Summary: The Left plans to pay the fantastic cost of the Green New Deal using an untried economic theory (we will be their lab rats, again). That is, never successfully tried (e.g., the Assignats of the French revolutionary regime failed badly). Here economist Ed Dolan discusses modern monetary theory (MMT). How does it differ from mainstream economics? Is it a cornucopia of money? Originally posted in 2012, I rerun it now for the presidential campaign. But fringe theories never go away (MMT has century-old roots in Chartalism).
“There is no such thing as Austrian Economics. Only good economics and bad economics.”
— Nobel Laureate Milton Friedman at a June 1974 conference at South Royalton VT. Ed Dolan was one of the organizers. It was a pivotal moment in the resurection of Austrian economics. His insight applies to all economic theories.
Ed Dolan explains modern monetary theory (MMT)
The first and simplest question.
Can governments go broke? In the sense that they can always create new money to settle any financial obligation that has a fixed nominal value in their own currency, the answer is, almost trivially, that they cannot go broke. On the other hand, they face the inflation constraint, and under conditions of hyperinflation, governments can “go broke” in the sense that they cease to be able to buy real goods and services with any finite nominal amount of currency.
Zimbabwe is a perfect example. It had a sovereign currency and did not blush to print octillion dollar banknotes, but eventually the people said “no thanks, I’d rather keep this loaf of bread than sell it to you for 1 octillion dollars.” Instead they used substitute currencies, mostly euros and rand, for day to day transactions.
The government said “no, you can’t do that! This is our sovereign fiat currency! You have to use it!” The government ranted “you have to pay your taxes and you have to pay them in Zimbabwe dollars!” People said, “why should we pay taxes to you bunch of clowns?” The Zimbabwe government went broke despite its mighty printing presses. See more about this episode.
The key to a good government budget.
One thing nearly everyone agrees on is that U.S. fiscal policy should be sustainable. But economists disagree about the meaning of sustainability. This post explores three meanings of fiscal policy sustainability and explores their significance for budget debates.
Sustainability as solvency.
The first, and simplest, meaning of sustainability makes it a synonym for solvency. The proposition that we do not have to worry about debts and deficits because the government can never “run out of money” has become a mantra among followers of Modern Monetary Theory (MMT). As L. Randall Wray puts it in his book Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems
“When we say that [perpetual government sector deficits] are ‘sustainable’ we merely mean in the sense that sovereign government can continue to make all payments as they come due – including interest payments – no matter how big those payments become.”
Strictly speaking, we should refer to the ability to meet financial obligations in full and on time as equitable solvency to distinguish it from balance-sheet solvency, which means negative net worth. No one ever seems to worry about governments’ net worth. Discussions of fiscal solvency always center on whether a government will be able to meet its financial obligations on a cash-flow basis, or will, instead, run short of cash and be forced to default.
Is MMT correct in its claim that a government can never become equitably insolvent? Yes, as long as the proposition is limited to governments that issue their own sovereign currencies and maintain floating exchange rates.
A country like Greece could literally run out of euros because it is a user rather than a sovereign issuer of the euro. Any fiscal policy for Greece that does not include a mechanism for obtaining enough euros from some external source to meet its financial obligations would be unsustainable in the sense of being inconsistent with equitable solvency.
A country, like the United States, that has a fully sovereign currency and a floating exchange rate is in a fundamentally different position. The U.S. government can always issue as many dollars as it wants, provided it does not bind itself with self-imposed restraints like the federal debt limit. Under some circumstances, fiscal deficits might become large enough to have undesired consequences (more on that later) but if it wanted to ignore those consequences, it could always get the dollars it needed to meet its financial obligations.
Some countries are in an intermediate position between Greece and the United States. Like Latvia. Although Latvia issues its own currency, the lats, its solvency is constrained in two ways. First, the Latvian government has borrowed large sums in foreign currency. To the extent it has done so, it is in the same position as Greece; its solvency depends on having a way to obtain the foreign currency it needs to meet those obligations. Furthermore, Latvia maintains a fixed exchange rate. That constrains its ability to meet obligations like salaries and pensions even when they are denominated in its own currency. Issuing too many new lats could put unsustainable pressure on the exchange rate, causing the government to choose between defaulting on its debts and defaulting on its commitment to maintain its peg to the euro. {Update: Latvia gave up its currency and adopted the Euro on 1-1-2014.}
Can we say that because a country with a sovereign currency and a floating exchange rate can never become equitably insolvent, its fiscal policy can never become unsustainable? In my view, we cannot. Solvency is only the starting point for a discussion of sustainability, not the whole story.
Mathematical sustainability.
A second meaning is that a fiscal policy is unsustainable if it causes the ratio of debt to GDP to grow without limit. The concern here is that a debt that grew without limit would eventually become unmanageable, leading to some unpleasant consequences like default, excessive inflation, or forced austerity. I will refer to this second meaning as mathematical sustainability.
As discussed in an earlier post, a country’s structural primary budget balance is a useful indicator of mathematical sustainability. The structural primary balance is the government’s surplus or deficit, excluding interest on the debt and adjusted to take into account the state of the business cycle {see Wikipedia}. In any given case, the conditions for mathematical sustainability depend on the starting debt-to-GDP ratio, the rate of interest on the debt, and the rate of growth of GDP. (For details of debt dynamics under various scenarios, see this slideshow.)
Typically, the rate of interest tends to be higher than the rate of growth. In that case, a country that starts with any debt at all must hold its structural primary balance at a small surplus in order to achieve mathematical sustainability. For example, since 1980, the interest rate on U.S. government bonds has averaged about 1.3 percentage points higher than the rate of GDP growth.
If that differential were to persist in the future, the federal budget would have to maintain a primary surplus of about 0.9% of GDP to stabilize the debt at its current level of approximately 70% of GDP. If the average inflation rate were to stay at the Fed’s target of 2%, interest payments would consume about 2.3% of GDP, so the overall balance, including interest payments, would show an average deficit of about 1.4% of GDP.
If, given those starting conditions, the primary surplus were less than its steady-state value of 0.9%, the debt-to-GDP ratio would, over time, increase without limit. For example, if the primary budget were held exactly in balance, the debt-to-GDP ratio would double every 50 years. In reality, as of 2011, the U.S. structural primary balance was in deficit by 5.8% of GDP, according to OECD data. With a structural primary deficit of that size and given the assumed values of other parameters, the debt ratio would grow much more rapidly, doubling about every 10 years.
From the IMF’s April 2019 “Fiscal Monitor.”
The structural primary deficit of the US is ~3% now – in the 9th year of the expansion. It is getting worse. Awful.
On the other hand, if the primary surplus were greater than the assumed steady-state value, the debt would shrink steadily as a percentage of GDP. For example, if the U.S. primary surplus were held at 2% of GDP, the debt would disappear in 50 years, after which the government would accumulate net assets in a steadily growing sovereign wealth fund.
Are such extrapolations of the debt-to-GDP ratio something we should really care about, or are they just a parlor game? Opinions differ as to whether it is a matter of pressing national importance to bring the U.S. structural primary balance into consistency with the conditions for mathematical sustainability.
Federal debt as a percent of GDP (updated).
For example, followers of MMT like to point out that the debt dynamics become much friendlier if the rate of interest is held permanently below the rate of growth. If that can be done, then regardless of the initial values of the debt and the structural primary balance, the debt-to-GDP ratio always converges to some finite value. It should be mentioned that many non-MMT economists worry that attempting to hold the interest rate below the growth rate over a long period would carry a risk of serious inflation, but exploration of that issue will have to wait for another time.
A further, and to my mind more realistic, argument made by some MMT followers is that the debt will never “explode” because something will happen to change the parameters of the model before an explosion takes place. Wray compares the discussion of unstable debt dynamics to speculation about what would happen to a person who constantly consumes more calories than he burns. Mathematically, such a person would eventually “explode,” yet we have never seen an exploding person. Something else always happens first.
Editor’s note: the “something else” for the obese is often death, from accident or illness resulting from obesity. See the list of the heaviest people. The “something else” for governments is often some form of collapse or crash.
The way I see it, mathematical sustainability is a useful benchmark for discussion of fiscal policy precisely because it causes us to focus on the changes that must take place if the current set of budget parameters implies an impossible outcome. Will they be changes for the better or the worse? Will they be changes that come about in an orderly way or changes that are forced and unpleasant?
To pick up on Wray’s analogy, suppose you step on the scales and find you are seriously overweight. You are not yet morbidly obese, but you are gaining steadily. Do the numbers on the scale mean you are at risk of literally exploding? Of course not, but they do indicate that you will have to face up to some hard choices. Will you start exercising and change the way you eat? Or will you wait until you have developed diabetes or suffered a heart attack, and then sign up for emergency gastric bypass surgery?
Editor’s note: Or will you die, as about 800 thousand Americans do each year from their cardiovascular disease?
Functional sustainability.
That brings us to the third meaning of sustainability: If a country has a set of rules and decision-making procedures that adjust fiscal parameters over time to serve some rational public purpose, we can say that its fiscal policy is functionally sustainable.
There is no one set of rules that is consistent with functional sustainability. For example, many MMT followers favor focusing fiscal policy on the goal of full employment and adjusting tax rates to moderate aggregate demand when and if a threat of inflation develops. (Such a scheme is a descendant of Abba Lerner’s writings on functional finance in the 1940s.)
At the other end of the political spectrum, many U.S. conservatives favor an annually balanced budget, preferably enshrined as a constitutional amendment. True, such a policy would be strongly procyclical. It would require austerity during recessions and would provide little restraint on spending during booms. (See here for a detailed critique.) However, procyclical or not, a balanced budget rule would be “functional” in the sense of providing a rule that is consistent with mathematical sustainability.
In between, a variety of fiscal policy rules have been proposed. One such rule would constrain each year’s structural primary deficit to a level consistent with mathematical sustainability. Unlike proposals for an annual balancing of the current budget, a policy of structural balance would allow the free operation of automatic stabilizers like income taxes and unemployment benefits. Alternatively, we could allow more room for discretionary countercyclical policy by requiring the structural primary deficit to remain on target on average over the business cycle rather than on a year-by-year basis. Countries like Chile, Sweden, Germany, and Switzerland provide examples of such rules.
Note that none of these fiscal rules say anything about the size of government or the content of spending. Any of them could be adapted to a big government with a generous social safety net; a big government with a strong defense establishment; or a small government limited to protecting property and enforcing the rule of law.
The trouble is that we don’t have any workable fiscal policy rules at all. As Herbert Stein observed almost 30 years ago …
“The basic fact is that we have no long-run budget policy – no policy for the size of deficits and for the rate of growth of the public debt over a period of years. Annually we make decisions about the size of the deficit that are entirely inconsistent with our professed long-run goals, with the explanation and hope that something will happen or be done before the long-run arises, but not yet.” {AEI Economist, December 1984.}
It would be hard to find a better characterization of a fiscal policy that is functionally unsustainable.
What can we agree on?
In light of all of the above, where can followers of MMT and non-MMT economists find common ground? I see three potential areas of agreement.
First, we should be able to agree that there is no point in arguing over the solvency vs the mathematical version of sustainability. Both are valid. They are complementary statements about different aspects of fiscal policy. Furthermore, neither approach amounts to more than a formal truism until we add the concept of functional sustainability.
Second, everyone should be able to agree that fiscal policy does not have to be procyclical to be “sound.” Whatever theoretical framework we start with, fiscal austerity during a slump is not a good idea. That should put MMT and non-MMT economists largely on the same side during budget negotiations.
Third, it should be possible to agree that just because the government can, in a solvency sense, always “afford” to spend, that does not mean more spending or lower taxes are always better. Even when the economy is operating below potential, as it is now, we need budget procedures that set sensible national priorities and winnow out spending and tax breaks that serve only to reward favored interest groups at the expense of the broader public.
Furthermore, we need to recognize that an economy in boom conditions needs to restrain aggregate demand. Rules can shape policies so that fiscal prudence operates when needed than simply to “hope that something will be done before the long-run arises, but not yet.”
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See Dolan’s slideshows about Fiscal Policy and Taxes
- Is the US Government Debt Really Out of Control? – This explains the simple arithmetic of debt dynamics. Currently, the US federal debt is not on an unsustainable path.
- Who Really Pays Taxes? The Question of Tax Incidence – Uses concepts of supply, demand, and elasticity to present the basic theory of tax incidence
- How do we Know if the Federal Debt is Sustainable? – Covers structural primary balance and debt dynamics. This slideshow can be used in conjunction with How Can We Tell if Fiscal Policy is Sustainable? Three Views.
- The Truth about Taxes: What are our Choices? – They focus on the issue of changes in tax rates vs. broader tax reform that broadens the tax base.
A clearer answer to the question
“The Uses and Abuses of Modern Monetary Theory” by Karl Smith (also a senior fellow at the Niskanen Center) at National Review – “Its advocates overlook its flaws.” Short version: no, MMT does not justify regarding the government as a cornucopia of money. He lists a few of many historical examples proving that should-be obvious truth.
About Modern Monetary Theory (MMT)
MMT is best known for stating that governments can print far greater amounts of currency without ill consequences than conventional theory suggests. It is in one sense the mirror image of the austerian (as in austerity, not Austrian) obsession with gold and inflation. They are bookends, in a sense. Many well-respected economists advocate this theory.
Other posts about MMT.
- The Left plans an experiment to pay for the Green New Deal.
- Can we happily borrow our way to a Green New Deal?
See these about MMT and the limits of monetizing the debt
- “Deficits Do Matter, But Not the Way You Think“ by L. Randall Wray, prof economics at Bard (2010). See his articles here.
- “Deficit Doves Meet the Deficit Owls“ by Stephanie Kelton at New Economic Perspectives, 2010.
- “Soft Currency Economics” (2008) — ebook by Warren Mosler (hedge fund manager), 32 pages.
- Seven Deadly Frauds of Economic Policy (2010) — ebook by Warren Mosler, 63 pages.
- “MMT and Why Historians Need to Reclaim Studying Money” by Rebecca L. Spang (Prof of History at Indiana U). Also, see a response by Maxximilian Seijo.
- MMT White Paper: Modern Monetary Theory (MMT) – “The purpose of this white paper is to publicly present the fundamentals of MMT.”
- “A Skeptic’s Guide to Modern Monetary Theory” by N. Gregory Mankiw (prof economics, Harvard).
- Stephanie Kelton’s The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy
Here are two clear explanations of MMT by Paul Krugman (not a fan of MMT).
About the author
Edwin G. Dolan is a Senior Fellow at Niskanen Center (Ph.D. from Yale). He was an Asst. Prof. of Economics at Dartmouth, and later on the faculties of U of Chicago, and George Mason U. From 1990 to 2001, he taught in Moscow, Russia, where he and his wife founded the American Institute of Business and Economics (AIBEc), an independent, not-for-profit MBA program. He has taught at several universities in Europe, including Central European University in Budapest, the University of Economics in Prague, and the Stockholm School of Economics in Riga. He is a Senior Fellow at The Niskanen Center.
During breaks in his teaching career, he worked in Washington, D.C. as an economist for the Antitrust Division of the Department of Justice and as a regulatory analyst for the Interstate Commerce Commission, and later served a stint in Almaty as an adviser to the National Bank of Kazakhstan. When not lecturing abroad, he makes his home in Washington’s San Juan Islands.
His publications include Introduction to Economics
For More Information
Ideas! For shopping ideas see my recommended books and films at Amazon. Also, see Chapter One of a story about our future: “Ultra Violence: Tales from Venus.”
If you liked this post, like us on Facebook and follow us on Twitter. For more information, see these posts about monetary policy, about fiscal policy, and especially these …
- What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!
- Are conservatives right about the Fed? Is it a malign force in America? – Spoiler: no. Written during one of the Right’s bouts of hysteria about the Fed destroying America!
- Harsh truths about the Federal debt, showing how Left & Right lie to us.
- Today’s mythbusting: the Fed is not suppressing interest rates.
See the case for MMT
The Deficit Myth:
Modern Monetary Theory and the Birth of the People’s Economy.
By Stephanie Kelton (2020).
From the publisher …
“The leading thinker and most visible public advocate of modern monetary theory – the freshest and most important idea about economics in decades – delivers a radically different, bold, new understanding for how to build a just and prosperous society.
“Any ambitious proposal – ranging from fixing crumbling infrastructure to Medicare for all or preventing the coming climate apocalypse – inevitably sparks questions: how can we afford it? How can we pay for it? Stephanie Kelton points out how misguided those questions really are by using the bold ideas of modern monetary theory (MMT), a fundamentally different approach to using our resources to maximize our potential as a society.
“We’ve been thinking about government spending in the wrong ways, Kelton argues, on both sides of the political aisle. Everything that both liberal/progressives and conservatives believe about deficits and the role of money and government spending in the economy is wrong, especially the fear that deficits will endanger long-term prosperity.
“Through illuminating insights about government debt, deficits, inflation, taxes, the financial system, and financial constraints on the federal budget, Kelton dramatically changes our understanding of how to best deal with important issues ranging from poverty and inequality to creating jobs and building infrastructure. Rather than asking the self-defeating question of how to pay for the crucial improvements our society needs, Kelton guides us to ask: which deficits actually matter? What is the best way to balance the risk of inflation against the benefits of a society that is more broadly prosperous, safer, cleaner, and secure?
“With its important new ways of understanding money, taxes, and the critical role of deficit spending, MMT busts myths that prevent us from taking action because we can’t get beyond the question of how to pay for it.”
The Deficit Myth:
Modern Monetary Theory and the Birth of the People’s Economy.
By Stephanie Kelton (2020).
From the publisher …
“The leading thinker and most visible public advocate of modern monetary theory – the freshest and most important idea about economics in decades – delivers a radically different, bold, new understanding for how to build a just and prosperous society.
“Any ambitious proposal – ranging from fixing crumbling infrastructure to Medicare for all or preventing the coming climate apocalypse – inevitably sparks questions: how can we afford it? How can we pay for it? Stephanie Kelton points out how misguided those questions really are by using the bold ideas of modern monetary theory (MMT), a fundamentally different approach to using our resources to maximize our potential as a society.
“We’ve been thinking about government spending in the wrong ways, Kelton argues, on both sides of the political aisle. Everything that both liberal/progressives and conservatives believe about deficits and the role of money and government spending in the economy is wrong, especially the fear that deficits will endanger long-term prosperity.
“Through illuminating insights about government debt, deficits, inflation, taxes, the financial system, and financial constraints on the federal budget, Kelton dramatically changes our understanding of how to best deal with important issues ranging from poverty and inequality to creating jobs and building infrastructure. Rather than asking the self-defeating question of how to pay for the crucial improvements our society needs, Kelton guides us to ask: which deficits actually matter? What is the best way to balance the risk of inflation against the benefits of a society that is more broadly prosperous, safer, cleaner, and secure?
“With its important new ways of understanding money, taxes, and the critical role of deficit spending, MMT busts myths that prevent us from taking action because we can’t get beyond the question of how to pay for it.”
