Individuals’ inflation expectations differ depending on a person’s experiences during their lifetime1. Growing up in Argentina I witnessed the direct relationship between monetized deficits and inflation. Later, I was schooled in traditional monetary theory: MV = PQ, and Milton Friedman was a rock star.
My first “crisis of faith” was the wake of the 2008 Great Recession. I then prophesized that crisis-related explosive growth in the quantity of money was fuel waiting to be lit by the match of velocity; i.e. that, as soon as banks started lending again, there simply would be too many dollars chasing too few goods. I was wrong – and by a lot. Not only did the Fed not tighten at the first evidence of increase in the multiplier, it further eased!
In the spirit of introspection, I will try to objectively analyze my monetary credo against the hip alternative: the modern monetary theory (MMT), which can be credited with having been empirically validated over the last decade.
Traditional monetary theory maintains that even if a government can print money to pay back its debts, the act itself creates inflationary pressures, increases interest rates, and fuels even greater deficits by increasing interest on the debt. If growth cannot match the increase in interest rates, further deficits will be created as tax revenues fail to keep up with expenditures.
At some point, investors may become unwilling to fuel deficits with further loans. The result: a government’s credit rating will decline, fostering an “economic doom loop.” In such times, reductions in government spending or increased taxes to reduce deficits may exacerbate the problem.
Now comes MMT. It holds that the assumptions underlying conventional thinking may have been wrong all these years. It is based in part on the belief that there may be a disconnect between deficits, inflation, and especially interest rates. Economist Stephanie Kelton argues that one reason the disconnect exists is the knowledge that a nation with its own currency can simply deal with deficits by printing more money. Only in extreme cases will this lead to greater inflation if the economy, productivity, and the supply of labor, goods, and services is growing. This is interpreted by some to suggest that such countries need not worry about deficits.
Exhibit A for Kelton’s argument is what is happening currently in the US. As deficits mount, interest rates remain low in part because of a good credit rating relative to other countries, a strong currency, and the ready flow of capital into the country. Inflation is held down by, among other things, low-cost import competition. In the world of MMT, deficits fuel growth that produces government revenue sufficient for public investment. As long as interest rates remain below the rate of growth—the current US experience—further government borrowing is a good strategy.
To borrow a quip about the Holy Roman Empire, my first observation was that MMT is neither modern, nor mostly about money, nor a theory. I address each one in turn:
1 Malmendier and Nagel, 2013
1 – MMT Is Not Modern
MMT traces its roots at least as far back as 1943, when Abba Lerner posited his “functional finance” theory.
My Argentine background comes in handy to recollect MMT experiments of the late twentieth century. Although most MMT experiments have taken place in Latin America, there have also been MMT-type policies in Turkey, Israel, and France. Almost every one of the Latin American experiments with major central bank-financed fiscal expansions took place under populist regimes, and all of them ended up badly, with runaway inflation, huge currency devaluations, and precipitous real wage declines. In Chile, Argentina, Brazil, Nicaragua, Peru, and Venezuela policy makers used arguments similar to those made by MMTers to justify extensive use of money creation to finance very large increases in public expenditures.
2 – MMT Is Not Mostly About Money
MMT upends traditional monetary theory by positing that essentially all government expenses can be paid for with fiat money and that taxes should be used to control inflation. Thus, inflation targeting is pursued through the tax code, not the management of the money supply. But what MMT proponents are never entirely explicit about is that the government can keep the newly spent money out of the economy only if it doesn’t simply turn around and spend the money it collects.
Of course, if the Treasury increased tax revenues without increasing expenditures, the Fed could allow Treasury deposits to simply accumulate. This would permanently take base money out of the economy. But this increasing Fed liability would have to be offset somewhere on the Fed’s balance sheet. One way to offset is just to let any increase in the Fed’s Treasury liabilities reduce the Fed’s capital account, in which case the total size of balance sheet would remain constant. But reducing the size of the Fed’s capital account, currently only $40 billion, has limits, unless the Fed adopts the accounting fiction of a negative capital account.
An alternative would be for the Fed to offset an increase in its liabilities with a newly invented asset, equal in amount to the increase in Treasury deposits, that it could label Treasury Currency or Reserves. Then the Fed’s balance sheet would increase on both sides by the amount of accumulating tax revenue. Either of these balance sheet expedients could permanently pull money out of circulation, reducing the monetary base through taxation. But MMTers tend to dismiss these accounting intricacies as the government’s “self-imposed constraints” that could easily be swept away. They remain vague about what new institutional arrangements they have in mind.
3- MMT Is Not a Theory
In fact, there is no unified description (much less a cogent model) about how MMT works. This is not due to lack of publications. Indeed, MMTers are prolific authors, and have published a large number of papers, pamphlets and books, including some primers, but such publications live mainly in the blogosphere and YouTube. The papers are not peer-reviewed, and none of the books were published by reputable university presses. In addition, these works contain very few (if any) equations or diagrams; MMT authors have generally avoided the language that, for better or for worse, has become dominant in scholarly conversations among professional economists2.
So, what do I make of the last 10-years’ empirical evidence, debunking my “crying wolf” in 2009? After reviewing the evidence, I regard it as an outlier: in depressed times MMT’s claims broadly coincide with classic theory. That is because the inflation constraint effectively vanishes, and depressed animal spirits suppress immediate financial sector stability concerns.
So, until I see persuasive science to the contrary, I still believe that how deficits are financed matters. Should I be called today to run a central bank, I would fiercely hold on to my independence, especially my ability to decrease the money supply when government deficits become excessive in the absence of either war or severe recession.
2 See, for example, Forstater and Mosler (2005), Tymoigne and Wray (2013), and Wray (2015, 2018), and the literature cited therein.