The theory, such as it is, has two primary claims:
- Countries that print their own currencies need not default on excess debts.
- Inflation in the end can and must be controlled by raising taxes or cutting spending, sufficiently to soak up such printed money.
Based on these claims, MMT advocates conclude that the US need not worry about deficits since it can print money to cover them. This conclusion holds, sort of; that is, deficits can be monetized since the Federal Reserve Bank (FED) is the government’s banker and can decide to hold any newly issued debt and provide funds (new money) to cover the expenditures.
A more general conclusion is that a country that prints its own currency can do so to cover any governmental expenditures (and debt) not funded by governmental securities (henceforth called bonds for brevity) that its central bank would sell to the public. (Most of the above comes from Dylan Matthews “Modern Monetary Theory Explained” – and John Cochrane’s blog posting on the subject.)
Now let’s visit the claim in the title. First the claim is not modern. It was introduced by GF Knapp (1905), who argued that “governments invented money to buy goods and services from the private sector without offering anything of equivalent value in return.” Economists call this process seigniorage.
Secondly, the claim relates to monetization of fiscal policy; thus, it is not independent of fiscal policy. Stated differently, under MMT, monetary policy has no independent role; it always accommodates fiscal policy. As a result deficit spending up to some level consistent with the potential output for the economy, would not put pressure on interest rates. Some MMT advocates even argue that the interest rates on governmental bonds should be zero and can be zero if the central bank just provides the funds to pay for whatever goods or services or income transfer is envisioned by the fiscal authorities.
Finally, to use Nobel economist Paul Samuelson’s observation, no meaningful theorem can exist without testable predictions. This requires a coherent model of the macroeconomy. No such model has yet been provided in refereed journals in economics. The claims made by MMT advocates, however, are consistent with the income expenditure model, the basic Keynesian one sector model that once-upon-a-time formed the core of introductory courses in macroeconomics. That model assumes that interest rates, prices, and wages are fixed with monetary policy playing the accommodating role of keeping interest rates fixed. Few economists believe that this model satisfies the (statistical and content) validity needed for a compelling theory.
Now, let’s examine the primary claim noted above. Is it the case that countries that print their own currency can’t default? Perhaps. If their government issues more bonds than the public is willing to hold, then the central bank, the FED in the U.S., has the choice of covering them with new money or allowing the market to determine at what reduced price (and higher interest rate) a bond auction would yield. Since MMT does not recommend the latter option, money growth must be employed to fund the excess bonds. Of course, if the goods and services to be purchased are in short supply then prices must rise unless price controls (and financial repression exist.)
For countries whose currency does not have an international role as a reserve currency, the ultimate result is hyperinflation (as has been the case in recent years in Argentina, Venezuela, and Zimbabwe.) When a country’s currency is held as a reserve currency – the US dollar is the prime example since 88% of all currency trades worldwide involve the dollar (Bank for International Settlements) – the question becomes: when will global forces decide that the risks of holding an inflated currency (e.g., the dollar) outweigh the benefits? No one knows the answer, but that line could be crossed without much warning as, for example, in 1971, when the US announced that the dollar no longer (pretended to be) would be linked to gold holdings in Fort Knox. Or, as Treasury Secretary John Connelly succinctly put it, “the dollar is our currency, but your problem.”
Inflation has remained under control (below 2% annually for most indicators) since the Great Recession and interest rates have not yet returned to levels – inflation adjusted (real) or market – that were perceived as normal prior to 2008. As a result, many policy advocates assume that docile inflation and low nominal and real interest rates will persist into the future. Despite significant annual federal budget deficits and total outstanding U.S. governmental debt now in excess of GDP, inflation appears to be stable. Furthermore, the Fed expanded its balance sheet through increasing reserves by a factor of five in response to the Great Recession and has yet to return its balance sheet to the pre-2008 level.
Such optimism will hold until there is a run on the dollar. That won’t take place until there is both sufficient risk of depreciation and somewhere to run to. The options are the Euro, the British pound, the Japanese yen, the Chinese Renminbi, the Swiss Franc, gold, or a cryptocurrency. The first four have fared poorly relative to the dollar in recent years, and there are not enough Swiss Francs to be taken seriously as a substitute currency. Recent history suggests that gold and cryptocurrencies such as bitcoin feature much higher volatility and downside risk than the dollar. For currencies such as the Argentinian peso, however, the flight to bitcoin makes a great deal of sense.
Of course, MMT advocates could argue (persuasively) that if inflation arises then taxes could be increased or spending reduced to remove the pressure on demand for goods and services. In an MMT world, by definition, there would not be an independent central bank. We would have to depend upon the legislature to act responsibly. In my view, that’s too risky a bet for a stable economy.
This blog posting has gone on long enough; however, it leaves unaddressed the question: what is the appropriate role for a country’s central bank? I plan to address that topic in a future posting.