That Mystical Monetary Theory

Authored by Joakim Book via The American Institute for Economic Research,

MMT, or Modern Monetary Theory, is on everyone’s lips – and it seems that everyone is keen on this long-obscure idea of how our public finances really work. 

In an article in the latest issue of Economic Affairs, I try to condense the argument into four propositions that form the core of MMTers’ understanding of the world. I do this by reviewing Stephanie Kelton’s book from June of last year, Kelton being the most vocal and well-known persona in the field. I show that there is great tension between these propositions and that most MMT arguments include accurate statements in the service of inaccurate conclusions. What is right about MMT is mostly old – and fairly trivial – and what is new about MMT is not quite right.

1. A currency issuer (a “monetary sovereign”) cannot run out of money 

With this proposition, MMTers stumble upon an old and long-accepted idea in monetary economics. The more others wish to hold your liabilities, the more you benefit. Everyone from private banks on a gold standard to Amazon and Starbucks’ gift cards, and more recently Elon Musk’s Tesla have realized that free lunches abound if consumers want to hold financial claims on you.  

Just like central banks issuing money, these companies can never run out of the paper promises they issue. Had they wished to, private banks could have issued as many notes as they wanted, just as Bezos’ Amazon can flood gift cards everywhere or Musk’s Tesla can print up as many Tesla-shares as its shareholders want. Nobody would want to, of course: Amazon would quickly make losses if the goods on their platform were mainly purchased by gift cards freely issued by a Bezos-spree; and not even Musk would know what to do with that much cash on Tesla’s balance sheet – not to mention the effect on the share price from flooding the market with new supply. 

Isn’t the money issued by central banks entirely different? Not really. True, the dollar or euro notes in my pocket cannot be redeemed for some outside commodity or Starbucks coffee but I can dispose of them by buying goods and services – just like I can with Starbucks and Amazon gift cards. If the hypothetical me instead is a whole population of people who no longer want to hold these paper slips, everyone tries to get rid of them at the same time – which we do in a monetary economy by buying things. Since money can’t escape its closed system, excess money holdings bounce around, hot potato-style, until prices have adjusted enough that the real value of your money holders are no longer excessive – in other words: large and rapid inflation. 

Yes, the Fed or the Bank of England can never “run out of” the paper money they issue (trivially true), but they can run into the consequences of issuing too many. Kevin Dowd writes that Kelton’s main mistake is “to presume that what is correct at the margin (i.e., that the government can avoid default by issuing a few extra dollar bills) is also correct under any circumstances, that is, at any scale.” 

2. Taxes don’t pay for government expenditures but generate demand for money

While the first proposition is trivially true but doesn’t mean quite what you think it means, this one is closer to “demonstrably false.” The first part is an accounting claim or at best a hypothetical proposition that central banks would honor payments by governments even if there were no funds in their Treasury accounts. 

According to MMTers, taxes don’t fund expenditures, as monetary sovereigns just create money to settle any transaction whenever it is spent. Taxes, in contrast, merely destroy money and keep a lid on aggregate expenditures. Compared to the public finance most students learn, this is completely upside-down – but more importantly, unprovable. Despite Kelton’s desire to describe the world as it really is, this is emphatically not how governments of the world operate. Yes yes, Kelton handwaves, and says that this is because they’re in thrall to mistaken economics and that if they wanted to, they could. OK, great. 

The second part is less ethereal, but more demonstrably wrong. When you tax something, you do not create demand for that good. When government taxes your income and requires that you pay that tax in some specific unit, that unit doesn’t become money for others; if the government would happen to pick a useful enough item – determined as such and valued by the consumers who use them – public receivability can benefit one monetary commodity over another such that this becomes a society’s general money. 

If mandating taxes is what generates demand for money and exorbitant privilege for their issuing country, it makes no sense that countries would ever give up that right. When Ecuador in January 2000 stopped resisting its people’s monetary choices by dollarizing and no longer issued its Sucre, this must have been a mistake. In the MMT story, it is unclear why they, or Venezuela and Zimbabwe or Lebanon in the 2010s, couldn’t just have taxed away the inflation that happened when money demand plunged. But with this argument we can go one step further: if money issuers get this grand benefit that the U.S. government has – that Kelton doesn’t think it’s (ab)using enough and that’s unfair towards countries of the world that can’t enjoy this power – why don’t we extend the logic? 

If it’s so bad that countries that don’t have monetary sovereignty can’t issue their own money, we can have the fifty states print their own dollars (why constrain states from spending on what they “desperately need?”). We can have a New York dollar, an Oklahoma dollar, a Georgia dollar and even an Austin dollar, and all of these jurisdictions can spend to their heart’s desire as they are now money issuers. I can issue Joa-coins right away (Dogecoin, anyone?) and command much more purchasing power for all the things I need! 

The missing piece for the argument to work is that I benefit only if all of you kindly accept the Joa-coins in exchange for goods and services, even when I’m issuing more and more of them. When you don’t, the purchasing power of any outstanding Joa-coins quickly goes to zero (i.e. infinite inflation) as you all try to get rid of them at any price. We’re back at money demand: the policy proposals of modern monetary theorists only work if there is a desire to hold more of the issuer’s money. Joa-coins can only save the (my?) world if you desperately want to hold them.  

3. Inflation is the only constraint that a monetary sovereign faces.

4. Capitalist economies have lots of idle resources (unemployment, spare capacity, fiscal space).

The fine-print of the MMT system arrives in the two final propositions, which MMTers freely advance Motte-and-Bailey style, against any criticism to their theory. What isn’t immediately obvious in an average conversation about MMT is that these fine prints severely restrict how far (1) and (2) can go in achieving the political ends that MMTers seek. 

Even if (2) would be factually correct, and taxes levied don’t pay for government expenditures, once (3) starts binding – which Kelton and others explicitly accept they would at some point – taxes and borrowing must be levied to control it. In a roundabout way, real government spending would then be financed by taxes and borrowing. 

When, in the MMT framework, do we get inflation? When there are no longer “idle resources” in the economy. This is an old idea in the Post-Keynesian tradition that when assets are not used (i.e. factories not operating, capital equipment not producing, houses not occupied) and labor is unemployed or out of the labor force, government spending becomes a free lunch. Spending, which in the MMT world means issuing more money, can bring these resources online without increasing prices because they are assumed not to have alternate uses. 

Of course, in real life they have; asset owners may have different plans than the central MMT planner, and labor markets can be unsynchronized for other reasons – geography, welfare payments, structural and frictional unemployment – than insufficient demand (if there even is such a thing). Adjusting Ludwig von Mises’ fable of the master builder only a little: if you find yourself in a minefield, the solution is not – as Kelton and others who worry about slack and spare capacity would have you do – to run as fast as you possibly could. It’s to stand still, survey the terrain, and carefully retrace your steps until you’re once again on safe ground. Only from there can you try to go around the minefield.

Even so, if and when idle resources and unemployed labor do not abound, government spending crowds out private spending and the alleged macroeconomic benefits come to a close (or public wants must trade off private wants). 

Aren’t Governments and Central Banks doing MMT Right Now?

Against James K. Galbraith’s argument that the MMT was vindicated by central bank actions of 2020, my AIER colleague Nicolás Cachanosky notes that

“The government spent a lot of money in a short period of time and inflation expectations remained below two percent. But that doesn’t tell us much about how such a policy would work in normal times. And the supposed evidence offered in support of MMT is also consistent with the standard view. To the extent that the fear of pandemic and government lockdown orders slowed spending, good old-fashioned monetary theory explains the observed low inflation rate in 2020.”

The real test for MMT is not the fervor with which policymakers around the world have taken MMT-like actions in the midst of a stop-all pandemic economy, but in a “normal” economy. If we make lots of resources idle (4), which governments did when they engineered a recession last year, MMT collapses into standard counter-cyclical Keynesianism with at best some cosmetic differences in form.

It’s not under today’s conditions that MMT’s policies must deliver, but in pre-pandemic years where unemployment had virtually disappeared, wages were rising across the income distribution, median incomes were rising, and labor force participation reversed its decades-long decline. Spending government funds like it’s World War II and doubling the monetary base during those conditions (without hitting capacity constraints!) is what would vindicate MMT. 

The MMT mistake lies in believing that any alleged shortfall in money or supply of U.S. Treasuries is big enough to finance their entire policy wish list for the foreseeable future. It also assumes that any potential labor or capital goods not currently used can be effortlessly moved to whatever production line politicians desire, without causing prices or wages to increase.

While MMT seems to offer grand justifications for spendthrift governments, the more (3) and (4) hold, the less revolutionary (1) and (2) seem. The monetary theory that calls itself modern remains mystically inadequate.