"Modern Monetary Theory," despite the arcane ring to the term, is a hot topic being bandied about in media these days.
Newcomers to the theory might assume that the whole idea is a contrived excuse to spend more federal dollars despite an already sizable deficit and debt load. Indeed, that may very well be the progressive Left's motivation for embracing the theory as of late (see the video "How Marxism and Modern Monetary Theory Go Hand-in-Hand"), but the theory itself has been around for a while. Mostly, the theory's adherents have been cloistered to economics departments (and only a small clique of economists, at that), so the academic theorists certainly have Bernie Sanders and Alexandria Ocasio-Cortez to thank for their moment in the sun.
Modern Monetary Theory starts with the observation that the US is the sole issuer of its currency. We are no longer constrained by a commodity currency (i.e. the gold standard). The primary insight of Modern Monetary Theorists is that federal deficits are not necessarily "bad" and surpluses "good" as is so often presumed. Fiscal deficits have no moral or qualitative value. They are simply accounting identities.
MMTers point out that, since the US is the sole issuer of its currency, it wields the power to print or destroy money. Through the printing press, it can create more money. Through taxes, it can effectively destroy money by taking it out of circulation. And since the Treasury Department has the capacity to print money ad infinitum, it technically can't default on its debt.
When the government spends money, it simply credits one account and debits another. That is, when the government contracts with a private sector actor for some sort of work or service, it does not need to go check the vaults to make sure there's enough money to pay. It can simply create the money and credit that to the private player's checking account. At the same time, it debits the Treasury account by that much, which leads to either the issuance of new Treasury bonds or to new paper currency printed.
Deficits, they argue, actually have a positive effect on economic growth because when the government spends, it is simply putting more money into circulation in the private sector. Moreover, they assert that government spending is a form of investment which should result in an increase in productivity. This increase in productivity should help to absorb the fiscal deficits taken on to fund this investment over time.
Taxation, on the other hand, takes money out of circulation. Government spending stimulates the economy while taxation cools it down. Thus, the higher the deficit, the more the private sector is being stimulated. "Federal deficits are private sector surpluses," says Stephanie Kelton, former economic advisor to Bernie Sanders.
And since government spending acts as an economic stimulus in this way, governments should do more of it until unemployment has been diminished to a very low level (or completely). "Unemployment is evidence that the deficit is too small," Kelton says. Some MMTers advocate a jobs guarantee to provide temporary employment (almost like a form of unemployment insurance) as an additional lever to regulate the economy.
Once you reach full employment, then additional government spending would be inflationary. At that point, the supply of money in circulation would rise faster than demand for money. But until then, if the government wants to increase economic activity and output (and why wouldn't it?), it should be a net spender rather than a net saver. In other words, it should run fiscal deficits until reaching full employment, at which time it should at least tighten the budget, if not balance it or even run a surplus.
Kelton uses WWII as an example of heavy government spending (and a huge run-up in federal debt) that didn't have any negative effect on the economy. Just the opposite, she says. After WWII, America entered into a decades-long period of high productivity growth and prosperity.
She also uses Japan as an example of a country whose massive debt has not had any negative consequences. Japan has run fiscal deficits since the mid-1970s, pausing for a brief surplus in the late 1980s and early 1990s only to plunge back into deficits once its real estate market crashed.
The purpose of money, according to prolific MMT advocate L. Randall Wray, is as legal tender, also known as a "promise to redeem" or a record of debt. Money is an IOU to its issuer. Or, more accurately, it's like a callable, zero-interest, perpetual government bond. This definition of money is predicated on the use of force and thus can only be an instrument of government. It requires the ability to issue credit in the form of money, and it also requires the ability to force other actors in society to accept the money and to pay taxes only in that currency. Fiat money has value not primarily because of trust in the issuer's economy or because it is a medium of private exchange, but rather because it is the means by which private actors pay their obligations to the state.
In fact, says Wray, even back in the olden days of a gold standard, what gave gold coins their value was not the intrinsic value of the material. Rather it was the face of the ruler imprinted upon it, reminding its bearer that the coin came from the government and that the government had the right to reclaim it, that made the coin valuable. This is why coins with the face of the Queen of England or the Premier of China are mere novelties here in America. Who cares about the metal they're made of? What makes them valuable is that they are backed by their issuing governments. Since the Queen of England and the Premier of China lack the authority to tax US citizens living in America, their currencies are essentially worthless here.
Governments must be the backer of the value of money / debt, say the MMTers. Otherwise, you are left with some form of barter system. Money has to be issued before it can be exchanged for goods or recollected by the government through taxation. Debt has to come before redemption. Sure, the private sector may produce the economy's intrinsically valuable goods and services, but those are always priced in units of government debt.
Warren Mosler, a hedge fund manager and one of the few MMT thought leaders with a non-academic background, uses the illustration of a subway station with entry tickets. It has to issue the tickets before it can redeem them for rides on the subway.
Since money is simply a unit of debt, it doesn't matter much if government spending is paid for with newly printed money or newly issued Treasuries. Sure, one pays interest while the other doesn't, but that interest can always be paid with printed money.
In short, Modern Monetary Theory attempts to throw off the old shackles and constraints of a commodity (i.e. gold standard) currency and fully embrace our fiat system.
Theory Vs. Reality
What to say about this revisionist perspective? First, it's important to note there is strong data that contradicts some basic claims of Modern Monetary Theory. Let's address some key points.
Possibility of Default? It simply isn't true that nations that issue their own currency cannot default on their debt. As pointed out by Charles Seville of the Fitch Ratings agency, countries such as Brazil and Russia that issue their own currency have defaulted on their debt in the past. During the Great Depression, even some nations that abandoned the gold standard defaulted on their debt. Which countries defaulted depended more on the nation's fiscal health and access to financial markets than on the ability to print money in one's own currency. Political upheaval, war, economic shocks, or sufficiently strong recessions can lead to situations in which the best or only possible solution is to default rather than devalue the currency by printing.
Perhaps this is why, as a recent survey shows, economists from across the ideological divide reject the notion that deficits don't really matter.
Japan's Deficit Spending. Though it is true that Japan has run fiscal deficits for many decades, these deficits have not correlated with a lower unemployment rate. Just the opposite. Unemployment averaged 1.5 to 2% from 1950 to 1975, then when more or less permanent deficits began, average unemployment actually rose to a little above 3% from 1976 to 2001. And the unemployment rate actually dropped during the government surplus in the late 1980s and early 1990s from a peak of ~3% to a trough of ~2%.
Moreover, if you look at the following chart of Japan's annual GDP growth, you can see a declining trend (black line) since the early 1980s despite the continual deficit spending, which, according to the theory, should be stimulative.
Japan's Annual GDP Growth. Source: Trading Economics
WWII Deficits. What about the massive deficit spending during WWII and the decades of prosperity that followed? Multiple factors make this period in history unique, including the fact that America, by necessity, became the world's premiere manufacturing powerhouse. But, pertaining to MMT, it's important to note that these decades of prosperity following WWII weren't fueled by the federal government carrying a large debt load. Rather, these decades were marked by sharp federal deleveraging:
Source: American Enterprise Institute
Indeed, the Roaring Twenties, another period of notable prosperity in America, were also marked by federal deleveraging corresponding with falling unemployment — just the opposite of what MMT would predict.
Deficits, Debt, and Growth. Another problem with the MMT way of thinking: deficit spending has not historically promoted economic growth or productivity growth. Just the opposite. A simple chart test proves this. Here's how the federal deficit has increased since the early 1970s:
In case you're wondering, a chart showing the federal deficit as a percentage of GDP shows the same pattern. And yet, as with Japan, US GDP shows no signs of having been stimulated by all this deficit spending (trend line sloping downward):
Source: Trading Economics
What about unemployment? Has deficit spending had a positive effect on employment? Apparently not. The following are charts showing (1) average unemployment from 1948 to 1974, a period of low or no annual deficits, as well as (2) average unemployment from 1974 to 2019, a period of ever-rising deficits.
Source: Trading Economics
As you can see, unemployment before the age of rising deficits averaged around 4.8%, but throughout the age of rising deficits it has averaged about 6.2%. Even if we restrict the time range to only 2001 to 2019, when the federal government has been running continuously high deficits, the result is the same — unemployment averaging slightly above 6%.
Source: Trading Economics
What about total factor productivity (TFP)? Also called multi-factor productivity, TFP measures output divided by the weighted average of labor and capital inputs. It doesn't merely measure the amount of output produced by an hour of work (aka labor productivity), which succumbs to the tyranny of averages (mixing extremely productive workers with highly unproductive workers to arrive at a mean number).
MMT predicts that increased deficits should, all other things being equal, result in increased productivity. Government spending, MMT advocates say, either directly funds or indirectly stimulates research and development as well as capital expenditures, both of which should ultimately lead to increased productivity (as measured by TFP). But this hasn't been the case. Compare the federal deficits chart above to the following chart, showing a slowing rate of TFP growth beginning around the same time as growing deficits in the early 1970s:
Source: Economist's View
Elevated federal spending has produced no discernible positive effect on economic output. In fact, it seems to correlate with lower GDP and productivity growth, as well as higher unemployment.
One might be tempted to think that all this deficit spending has dramatically increased federal debt, which has diverted capital away from productive spending toward ownership of unproductive government debt securities. Not to mention the gradual lowering of interest rates, which increases the issuance of all debt securities (private and public), eating up more and more capital that could have found more productive uses.
Dollar Hegemony. MMTers seem to think that as long as a nation can issue its own currency, the only real constraint on spending is inflation (and only then after reaching full employment). But there is another risk pertaining to a currency's status in world reserves and as an international medium of exchange.
Nothing is set in stone saying that the US dollar must remain the global reserve currency. Though there's no other currency that is immediately poised to overtake the dollar in the case of weakness, others certainly could arise. It could be a basket of currencies, gold, a new gold-backed currency, a cryptocurrency, or a new fiat currency based on a league of nations like the European Union. It also could be that there is no dominant global currency but rather multiple currencies with regional dominance (as Russia and China would certainly prefer).
Such a scenario wouldn't happen all at once but over a period of time, slowly diminishing American dominance as the business currency of the world. In the grand scheme of history, reserve currencies come and go. The pound sterling once served that role but was overtaken by the dollar in the wake of World War II.
Foreign buyers of Treasuries are already curbing their buying (and have been doing so since 2014), which is putting more pressure on domestic buyers. For now, domestic Treasury investors fear the ensuing global economic weakness and a likely near-future recession and have thus shifted heavily into government bonds. (I have personally done this with ultra-long and ultra-short duration Treasuries.) But what happens when the appeal of Treasuries dries up among domestic buyers? The dollar weakens and rates go up. Then some other currency or currencies become more attractive in comparison.
The laws of supply and demand still exist. Increasing the supply of Treasuries, all else being equal, does suppress the price of those Treasuries, which raises the yield. But all else has not been equal. Many factors have been at play which have offset the increased supply with increased demand:
(1) The Fed has progressively pushed down rates since the early 1980s, making pre-existing Treasury yields more attractive; (2) the Federal Reserve has also dramatically expanded its balance sheet assets in the past decade, including about $2 trillion in Treasuries, effectively increasing demand; (3) the trade deficit with China and other countries has grown, putting more dollars into foreign hands that primarily use them to purchase Treasuries; (4) pension funds, life insurance companies, and banks have grown in size and have necessarily grown their Treasury holdings accordingly; (5) and the US population is aging, producing more demand for safe fixed income securities such as Treasuries.
We should not expect these demand-producing factors to be in play forever, at least not to the degree that they are currently. Contrary to MMT, the US cannot pump out unlimited amounts of dollars and Treasuries and expect them to be absorbed exactly as they have been since the 1970s.
Interest Payments. There is a cost to issuing debt. This should be intuitive. Debt and interest go hand-in-hand. And federal interest payments are rising fast — the fastest growing part of the federal budget, in fact. According to CBO projections, federal interest payments are set to triple between 2018 and 2028, surpassing Medicaid costs by 2020, defense spending by 2023, and all non-defense discretionary spending by 2025.
Interest payments could top $1 trillion per year by 2030. At that point, they would likely eat up the highest percentage of GDP in American history, despite interest rates remaining low (per the CBO projections). Interest payments are mandatory spending, and thus any increase in interest as a percentage of the budget or GDP limits the government's ability to spend on other (more productive) uses.
One proposal derived from MMT (articulated by Warren Mosler) is that the Fed Funds rate should be set permanently at zero. This will minimize the cost of government borrowing, which will allow the government to do more of it. It will also, in his opinion, reduce the occurrence of rentiers (people living off of passive income such as rent, interest, and dividends), which should increase output by increasing labor hours. However, he also acknowledges that such a policy hurts savers (which I talked about in "Blame the Fed for the Plight of the Average American"), though he neglects to mention that their pain is not just from lost interest income but also over-indebtedness from being lured into taking on too much low-interest debt.
Permanently zero-bound rates would have many other negative consequences. They would perpetuate the trend of low rates leading to increased market concentration, which suppresses wages and diminishes productivity growth. They would further exacerbate the underfunding of pensions, which have traditionally relied on a certain return from interest-bearing debt securities. They would expand the rising tide of zombie firms currently being sustained by low interest rates and leveraged loans. And they would pave the way for even more corporate share buybacks, which, as I have shown, increase as interest rates fall.
On a separate occasion, Mosler argued that the government should only issue short term Treasury bonds — say, up to three months — so as to keep all government debt fixed at zero percent interest. But this would limit debt as a financing instrument. The appetite for zero return bonds is limited in normal economic circumstances. Perhaps if investors expected strong deflation or negative economic growth coming soon, zero-interest Treasuries would be attractive, but in lieu of these, potential buyers would be limited to banks, pensions, life insurance companies, and other institutions which are required to hold certain reserves. If inflation is picking up, zero-interest Treasuries are especially unattractive.
And, of course, it would leave the problem of how to price private sector debt securities, which have always been priced in relation to Treasuries.
Political Workability. This criticism is perhaps the death knell of MMT, sounding before the theory has even been fully implemented: In reality, where the political rubber hits the road, MMT wouldn't work as the theorists envision it.
Do we really expect legislators in this age of polarized politics to come together in a timely manner when legislation is needed to do the politically unpopular — raise taxes across the board? And yes, taxes would need to be raised across the board, for the lower and middle classes as well as the upper class. Seventy percent of GDP comes from consumption, and the vast majority of that from the lower and middle classes. If taxes are to tame out-of-control inflation, higher taxes would have to be imposed on everyone, not just the rich.
And then, of course, one needs to factor in the inevitable input from K Street.
Linette Lopez, writing for Business Insider, points out that the massive amount of corporate lobbying done currently would explode further in an MMT world. This would happen in two ways: First, with increased spending during times when unemployment allowed it, lobbyists would fight hard to capture as much of the government largesse as possible. And history shows that they would probably be successful. Second, when it comes time to cool down or prevent inflation, the lobbyists would be prowling all over Capitol Hill to ensure as many favorable loopholes and carveouts as possible. And since legislators would not themselves be experts in Modern Monetary Theory, lobbyists would have plenty of room to argue that such and such modification to the legislation (which just so happens to benefit a certain special interest) would be helpful in taming inflation.
It's useful to point out that, despite my criticisms of the Fed, the central bank's independence (at least compared to Congress) is a huge benefit in determining policy. Lobbyists are not knocking on Jerome Powell's office door. Nor are corporations writing seven-figure checks to support his re-appointment bid.
But who are the lobbyists visiting and the corporations writing checks to? Congressmen — the very legislators that MMT would rely on to raise taxes and implement other contractionary policies when inflation is heating up.
In a stagflationary scenario in which economic growth is slow even while inflation is rising due to excessively accommodative monetary policy, do we really expect our elected representatives to come together to pass thoughtful legislation to evenhandedly curb inflation? Do we expect the moneyed interests who have so much sway in Washington to simply "take one for the team" as their tax rates are hiked? Worse yet, do we expect congressmen to go home and explain to their irate constituents that, despite their financial pain, their taxes need to go up because Modern Monetary Theory says so? In my estimation, this is part of the theory that works only in theory but, in reality, would lead to a nasty economic crisis.
Final Word (For Now)
More could be said about the issues with Modern Monetary Theory, but the above will suffice for now. The theory takes a few ostensible observations — e.g. governments who issue their own currency cannot default — and arrive at conclusions which contradict the record of history and violate longstanding economic principles. These principles, MMT proponents say, are vestiges of the passé idea of commodity money.
But, as I believe I've shown, some economic principles hold true regardless of the currency system. Too much debt and too rapid money supply growth have certain consequences, and most of them are not benign. We have not yet experienced some of the uglier consequences of our quasi-MMT experiment over the last half-century, but it would be foolish to assume we never will.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.