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Beware the deceptive charms of modern monetary theory

High US inflation may have begun to knock the stuffing out of MMT (Photo: Bloomberg)

The squabble over whether ‘modern monetary theory’ (MMT) is a Copernican revolution for public policy or nonsense has not been very enlightening. As it happens, I’m more open to MMT than you might expect: It asks good questions and proposes clarifying thought experiments. But it ends up in the wrong place.

At the height of policymakers’ interest in ‘monetarism’, I worked in the UK Treasury, helping produce short-term forecasts of the money supply. This exercise didn’t use the Treasury’s economic forecasting model but instead estimated financial flows using sectoral balance sheets, flows of funds, and accounting identities. Everything added up; each sector’s surplus was another’s deficit. It was much like doing MMT. This flow-of-funds perspective jarred with the standard textbook treatment. Our tables made it clear that the monetary base (currency plus central-bank reserves) wasn’t a policy variable; it moved around to reflect the public sector’s deficit, among other things. And the data showed how government spending could be self-financing, which is MMT’s central claim. Together with the central bank, the Treasury can create new money by the very act of spending it.

Why, MMT asks, is public borrowing a problem? Why does a government need to borrow at all if a currency issuer can issue as much as it likes? The only constraint, it says, is the economy’s capacity to meet demand. If too much money is spent, excess demand will cause inflation. So there’s no limit to what a state can spend. That it might turn out inflationary is the only concern.

Up to this point, this is not really at odds with orthodox macroeconomics. Yet, economists also talk about the sustainability of government finances. MMTers mock such talk, but they’re mistaken for two reasons. The first is that the risk of inflation is itself a constraint on government spending. The other is that one of the main purposes of a central bank is to control inflation. MMTers fail to reckon with the implications of this.

The US Fed is about to raise interest rates to curb inflation, which continues to surge. Using monetary policy to restrain demand means the Fed can’t permanently monetize government spending. This puts fiscal sustainability back on the table. Policymakers now have to ask: What is the outlook for growth, interest rates, deficits and debt? Suppose the Fed succeeds in containing inflation but the government maintains its spending. Will higher interest rates cause public debt to grow faster than the economy, faster than might be sustainable? Granted, for MMT, this question doesn’t arise—but not because of secret truths encoded in accounting identities. The reason is that MMT assumes that the Fed will play no role in fighting inflation. The MMT prescription for monetary policy is “leave the policy rate at zero and issue money as required." So fiscal policy must do everything. It must realize expansive ambitions for public spending—guaranteed employment, a green new deal, universal health care, retirement security, tuition-free college, student-debt forgiveness, etc—and contain the resulting inflationary pressure.

How does MMT propose to do this? Perhaps in due course by raising taxes, though MMTers have mixed feelings about this (to acknowledge this need is to accept that not everything can be afforded). Maybe with direct controls on prices, wages, profits and credit. Perhaps by examining spending minutely, scheme by scheme, favouring outlays that mitigate inflationary pressure (say by boosting labor supply) and avoiding those that worsen it (for instance by adding to demand in overstretched sectors). This is a tall order for a US Congress that generally struggles to do anything, never mind execute a demanding new fiscal policy with foresight and technocratic exactitude.

Most economists have long advocated a division of labour between fiscal policy (subject to swirling political pressures, biased by short-term calculation toward inflationary excess) and monetary policy (delegated to independent central banks, charged with anchoring expected inflation). They had reason to. In removing the Fed from the picture, MMT ignores lessons learnt over the course of decades.

One more thing: MMTers are right to say they are proposing a radical change of regime. MMT neuters the institution tasked with controlling inflation, demands unimaginable levels of wisdom and competence in Congress, advocates more state spending, minimizes the costs of inflation, and views talk of fiscal discipline as gibberish.

If MMT advocates were put in charge, inflation expectations would surge before they even made a single policy announcement. Thus the only constraint on spending they acknowledge would tighten at once, throttling their ambitions and hobbling their programme at the outset.

But, as I said earlier, their ideas are really interesting.

Clive Crook is a Bloomberg Opinion columnist and member of the editorial board covering economics, finance and politics.

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