Implications of Modern Monetary Theory

What you need to know as MMT gains traction in policy-setting

In the last few decades, monetary policy has been widely seen as the most effective tool for managing the economy. However, this assumption is now being called into question. Enter Modern Monetary Theory (MMT), a new way of thinking about government spending. Crucially, its swelling supporters argue that fiscal policy should be the primary tool for macroeconomic growth and stability. Whether investors agree with MMT or not is irrelevant. The world is steadily moving toward the adoption of its ideas.

It always takes a trauma to shake up economic thinking. The Great Depression set policy on a far different path, ushering in a Keynesian era where governments used budgets to fine-tune growth and inflation. That orthodoxy came crashing down in the raging inflation of the 1970s.

From there, central bankers emerged as the leading macroeconomic managers. Of course, interest rates were their weapon of choice. U.S. Federal Reserve Board Chairman Paul Volcker, with his towering presence and cigar-smoking press conferences, oversaw a boost in borrowing costs to 20% in the 1980s. The cult of the central banker was born.

Alan Greenspan, who led the Fed from 1987 to 2006, took it to a whole new level. Dubbed the “maestro,” he developed an impenetrable linguistic style, clearly indulging – even enjoying – his oracular aloofness. At one point, Greenspan could have stuck a licked finger in the air to convince the public of the economy’s direction.

Monetary policymakers were more like modern-day rock stars. And for good reason. They had routed the inflation enemy. In the U.S., inflation averaged around 5% through the 1970s. Then, it steadily melted. In other developed nations, it has been broadly a similar story.

Central bankers were not shy about celebrating their victory. In the mid-2000s, they would boast of having achieved a “great moderation”: Economic and inflation variability had been tamed. Few disagreed that monetary policy was the most effective tool for managing the economy.

Yet all that changed after 2008’s global financial crisis. To fight the downturn, central banks pursued unbridled monetary expansion. Over US$16 trillion was added to their collective balance sheets. Plenty of voices warned that inflation would come roaring back. It didn’t. Today’s levels of inflation are still lower than a decade ago.

In fact, central bankers have consistently fallen short of their inflation and growth targets. The President of the European Central Bank put it plainly in 2014: “Deflation is the ogre that now must be fought decisively.”

All of which brings us to today. Globally, almost US$12 trillion in monetary and fiscal support has been pumped into the economy to fight the impact of Covid-19, leading to soaring budget deficits and public sector debt in all major economies. Have governments done too much? Apparently not. The world has been stuck with inflation stubbornly below official targets, and bond yields at new lows.

With this backdrop, it is no surprise that a global policy debate has been sparked. Why does recent experience seem to totally refute standard macroeconomic theory? And what, pray tell, is the right policy mix for the times?

Enter Modern Monetary Theory (MMT), a new way of thinking that has electrified the policy atmosphere. Its prescriptions are so potent and alluring that it seems to pass directly into the bloodstream. At least that’s how this author felt upon spending the last three months wading through a mélange of white papers, academic literature and, not to be forgotten, online blogs and debates best characterized as a few degrees below collegial. It is a very controversial topic. And it may be the first economic theory that has quickly mobilized a band of politically engaged bloggers – with religious fervor, no less – to spread the gospel.

MMT for dummies

But what exactly is MMT? Fortunately, a new best-selling book, The Deficit Myth (2020), provides a clear exegesis. Its author, Stephanie Kelton, also happens to be MMT’s most mediagenic expert. Her words – both in print and person – have the arc of well-thrown darts.

She also has deep experience in Washington (which she recalls with less than flattering observations). When Bernie Sanders ran for the Democratic nomination, Kelton became his chief economic adviser. Before that, she served as chief economist on the Senate Budget Committee. Her work builds on a theory that began to take shape in the 1990s when academics began publishing new research that challenged traditional thinking.

Kelton’s first chapter gets right to the point and – as if to lean in conspiratorially – reveals its central doctrine:

“The truth is the federal government is nothing like a household or a private business. That’s because Uncle Sam has something the rest of us don’t – the power to issue the US dollar. Uncle Sam doesn’t need to come up with dollars before he can spend…Uncle Sam will never go broke. When governments try to manage their budgets like households, they miss out on the opportunity to harness the power of their sovereign currencies to substantially improve life for their people.”

At its core, MMT argues that almost everyone has the economy backward. Conventional wisdom holds that government and household budgets are alike. Governments tax in order to fund their expenditures, in the same way that households have income and spending.

MMT refutes this. Households are “currency users” that must earn money before spending it. Governments, at least those that control their own money, are “currency issuers.” The government then, which is the source of all dollars, spends first and taxes later. When it funds programs, it literally spends money into existence, injecting cash into the economy. The order of operations is key: Government spending comes before tax and borrowing, not after.

Got all that? Good. Because it is a crucial point. What follows is that the usual fears about the federal government being able to repay national debts aren’t important. Instead, the constraint on government spending is inflation. We will know government spending has gone too far when prices start rising too much. The real limit, MMTers argue, is the capacity of the economy – employees, materials and so on.

There is much more to MMT. For example, Kelton proposes a federal jobs-guarantee program that would function as an automatic stabilizer. When the economy tanks, more people enter the program, and spending increases. When the economy improves, people move on to better jobs in the private sector and spending shrinks.

Crucially, she also urges the demotion of monetary policy. “The best they can do to promote employment is to try to establish financial conditions that will give rise to borrowing or spending,” Kelton says. Instead, we should “elevate fiscal policy as the primary tool for macroeconomic stabilization” (if that wasn’t clear already).

If your jaw has not already dropped to the floor on all this, stay with us (and, hey, don’t shoot the messenger). The basic assumption of MMT is seductively simple: governments should not budget like households because they can simply create their own money.

What follows is that currency-issuing governments could spend as much as they need to provide full employment and other social goods. After all, the federal government never “runs out” of money. Kelton pokes fun at all the government theatrics about budget constraints and fiscal cliffs, which she says are used to justify defunding social programs.

What’s more, Kelton argues that the U.S. economy has operated most of the time, if not always, below potential output. Chronic excess capacity implies that we can, and should, imagine an entirely new approach to fiscal spending.

This is next level thinking. A free lunch awaits if the economy has un-tapped resources that could raise aggregate demand. The policy potential is near limitless. Kelton imagines a lofty and near-utopian world where millions of people have access to improved healthcare, advanced education, better pensions, and world-beating infrastructure.

Next time: MMT and the new realities – investment implications for an untested theory.

Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s Aug. 31 edition of “Ask Forstrong,” available on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

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