Modern Monetary Theory: Not Necessarily a ‘Win-Win’ Solution to the World’s Problems
Modern Monetary Theory (MMT) is held out by some of its proponents as the antidote to the high debt, low growth and inflation environment that many countries have found themselves in. To these proponents, what is most appealing about MMT is that it holds out the prospect of a ‘win-win’ scenario, whereby there are no losers. Though there is always debate over economic theories, it is interesting to look at just two considerations which raise the prospect that MMT may not provide the ‘win-win’ scenario that some of its proponents point to.
As MMT is not a distinct theory, but rather the drawing together of a range of existing ideas into a policy framework, determining exactly what is meant by MMT can be a bit problematic. That said, at its heart is the notion that the financing of government expenditure should not be constrained by private capital markets. Essentially, so long as the government has sovereign authority over domestic money creation, there should not be any technical limit to the central bank’s ability to create money to finance the government. Due to this, MMT advocates that governments bypass private capital markets and sell their bonds directly to the central bank as an ongoing strategy to fund government spending, i.e. essentially printing money.
It is the printing of money to finance the trade-off between expenditure and taxation which leads some proponents of MMT to argue that it is the solution to the environment of low growth and low inflation that many global economies currently find themselves in. To see why, let’s start by considering the dynamics behind the targeting of inflation, i.e. objective of increasing inflation. At its essence, MMT holds that governments ultimately need to fund deficits by (a) raising taxes and/or (b) printing money. The key word here is ‘ultimately’, as the government can borrow money to fund a budget deficit; though this simply defers the decision of whether to raise taxes or print money. The key for a government wanting to target an inflation outcome is therefore to manage the imbalance between aggregate supply and demand, i.e. manage ‘demand-pull’ inflation. Within such a policy framework, it becomes clear that (a) raising taxes is deflationary while (b) printing money is inflationary. By implication, monetary policy simply becomes an extension of fiscal policy, i.e. central banks cease to be independent but simply fund government expenditure when needed. The answer to low inflation is therefore the creation of ‘demand-pull’ inflation by ensuring that there is a lot more currency trying to buy ‘real stuff’ than there is ‘real stuff’ to buy. This the government can achieve by simply having the central bank print more money to fund increases in government expenditure relative to the level of taxation. This creates the cornerstone of the potential ‘win-win’ scenario through the ‘responsible’ application of MMT, as there is now not only higher inflation but also higher growth (via the increase in government expenditure and/or lower taxes) and lower government debt (via the printing of money to fund the deficit).
While this framework is appealing, there are some complications which initially raise questions regarding the conditions necessary for MMT to prove successful at ‘pulling up’ inflation. At the core of this is the issue of the conditions under which increases in money supply have the largest multiplier impact on inflation. To highlight the economic relationships, one can consider the equation of exchange where:
Money * Velocity of Money = Price Level * Real Value of Aggregate Transactions
Considering the equation of exchange highlights the potential trade-offs arising from the direct linkage of government expenditure and money supply. To start with, it is worth noting that if an increase in Money is to have the maximum impact on the Price Level, then the Real Value of Aggregate Transactions needs to be relatively constant. Put another way, in order to ensure that there is a lot more currency trying to buy ‘real stuff’ than there is ‘real stuff’ to buy, the economy mustn’t be able to materialy increase the amount of ‘real stuff’ through either domestic production or imports. This implies that, just as with traditional monetary policy, the ability to increase inflation is greatest when economies, both domestically and globally, are operating at or near full capacity. For economies which are operating well below full capacity, increasing the supply of money is less likely to generate ‘demand-pull’ inflation.
It is in the trade-off between government expenditure and the impact on ‘demand-pull’ inflation which initially undermines the attraction of MMT as a ‘win-win’ policy response. The reason for this is that to have the greatest potential for boosting inflation, MMT should be applied when an economy is close to capacity. Yet increasing government expenditure at this point risks crowding out private expenditure, as the government’s claim of resources will reduce those resources available to the private sector. If the marginal economic value of government expenditure is less than that of the private sector, i.e. the government sector is less efficient than the private sector, the result is a net dead weight loss to society. To minimise the potential net dead weight loss from an increase in government expenditure, it is best for the boost from the increase in government expenditure to occur when the economy is operating well below capacity, i.e. excess resources so that the government and private sector aren’t competing. However, because there is excess capacity, the increase in the money supply associated with the increase in government expenditure is less likely to create ‘demand-pull’ inflation. This highlights the trade-off and potential inconsistency in utilising government expenditure and the money supply to simultaneously push up inflation and economic growth. Just as importantly, it highlights why creating higher inflation is no longer necessarily a zero-sum game.
The second potential trade-off highlighted by the equation of exchange is around the concept of ‘responsible’ utilisation of MMT by governments to boost stubbornly low inflation. One of the issues with democratically elected governments is the fact that they are popularly elected bodies. This can result in the pursuit of policies over time which are inconsistent and thus create uncertainty. In order to overcome this, efforts have been made to separate monetary policy decisions from fiscal/spending decisions.
Yet this separation misses the point that the ability to control inflation comes down to the perceived ‘responsibility’ of policy makers. Why is this? One way to increase the level of inflation is to boost the Velocity of Money. Though there are many factors impacting on the Velocity of Money, one of the key ones is the extent to which currency, which is nothing more than a government IOU, is perceived as holding its value relative to ‘real stuff’. To the extent that market participants view currency as holding its value less effectively than ‘real stuff’, they will try and exchange money for ‘real stuff’ more quickly, thereby increasing the Velocity of Money and inflation. The problem, as suggested by history, is that one of the key ways of materially increasing the Velocity of Money is for a government to be perceived by the holders of its currency as irresponsible or unstable. Put another way, it’s the very concern a government will deliberately pursue policies which will debase the value of the currency that’s more likely to create inflation as this increases the Velocity of Money. The implication is that low inflation may be the positive by-product of stable government and good political stewardship, as opposed to the independence of central banks per se. Ironically, this means that for the utilisation of MMT to have the greatest potential to boost inflation, its implementation must be perceived by market participants as being applied ‘irresponsibly’.
In many ways, MMT is not a new theory but rather the bringing together of previously developed ideas into a policy framework. Though there is little debate around the separate components of the policy framework, more contentious is the proposition by some that it can provide a zero-cost means of overcoming the low inflation environment which many governments have found themselves in over the last decade or so. Though initially appealing, once account is taken of the potential costs and trade-offs associated with the separate components of the policy framework, it is highly debatable that the ‘responsible’ utilisation of MMT will prove any more effective at increasing inflation and growth than the more traditional approaches to monetary policy pursued to date by central banks.
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As a digression, it is worth highlighting that there is a material theoretical difference between MMT and quantitative easing (QE) as practiced by many central banks. This distinction is important to recognise as many may say, “Well, haven’t various central banks been printing money for some time now?” The difference is that under QE the central bank decides how many bonds they buy based on the liquidity needs of the financial system. In contrast, under an MMT framework, the amount of bonds bought are determined by the government based upon their desired trade-off between expenditure and taxation.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...