Summary: The Democrat’s party has big goals for America, requiring big sums of money. They won’t get it from taxes. Modern monetary theory is the easy solution, a cornucopia of money. Economist Karl Smith explains why it won’t work.
Solving our problems is easy!
The Uses and Abuses of Modern Monetary Theory
By Karl Smith.
Its advocates overlook its flaws.
Newly elected representative Alexandria Ocasio-Cortez (D-NY) argued that Modern Monetary Theory (MMT) ought to be a part of the conversation when it comes to funding major social-policy initiatives, such as her proposed Green New Deal. Stephanie Kelton, former economic advisor to Bernie Sanders, has likewise insisted that MMT should replace our current thinking about government finance {see her new book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy
At its heart, MMT is a way of describing the federal budget and the Federal Reserve as if they were unified under a single executive authority. In describing the system so, the dangers of federal deficit spending are no longer that it crowds out private investment and slows economic growth, but that it leads potentially to excess inflation.
Yet Modern Monetary Theorists then invariably argue that inflation is not, and indeed could not be, a major problem for the United States. Many hard-core adherents go so far as to propose a job-guarantee program paid for by the federal government, which, they argue, will virtually eliminate both unemployment and the possibility of runaway inflation.
The tenets of MMT should be familiar to an older generation of fiscal conservatives. Before the 1980s, central banks such as the Federal Reserve were controlled far more directly by their governments. As a result, they could – and often did – bail out profligate governments by simply printing more money to cover the government’s debt. This led to massive currency devaluation, runaway inflation, or both. In the early 1980s, however, central banks in the developed world were granted independence in the hopes that doing so would stop the spiraling inflation of the late 1960s and 1970s.
In the U.S., Fed chairman Paul Volcker was spectacularly successful at this. So were, to varying degrees, most central banks in the developed world. Some holdouts existed, notably in Southern Europe – a situation that would come back to haunt them decades later.
But MMT waves away the significance of these developments, instead focusing attention on several technical facts. First, when the federal government wants to spend money, it does so by having the Treasury issue checks. These checks are processed by the Federal Reserve Bank of New York (FRBNY). Second, the FRBNY does this literally by marking up the value of digital reserves in an account belonging to the check recipients’ bank and marking down the account of the Treasury by an equal amount.
These two operations are, in theory, separate. There is no technical reason why the FRBNY has to mark down the Treasury account. It only does so because laws require the federal government to meet all of its obligations. Such laws, argue Modern Monetary Theorists, cannot bind Congress, which after all has the power to alter them. MMT advocates argue that Congress should ask the Treasury to sell Treasury bonds to cover any of its outstanding obligations. This is not, however, because they think it is necessary to fulfill the government’s obligations, but because doing so would help stabilize the macroeconomy.
All well and good. But at some point, won’t the debt become so large that merely paying interest on it will require issuing additional debt? Won’t this process feed on itself until all the borrowing capacity in the economy is soaked up?
No, MMT advocates reply, because the government can simply stop issuing debt – meeting its obligations instead by having the Federal Reserve simply create money on its behalf. Indeed, this is what distressed governments have traditionally done when their liabilities add up – and the result has typically been hyperinflation. Modern Monetary Theorists argue that this need not be the case. Their exact reasoning differs. At times, they argue that hyperinflation only occurs in countries that borrow from abroad in debt denominated in a foreign government’s currency. I don’t know enough about every single instance of hyperinflation to verify this claim, but it is true that the worst incidences of hyperinflation are typically associated with borrowing from abroad.
When a country prints money in an attempt to fund the government, the international exchange value of its currency collapses. If the country owes debt denominated in a foreign currency, that debt becomes more difficult to pay down as its own currency falls. Then the country has to print even more money to meet its debt payments, which of course causes the exchange value of its currency to fall further, creating a vicious circle that ends in hyperinflation. Modern Monetary Theorists argue that this can’t happen to the United States because all of our debt is in the form of Treasury bonds that are denominated in dollars. If the international exchange value of the dollar falls, that does not change the value of our debt.
It does, however, mean that foreigners will be repaid in a currency that will be worth much less to them. Foreign bondholders are not stupid; they would regard this as a type of unofficial default. After experiencing this type of default through currency devaluation, they would be much less willing to buy Treasury bonds or indeed any type of American security again. This is precisely the situation that Italy, Spain, and Greece found themselves in during the 1980s.
Both countries had regularly devalued their currency as a way to get out from underneath foreign debts and were increasingly locked out of international markets. The euro was created, at least in part, in an effort to solve this. It could ultimately be printed only with the authority of the European Central Bank, meaning that neither Italy, Spain, Greece, nor any other member country could avert a debt crisis by devaluing its currency. Instead, they would have to raise taxes to meet their obligations.
That brings us to the second argument MMT advocates invoke when arguing that we should not worry about excessive debt leading to inflation: If inflation becomes a problem, the federal government can simply raise taxes, slowing down the economy which, in turn, will cool inflation.
But there are two problems with this approach. First, it is political suicide. At a time when consumers are facing ever-rising prices, it would seem cruel beyond measure to slap them with a tax increase. Very few governments would have the nerve to do this. If anything, history shows us that governments will instead resort to spending money on subsidies to ease the burden of rapidly rising prices.
Second, committing to this approach would risk an economic calamity. In 1973, OPEC placed an embargo on the United States that resulted in the price of oil quadrupling overnight. The sharply rising price of oil led both to a slowing economy and an increase in inflation – a dangerous mix.
A slowing economy lowers tax revenues, making it more difficult for the government to meet its debt payments. Suppose, at a time when the economy was slowing but inflation was rising, the U.S. government had firmly committed itself to MMT principles and refused to waver. In that case, it would not be able to resort to money printing because inflation was rising. Instead, it would be obligated to raise taxes both to meet its debt payments and to slow the rate of inflation.
Sharp increases in taxes during a recession, however, can be self-defeating. This is exactly the situation that Greece, and to a lesser extent Italy and Spain, found themselves in during the Great Recession. The crises lowered revenue, which worsened their budget deficits.
As a result, the government was forced to raise taxes and lower spending during the recession. This caused the economy to contract further, which caused tax revenue to fall so much that the budget deficit actually rose. In the case of Greece, this self-defeating cycle of higher taxes and lower revenues caused the government to ultimately default on its debts anyway. That, of course, worsened the economic crisis the country was already facing.
In the face of such a calamity, no sovereign government would or perhaps even should refrain from devaluing its currency and inflating away at least some of its debts. For that reason, governments have designed institutions to avoid falling into this trap.
In the United States, that means both making the Federal Reserve independent and not subject to the direct authority of the Treasury, and requiring the Treasury to meet all of its obligations with cash raised from tax revenues or Treasury-bond sales. In effect, we’ve outlawed the methods of Modern Monetary Theory – and with good reason.
This was originally published at National Review,
and appears here with the generous permission of the author. Links added.
———————————
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?
- “Can MMT pay for the Democrats’ Green New Deal?” by Ed Dolan.
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
(2020).
Here are two clear explanations of MMT by Paul Krugman (not a fan of MMT).
About the author
Karl Smith has a PhD in economics from NC State U. He was an Assistant Professor of Economics at the U-NC, then a senior fellow at the Niskanen Center. Now he is VP for Federal Policy at the Tax Foundation. His articles have been published in outlets including The Financial Times, Forbes, The Atlantic, Foreign Policy, Foreign Affairs, and The Washington Post. See his columns at Bloomberg, Follow his tweets at @karlbykarlsmith.
See my post about another article of Smith’s, in which he tells us about the wonderfulness of unemployment.
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.”
Good article. Doubt that AOC and company would let the fact that MMT won’t work to get their Green New Deal stop them.
Michael,
Interesting times ahead if the Democrats win control of the Presidency and Congress.
Larry,
My bet is they won’t. Note for a shot of optimism.: See James Howard Kunstler today: Two for One Holiday Special.
Michael,
I think a more reliable indicator for 2020 – both the Presidency and Congress – is the economy. While we are too far out to see clearly, the current estimate for Q4 real GDP is 2% SAAR. There are few signs of a looming downturn. That’s a positive for the GOP.
Predicting the presidential race is a coin toss, despite people’s mad belief that they can do so 11 months out. But the Democrats have a firm hold on the House, and need to pick up only 4 seats in the Senate. So the D’s might get control. Too soon to say.
Larry– “Too soon to say”. That’s for sure. One help for Trump is the Dems may not get their candidate until the convention giving him plenty of time to make his case and so called “impeachment/Democrat projection” a dimming memory.
Article: “At its heart, MMT is a way of escribing the federal budget”
Should that be: “At its heart, MMT is a way of describing the federal budget”?
Pluto,
Thanks for catching that. Fixed.
“Modern monetary theory is the easy solution, a cornucopia of money,” and possibly also a theoretical and practical justification for a more and more powerful national State.
Is it the case that central banks have often been unable to gain autonomy under authoritarian regimes and that institutions like our Federal Reserve are themselves creatures of modern democratic processes–but with significant and increasing democratic deficits?
For example, According in Adam Tooze in “Crashed: How a Decade of Financial Crises Changed the world (,pgs. 211-215) our Federal Reserve lent to “… the ECB, the Bank of England, the National Bank of Switzerland as well as central banks of Scandinavia over $10 trillion in precious dollar liquidity through swap lines and these same central banks then channeled this liquidity to the European mega-banks at one remove. One European central banker remarked about this process that we became the thirteenth Federal Reserve district. Furthermore, according to Tooze, the Federal Reserve used every legal means at its disposal to prevent detailed information about such support programs to both domestic and foreign banks from leaking to the general public.”
Is our Federal Reserve acting as a transformer of U.S. State power increasingly converting its own independence into a more and more unrestrained enclave strategically geared to the demands of world-wide financial markets and their agents?
James,
(1) “Is it the case that central banks have often been unable to gain autonomy under authoritarian regime”
Substitute “almost always” for “often.” The point of running an authoritarian regime is not to allow powerful independent government agencies.
(2) “that institutions like our Federal Reserve are themselves creatures of modern democratic processes”
The Fed (the central bank, not the regional banks) is totally a part of the Federal government. Like many agencies, it has a small degree of independence given it by its Congress- approved board members. But Congress can yank the chain any time it chooses to do so – making any changes it desires (so long as the President signs the bill).
(3) “but with significant and increasing democratic deficits?”
I see zero evidence of that.
(4) “detailed information about such support programs to both domestic and foreign banks from leaking to the general public.”
As anyone familiar with Freedom of Information Act requests knows, almost all Federal agencies fight key info leading to the public. They often fight info leaking to Congress (but have to surrender if Congress makes an issue of it).
(5) “Is our Federal Reserve acting as a transformer of U.S. State power ”
No. It is a govt agency carrying out the will of Congress and the President. It has low legitimacy with the public, and so little independence. On the other hand – the US military has high legitmacy with the public – by many measures, more than does the Presidency or Congress – and so often acts with stunning independence.
RE: “… Yet Modern Monetary Theorists then invariably argue that inflation is not, and indeed could not be, a major problem for the United States. … …”
• Nobody has ever argued this.Obviously if the govt spends and hits full employment and then keeps spending without an offset, inflation CAN becme an issue. But why would anybody do this? It’s a strawman argument.
RE: “…Before the 1980s … No, MMT advocates reply, because the government can simply stop issuing debt – meeting its obligations instead by having the Federal Reserve simply create money on its behalf. Indeed, this is what distressed governments have traditionally done when their liabilities add up – and the result has typically been hyperinflation…”
• Inflation is too many dollars chasing too few goods and can come from different mechanisms. For example, it can come from:
1) an external shock in a commodity that an economy needs to import – such as the oil embargo in the 1970s, causing a price increase in gasoline -> fertilizer -> food -> and labor through union cost of living contracts.
2) excessive borrowing in an external currency or commodity and then a rise in that commodity and falling into a spiral as the country prints in order to make ever increasing payments (Weimer Republic making payments in gold, Venezuela, USSR, Argentina borrowing in dollars),
3) a catastrophic supply shock in the production of a key output/export product coupled with foreign currency debt or import requirements (Weimer Republic – > France took over their steel making capacity when they fell behind in gold payments; Zimbabwe –>Mugabe expropriated farms from experienced white farmers and giving it to his inexperienced urban cronies resulting in a 40% drop in grain production, swinging the country from grain exporting to grain importing.
• Its actually kind of hard to induce inflation (see: Japan in last 20 years and US in last 8 years)
RE: “… n the U.S., Fed chairman Paul Volcker was spectacularly successful at this …”
• Volcker was a spectacular failure causing untold misery for millions in the US.
RE: “… Some holdouts existed, notably in Southern Europe – a situation that would come back to haunt them decades later. …”
• European countries are being haunted by the fact that they gave up their curerncy sovereignty and the European Union is criminally imposing austerity on them.
RE: “… But at some point, won’t the debt become so large that merely paying interest on it will require issuing additional debt? Won’t this process feed on itself until all the borrowing capacity in the economy is soaked up? …”
RE: “… All well and good. But at some point, won’t the debt become so large that merely paying interest on it will require issuing additional debt? Won’t this process feed on itself until all the borrowing capacity in the economy is soaked up?…”
• The US government debt is not a problem in any way shape or form. In fact, it can be repaid tomorrow without a negative repercussion. That would simply involve replacing government bonds with deposits at the Federal Reserve Bank with similar interest and maturities. The similar or even better risk/reward terms assure no change in investor savings/spending preference or desire to hold dollars. Not recommending this course of action, just pointing out that it is possible. Private Debt, by the way, can be a problem and is largely responsible for many of our recessions …”
RE: “… I don’t know enough about every single instance of hyperinflation to verify this claim, …”
• Then educate yourself.
RE: “… When a country prints money in an attempt to fund the government, the international exchange value of its currency collapses …”
• Not true. The govt issues money every day. If
• A key is that issuing currency and spending will not cause inflation or “currency collapse” as long as there are underutilized resources in the economy (unemployed folk) since business people go wakey wakey and produce more goods and services to offset the money issued.
RE: “… After experiencing this type of default through currency devaluation, they would be much less willing to buy Treasury bonds or indeed any type of American security again. …”
• So?
RE: “… This is precisely the situation that Italy, Spain, and Greece found themselves in during the 1980s. …”
• Did they borrow in foreign currencies? What happened to analysing a situation where the country does not borrow in a foreign currency.
RE: “… The euro was created, at least in part, in an effort to solve this …”
• And how is it going for them?
RE: “… the federal government can simply raise taxes, slowing down the economy which, in turn, will cool inflation.
But there are two problems with this approach. First, it is political suicide. …”
• The Job Gty/Green New Deal law should include automatic across-the-board tax increases that kick in when certain monthly wage inflation target are hit-say for 6 months in a row. These can include:
a) Income Taxes,
b) Sales/VAT Taxes
c) Asset Value (or Wealth) Taxes
That’ll cool things off pronto. No political suicide.
RE: “… A slowing economy lowers tax revenues, making it more difficult for the government to meet its debt payments. … Instead, it would be obligated to raise taxes both to meet its debt payments and to slow the rate of inflation. …”
• The govt doesn’t need to tax in order to spend. The key is to have a Job Gty in place. If inflation becomes a problem taxes can be raised but everybody is always working.
RE: “…In effect, we’ve outlawed the methods of Modern Monetary Theory – and with good reason. … …”
• Which has resulted in decades of unemployment and flat wages for working class Americans. Swipe left.
• Here is the solution: https://fflorescpa.wordpress.com/2018/07/28/financing-economic-solutions-to-unemployment-and-accompanying-social-problems/
fflorescpa,
Try taking the blinkers off and re-reading the text. You have spectacularly misinterpreted much of it. I’m pretty sure discussion would be a waste of time, but I’ll note one esp spectacular error.
Smith: “… Yet Modern Monetary Theorists then invariably argue that inflation is not, and indeed could not be, a major problem for the United States. … …”
You: “Nobody has ever argued this.”
That about inflation is the most frequent comment by advocates of MMT in the comments here, said many scores of times. They are getting that idea from somewhere.
So, show me one quote where an MMT scholar or advocate states that inflation can never be a major problem. It’s never been said before – except by MMT critics trying to create a straw man (See: mirror).
A major premise of MMT-based policy proposals is to change what is measured and managed. Folks in the economics profession invariably stress out over measuring the wrong things: money supply, Federal Debt, Federal Budget Deficit, their hand size. As a gentleman and a scholar often quotes:
“This is all reading tea leaves. It doesn’t matter. Measure and manage what matters:
1) Unemployment as in keep it at ZERO at all times.
2) Inflation – as in keep it at a low comfortable level so folks don’t stress out.
When you have a printing press – you don’t worry about the debt, interest et al.
When you can – tax, spend, buy/sell securities, and manage interest paid on reserve deposits – you don’t worry about inflation. You manage it.”
Easy Peasy.
It’s MMT critics who always stress about inflation. A key is that issuing currency and spending will not cause inflation as long as there are underutilized resources in the economy (unemployed folk) since business people go wakey wakey and produce more goods and services to offset the money issued.
fforescpa,
“So, show me one quote where an MMT scholar or advocate states that inflation can never be a major problem.”
Please try responding to direct quotes, instead of making stuff up as bold accusations.
Anyways, thanks for commenting. If you post material from actual economists relevant to this post, it will be go up. Otherwise, no.