Governments across the world have dramatically increased their spending in an effort to prevent economic collapse. So how will they pay for it all?
The traditional economic answer to that question is that governments should run large budget deficits, issue new debt today and service that debt over time as the economy rebounds.
That conventional view has come under attack by the proponents of so-called Modern Monetary Theory (MMT), whose most visible advocate is former Bernie Sanders adviser Stephanie Kelton.
The argument behind this theory is that, actually, we shouldn’t worry about budget deficits at all. In doing so, MMT makes two claims: one weak and one strong.
The weak claim is that a country that can issue debt denominated in its own currency, say dollars, can always finance a shortfall between its spending and its revenues. The central bank can, at the press of a button, create unlimited new dollars.
Because of this, a government can never fail to make payment on dollar-denominated liabilities. In this sense, there can never be a problem financing government deficits. In Kelton’s words, the deficit is a “myth”.
This is neither a new nor a controversial idea. It is well accepted by central bankers, treasury officials, academic economists, and other experts — even if it’s not well understood by various politicians and commentators who are all too quick to talk as if the government budget is just like a household budget. It is not.
But if this view is so well accepted, why don’t countries usually finance budget deficits this way?
The answer is because the strong claims of MMT do not follow from this weak claim. The important constraint facing a government is not how to cover liabilities denominated in its own currency. The important constraint is how to pay for real goods and services. After all, no one cares about currency for its own sake. They care about what they can buy with that currency.
In this sense, the real constraint is inflation. Indeed, the more sophisticated MMT proponents like Kelton agree with conventional economics on this point.
So the real question is: when and under what circumstances is a government likely to run into the inflation constraint?
Conventional economics offers a comprehensive analysis of the circumstances under which different monetary and fiscal policy settings and different economic shocks lead to inflation — or deflation for that matter.
Although policy makers all know that a country can never run out of its own currency, they nonetheless use conventional economic analysis to guide policy. That’s because the weak MMT claim is largely irrelevant for thinking about how to respond to a crisis.
By contrast, proponents of MMT don’t have much to say about when the inflation constraint will bind or what consequences follow if it does.
Some proponents of MMT suggest that the inflation constraint cannot bind if the economy is at substantially less than full employment, as it is right now. According to this view, absence of inflation is a sign the economy is below full capacity and the presence of inflation is a sign that it is hitting capacity.
But this simplistic thinking provides no guide as to how inflation interacts with the real economy when the economy is at less than full capacity. Can inflation bring down the real debt burdens of households and firms? Can inflation bring about changes in real wages even when nominal wages don’t change? And if so is that a good thing?
Perhaps more importantly, can inflation spiral out of control even when an economy is below capacity? Even well-functioning economies can experience large increases in inflation when there is a structural deterioration of underlying fiscal capacity (e.g capacity to raise taxes,
or to cut spending) — as in France in the early 1980s, New Zealand in the mid 1980s, and South Korea in the early 1990s.
All that said, inflation is not the problem we’re dealing with now. We are in the midst of what is likely to be the largest recession since the Great Depression.
With private demand weak and monetary policy options limited, the need for ongoing fiscal stimulus is very compelling. Alarmism about deficits and an embrace of austerity is counterproductive.
By focusing on the trivial issue of how a government mechanically supplies enough currency to cover liabilities denominated in its own currency, supporters of MMT do a profound disservice to their larger policy goals. If you believe in a “Green New Deal” or a larger social safety net, then those goals should be argued for on their own terms. They don’t suddenly become good ideas just because the government can print money.
Keynes didn’t need MMT to argue for fiscal stimulus in a severe recession. We don’t either.
Chris Edmond, Richard Holden and Bruce Preston are professors of economics at the University of Melbourne, UNSW Business School and the University of Melbourne, respectively.