MMT: A Free Lunch? Or A Stale, Old Lunch In A Shiny New Lunchbox? (Part I)

MMT in a Nutshell, and Mainstream Criticism

With government deficits exploding around the world as economic officials seek to counter the various demand and supply shocks associated with the Covid-19 scare, Modern Monetary Theory (MMT) has become the favourite in the latest beauty contest of economic theories being offered up to justify yet another round of expansionary policies. Stephanie Kelton, economic advisor to Bernie Sanders, keeps the MMT debate alive with her new book, The Deficit Myth, and last year’s prominent textbook by Mitchell, Randall Wray and Watts challenged mainstream assumptions on economic theory.

However, MMT is not actually modern in origin, and, while it does qualify as a theory in certain respects, when examined closely it is incomplete in its understanding of how an economy works and incompatible with the basic principles of information and complexity theory. That it is nevertheless now front and centre on the policy debate stage probably has more to do with its self-serving-selection from a range of more robust, alternative economic schools of thought which, rather than promising a free-lunch, are more realistic in their assessments of what expansionary monetary and fiscal policies can achieve.

MMT in a Nutshell

Before critiquing MMT, I think it fair to describe it here in unbiased fashion rather than construct a feeble straw man to knock over. For a more thorough discussion, I recommend this CASS working paper recently published at the Social Science Research Network.

Proponents of MMT describe it as a natural evolution from classical to modern monetary economics, in particular an explicit recognition that, in a post-gold-standard world, there is no natural constraint on money creation (or demand), nor a need for private entities to create money. Indeed, MMT postulates that if the state fully nationalises the creation of money – Chartalism as it was known in the 19^th century, revived as an early form of Monetarism in the 1930s – then the transmission difficulties and associated inequalities of the current, mostly privatised system of bank money creation can be overcome and, moreover, used as an effective means of centralised economic management.

In MMT, money creation (or destruction) is the primary means to manage an economy so that it grows consistently near its potential. Rather than leave the greater portion of de facto money creation to the private sector through various forms of bank lending, the public sector essentially nationalises the creation of even ‘broad’ forms of money such as bank deposits. These deposits can then be credited directly (via public spending) in order to maintain what is considered to be a sustainable rate of growth in aggregate demand. If demand appears to be flagging, public spending rises, pumping in new money to the economy. If demand is rising beyond what is estimated to be potential growth, spending can be reduced, new money creation can cease entirely if necessary and taxes can be increased to soak up excess liquidity.

MMT in this way sees public money creation as a ‘vertical’ pushing money all the way out into the real economy, not merely into bank reserves. Commercial banks will still operate in an MMT regime, but these operations will be ‘horizontal’ only – that is, no new money is created; rather, the public money already created vertically is then allocated horizontally to private sector businesses and households.

According to MMT advocates, this centralisation of direct money creation gets around the perennial problem that, when the propensity of the private sector to save increases for whatever reason, new money creation tends to get stuck within the banking system as new loan demand declines or as old loans go into distress or default. However, under an MMT policy regime, new money can be created (via public spending) as desired to compensate for any negative impact that contracting credit has on aggregate demand. No new private sector loans need to be originated at all. In other words, not only does MMT allow the monetary authority to lead the horses to water; the authority can, in effect, force them to drink. The reverse is also true. That is, when the propensity to save declines and the private sector beings to spend anew, then the authority can slow or perhaps halt entirely the creation of new money.

Many economists, and not only MMT advocates, consider this enhanced ability to control the monetary transmission mechanism highly desirable. Much economic analysis done regarding the US Great Depression tries to understand why the private banking sector failed to create enough broad money to sustain demand. Milton Friedman and Anna Schwarz, among many others, blame the US Federal Reserve for gross mismanagement of the US money supply during the early years of the Depression. Others, such as John Maynard Keynes, blamed what he called ‘animal spirits’.

Some economists blame the Fed for the entirety of the Depression right through into the 1940s. Others claim that there was no monetary ‘solution’ to the Depression at all; rather, the massive fiscal war spending stimulus and associated public deficits, entry of women into the work force, and a soaring private savings rate were the key ingredients to the US finally clawing its way out of what might have been an even more prolonged economic malaise.

Such evidence, MMT advocates claim, helps to bolster their case that public money creation via spending is the solution to what, to many, appears to be a prolonged, soft depression today. Indeed, many critics of MMT indeed justify current or proposed unconventional monetary policies and/or fiscal stimulus proposals using similar arguments, if not advocating the same mechanics.

Thoughtful MMT advocates stop short of claiming that there is somehow a ‘magic money tree’ from which economic resources can be picked without restraint. One facile critique of MMT is that it implies there is no limit to growth potential if, indeed, one need only create money to create growth itself. No so, according to the more serious proponents of MMT, who explain that, if you create more money than can be absorbed by potential economic growth, you are going to end up with an inflation problem, with the usual frictions and resource misallocations that entails.

As such, it is important to monitor the real resource constraints of the economy by keeping an eye on leading indicators of inflation. If these begin to flash red, for whatever reason, it is a sign that the public sector has been creating too much money and/or has overestimated the potential economic growth rate. In either case, tax increases can soak up any excess liquidity in order to keep the economy on a sustainable path.

In this regard, the more serious MMT advocates seek to balance what to some appears to be a radical policy with reason, restraint and common sense. Keynes did much the same when promoting his ‘General Theory’ in the 1930s by pointing out that, if you’re going to run deficits to support demand on the downside, you subsequently need to run surpluses when times are good in order to prevent the accumulation of an (eventually) unserviceable debt.

Mainstream MMT Critiques

Although MMT has much in common with the contemporary economic mainstream, in particular its advocacy of a prominent role for the public sector in actively managing the economy, it has prominent critics regarding precisely how this management should be done. For example, modern Neo- or New-Keynesians, including those running most major central banks today, tend to argue against MMT on the grounds that by effectively combining fiscal and monetary policy into a unified spend-and-print policy regime, there would be no effective restraint on money creation and so it would be impossible to control inflation effectively.

An associated mainstream critique of MMT is that it implies that persistent and rising government budget deficits are necessary for an economy to grow at a healthy and sustainable rate. Using accounting identities, MMT advocates point out that any government deficit must be offset by a private sector surplus, i.e. savings. Some go so far as to say that, without a public sector deficit, the private sector would be unable to save, or at least to save in what are regarded as essentially ‘risk free’ assets, e.g. bank deposits.

One of the more thoughtful mainstream MMT critics, and one with extensive policy experience as a central banker involved in financing government deficit spending, is Raghuram Rajan, former Governor of the Reserve Bank of India. In a recent podcast interview with Macro Hive CEO Bilal Hafeez, Rajan dismisses MMT: ‘The idea that there are free lunches, which certainly is what the layperson takes away from MMT, the modern monetary theory, is sort of attractive, seductive, but it is absolute nonsense. So, if that’s the message that is sought to be communicated, it is wrong.’

He goes on to explain how, when you spend what you don’t have, you have to borrow. It is fine to take advantage of periods where there is greater capacity to borrow, but you should spend wisely. He stressed that borrowing through expansion of central bank balance sheet was, at the end of the day, the same as government borrowing. ‘Think of the central bank issuing debt as the same as the government issuing. That is the consolidated balance sheet you’re looking at. Somebody is responsible for repayment.’

As inflation and economic activity picks up, the ultimate borrower matters more because ‘the central bank often is financing itself with effectively forced loans from the banking sector. And there’s a limit to how much the banking sector is willing to do that, especially as economic activity picks up.’

Rajan’s last statement is key. While I don’t disagree with him, I find all these mainstream critiques of MMT somewhat misdirected because they assume that there exists a natural fiscal-monetary conflict restraining the public sector from excessive, unsustainable spending. An MMT regime, so these critiques claim, would do away with any fiscal-monetary conflict – a de jure end to what is presumed to be a de facto regime of central bank policy independence today. Without independent central banks able to set interest rates (by implication the interest rates on government borrowings) there would be a tragedy of the commons as the public sector inevitably caved to pressure for increased spending in all areas, all the time, without any market discipline. The ‘bond vigilantes’, as they are sometimes called, would be completely disarmed, unable even to signal danger, much less prevent disaster.

But is this presumption of independence true in practice? Is there really an effective fiscal-monetary conflict? Do the bond vigilantes truly exist, or are they an urban myth? And should we assume that central banks, even if independent, promote economic stability? In Part II of this series I turn to these questions as I explore some prominent non-mainstream critiques of MMT.