An obscure and heterodox branch of economic theory is quickly gaining support from prominent politicians in the US and beyond, which could have big implications for policymaking, argues David Nowakowski.
10 minute read
For the best part of four decades, since monetarism fell out of favour, it has been commonplace to find governments handing responsibility for stabilising the business cycle to independent central banks. Their primary objective was to set short-term interest rates at an appropriate level to meet an inflation objective.
Under this system, the government’s task was largely confined to ‘supply-side reforms’; ensuring product, labour and consumer markets functioned as efficiently as possible. While it was permitted to run deficits during economic downturns, as automatic stabilisers kicked in, according to prevailing wisdom it was supposed to balance its books over the course of the economic cycle.
Those prepared to question the efficacy of this ‘New Keynesian’ method of economic management were few and far between, not least because its introduction coincided with a sharp drop in the volatility of the business cycle in the US and elsewhere. In a 2003 paper entitled Has the Business Cycle Changed and Why?, US economists James Stock and Mark Watson, coined the term the "great moderation" to describe the preceding 15 years.1 UK finance minister Gordon Brown went as far as to claim he had “put an end to boom and bust”, even if he subsequently admitted such hubris had been ill advised.2
A decade on from the financial crisis, however, New Keynesian economics is under attack, in turn placing textbook economic theory back under the microscope. Although the unprecedented steps taken by leading central banks may well have saved the world from a repeat of the Great Depression, traditional macroeconomic frameworks have been found badly wanting. Not only is economic growth perceived to have been unsatisfactory across the developed world, low interest rates and quantitative easing (QE) have driven wealth inequality to dangerously high levels by boosting the price of assets that are mainly owned by the rich. Inequality has been further aggravated by fiscal austerity, the brunt of which has been borne predominantly by poorer members of society.
In 2016 Olivier Blanchard, former chief economist of the International Monetary Fund, described the so-called dynamic stochastic general equilibrium (DSGE) econometric models underpinning New Keynesian theory as “seriously flawed”. He argued they were based on “unappealing assumptions”, and yielded policy implications that were “not convincing”.3 The same year, Nobel Laureate Paul Romer wrote that economic theory had regressed for more than three decades with models now using “incredible assumptions to reach absurd conclusions”. 4
As economists and policymakers alike continue to debate why so few of them saw the crisis coming and how to ensure there is no repeat, some are proposing a radically new method of economic management that threatens to turn textbook theory on its head.
While Modern Monetary Theory (MMT) has been championed by the likes of Stephanie Kelton (a former adviser to Democrat senator Bernie Sanders), L. Randall Wray, Bill Mitchell (who coined the term MMT), and Warren Mosler since the mid 1990s, until recently their views were confined to the fringes of economic debate, being largely restricted to blogs and lecture halls at a handful of colleges, including the University of Missouri-Kansas City.
However, when high-profile Democrat lawmaker Alexandria Ocasio-Cortez told Business Insider in January that MMT “absolutely” needs to be “a larger part of our conversation”, it shot to prominence.5 In no time it has become a major topic of discussion among politicians, business leaders, economists and financial market practitioners in the US and beyond. In the process it has captured an expanding fanbase on the political left.
MMT draws upon multiple stands of economic thought, including: Georg Friedrich Knapp’s book the State Theory of Money, originally published in 1905, which established the chartalist school of monetary theory; Alfred Mitchell Innes’s 1914 paper The Credit Theory of Money; 6 Abba Lerner’s 1943 article entitled Functional Finance And The Federal Debt;7 Hyman Minsky’s views on banking outlined in his 1986 paper Stabilising an Unstable Economy;8 and the sectoral balance approach advanced by Wynne Godley in his 1996 article Money, Finance, and National Income Determination.9
In part because it lacks a Magnum Opus such as John Maynard Keynes’s The General Theory of Employment Interest and Money, a common complaint is that it is unclear what MMT is and what it stands for.
It does however contain some key ideas. Chief among them is the notion a government that can print its own money need never default on debt denominated in that currency. This means such a country can, and indeed should, run substantial and persistent budget deficits at near-zero cost and hence without fear of the consequences, especially when inflation is low. In fact, it can buy goods and services without issuing debt, or even raising taxes, in the first place. In contrast to orthodox thinking, MMT suggests because of the way in which money is created, higher deficits tend to put downward pressure on interest rates. It is only where governments choose to sterilise the impact of any deficit spending by issuing bonds – something MMT sees as unnecessary – that interest rates may rise.
As for the policy implications, MMT takes much of its cue from Lerner. His functional finance doctrine argued fiscal policy should be judged by its macroeconomic outcomes, not whether the financing was “sound”. Although he was one of Keynes’s original disciples, the two disagreed on the need for governments to balance their books. Lerner concluded the government’s overriding aim should be to set fiscal policy at a position consistent with full employment. MMT advocates argue this could be done for example by offering a blanket job guarantee.
Unsurprisingly, the economics establishment that has gone largely unchallenged for so long has been scathing in its criticism. Federal Reserve (Fed) Chairman Jerome Powell told a congressional hearing the concept of MMT was “just wrong” and scoffed at the idea the dollar’s status meant the US deficit did not matter.10 As for Harvard professor Kenneth Rogoff, he labelled it Modern Monetary Nonsense.11 Interestingly, left-of-centre economists have been just as critical. Bill Clinton’s former treasury secretary Larry Summers described it as the new “voodoo economics”,12 while Paul Krugman, a Nobel prize winning Keynesian, complained its devotees change the rules on a whim.13
Krugman and Kelton have recently engaged in a fractious debate across the pages of The New York Times and Bloomberg. Their exchange sheds light on the fissures between conventional economics and MMT. Krugman takes particular issue with the idea the deficit should be set at a level consistent with full employment since this ignores what he sees as a trade off between monetary and fiscal policy.
To illustrate his point, he employs the IS-LM framework devised by British economist John Hicks as a means of graphically representing the core ideas advanced by Keynes in his General Theory.* This model shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS curve (impacted more directly by fiscal policy) and the LM curve (moved by the central bank) intersect, resulting in a short-run equilibrium rate of interest and level of output.
For Krugman, since different rates of interest correspond to different levels of private sector investment, at any given point in time there is a downward sloping relationship between interest rates and GDP, as shown by the lines IS1, IS2 and IS3. This means the fiscal position consistent with full employment will vary according to the level of interest rates.
Kelton rejects this analytical framework, pointing out that even Hicks saw some of its shortcomings. Unlike Krugman, she sees little or no ability to substitute monetary for fiscal policy, arguing that in a slump, cutting interest rates is “weak tea” against depressed profit expectations.14
In fact, Krugman would concede that as interest rates approach the so-called zero lower bound, the trade off between monetary and fiscal policy begins to disappear. For example, if private sector activity is so weak the economy is operating on curve IS1, even with interest rates at zero, GDP would only be at A. In this situation – dubbed a liquidity trap – monetary policy is impotent and fiscal expansion the only means of returning the economy to full employment and preventing a recession turning into a depression.
Where the two differ is in explaining what happens when the economy is not in a liquidity trap. Assume the economy is at point B on curve IS2, and the government then opts to increase its deficit, shifting the IS curve upwards to IS3.
For Krugman, since the economy is already operating at full capacity, either inflation will begin to rise sharply, or the central bank will be forced to hike interest rates to prevent the economy overheating. In his view, this will in turn cause private-sector investment to be ‘crowded out’. Either way, the impact of the fiscal expansion will be entirely offset by lower private sector spending as the economy moves to point C.
By contrast, Kelton thinks raising interest rates “does little to quell new activity”. Using Hicks’s IS-LM framework, it is as if in her world the economy behaves as if it is in a permanent liquidity trap.
Her conclusion is that governments should wrest control of the economy back from central banks since fiscal policy is a more direct method of regulating economic activity than monetary policy. Interest rates should simply be set at a low level, or even zero, and left there. Although like Lerner, MMTers concede boosting spending with the economy at full capacity can lead to inflation, this can be easily quelled by raising taxes or issuing bonds to remove excess liquidity.
Mainstream economists such as Krugman say a second major problem with MMT is that it fails to address the potential problem of snowballing debt. For them, if a country’s real economic growth rate does not exceed the inflation-adjusted cost of servicing its debt, it must run a primary budget surplus to keep its debt-to-GDP ratio stable.
As Krugman wrote in The New York Times: “I’m not arguing against an ambitious (fiscal) agenda. But heterodox monetary theory won’t let you avoid the reality that this agenda will have to be tax-and-spend, not just spend. 15
For Kelton, however, preventing a “doomsday scenario” is not difficult. All the monetary authority needs to do is ensure interest rates are below the country’s growth rate. She cites Japan as a prime example. Even with a debt ratio she says may well rise to 300 per cent one day, “rates sit right where the Bank of Japan sets them”, meaning the government can “easily” sustain its primary deficit.16
Economic theory’s inflation problem
While the debate between Krugman and Kelton highlights some well-known flaws in Hicks’s model, it more importantly reveals a major shortcoming in macroeconomics: its failure to provide a coherent and empirically provable explanation of what causes inflation.
Several theories have been advanced over the years. One of the earliest was the Quantity Theory of Money, which stated the general level of prices was directly proportional to the money supply. It was challenged by Keynes in the 1930s when he pointed out fundamental flaws in the theory’s central equation. Firstly, the velocity of money was not stable and, secondly prices were ‘sticky’, at least in the short run. Although it was revived by monetarists such as Milton Friedman in the 1960s, leading to it being adopted by policymakers two decades later, it soon fell out of favour once again.
As for another noteworthy effort – the Phillips Curve – it too has in recent years been called into question. In 1958, New Zealand economist William Phillips identified an historically stable inverse relationship in the UK economy between rates of unemployment and wage inflation that had held for a century.17 Two years later, US economists Paul Samuelson and Robert Solow went one step further, establishing a link between unemployment and inflation in the United States.18
While economists have debated the merits of Phillips’s analysis ever since, it has become a particularly hot topic of late, especially in the US where inflation remains much more subdued than would have been expected with unemployment at a 50-year low.
In a June 2018 paper, The Case of the Disappearing Phillips Curve, St Louis Fed President James Bullard noted that across the G7 the relationship between inflation and unemployment had been getting steadily weaker since 1995. He concluded policymakers “are unlikely to glean a reliable signal for monetary policy based on empirical Phillips curve slope estimates – they have to look elsewhere”.19
This matters, because one of the main arguments advanced by conventional economists against MMT is that the policies it advocates risk much higher inflation. As Summers wrote in his critique of MMT: “It is not true that governments can simply create new money to pay all liabilities coming due and avoid default... past a certain point, this approach leads to hyperinflation.”20
Part of the problem with this line of reasoning is that the same arguments were widely advanced when QE commenced in late 2008. Yet more than a decade on, the high inflation predicted by many has failed to materialise despite massive monetary stimulus. In the US at least, this is largely explained by the deep liquidity trap the economy fell into during the financial crisis, and the subsequent impairment of the credit-creation process.
While central banks primarily control narrow measures of the money supply, it is privately-owned banks which primarily influence broader measures of money. As the chart below shows, it wasn’t until 2011 that the annual growth rate of a broad measure of the US money supply turned positive as households stopped deleveraging. Furthermore, since that time broad money growth has been subdued by historical standards.
No Weimar Germany
As for those who cite the example of Weimar-era Germany, or more recently Zimbabwe, when pointing out the dangers of MMT, they omit some crucial points.
For instance, Germany’s situation in the 1920s was unique. Already saddled with huge debt following World War I, the country was then told to pay huge reparations to the Allied powers. That crippled the economy, forced the country to print banknotes to acquire the gold or foreign currencies it needed, and ultimately led to the mark collapsing and hyperinflation. As for other episodes of hyperinflation, they have usually been caused by major wars or other disruptive supply shocks. While these events can lead to bigger deficits, fiscal profligacy has rarely been the cause of hyperinflation.
Having said that, even if one concedes there is considerable uncertainty as to what causes inflation, it seems likely Ocasio-Cortez’s proposed Green New Deal to wean the US off fossil fuels or Sanders’ plan to provide Medicare for all and free college tuition would be highly inflationary. Regardless of funding proposals, given their sheer scale and the fact there is little spare capacity in the US economy, it seems hard to argue otherwise.
Policymakers are, however, in a bind. With interest rates at record lows in much of the world ten years into a global economic rebound, they find themselves in an extremely uncomfortable position. While the Fed may have a little room for manoeuvre with interest rates currently at 2.5 per cent, courtesy of the recovery being most advanced in the US, other central banks are all but out of conventional ammunition, particularly with the drawbacks of QE and negative rates becoming ever more apparent. Should the world head back towards recession, there is a growing likelihood governments will adopt a more interventionist fiscal stance. Some politicians may feel they have nothing to lose by printing money to finance increased spending.
Moreover, while MMT may mark a radical departure from textbook theory, it should be remembered that new economic regimes tend to be born out of disruptive events. Keynes wrote his seminal work, in which he proposed governments spend their way out of a deep recession, largely in response to the Great Depression. As for monetarism, it was seen as an antidote to the high levels of inflation suffered by many leading economies in the 1970s.
The view that governments do not allocate resources efficiently is both widely held and deeply ingrained. That suggests few nations will be in a rush to abandon the New Keynesian framework that has underpinned policymaking for the past four decades. Doing so would simultaneously draw a critical response from the economics establishment and meet with stiff resistance from central bankers. But as a growing number of politicians throughout the West start to question the wisdom of handing so much power to unelected central bankers, could it be that monetary policy as we know it has had its day?
What seems certain is that MMT will continue to be hotly debated. It is both a symptom of the scepticism surrounding mainstream economics as well as a potential trigger for a new wave of economic thinking, centred around a better understanding of saving and debt across sectors, and how the banking system really works.
It will also inevitably feature in the 2020 US presidential race. For the past 40 years the US deficit has tended to rise under Republican presidents as they looked to finance tax cuts and higher defense spending, leaving Democrats to clean up. As and when the US next enters recession, if not earlier, it is possible a Democrat president could view MMT as a convenient way of removing the straightjacket imposed by the idea spending always has to be paid for with tax increases. After a decade of unconventional monetary policy, it may be time for experimental fiscal policy to take over.
- James H. Stock & Mark W. Watson (Jan 2003): Has the Business Cycle Changed and Why?, National Bureau of Economic Research Macroeconomics Annual 2002, Volume 17
- Gordon Brown admits he was wrong to claim he had ended 'boom and bust', Daily Telegraph 21 Nov 2008
- Olivier Blanchard (Aug 2016): Do DSGE Models Have a Future?, Peterson Institute For International Economics Policy Brief
- Paul Romer (Jan 2016): The Trouble with Macroeconomics, Stern School of Business
- Alexandria Ocasio-Cortez says the theory that deficit spending is good for the economy should 'absolutely' be part of the conversation, Business Insider 7 Jan 2019
- Alfred Mitchell Innes (Dec 1914): The Credit Theory of Money, The Banking Law Journal, Vol. 31
- Abba Lerner (Feb 1943) Functional Finance And The Federal Debt, Social Research, Vol. 10
- Hyman Minsky (Sept 1986): Stabilising an Unstable Economy, Washington University paper
- Wynne Godley (June 1996): Money, Finance and National Income Determination: An Integrated Approach, Working Paper No 167, Levy Economics Institute
- Jerome Powell Says the Concept of MMT Is ‘Just Wrong’, Bloomberg, 26 Feb 2019
- Kenneth Rogoff (4 Mar 2019): Modern Monetary Nonsense, Project Syndicate article
- The left’s embrace of modern monetary theory is a recipe for disaster, Washington Post opinion piece by Lawrence Summers, 4 Mar 2019
- Running on MMT… Trying to get this debate beyond Calvinball, New York Times opinion piece by Paul Krugman, 25 Feb 2019
- Paul Krugman Asked Me About Modern Monetary Theory. Here Are 4 Answers, Bloomberg opinion piece by Stephanie Kelton, 1 March 2019
- How Much Does Heterodoxy Help Progressives?, New York Times opinion piece by Paul Krugman, 12 Feb 2019
- Modern Monetary Theory Is Not a Recipe for Doom, Bloomberg opinion piece by Stephanie Kelton, 21 Feb 2019
- A W Phillips (Nov 1958): The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957, Economica, New Series, Vol. 25, No. 100
- Paul Samuelson & Robert Solow: Analytical Aspects of Anti-Inflation Policy, American Economic Review, May 1960
- James Bullard: (June 2018): The Case of the Disappearing Phillips Curve, Federal Reserve Bank of St Louis paper
- Summers, op cit