What if governments could spend without collecting taxes or raising debt? What if printing money and spending it on goods and services weren’t inflationary? What if governments could never go bankrupt? What if everything that you’ve learned about money and public finance was wrong?
These and other ideas are the basis of Modern Monetary Theory (MMT), a new macroeconomic paradigm aimed at challenging the foundations of mainstream economic theory. Despite representing a minority within academia, MMT proponents have managed to introduce their ideas into the political debate, attracting the interest of politicians, including President Trump and Representative Alexandria Ocasio-Cortez.
Two reasons explain the rise of MMT. First, politicians are naturally attracted to an economic theory that claims that taxes and debt don’t constitute limits to how much governments can spend, especially at a time when public spending and debt levels are skyrocketing as a result of the policies implemented to fight the pandemic.
Second, MMT has gained popularity among the public because it encompasses a coherent and controversial set of ideas that challenge the status quo. For this reason, it shouldn’t be dismissed at first glance. Indeed, MMT proponents make some interesting arguments that are worth discussing.
According to MMT, public spending isn’t constrained by how much taxes the federal government can collect or how much debt it can raise. The reason is simple: governments can always make use of the money-printing press to finance their expenses. Some would argue that this is unrealistic since most governments don’t have the prerogative to issue currency. It’s an independent institution, a central bank, that manages a nation’s currency.
But let’s assume for a moment that there is no central bank or that the central bank is directly controlled by the Treasury Department. If this were the case, governments could never go bankrupt. In effect, if a country issues bonds in its own currency to finance its operations, it can always print more money to repay its debt.
Nonetheless, MMTers admit that spending via money printing can lead to inflationary pressures, but only if the economy is at full capacity (i.e. there is no involuntary unemployment). So long as that isn’t true, government can fund any expense it wishes without triggering an inflationary spiral, including the job guarantee programs proposed by several leading MMT thinkers.
What if inflation rises? No problem, argue MMTers. The government just needs to either raise taxes or issue bonds to take money out of the economy, thereby putting downward pressure on prices. For MMT proponents, taxes and debt are just tools to control the price level, not sources of funding for the government.
Based on the MMT framework, we should wonder why we need independent central banks. After all, they only prevent governments from undertaking policies that would benefit the country as a whole. Without them, governments could spend much more than they do now without having to worry about the possibility of bankruptcy or inflation.
Unfortunately for its proponents, MMT suffers from several problems. Strictly speaking, it is true that a government that controls the monetary base can spend as much as it wishes. In addition, it can demand the payment of taxes in its own currency, creating an artificial demand for it. However, MMTers overstate the capacity of governments to maintain the purchasing power of their currencies if the limits imposed by taxes and debt are removed.
Economic agents demand money for reasons other than paying taxes, mainly as a medium of exchange to buy goods and services and as a store of value in which to save part of their income. Were these agents to perceive that a particular government were recklessly spending via money-financed deficits, the demand for its currency would collapse due to a loss of confidence in the issuer. This in turn would result in a hyperinflationary episode similar to the one that has recently taken place in Venezuela. If you think the Venezuelan government was able to control inflation via higher taxes or new bond issuances denominated sovereign bolivars, look at this graph.
Can money-financed deficits pay for job-guaranteed programs without bringing about inflation? When there are idle resources in the economy and unemployment is high, fiscal stimuli financed by printing new money isn’t necessarily inflationary, but it can be. In fact, there are many examples in history of periods of high unemployment and high inflation (e.g., the 1970s stagflation).
The key isn’t so much whether the economy is working below, above, or at full capacity, but the confidence economic agents place in the monetary authority responsible for issuing the currency. Without an independent central bank committed to price stability, any government attempt to pay for job-guaranteed programs by printing new money would be perceived as inflationary. After all, the reputation of the currency issuer plays a key role in determining inflation expectations. Would you trust a government with such a power?
Finally, a government with monetary autonomy can never go bankrupt in the sense that it can always print more money to pay off its debt obligations. However, doing so would result in the depreciation of the currency, which means that investors would demand increasingly higher yields to compensate for expected inflation. This in turn would lead to government printing more money to repay investors, creating an inflationary spiral that would end with the currency losing all its purchasing power.
MMT proposals may seem like common sense. Yet in economics, we must follow the advice of 19th-century French economist Frederic Bastiat and look beyond the visible effects, trying to unravel the unintended, not so obvious consequences of government policies. If we do, we find that following the recipes of MMT would only lead to disaster.