The rapid rise in federal debt caused by the need to support an economy devastated by COVID-19 has renewed interest in a school of economic thought called Modern Monetary Theory (MMT). It is easy to understand why: MMT provides an economic rationale that absolves politicians from having to pay for new government spending with unpopular tax increases or spending cuts in other areas.
As Stephanie Kelton, one of MMT’s leading proponents, wrote in a recent New York Times op-ed:
"An understanding of Modern Monetary Theory matters greatly now. It could free policymakers not only to act boldly amid crises but also to invest boldly in times of more stability. It matters because to lift America out of its current economic crisis, Congress does not need to ‘find the money,’ as many say, in order to spend more. It just needs to find the votes and the political will."
According to Kelton, because the United States issues its own currency, it “can increase spending without needing to raise taxes or borrow from other countries or investors.” The only restraints are “inflation and the availability of labor and other material resources in the real economy.”
On the surface, MMT is boosted by the fact that Congress and the president have already spent trillions in response to the COVID-related recession while interest rates and inflation have remained unusually low. In Kelton’s view,
"Congress has been showing us — in practice if not in its rhetoric – exactly how M.M.T. works: It committed trillions of dollars this spring that in the conventional economic sense it did not ‘have.’ It didn’t raise taxes or borrow from China to come up with dollars to support our ailing economy. Instead, lawmakers simply voted to pass spending bills, which effectively ordered up trillions of dollars from the government’s bank, the Federal Reserve. In reality, that’s how all government spending is paid for."
The Right Medicine at the Right Time
It is important to distinguish between what is appropriate in a time of economic crisis, such as now, and what is appropriate as a longer-term strategy.
When you are sick, you take medicine. When the illness is gone, you stop taking the medicine.
Today, our economy today is sick. Millions of Americans have been forced out of work to contain the spread of a deadly disease that has already claimed more than 117,000 lives. A sudden and sharp recession began in February as real GDP declined by 1.2 percent in the first quarter of the year and unemployment surged to almost 15 percent in April.
The outlook is not much better. Second quarter GDP is expected to slump far deeper than the first quarter, perhaps by more than 10 percent, attributable to business closures and stay-at-home orders that took hold across the nation. Unemployment declined marginally in May, but at 13.3 percent is still substantially higher than at any point during the Great Recession and is expected to remain close to 10 percent into next year.
The fiscal medicine for this economic malady has been massive debt-financed federal spending. Proceeds have been used to fight the virus and provide individuals and businesses affected by the stay-at-home orders with direct supplemental income. This prescription has been supported by organizations across partisan and ideological lines, including The Concord Coalition.
When the economy recovers, however, the need for unlimited doses of deficit medicine will wane and normal constraints will re-emerge. According to former Obama Administration officials, Treasury Secretary Larry Summers and former chair of the Council of Economic Advisers Jason Furman:
"Fiscal constraints are real. Even if one accepted the MMT idea that inflation is the only constraint on government spending, there is still some constraint on what government can afford. As long as we eventually face a budget constraint, then the government needs to prioritize among the many worthy, and some not so worthy, claims on scarce resources. Without this limit, how can we say no to any sympathetic group or force tax increases on any except the most reviled?"
In a similar vein, Jared Bernstein, Senior Fellow at the Center on Budget and Policy Priorities and former Chief Economist and Economic Adviser to Vice President Joe Biden, posed the following questions about MMT:
"Though we should always be willing to deficit spend in the near term when economic conditions warrant it, should we not structure long-term fiscal policy to avoid structural deficits (a structural deficit is one that persists even at full employment)? At least in a political sense of protecting vital social insurance programs, isn’t the prudent approach, as difficult politically as it may be, to try to lock in a level of revenue collection that meets our future obligations?"
Nevertheless, the allure of a free lunch in hard times might motivate some to support MMT. In that regard, it is similar to the long debunked “supply-side” theory that tax cuts pay for themselves. As noted by Larry Summers:
"Modern monetary theory ...is the supply-side economics of our time. A valid idea — that traditional fiscal-policy taboos need to be rethought in an era of low real interest rates — has been stretched by fringe economists into ludicrous claims that massive spending on job guarantees can be financed by central banks without any burden on the economy. At a moment of economic and political frustration, some in the more extreme wing of the out-of-power political party are seizing on the possibility of a free lunch to offer politically attractive ways out of economic difficulty."
The Practical Challenges of MMT
Aside from the free lunch connotations, MMT has certain practical challenges. First, it ignores any policy response by the Federal Reserve, which would almost certainly raise interest rates to combat the inflationary impact of unrestrained spending. The Fed’s current chair, Jerome Powell recently stated,
"The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong."
It should be noted at this point that advocates of MMT reject the notion that they are offering a free lunch. They acknowledge that resorting to the central bank’s printing press to fund an expansion of government spending could eventually cause a problem with inflation, but they insist that this could be prevented by Congress raising taxes to curb demand.
However, this highlights a second practical challenge with MMT: Expecting politicians to raise taxes as an inflation-fighting tool is placing a very big bet on a very slow horse. Again, to quote Jared Bernstein:
"That’s fine in theory, but how does that work in the real political economy? The president goes to Congress and proposes a tax increase to bring us back down to potential, and Congress says, “sure, boss. We’re on it!”? Presidents and Congresses don’t like tax increases, and they don’t happen quickly (yes, the last tax plan came together pretty quickly—because it was a cut!), they have distributional implications, and there’s a huge industry to fight you tooth and nail.
That’s why we have a Federal Reserve that can quickly and without political interference decide to take money out of the economy (to be clear, monetary policy also has distributional implications). That seems like an immeasurably more reliable way to handle the overheating problem, but I don’t think the MMT crowd agrees, or at least I don’t understand where the Fed and interest rates exist is their cosmology."
A third practical challenge is how MMT would work in a global economy. Skeptics worry that it could debase the dollar. According to the Nobel-winning economist Paul Krugman,
"The point is that under normal, non-liquidity-trap conditions, the direct effects of the deficit on aggregate demand are by no means the whole story; it matters whether the government can issue bonds or has to rely on the printing press. And while it may literally be true that a government with its own currency can’t go bankrupt, it can destroy that currency if it loses fiscal credibility. [emphasis added]"
And Summers has similarly warned,
"Modern monetary theorists typically reason in terms of a closed economy. But a policy of relying on central bank finance of government deficits, as suggested by modern monetary theorists, would likely result in a collapsing exchange rate. This would in turn lead to increased inflation, increased long-term interest rates (because of inflation), risk premiums, capital fleeing the country, and lower real wages as the exchange rate collapsed and the price of imports soared."
While MMT and traditional economic theory converge on the need for an aggressive response to the sudden and sharp recession that began in February, they diverge on long-term fiscal and economic policy. The Concord Coalition believes that MMT has too many dubious policy assumptions and political risks to serve as the foundation for the post-pandemic economy. The nation was already on an unsustainable path before the pandemic hit. Despite steadily rising deficits and debt, economic growth projections were weak. Doubling down on a policy of ever-rising debt by printing money to “fund” new spending commitments would leave future generations with an even higher mountain of debt and no guarantee (or even likelihood) that MMT could somehow avoid hyperinflation, huge tax increases and a devalued currency.
Policies should be built to last for the long-term; to be sustainable. MMT fails the test.