Modern Monetary Theory

The debate surrounding Modern Monetary Theory

Modern Monetary Theory (MMT) suggests, controversially, that rising levels of government debt do not in and of themselves pose a problem. Once a fringe school of thought, MMT is now helping to shape the discussion surrounding monetary and fiscal policy. Many questions remain open, however, particularly for the eurozone. We have prepared an overview for you.

Rising government debt and ultra-expansionary monetary policy have been a consequence of the coronavirus restrictions. This is sparking widespread fears: Will these expansionary fiscal measures make government debt unsustainable before too long? Will central banks lose their independence in monetary policy because interest rates will need to be kept artificially low in order to prevent such a scenario? The biggest concern for investors will be whether rising debt levels could, for example, snowball into a crisis as a result of rampant inflation.

Those economists who subscribe to Modern Monetary Theory (MMT) take a more relaxed view. But why? MMT, which was first proposed in the 1990s, has gained a lot of traction in recent years. This is in no small part due to the fact that inflation has been conspicuous by its absence despite a long period of loose monetary policy coupled with central bank bond buying. In fact, inflation rates in the eurozone, Japan and the US have remained stubbornly below the target level of around 2 per cent. We have also not seen any major sovereign debt crisis.

The coronavirus crisis has cemented the trend towards low interest rates coupled with rising debt, however. The Federal Reserve, by its own reckoning, is not expecting to raise interest rates even by 2023, for example. In 2020, as part of a strategic review of its monetary policy, the Fed announced that it would tolerate a moderate overshoot of its inflation target for a certain time following years of under-target inflation. This overshoot would be tolerated if the economic conditions demanded it – for example if employment was not sufficiently high.

Central banks’ balance sheets surge

in US$ trillion

Central banks' balance sheets
Source: Macrobond; as at: December 2020

Core propositions of MMT

The core propositions of MMT are as follows: Modern nation states effectively have unlimited spending power as they have the ability to repay their debts at any time by simply creating new money. One objective of this government spending should be achieving full employment. And for as long as capacity utilisation in the economy remains below the level of full employment, the size of the budget deficit is irrelevant.

MMT assumes that an increase in government spending does not need to be funded by an increase in tax. Quite the opposite, in fact: It argues that governments first need to spend money before this can be collected again in the form of tax receipts. However, this only works if the country in question holds debt only in its own domestic currency and it has sole power to issue this currency.

Consequently, the kind of budgetary constraints faced by households and businesses do not apply to governments. This is because households and businesses cannot, of course, create their own money. Only a sovereign state has that power. The question of how government spending can be funded is therefore rendered moot.

COVID-driven fiscal stimulus a step towards MMT

Put bluntly, MMT would seem to have solved the riddle as to why expansionary monetary policy and rising government debt have not, so far, caused the financial system to collapse. It postulates that the state always has control over how much money it supplies to the economy. The only thing that matters is whether this government spending is used to achieve economic policy objectives and a flourishing economy, for example in the labour market.

MMT has gained broad recognition thanks to the US economist Stephanie Kelton, who served as economic advisor to US presidential candidate Bernie Sanders and whose ideas have taken hold in the ultra-progressive wing of the Democratic party. In many ways, the fiscal stimulus packages initiated by many governments to combat the coronavirus crisis appear to be a step in this direction, as they are intended to bolster growth by driving innovation and increasing spending on research and development. Based on empirical findings, MMT contends that businesses will invest capital because of their growth expectations and not because of how cheap it is to borrow this capital.

Spending, not money printing, drives inflation

Critics of MMT point out that government spending has the effect of crowding out demand in the private sector, which may result in a less efficient economic structure. Because resources are not being used in the optimum way, this could create inflationary pressure as demand is not being adequately satisfied.

MMT makes the case that there would no crowding out because the money taps would be turned on only when capacity is underutilized. The risk of inflation would then arise only if the economy reaches its ‘internal speed limit’. A government could counter this by raising taxes, thereby removing purchasing power from the private sector and thus the pressure on prices. In this sense, inflation is a phenomenon of the real economy not of monetary policy, i.e. it occurs when money is spent not when it is printed. In addition, inflation could arise as a result of the market power of individual companies, but this would need to be addressed through regulation rather than monetary policy.

What is the capital markets’ assessment?

There are various layers to consider when it comes to specific implications for the capital markets. Advocates of MMT do not see a problem with central banks piling more and more sovereign and private debt onto their balance sheets. They believe that, ultimately, the government has the power to control inflation and money creation.

Moreover, according to MMT, expansionary fiscal policy will cause interest rates to fall rather than rise. This is because any money spent by the government represents income for the private sector, and as such would flow into the banking system, raising the banks’ minimum reserves held at the central bank in the process. Large budget deficits would thus create an excess of reserves in the banking sector, which would push interest rates down. MMT proposes that issuing government bonds would provide somewhere for these excess reserves to be invested and would stabilise interest rates.

Limited application for the eurozone

MMT is of little relevance when it comes to the eurozone. This is because the economic area does not have all the features of a sovereign state and its currency – the euro – is in essence still a foreign currency for the individual member states. Without an integrated fiscal policy, the eurozone will not be able to manage inflation as envisaged under MMT. Deriving monetary or economic policies on this basis is therefore not a practical option in the eurozone’s current form. This means that MMT is not a suitable analytical instrument to identify the inflationary risks that could arise in the eurozone because of rising sovereign debt.

In conclusion, the theoretical framework of MMT in regard to debt and inflation is less extreme overall (at least in the version propagated by US economics professor Stefanie Kelton) than its critics sometimes claim. The assumption that decisions concerning capital spending are primarily made on the basis of expected demand appears to be much closer to reality than any focus on the cost of capital. This inevitably leads to the question as to whether the more direct route to stimulating demand via fiscal policy is not in fact the better option.

The problems in relation to practical implementation, however, need to be looked at with a much more critical eye. This is because MMT puts full responsibility for the government’s money creation, capital allocation and spending decisions into the hands of elected political actors – with all the ramifications that this entails. The assumption that inflation, in effect, manages itself appears less plausible. Nevertheless, MMT remains a relevant part of the debate about the structuring of fiscal packages and their impact.

USA: interest burden will initially fall despite a significant rise in debt

BO: Long-term projection of interest expense

CBO
Source: Macrobond; as at: December 2020

Central banks are likely to hold a higher proportion of government debt on their balance sheets for a long time to come, however, including in Europe. Generally speaking, a rising debt burden on central banks’ balance sheets could lead to a credibility problem. Nevertheless, when it comes to the sustainability of the debt level in the US, the Congressional Budget Office (CBO) in Washington, for example, expects that the overall burden of interest (see chart) will either fall or remain stable in the short and medium term. This is because yields on government bonds will remain low for the time being.

 

As at: 21 January 2021