Modern Monetary Theory: Part 2
“We’re not describing any new economic policy. We’re describing reality, the way the U.S. government actually spends.”
L. Randall Wray, MMT Advocate, 2019
“I don’t feel like just because we’re staring down trillion-dollar deficits we’re out of room and Congress can’t be considering ambitious spending. The debt to GDP ratio could easily reach 150% without causing problems for the economy.”
Stephanie Kelton, MMT Advocate, 2019
Although Modern Monetary Theory, or MMT, dates back 25 years or more, it has recently come into prominence in the U.S. Endorsements from high profile politicians (Bernie Sanders, AOC, and in practice Trump), capital market participants, like Paul McCulley, and others, that see MMT as the only way to facilitate the reflation trade, have brought MMT to America. It’s also reflective of the move away from global efficiency and toward greater income equality, which is at the heart of the populist movement. The fact that the top 10% of households earn the same as the bottom 90% is an indicator of why the mood has changed. Bill O’Grady at Confluence Investment Management states that every major shift in the efficiency/equality cycle has coincided with a favored economic theory to promote the change. Equality cycles are characterized by policies that favor labor through high marginal tax rates, easy monetary policy, and policies that favor unions, and social mores that promote the common man. Equality cycles end when the economy needs to build productive capacity to reduce inflation and thus needs to favor efficiency or policies that favor capital. These policies include low tax rates, reduced regulation, anti-organized labor policies, and social mores that lionize wealth.
Also helping MMT’s emergence is timing. High government debt among all developed economies, with corresponding low unemployment and low inflation, is empirical evidence supporting MMT’s claims, or so they say. MMTers claim that old world, orthodox economic models that view inflation as partly a function of the unemployment rate appear to have lost their power; as in the Phillips Curve. Record low unemployment in the U.S. should be firing up inflation but it's not. And since the fight against inflation is no longer public enemy number one (thanks Paul Volker), we should be more focused on the more important fights: economic equality and universal health care, both of which can be financed with government debt.
MMTers are heterodox thinkers, neither freshwater nor saltwater, believing the government is the source of the solution. They advocate thinking of MMT not as a set of policy initiatives, but as a method of opening our eyes to what tools are available to the government to make life better for its citizens. And many of those tools aren’t being used today, only because of self-imposed restrictions.
Self-Imposed Financial Constraints
At the core of MMT is the idea that a monetarily sovereign government is not like a household since it can never run out of money and can always make debt payments when due. In other words, governments that issue their own currency and borrow in that same currency can never involuntarily default on their debts since it can always issue more currency. Thus, MMT wants us to believe financial constraints are not organic but politically imposed. The only limits to spending would come from supply-side shortages that might threaten to ignite inflation. When markers of inflation appeared, MMT advocates simply pulling the excess currency out of the economy through taxation, and/or bond sales. Once supply caught up then the government could begin spending again. MMT thinks of the spending process as a circle of events: currency creation through spending, tax receipts, and bond sales. The spending by the government logically comes first before the government obtains tax revenue or sells bonds.
Inside of this spending philosophy is the total rejection of the conventional Government Budget Constraint (“GBC”) where State spending must first be financed by tax revenues, along with borrowing or printing money. MMTers call out that a government’s finances are not the same as a typical household since governments can continue to supply liabilities so long as they continue to be demanded. Therefore, government finance concerns should be based on the functional needs of its people, not on a need for budgetary balance. Government budgets should focus on societal goals, such as fighting climate change, Medicare for all, free school tuition, guaranteed jobs, universal basic income, etc.
The Role of Taxation and Functional Finance
MMT’s Functional Finance View of State Budgeting states that because the State spends by emitting its own liability, it does not need tax revenues or the proceeds from borrowing in order to spend. The first principle of functional finance is that the state should increase taxes only if the public’s income were too high and thereby threatening general inflation. The second principle is that the State should borrow (sell bonds) only if it is desirable for less money and more government bonds in the hands of the people.
Functional Finance opposes the notion of sound finance, or that government budgets should be set to balance tax revenues and spending. Didn’t Reagan prove to the world that deficits don’t matter? Further, taxes should never be raised to reduce budget deficits. That should be done only under the specter of rising inflation. Correspondingly, bonds should be sold by the government only when there is an observed downward pressure on interest rates likely to go below the Central Bank’s target.
MMT claims to be agnostic over budget surpluses and deficits. They say a functional finance approach insists that the fiscal position of the government is not a relevant policy objective for a monetarily sovereign government. Price and financial stability, moderate growth of living standards, and full employment are the more relevant macroeconomic objectives, and fiscal position of the government is to be judged relative to these goals.
Macroeconomic Policy Through Fiscal Policy
MMT rejects the notion the economy should and can be controlled through the money supply and interest rate adjustments – or, monetary policy. Instead, MMT says a more effective way to manage the economy is through government spending and taxation – or, fiscal policy. MMT proposes to make the Fed’s liabilities legal tender so that the Fed can directly fund the expenditures of the federal government, which would require a re-write of the Federal Reserve Act. As Dr. Lacy Hunt describes it, “MMT advocates using the Fed’s balance sheet as a cash cow to fund expansive new social programs, especially in view of low-interest rates and low inflation”. He postulates a possible way for MMT to make it work would be to have the Treasury issue zero maturity and zero interest rate liabilities to the Fed, who, in turn, would increase the Treasury’s balances at the Federal Reserve Banks. The Treasury could spend these deposits directly to pay for programs, personnel, etc. The effect of this approach would be to pull the responsibility of the economy out of the hands of the Fed and place it with Congress, whose members would act responsibly or suffer their fate at the ballot box next election. This is a more democratic approach, in the sense that it lets the people decide what macroeconomic policy is best suited to the current times.
Origin of Money
Under the more well-known orthodox model says that money is a veil for exchange and doesn’t affect real economic variables. Money performs three basic functions: a) a medium of exchange, b) a unit of account, c) a store of value. Thus, the orthodox crowd believes the origin of money was barter.
The MMT philosophy departs from this and counters with its State Theory of Money. The State Theory of Money claims taxes, or the requirement of tax payments to the State under the threat of force, as the real origin of money, not trade. The State spends its money first and then recalls that same currency by imposing taxes. In other words, the validity and value of money are through government proclamation, where the State dictates what it will accept to satisfy the obligation of its people to the State. The State chooses the unit, names the thing accepted in payment of obligations to itself, and issues the money-thing it accepts. The state-centric narrative is based on the concept that money is linked to debt. Money can relieve the debtor of his burden, and the state determines the nominal value of that burden.
Once the State has created the unit of account and named what can be delivered to fulfill obligations to the State, it has generated the necessary pre-conditions for the development of markets. Credits and debts preceded markets and created the need for markets. The primordial debt is the tax obligation, which then creates the incentive for private credits and debts and then for markets.
Causes of Inflation
MMTers promote the idea that inflation is caused by the lack of goods, or labor, or capacity. So, they ask, why doesn’t the government increase spending until there is no more unemployment? Only when the supply of labor becomes restricted will the government be bidding up the price of it. This idea promotes the philosophy that the government must use its position as a monopoly issuer of the currency to ensure full employment. Full employment is the upper limit of non-inflationary spending.
If there’s too much money in the system and inflation is rising, then taxes would effectively destroy money and reduce price pressures. Higher marginal tax rates would reduce inequality, and taxes could be used to induce the production of “good” things and to reduce the production of “bad” things. And finally, if a particular industry or consumer benefitted from a public good they should pay for part of its provision. The redistribution argument is about changing behavior, not about Robin Hood type stories.
Macro Identities and Flows
There are three sectors of the economy: private, government, international. What is a deficit for one is a surplus for the others! If the government sector runs a surplus the private sector will run a deficit, which must be funded by the banks, making the private deficit an accumulation of private debt – which is not sustainable. However, the government running a deficit and the private sector running a surplus is sustainable, especially for the reserve currency nation, since the government can create its own money.
MMT argues the fiscal position of the government sector is ultimately driven by the desired net financial accumulation of the non-government sectors. Usually, the domestic private sector desires to net save, therefore the government sector must be in deficit. If the government fiscal position is in surplus, or in a deficit that’s not consistent with the desired net savings of the domestic private sector, nominal national income will adjust as the domestic private sector changes its spending level. As national income changes so do automatic stabilizers, and so the fiscal position will move to be consistent with the level desired by the non-government sector. Furthermore, as long as the domestic private sector desires to have a net accumulation of government currency, there is no need to retire all of the emitted currency through taxation – there is no need to have a balanced budget. The proper fiscal stance at full employment, or any other economic state, cannot be determined independently of the non-government sectors’ desire in terms of net accumulation of federal government financial assets. There is no need to assume the federal government budget needs to be balanced at full employment to prevent inflation. The fiscal balance at full employment will depend on the desired net saving of the non-government sectors at full employment income. If the desired net savings of the domestic sector is positive at full employment income, there is no inflationary pressure from a fiscal deficit. If the budget deficit is too high relative to the desired net savings of the domestic private sector, there will be demand-led inflationary pressure around full employment. As national income rises non-discretionary government spending will decline and taxes will rise as a result of automatic stabilizers, not a new policy. But this does not mean that a surplus is needed during an expansion. MMT does not say that the government budget cannot be balanced at full employment. It just states that the balanced budget is not up to the government sector to decide.
From these macroeconomic identities, MMT works if the sovereign currency is not convertible into gold or any other commodity. Although it’s not essential, a floating exchange rate gives policymakers less constraint on fiscal and monetary policy. Under conditions of convertibility, the orthodox model of money holds.
MMT claims to promote a political process that allows the will of the people to be expressed, uncluttered by talk of financial constraints. MMT wants to emphasize discussing the pros and cons of a particular government program under the ideas of accountability and transparency, fairness, full employment, and financial and price stability, and de-emphasize financial constraints. The fact that a government can spend an unlimited amount of money doesn’t mean it should, and ultimately the choice of how much a government should spend is a political question.
Although MMT does not advocate “fine-tuning” of the economy, it does propose to diligently watch over the aspects of unemployment, arbitrary income distribution, price, and financial instability, on a continuous basis and throughout the business cycle. To accomplish such goals MMT’ers would launch macroeconomic programs that directly manage the labor force, pricing mechanisms, and investment projects, and constantly monitoring financial developments. Because those programs would be permanent and structural, rather than discretionary and specific to one Administration, they would be isolated from the political cycle and political deliberation. The claim is that these policies would eliminate problems of lags, credibility, and time inconsistency that pervade the U.S. economy through the stewardship of the Fed.
A central macroeconomic program is the Jobs Guarantee Program (a la Hyman Minsky), which targets developing a pool of employable labor while at the same time ensuring continuous employment of those ready and willing to work. This they claim is a rightly distributed spending program in which government spending is directed precisely to those who want to work. Since workers in the program are part of the surplus (a redundant labor force) there is no added pressure on wages and prices. Employing workers from the program is no more inflationary than leaving them unemployed, but if it does, the government has all its same tools to fight inflation. The difference is that the government would not be able to fight inflation by increasing unemployment. With this program in place, the inflation-fighting adjustments to spending will occur among the employed rather than causing unemployment and poverty. The added benefit is the government’s budget would be made more counter-cyclical as government spending increases in the slump when workers move from higher-paid employment to the Jobs Program; the process is reversed in a robust expansion, where when the private sector hires out of the Jobs Program pool.
Another key policy initiative relates to the role of the Fed and its real purpose of promoting financial stability. The MMT policy would focus on the promotion of safe underwriting, the establishment of a banking structure that promotes long-term relationships, and the regulation of financial innovations toward safe financial products.
MMT policy would also eliminate the Social Security system and the payroll tax since taxes are part of a system that creates winners and losers. Taxes can be advocated but not with a view of funding Social Security, but rather to reduce the purchasing power of those of working age in order to leave enough for retirees to consume. By discussing taxes in terms of a means to pay for something confuses matters and leaves one open to conservative critiques that taxes are a burden instead of a means for fighting inflation.
Since the debt ceiling is not an economic problem, and instead of a political one, MMT policy would advocate Removing the debt ceiling and allowing the central bank to directly fund the Treasury would not directly promote price and financial instability and such changes do not necessarily promote careless spending. This MMT construct is said to reframe the debate away from the need to reduce our national debt and toward the need to abolish the debt ceiling. After all the debt ceiling is a relic of the gold-standard that contradicts other budgetary procedures of Congress. Taxes and bond offerings would still happen, but just to make sure that the government is involved in the economy according to the wishes of the people.
Japan Since the 80’s: MMT advocates are quick to point out the history of Japan’s economy since their excesses of the 1980s. In Japan government debt to GDP jumped from 52% in 1988, to 80% in 1998, to 200% in 2018, an all-time high, including periods of war. Correspondingly, the current 10 year and 30-year JGB’s are yielding -0.1% and 0.5% respectively. Apparently, massive government spending didn’t spark inflationary concerns in Japan.
United States Since the Great Financial Crisis: The same holds true in the U.S. In the past 10 years government debt to GDP ratio surged 45 percentage points to the highest level on record, with the exception of war years and the year immediately thereafter. And yet, interest rates are historically low, and inflation can’t be ignited even with the concerted effort of the Fed to do so.
In my next post, I’ll talk about various capital market participants critique of MMT, and the consequences of its implementation.