Magic, madness or revolution?

Modern Monetary Theory and Its Implications

By Cassi Ainsworth Grace

Conventional wisdom on macroeconomic policy has of late been shown the backdoor. The previously accepted understanding, that the main concerns of a federal government’s balance sheet are structural and intergenerational problems, is no longer the case. With the Global Financial Crisis and the pandemic, the priorities of a federal budget are now smoothing out the economic shocks to the private sectors. This is even more of an urgent concern, as the possibility of significant economic scars grow with the deepening of the global recession.

And this is not even accounting for upheaval of our contemporary understanding of monetary policy. The effectiveness of the traditional tool of central banks, the cash rate, seems to have grown stale, as rates drop to near zero in a number of countries. In response, many central banks have begun experimenting with new policies with which to flatten the falling economic growth rate.

In Australia, the Reserve Bank of Australia (RBA) has deployed a new ‘yield curve control’. This has seen the RBA attempting to stimulate the economy by capping interest rates on government bonds of a certain maturity. On March 19th, the RBA announced its cap of 0.25% on bonds with maturities of three years, to lower funding costs across the Australian economy. The RBA has made it clear that they will maintain this target until it feels enough progress has been made in achieving the goals of full employment and stable inflation.

This maneuver has been watched by the US Federal Reserve, who have just extended their emergency lending programs through to the end of 2020 as the US unemployment rate remains in the double digits. There is now mounting concern about how central banks will extract themselves from these new experiments and return to their traditional role down the line.

There has also been talk of what it means to have a ‘monetary financing of fiscal policy’. Referring to the central bank funding federal government spending, this source of deficit funding has attracted attention. Whilst this means the federal government would continue to determine how the money is spent through fiscal policy, the central bank would provide the funds to the point where its own goals of stable inflation and low unemployment rate are met.

Yet, leading economists like Stanley Fischer, Vice Chair of the US Federal Reserve, maintain that this is only appropriate for particular circumstances. These include the exhaustion of monetary policy, the struggle of fiscal policy to issue major stimulus given increasing debt and time lags, and if the central bank is failing to meet the goals in its charter.

This situation has also been made all the more complicated with the persistently slack inflation that dominates a number of major economies, despite significant and record-breaking monetary policy expansion. As a result, economists have had to reconsider the previously assumed inverse relationship between economic activity and inflation, as explained by the Philips curve relationship.

From this colossal miasma, out walks Modern Monetary Theory (MMT).

MMT appears radical in its main propositions. Previously upheld by a few members of the left-wing fringe, MMT has been disparaged as ‘Magic Money Theory’. Yet MMT has caught more popular attention of late, receiving its own articles in publications like Bloomberg and Business Insider, and touched upon in The Economist.

MMT has grown out of the heterodox school of economics. This school takes the view that economics is not separate from society. Division between the two spheres is fallacious, and our understanding of economics must negotiate traditionally noneconomic concerns like power, discrimination, race, prejudice and uncertainty.

It is this school from which MMT has emerged. Through the lens of MMT, the issuer of a currency has no financial constraints in the creation of money. If the country produces its own currency, it can never run out, and never become insolvent in its own currency. Or in other words, will never be unable to pay the debts it owes if the debt is written in the currency it produces. In this way, a government that controls its own money can spend it how it sees fit, with little concern with the debt it accumulates in their own currency.

As a consequence, a government deficit is something we should not be afraid of. MMT suggests the government should feel free to spend in order to grow the economy, whether this be on the private sector, universal healthcare, free education and improvements in sustainable technology. Key proponents suggest that we should not see the government running a budget in the same way as a household or firm. Businesses and individuals use money to make and receive payments. Governments create it.

There is one limit to this government spending. Inflation. Inflation has long been thought of as the speedometer of our economy, and with MMT this is no different. Under this theory, evidence of a government deficit that is unsustainable is accelerating inflation rates, whilst a deficit too small is evidenced by unemployment. This concept has been reiterated by lead MMT theorist Stephanie Kelton. One of her main mantras in her discussion of MMT is that as long as a country is not facing a long-term inflation problem, then it is not looking at a long-term debt problem.

We can see this concept at work in Japan. Japanese government debt has wandered close to the 240% of GDP mark, yet has encountered little inflationary pressures, with rates barely rising above 1%. Despite the significant size of this government debt, there have been no real negative consequences. As a result, Kelton suggests that the very way we look at new government spending must be shifted. Rather than looking at the policies impact on deficit size, we must assess whether it poses an inflation risk.

The Economist was quick to dismiss MMT, and rather claimed that whilst we were wandering into a new era of both fiscal and monetary policy, we “must beware the lure of free money”. It was not alone in this warning, as the RBA’s Governor, Philip Lowe, likewise echoed the sentiment in his July Speech, emphasising that no matter how the RBA created money, someone would end up paying for it, whether that be individuals, the government or the private sector.

So, it appears that “there is no such thing as a free lunch” reigns supreme. But how does this hold up if the government creates its own currency? Is the age-old economic problem of scarcity still applicable here?

Perhaps the orthodox understanding of economics today nurses a hangover from the days of the gold standard. In the era of the gold-standard and the Bretton Woods international monetary system, currencies were backed by precious metals like gold, or a foreign currency. In this situation, the government would have to make use of its reserves of gold and foreign currency to service its debt. If this dried up, the government would have to default.

Yet, with our modern-day fiat currency, like the AUD and USD, a government-issued currency is simply not backed by a commodity or by foreign currency. Monetary and fiscal policy is freed from its job of accumulating these reserves and are no longer required to defend exchange rates, which are largely determined by the forces of supply and demand in the foreign exchange market. In this way, countries like the United Kingdom, Australia, New Zealand and the United States of America will never run out of money. They can always produce more and are neither revenue constrained nor reserve constrained.

Perhaps our fear of printing more currency and high government spending is the legacy of a system we have long since abandoned.

Ultimately, this debate leads us back to our very start as economists – university. Out of all the social sciences, economics ironically appears to be the most dislocated from reality. Economic theory is often taught at tertiary level in the same way as the proven ‘laws in science’, and fails to acknowledge that what we know is predominantly theoretical, and often unverifiable. There is little latitude for the breadth of interpretations that colour the rest of the Arts. Perhaps rather than sweeping aside nascent theories like MMT, we should create space to consider its merits as well as its shortcomings, and question already accepted schools of economic thought.

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