of history; it's been replaced by a belief that machines and algorithms can solve fundamental/natural/organic problems.  However, society is not a machine.   Edward Chancellor strikes an appropriately cautionary note in his history of the Mississippi Company.  Here is the key parallel with our own progression from QE to MMT:

France boomed, unemployment disappeared and the sovereign debt crisis was forgotten. Such was the magical effect of paper money. Or was this prosperity, as some contemporaries suspected, merely a chimera? In the early stages, the Banque Royale’s notes weren’t used for normal commercial activities. Instead, they were supplied to speculators as loans to buy shares. The company supported its own share price, by borrowing and buying back a vast amount of its own stock, in much the same manner as corporations in recent years have used cheap credit to repurchase trillions of dollars’ worth of shares.

Once the bank money seeped out of the financial world and into the real economy, however, asset price inflation was replaced by the consumer variety. By the end of 1719, food prices had doubled. This left Law in a tricky position. He could either tighten monetary policy, or he could stand pat and let inflation rip. In the summer of 1720, Law chose the deflation option. The bubble burst and the Scotsman was forced to leave the country in disgrace, his scheme in ruins.

One might contend that, well, we’re talking about the UNITED STATES, not France--much less some lowly third world country.  We have the “exorbitant privilege” of making others accept our depreciating currency.  Or, to quote Nixon’s Treasury Secretary John Connally (when the US broke the dollar’s link to gold): “The dollar is our currency, but your problem.”

Nobel Laureate Bob Mundell corrected him, noting that, “the problem with the pure dollar standard is that it works only if the reserve country can keep its monetary discipline.”  Given history, it's worrying to imagine what could happen if/when the world’s reserve currency (supplied amply by the central bank of a dying empire) finally succumbs to a genuine inflation.

Bernanke and the MMT crowd must be awfully confident of their ability to engineer just the right dose.

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