Modern Monetary Theory : Sensible or Dangerous

MMT’s should be an increasingly relevant tool, to be used with but not supersede traditional macroeconomics for the recovery for Covid-19

Increasing government debt has allowed Modern Monetary Theory (MMT) to become a large part of the political and academic conversation, with MMT gaining more and more proponents per day. Is it a new toolbox to allow governments to fight recessions, eliminate the business cycle and ignore deficits? Or is it a dangerous ‘free lunch’ that gives too much power to partisan politicians (instead of independent central banks) and should be confined to the realm of ‘voodoo’ economics?

MMT is an economic theory that believes that fiscal policy (actions taken by the Government), instead of monetary policy (actions taken by the Central Bank), should be the primary tool to deal with economic downturns and achieve full employment. It differs from Keynesian Economics by arguing that governments with ‘monetary sovereignty’ should ignore budgetary outcomes and view the budget solely as a means to create full-employment (while being vigilant about any inflationary pressures). Monetary sovereignty is not universal- as governments need to have fiat money and not rely on foreign debt- but the UK, the USA and the Eurozone all have monetary sovereignty. MMT is a descriptive economic theory as it eschews mathematical formulas and doesn’t comment on government spending- except for Stephanie Kelton (a prominent supporter of MMT), who advocates for a federal jobs guarantee. MMT’s fundamental assertion is repudiating the view that government spending is like household spending (famously asserted by Margaret Thatcher) as the Government can issue currency. Stephanie Kelton uses the analogy of a bridge game in her book, The Deficit Myth, to describe the government’s ability to create debt: “MMT sometimes describes the Fed as the scorekeeper for the dollar. The scorekeeper can’t run out of points”. Jerome Powell (Chairman of the Federal Reserve) also said that “deficits don’t matter for countries that can borrow in their own currency”. This is why Modern Monetary Theory argues that since deficits are unimportant, the limit to budget deficits or surpluses is how much spending leads to the NAIRU (non-accelerating inflation rate of unemployment)

While there are no elected governments who support MMT, the Great Recession and the economic crisis caused by Covid-19 have prompted governments to use fiscal stimulus to deal with the economic crises. This is because the usage of monetary policy to deal with the ‘bust’ part of business cycles has become less useful than it used to be due to the severity of these crises. This is because most economists believe that the base-rate imposed by the Central Bank cannot fall below zero and with the current base interest rate in the UK being 0.1%, fiscal policy is needed to supplement any economic stimulus. The sizable shift in economic policy due to the economic crash is illustrated in the UK, where the Conservatives, who had previously argued against the existence of a magic money tree, are projected to borrow over £350 billion in 2020. Moreover, in America, both the Republican Party and the Democratic Party support fiscal stimulus to combat the economic effects of Covid-19 (with both the fiscal stimulus having bipartisan but unanimous support in the Senate). Looking ahead to 2021, the smaller Democratic majority in Congress (which, at the time of writing, is 222 seats in the house and 48-50 seats in the senate) means that progressives, such as Alexandria Ocasio Cortez and ‘the Squad’, have more influence when creating legislation, which is amplified because both Democrats and Republicans agree more fiscal stimulus is necessary. This also occurred in 2008, when monetary policy was not sufficient to fight the economic downturn as the base interest rate necessary to prevent the recession would have been below zero, meaning fiscal stimulus was needed to supplement the response. Stephanie Kelton argues that while monetary policy can be used, fiscal policy should be the only tool to deal with economic recessions (since monetary policy encourages companies to take up more debt than they actually may not afford).

However, some have criticised MMT for being imprecise (especially since it fails to use mathematical models). Nobel prize-winning Keynesian economist Paul Krugman argues that MMT doesn’t actually differ from regular Keynesian Economics and isn’t clearly defined. He wrote an opinion piece in the New York Times that argued: “every time you think you’ve pinned them down on some proposition, [proponents of MMT] insist that you haven’t grasped their meaning”. MMT’s alleged failure to distinguish themselves from conventional Kensyian economics is exacerbated by MMT’s disregard for mathematical formulas (except the idea that “Government deficit = Non Government surplus”) which prevents MMT’s application in practical decision-making. More importantly, MMT’s reliance on the Philip’s curve (the concept that inflation and employment are inversely correlated) means that it cannot be used if both inflation and unemployment are rising. This occurred in the 60s and 70s as Lyndon Johnson failed to combat rising inflation and unemployment with fiscal policy (Johnson increased taxes in 1968 to create a budget surplus in 1969) as inflation carried on rising steadily to 6.4% in 1970. This suggests that government spending may not be as effective at preventing inflationary pressure.

While no country has fully implemented or embraced the MMT philosophy, Japan and the USA provide examples of how countries have dealt with elements of MMT. Japan illustrates the power of the central bank to deal with high amounts of government debt. This is because in 2010, the Bank of Japan chose to control both the short-term and the long-term interest rate by introducing a comprehensive monetary easing policy in October 2010 to encourage a decline in long term interest rates. It found that a “combination of the negative interest rate policy and large-scale [bond]purchases was an effective means to exert influence on the entire yield curve”, meaning that they could control the interest rate to protect Japan from its high debt burden (237% of GDP). Moreover, it seems likely that budget surpluses do increase household and corporate debt (as the government is taking money out of the economy). Frederick Thayer argued that budget surpluses were often a cause for recession as the “US has experienced six significant economic depressions,” and “each was preceded by a sustained period of budget-balancing”. 
Overall, MMT should be used to supplement economic decision-making (as fiscal stimulus is a highly important tool that governments have to use to deal with the business cycle) but policy-makers should use both a combination of monetary and fiscal policy to deal with future recessions. MMT is limited by its descriptive nature; something that will have to change if it wants to become more mainstream. Finally, the notion that MMT is in itself dangerous seems exaggerated as MMT doesn’t seem to radically diverge from traditional Keynesianism and is vigilant against inflationary pressures.

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