Modern Monetary Theory: Nothing New Under the Sun

To understand this situation, it is important first to clarify what MMT is and is not. At least as I understand this theory, the term “modern” in MMT does not refer to something new or novel but to the modern-world way of doing monetary policy. Namely, the term modern refers to the epoch that starts with the abandonment of the remaining remnants of the gold standard 1971. “Modern” refers to the full adoption of fiat money; it is not a reference to a new model or theory. We can agree that the adoption of fiat money is a gamechanger in policymaking but disagree on the implications of such monetary regime change.

The fact that central banks issue fiat money means they do not have any IOU obligation to redeem the banknotes into gold or any other asset. Therefore, if the government can issue debt denominated in its own currency, treasury bonds can be paid for with monetary expansion without any risk of default. Furthermore, there is no limit to how much debt the Treasury can issue. Consequently, there is no limit to how much government spending can increase. There is no inflation risk in monetizing the deficit. Because this country issues a world-reserve currency, its demand is unlimited.

This is, in a nutshell, MMT’s thesis. Suppose a country can issue debt denominated on its own currency. In that case, modern-world conditions mean that its government can increase its spending without any limit. MMT’s conclusion that money creation is a free lunch has been seriously questioned by the economic profession. MMT conclusions seem more magical4 than real. It is no wonder that progressive-leaning policymakers are fond of MMT. This theory promises that paying for large programs such as the Green New Deal is free of economic problems.

Nothing New Under the Sun I: The Model

One of MMT’s problem is its lack of clarity, especially when it comes to explaining why its bold predictions are consistent even if not self-evident and in contradiction with the profession at large. This lack of transparency makes it difficult to identify MMT’s uniqueness. One way to highlight MMT’s distinctiveness is to re-frame MMT in terms of standard economic models. By doing this, any difference between MMT and well-known models or theories should become apparent. So far, MMT has not provided that exercise. The point is not so much about having a mathematical model per se, but us about building one as a way to bring clarity and self-awareness to what MMT stands for. If MMT is found confusing by a large audience of professional economists, as seems to be the case, then the problem is not with the audience but with MMT.

As a matter of fact, we already have models and theories that offer the same predictions as MMT. Old Keynesian models, such as the IS-LM and the Keynesian cross, predict the possibility of an increase in aggregate demand without affecting the price level. These models reach this prediction by assuming the price level is constant (the price level is not part of the model) because of the large number of idle resources. MMT reaches the same prediction by assuming an infinite demand for money. Leaving the merits and demerits of these Keynesian models aside, MMT fails to offer a significant difference. Consider, for instance, what the assumption of an infinite demand for money implies for the MMT model. Assuming an infinite demand for money means that the price level is stable even if monetary expansion occurs under full employment.

Furthermore, the simple-Keynesian characteristic of MMT does not work in its favor. These models’ price level stability depend on very particular conditions, such as a large number of idle resources. However, as the economy approaches full employment, inflation is to be expected. When pushed regarding this situation, MMT advocates recognize that inflation can be a problem in the limit. In such a case, fiscal policy (taxes) should be used to bring inflation under control. This stepback makes MMT look just like simple Keynesian models with a new cover. The alternative is that MMT is a theory that holds the undefendable assumption that there is no resource scarcity.

MMT’s recognition that inflation may be a problem is not a minor detail. It means that MMT’s prediction is contingent on present economic conditions rather than on universal assumptions. However, recognizing this contingency provides a difference between the Keynesian episode of the 1930s and MMT. The Keynesian revolution occurred during the Great Depression, a time where the assumption of high unemployment was appropriate. It was also a time with smaller governments and lower levels of public debt than the levels we see today. MMT arose, however, in a context closer to full employment and already large governments with more debt on their shoulders.

It is the case that, in contrast to the time of Keynes’s General Theory, today central banks issue irredeemable fiat money. It does not follow, however, that the possibility of monetizing deficits is a free lunch. MMT’s conclusion does not follow from its own premises. If MMT conclusions were correct, we should expect to see inflation rates go down in countries that issue a world-reserve currency. Yet, we know this is not what happened. Countries like the United States have seen the inflation rate increase with fiat money adoption rather than fall.

MMT does not seem to offer anything significantly different than the simple Keynesian models. However, as problematic as they may be, the simple Keynesian models were developed by paying consideration to the economic conditions present at the time. MMT seems to assume unrealistic initial conditions. Even if theoretically consistent, the admission that inflation can be a problem means MMT is inapplicable in current times.

Nothing New Under the Sun II: The Political Economy of MMT

There is no mystery about the political appeal of MMT. This idea promises a way to do away with the price tag of large government projects such as the Green New Deal, free healthcare and education for everyone, or any type of full-employment program. MMT is a gospel5 for policymakers who favor big government plans. For them, MMT means there is no budget constraint. The limit is their own imagination and any opposition from other political parties. It should not be a surprise if this description sounds familiar. Once again, MMT offers a parallel to the Keynesian episode.

MMT is not only known for its bold predictions. It is also known for its confusing, opaque, and contradictory rhetoric.6 Anyone familiar with Keynes’ General Theory will probably remember how confusing, opaque, and contradictory it is. However, for policymakers, such semantic confusion proved to be an asset rather than a shortcoming. Keynes’ General Theory provided an ideal platform7 (or excuse) to embark on a big government project.

John Maynard Keynes, a renowned British Professor, discovered an obscure economic insight that justified the execution of large government programs. Keynes did not provide just theoretical support to large spending advocates; he also provided psychological support. The success of the Keynesian-view of the world was partly due to a combination of a moral mandate and the political convenience of embracing Keynes’ ideas. In the long-run we are all dead, Keynes famously said; it is therefore immoral to sit and wait for the free market to finally correct itself. The government has the capacity and the moral obligation to take over when the market fails.

Taking the high moral ground that the government ‘must do something’ during a crisis means the theoretical shortcoming of Keynes and MMT theories become less relevant. Because the moral argument takes precedence, those who oppose an extensive spending program or MMT insights must be either ideological blindfolded or protecting their own self-interest. James Galbraith’s recent defense8 of MMT is an example of this situation. Maybe the fact that an MMT defense must resort to this type of ad-hominem strategy9 is inidcative of its inconsistency problems. This is the rhetorical argument surrounding MMT policies. The government has a moral mandate to create jobs or save the environment. And MMT provides an eye-opening theoretical discovery that only those who can (or want to) understand it can see.

The field of Public Choice offers an extensive literature that explains how and why ill-designed policies get to be embraced by policymakers. It is a common feature in economic history that many well-established economic conclusions clash with policymakers’ ambitions. Avoiding minimum wages, adoptiong free trade and peaceful immigration, and low and simple taxes are only some examples of how far the political world is from basic economics. Maybe the rapid and enthusiastic embrace of progressive-leaning policymakers of MMT should be read as a warning sign rather than as a missed opportunity to embark on pharaonic projects.

Nothing New Under the Sun III: The Historical Evidence

Another salient feature of MMT is its speculative tone. MMT predicts what would happen under certain conditions if a specific policy is executed. Explaining what actually happened seems to be less relevant. This builds some tension between historical records and MMT’s predictions.

It seems futile to point out countries that suffer or have suffered inflation as proof of MMT inconsistencies. The reason is that these countries do not evince the conditions required for MMT to hold. That is, they either cannot issue debt on their own currency, or they do not issue a world-reserve currency. Take the case of Argentina, which has been suffering high inflation rates for more than a decade. Argentina cannot issue peso-denominated debt, and its currency has no demand in the rest of the world. It is not even a good store of value for Argentines. Argentina’s inflation does not offer conflicting evidence to MMT because the required pre-conditions are not present. And this is the situation for any country with high inflation. Suppose one were to contrast MMT with real-world experience. In that case, one will find that either inflation is present in countries that do not conform to MMT requirements or countries that do evince MMT requirements but do not put into practice MMT policies. Either way, there is no empirical challenge to MMT.

However, the lack of empirical evidence regarding MMT’s prediction changes significantly if we revise the previous paragraph’s question. Instead of asking if countries with high inflation contradict MMT predictions, we should ask if MMT is not the reason these countries are where they are today. By changing the focus of the question from present conditions to past policies, the historical record becomes more illuminating. These countries become economically troubled (high inflation and unable to issue debt on their own currency) by following what we can call “MMT ideas.” Latin America10 can be considered a continental-size experiment of the outcomes of MMT-inspired policies. Countries like Argentina11 are not a challenge to MMT because they suffer inflation if they print too much money, but because MMT-type policies are how they got to be in their current situation. The historical view is important to avoid a misreading of the empirical evidence. The experience of countries such as Argentina is relevant because they came to lose the MMT-requirements precisely by adopting MMT ideas.

Conclusions

MMT has been enthusiastically embraced in some corners of the political world. It will not be a surprise if its popularity increases in the short-term. MMT offers a convenient gospel and a rhetorical device for the big-spending programs favored by the new government administration.

The critical reaction to MMT from a broad spectrum of economists is not because this theory is complicated. It may seem that the economics profession has overreacted to MMT. After all, there is no clear theory nor novel insight to reply to. The reason for such a critical reaction is because, far from being a free lunch policy, adopting MMT would be playing with fire.12 As far as MMT increases in popularity, we may conclude the opposite, that the critical reaction was not strong enough. Paraphrasing George Selgin,13 MMT is too good to be true, though a very appealing doctrine for policymakers.

Footnotes

[1] Krugman, Paul (2019). “Running on MMT” (Wonkish). The New York Times. February 25th.

[2] Summer, Lawrence H. (2019). “The Left’s Embrace of Modern Monetary Theory is a Recipe for Disaster.” The Washington Post. April 4, 2019.

[3] Rogoff, Kenneth (2019). Modern Monetary Nonsense. Project Syndicate. March 4th.

[4] Cochrane, John (2020). Maginal Monetary Theory Full Review. The Grumpy Economist. July 5th.

[5] Lemieux, Pierre (N/A). MMT Gospel : Is This Time Different?. Library of Economics and Liberty, Feb. 3, 2020..

[6] Bisin, Alberto (2020). Book Reviews. Journal of Economic Literature 58 (4): 1197-1201.

[7] Buchanan, James M. and Richard E. Wagner (1977[2000]). The Collected Works of James M. Buchanan: Vol. 8 Democracy in Deficit. Library of Economics and Liberty. Indianapolis: Liberty Fund.

[8] Galbraith, James K. (2020). Who’s Afraid of MMT? Project Syndicate. December 23rd.

[9] Cachanosky, N. (2021) Galbraith Offers a Poor Defenseof MMT. American Institute for Economic Research. January 16, 2021.

[10] Edwards, Sebastian (2019). Modern Monetary Theory: Cautionary Tales from Latin America. Economic Working Paper 19106. Hoover Institution.

[11] Cachanosky, N. (2019). What Should Modern Monetary Theory Learn from Argentina? American Institute for Economic Research. March 27, 2019.

[12]Yang, Ethan (2020). Modern Monetary Theory is Playing with Fire. American Institute for Economic Research. August 8, 2020.

[13]Selgin, George (2019). “The Modern New Deal That’s Too Good to be True. “Alt-M: Ideas for an Alternative Monetary Future. February 8, 2019.