Modern Monetary Theory: too good to be true
As a result of the pandemic, global budget deficits and fiscal stimulus programs have been rising sharply. Modern Monetary Theory (MMT) is controversial in the debate on the financing of this fiscal stimulus. According to MMT, fiscal policy is central as a policy instrument, while monetary policy serves only to finance budget deficits. However, MMT is also often used to create the illusion that there are actually no hard budget constraints. After all, central banks can finance all sorts of projects through the money printing press. However, entrusting a significant part of budgetary financing to the central bank creates a huge moral hazard problem for fiscal authorities. In practice, this will inevitably lead to run-away inflation. After all, also in the world of MMT, there is no such thing as a free lunch, and we still have to make political choices about how to distribute scarce economic resources.
There are a large number of economic challenges at the moment, such as the recovery from the pandemic, the climate transition and managing the budgetary costs of ageing. All of which present a difficult balancing act for public finances. In the debate on affordability and possible forms of financing, Modern Monetary Theory (MMT) has occupied a controversial place for several years (see also the KBC Economic Opinion “The seductive utopia of ‘Modern Monetary Theory’” of 21 June 2019).
Monetary policy sidelined
Fiscal policy is the all-important policy instrument in MMT’s thinking. The fiscal balance is the central policy instrument for stabilizing the business cycle around an unemployment rate target. The necessary budget balance is, as it were, a direct derivative of that labour market target. The central bank’s task in this respect is solely to (fully) finance any deficits by creating money, more specifically by creating what is known as base money (mainly reserves held by commercial banks in their accounts at the central bank). In theory, the central bank has no formal limits on such money creation. MMT concludes from this that budget deficits and government debts do not matter as long as they are expressed in the country’s own currency. This means that a government that issues its own currency can formally always repay its debts in that currency. The purchasing power of this repayment is, of course, another question. After all, there is a risk that inflation will rise sharply as a result of unbridled money creation.
To keep inflation under control, MMT proposes to take excess liquidity out of circulation by means of extra taxes, which reduce the budget deficit and thus, at least in the MMT world, automatically also the growth of base money. The reason is that the central bank has to create less base money (or can even shrink it in case of a budget surplus). Besides a tax increase, issuing bonds to private investors is a second option.
A critical look at MMT
The most important feature of MMT for economic policy is that the central bank no longer pursues an independent monetary policy, but has literally become a department of the Ministry of Finance, with the sole mission of financing the fiscal balance in a quasi-mechanical manner. The loss of the monetary policy instrument has an economic cost. When the government pursues two (or more) separate policy objectives, such as full employment and price stability, it also needs in principle two (or more) independent policy instruments (the so-called Tinbergen principle). If monetary policy is eliminated as a policy instrument, the government is severely constrained in being able to achieve its macroeconomic objectives simultaneously.
A second fundamental concern is that MMT attributes the role of pursuing price stability to fiscal policy, since the budget balance translates mechanically and almost immediately into the growth rate of base money, and through that channel, according to MMT, also into inflation. However, this very monetarist approach is not supported by the practical experience of most central banks in recent decades. The link between base money growth and short-term inflation is empirically weak and far from stable. Among other things, the complex process of credit provision by the financial sector distorts this link. The global experience following the financial crisis from 2008 on testifies to this. It is precisely because of this weak link that all major central banks have long since shifted to pragmatic ‘inflation targeting’, with a whole range of macroeconomic indicators in addition to base money growth as the guiding principle, and policy rates as the main conventional policy instrument. MMT’s recipe for pursuing price stability would thus almost certainly be doomed to failure.
Moreover, it is far from certain that the Minister of Finance will want to ensure price stability, even if he or she would be able to do so. Monetary financing of public expenditure creates an enormous ‘moral hazard’ problem for governments. In the short term, the government can avoid making necessary policy choices, because the financing by the central bank is always assured anyway. This temptation would certainly be strong at present, given the still moderate inflation forecasts. The risks would not diminish as a result, but only materialise in the longer term. A short-sighted government can therefore ignore them for a while. Which minister, just before an election, would raise taxes to mitigate longer-term inflation risks? The experience of the UK before 1997, when the Chancellor of the Exchequer ceded to the Bank of England the right to set policy rates, illustrates this problem.
However, elected politicians’ preference for (higher) inflation leads to second-best macroeconomic outcomes. Indeed, investors are aware of the danger of a politically tolerated inflationary surge and are therefore too cautious in their current investment decisions. Precisely for this reason, an academic consensus has developed since the 1970s that the credible pursuit of price stability is best entrusted to an independent authority (see Kydland and Prescott (1977)). Certainty about future price stability improves the overall investment climate.
Finally, there is the argument of the fairness and efficiency of the collection of taxes by the government. Money creation as the standard form of financing the government budget is an arbitrary and, above all, non-transparent way of levying taxes, without any parliamentary debate. Such an inflation tax mainly affects population groups that can least protect themselves against the loss of value of money. These are also often the vulnerable groups in society.
Not a good idea
On balance, then, MMT is neither theoretically nor practically an attractive policy option. Nonetheless, the academic debate on this issue will undoubtedly continue for some time. After all, we are currently living in a period of a paradigm shifts with regard to the role of fiscal policy. The role of monetary policy should be an integral part of that debate.