Bold Hypothesis or Reality: Modern Monetary Theory

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With the aftermath of the COVID pandemic causing a rise in public sector debt levels across the globe, a new economic & political niche has evolved which supports unlocking the full potential of state spending. Entering the debate is Modern Monetary Theory (MMT) which, whilst currently a purely hypothetical proposal, could turn into reality very quickly. MMT flips the switch on mainstream economic thinking which dictates that a government must act like a household in terms of rationing their spending, income (taxes), and borrowing in a way that is fundamentally sustainable, just like us.

Such thinking is not just commonplace in economics but also in the news: you will frequently find stories worrying about US debt swelling too high, and the same can be said for the UK. However, when one notices that almost every OECD economy has been or currently is in a structural balance deficit - meaning that even at maximum output the government budget is still in deficit - questions surrounding the sustainability and nature of this debt have arisen.

The mainstream doctrine states that a structural balance deficit is fundamentally unsustainable. If government finances are in such a position, then one of two consequences will occur. The first and obvious one is a default, and the second is getting assistance from organizations such as the IMF & World Bank to repay bad debts. As such, this pressures governments to act in a countercyclical manner which is quite similar to that of households. Effectively, during economic downturns, governments employ Keynesian economics and overspend (borrow) to create a fiscal deficit to support the economy. Then, once the economy starts to grow and full employment is close to being reached, we cut down on spending (maybe increase taxes) and reach a fiscal surplus to repay previous debts.

Voila, we have a business cycle. Growth turns into a slump and vice-versa. Theoretically, this allows for Keynesian economics to work as investors take on risk by lending to governments during slumps and then see rewards during peaks. Yet, as previously stated, almost every OECD economy is running a structural balance deficit, suggesting that the investors are not getting paid. To understand why this is, we must look towards MMT, and, when we do, we might notice that our modern economies operate much closer to this theoretical doctrine than we first thought.

The first change we have to make is in how we view the nature of the business cycle in economics by subscribing to a slightly different school of thought: Post-Keynesian Economics. PKE suggests that there is no clear business cycle that an economy follows as the three paradoxes of thrift, debt & tranquillity create order in disorder and vice versa. As such, the economy is a naturally chaotic system, and, with free markets having no self-balancing mechanisms, meaning that whenever the economy slumps, government spending is necessary.

Reinforcing this belief is the work of famous economist Wynne Godley, who showed that paradoxically, the introduction of austerity measures during boom periods to achieve balanced structural spending creates further disarray. This is because a government surplus during these periods suggests that excess money is taken out of the circular flow, or in other words that the more efficient private sector is being deprived of resources and runs a deficit. Wynne Godley used this methodology to predict major recessions during his time, and as such, countercyclical spending is illogical - instead of balancing the budget, the government should balance the economy. This is what MMT is all about. To understand how MMT functions we first must know the limitations on government spending. The first and foremost are investors. Through the free market, investors can influence how, when, and in which direction bond yields swing, which acts as a price signal towards the state to show whether or not its fiscal position is popular. In other words, investors exert power over the state. The second limitation is the exchange rate. If the government spends too much, domestic production will be outweighed by demand, causing a rise in imports and a depreciation of the exchange rate. Simultaneously, if the government's fiscal position is deemed risky, then, foreign investors may sell their bonds, causing further exchange rate problems. The final and most important limitation for MMT is inflation, which is caused by both an aggregate supply constraint and the aforementioned depreciating exchange rates. Where mainstream economic thinking believes that it supports the idea of the investors having power over the government, it really doesn’t. Actions speak louder than words and central banks have frequently performed QE operations, which, either intentionally or unintentionally, have artificially depressed bond yields during times of crisis. In other words, for countries such as the US which have monetary sovereignty, debt default is unlikely. MMT recognises that governments do not want investors and chooses to embrace this. Therefore, a full transition towards MMT would likely involve the state taking over central bank operations, creating money via QE and then using this to repay all investors. This would allow monetary sovereign governments such as the UK to no longer act like households when spending. This is because these governments are monopoly issuers of their own currency: just like how a bowling alley cannot run out of points to give to players, monetary sovereign countries do not run out of their own money. Therefore, instead of choosing to borrow, the government simply creates money to finance its spending. Under this model, the role of taxation changes as instead of using state income to repay investors, the state can simply delete the money out of existence to tame inflation. Instead of balancing the budget and keeping investors happy, the state can now fully focus on balancing the economy.

As such, through MMT, the state can unlock its spending to its full potential. Under MMT, investor limitations disappear, and the only real limit is that of inflationary forces derived from aggregate supply constraints and exchange rate issues arising from rising import demand. Overall, the tools to transition to this new system of spending and taxing are already in place, we are much closer to an MMT economy than most think. Whether or not transitioning is the right choice, however, is still up for debate. Whilst the economics of it all lines up and makes logical sense, perhaps it is not the economics which we should follow, since holding governments accountable is important - choosing to give up this increasingly scarce ability may not be the best idea, despite the economic benefits.