Modern Monetary Theory
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Modern Monetary Theory or Modern Money Theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly for a government and unemployment as the evidence that a currency monopolist is restricting the supply of the financial assets needed to pay taxes and satisfy savings desires. MMT is seen as an evolution of chartalism and is sometimes referred to as neo-chartalism.
MMT advocates argue that the government should use fiscal policy to achieve full employment, creating new money to fund government purchases. The primary risk once the economy reaches full employment is inflation, which can be addressed by raising taxes and issuing bonds, to remove excess money from the system. MMT is controversial, with active debate about its policy effectiveness and risks.
MMT states that a government that can create its own money, such as the United States:
- Cannot default on debt denominated in its own currency;
- Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
- Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilized at full employment;
- Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
- Does not need to compete with the private sector for scarce savings by issuing bonds.
These tenets challenge the mainstream economics view that government spending should be funded a priori by taxes and debt issuance. MMT asks in effect: "Why not create the money to buy what we think is important, and then raise taxes or issue bonds when we get inflation?"
The first four MMT tenets are not in conflict with mainstream economics in terms of how money creation is executed and inflation works. For example, as former Fed Chair Alan Greenspan said, "The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default." However, MMT disagrees with mainstream economics about the fifth tenet in terms of impact on interest rates.
MMT synthesizes ideas from the State Theory of Money of Georg Friedrich Knapp (also known as Chartalism) and Credit Theory of Money of Alfred Mitchell-Innes, the functional finance proposals of Abba Lerner, Hyman Minsky's views on the banking system and Wynne Godley's Sectoral balances approach.
Knapp, writing in 1905, argued that "money is a creature of law" rather than a commodity. Knapp contrasted his state theory of money with the Gold Standard view of "metallism", where the value of a unit of currency depends on the quantity of precious metal it contains or for which it may be exchanged. He argued that the state can create pure paper money and make it exchangeable by recognizing it as legal tender, with the criterion for the money of a state being "that which is accepted at the public pay offices."
The prevailing view of money was that it had evolved from systems of barter to become a medium of exchange because it represented a durable commodity which had some use value, but proponents of MMT such as Randall Wray and Mathew Forstater argue that more general statements appearing to support a chartalist view of tax-driven paper money appear in the earlier writings of many classical economists, including Adam Smith, Jean-Baptiste Say, J.S. Mill, Karl Marx, and William Stanley Jevons.
Alfred Mitchell-Innes, writing in 1914, argued that money exists not as a medium of exchange but as a standard of deferred payment, with government money being debt the government may reclaim through taxation. Innes argued:
Whenever a tax is imposed, each taxpayer becomes responsible for the redemption of a small part of the debt which the government has contracted by its issues of money, whether coins, certificates, notes, drafts on the treasury, or by whatever name this money is called. He has to acquire his portion of the debt from some holder of a coin or certificate or other form of government money, and present it to the Treasury in liquidation of his legal debt. He has to redeem or cancel that portion of the debt...The redemption of government debt by taxation is the basic law of coinage and of any issue of government ‘money’ in whatever form.— Alfred Mitchell-Innes, The Credit Theory of Money, The Banking Law Journal
Knapp and "chartalism" are referenced by John Maynard Keynes in the opening pages of his 1930 Treatise on Money and appear to have influenced Keynesian ideas on the role of the state in the economy.
By 1947, when Abba Lerner wrote his article Money as a Creature of the State, economists had largely abandoned the idea that the value of money was closely linked to gold. Lerner argued that responsibility for avoiding inflation and depressions lay with the state because of its ability to create or tax away money.
Economists Warren Mosler, L. Randall Wray, Stephanie Kelton, Bill Mitchell and Pavlina R. Tcherneva are largely responsible for reviving the idea of chartalism as an explanation of money creation; Wray refers to this revived formulation as Neo-Chartalism.
Bill Mitchell, Professor of Economics and Director of the Centre of Full Employment and Equity or CofFEE, at the University of Newcastle, New South Wales, refers to an increasing related theoretical work as Modern Monetary Theory.
Scott Fullwiler has added detailed technical analysis of the banking and monetary systems.
Rodger Malcolm Mitchell's book Free Money (1996) describes in layman's terms the essence of chartalism.
Some contemporary proponents, such as Wray, label chartalism within post-Keynesian economics, while chartalism has been proposed as an alternative or complementary theory to monetary circuit theory, both being forms of endogenous money, i.e., money created within the economy, as by government deficit spending or bank lending, rather than from outside, as by gold. In the complementary view, chartalism explains the "vertical" (government-to-private and vice versa) interactions, while circuit theory is a model of the "horizontal" (private-to-private) interactions.
Hyman Minsky seemed to favor a chartalist approach to understanding money creation in his Stabilizing an Unstable Economy, while Basil Moore, in his book Horizontalists and Verticalists, lists the differences between bank money and state money.
In February 2019, the first academic textbook based on the theory was published.
In sovereign financial systems, banks can create money but these "horizontal" transactions do not increase net financial assets as assets are offset by liabilities. According to MMT adherents, "The balance sheet of the government does not include any domestic monetary instrument on its asset side; it owns no money. All monetary instruments issued by the government are on its liability side and are created and destroyed with spending and taxing/bond offerings, respectively." In MMT, "vertical money" enters circulation through government spending. Taxation and its legal tender enable power to discharge debt and establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that must be met. In addition, fines, fees and licenses create demand for the currency. This can be a currency issued by the domestic government, or a foreign currency. An ongoing tax obligation, in concert with private confidence and acceptance of the currency, maintains its value. Because the government can issue its own currency at will, MMT maintains that the level of taxation relative to government spending (the government's deficit spending or budget surplus) is in reality a policy tool that regulates inflation and unemployment, and not a means of funding the government's activities by itself. The approach of MMT typically reverses theories of governmental austerity. The policy implications of the two are likewise typically opposed.
MMT labels any transactions between the government, or public sector, and the non-government, or private sector, as a "vertical transaction". The government sector is considered to include the treasury and the central bank. The non-government sector includes domestic and foreign private individuals and firms (including the private banking system) and foreign buyers and sellers of the currency.
Interaction between government and the banking sectorEdit
MMT is based on an account of the "operational realities" of interactions between the government and its central bank, and the commercial banking sector, with proponents like Scott Fullwiler arguing that understanding reserve accounting is critical to understanding monetary policy options.
A sovereign government typically has an operating account with the country's central bank. From this account, the government can spend and also receive taxes and other inflows. Each commercial bank also has an account with the central bank, by means of which it manages its reserves (that is, the amount of available short-term money that it holds).
When the government spends money, the treasury debits its operating account at the central bank, and deposits this money into private bank accounts (and hence into the commercial banking system). This money adds to the total deposits in the commercial bank sector. Taxation works exactly in reverse; private bank accounts are debited, and hence deposits in the commercial banking sector fall.
Government bonds and interest rate maintenanceEdit
Virtually all central banks set an interest rate target, and conduct open market operations to ensure base interest rates remain at that target level. According to MMT, the issuing of government bonds is best understood as an operation to offset government spending rather than a requirement to finance it.
In most countries, commercial banks’ reserve accounts with the central bank must have a positive balance at the end of every day; in some countries, the amount is specifically set as a proportion of the liabilities a bank has (i.e. its customer deposits). This is known as a reserve requirement. At the end of every day, a commercial bank will have to examine the status of their reserve accounts. Those that are in deficit have the option of borrowing the required funds from the central bank, where they may be charged a lending rate (sometimes known as a discount rate) on the amount they borrow. On the other hand, the banks that have excess reserves can simply leave them with the central bank and earn a support rate from the central bank. Some countries, such as Japan, have a support rate of zero.
Banks with more reserves than they need will be willing to lend to banks with a reserve shortage on the interbank lending market. The surplus banks will want to earn a higher rate than the support rate that the central bank pays on reserves; whereas the deficit banks will want to pay a lower interest rate than the discount rate the central bank charges for borrowing. Thus they will lend to each other until each bank has reached their reserve requirement. In a balanced system, where there are just enough total reserves for all the banks to meet requirements, the short-term interbank lending rate will be in between the support rate and the discount rate.
Under an MMT framework where government spending injects new reserves into the commercial banking system, and taxes withdraw it from the banking system, government activity would have an instant effect on interbank lending. If on a particular day, the government spends more than it taxes, reserves have been added to the banking system (see vertical transactions). This will typically lead to a system-wide surplus of reserves, with competition between banks seeking to lend their excess reserves forcing the short-term interest rate down to the support rate (or alternately, to zero if a support rate is not in place). At this point banks will simply keep their reserve surplus with their central bank and earn the support rate.
The alternate case is where the government receives more taxes on a particular day than it spends. In this case, there may be a system-wide deficit of reserves. As a result, surplus funds will be in demand on the interbank market, and thus the short-term interest rate will rise towards the discount rate. Thus, if the central bank wants to maintain a target interest rate somewhere between the support rate and the discount rate, it must manage the liquidity in the system to ensure that there is the correct amount of reserves in the banking system.
Central banks manage this by buying and selling government bonds on the open market. On a day where there are excess reserves in the banking system, the central bank sells bonds and therefore removes reserves from the banking system, as private individuals pay for the bonds. On a day where there are not enough reserves in the system, the central bank buys government bonds from the private sector, and therefore adds reserves to the banking system.
It is important to note that the central bank buys bonds by simply creating money—it is not financed in any way. It is a net injection of reserves into the banking system. If a central bank is to maintain a target interest rate, then it must necessarily buy and sell government bonds on the open market in order to maintain the correct amount of reserves in the system.
MMT and quantitative easingEdit
Proponents of MMT claim that it provides a better framework for understanding quantitative easing (QE) than the traditional textbook money multiplier model. Paul Sheard argues that, when the central bank purchases government debt securities as opposed to private sector risk assets, QE is best viewed as a debt refinancing operation of the consolidated government. MMT emphasizes that governments create central bank reserves when they run budget deficits and expunge those reserves when they issue debt securities. Sheard argues that QE can be seen as the third stage in this process, turning the government debt securities back into reserves. The unwinding of QE just reverses this yet again.
MMT economists describe any transactions within the private sector as "horizontal" transactions, including the expansion of the broad money supply through the extension of credit by banks.
MMT economists regard the concept of the money multiplier, where a bank is completely constrained in lending through the deposits it holds and its capital requirement, as misleading. Rather than being a practical limitation on lending, the cost of borrowing funds from the interbank market (or the central bank) represents a profitability consideration when the private bank lends in excess of its reserve and/or capital requirements (see interaction between government and the banking sector).
According to MMT, bank credit should be regarded as a "leverage" of the monetary base and should not be regarded as increasing the net financial assets held by an economy: only the government or central bank is able to issue high-powered money with no corresponding liability. Stephanie Kelton argues that bank money is generally accepted in settlement of debt and taxes because of state guarantees, but that state-issued high-powered money sits atop a "hierarchy of money".
Imports and exportsEdit
MMT proponents such as Warren Mosler argue that trade deficits need not be unsustainable and are beneficial to the standard of living in the short run. Imports are an economic benefit to the importing nation because they provide the nation with real goods it can consume, that it otherwise would not have had. Exports, on the other hand, are an economic cost to the exporting nation because it is losing real goods that it could have consumed. Currency transferred to foreign ownership, however, represents a future claim over goods of that nation.
Cheap imports may also cause the failure of local firms providing similar goods at higher prices, and hence unemployment but MMT commentators label that consideration as a subjective value-based one, rather than an economic-based one: it is up to a nation to decide whether it values the benefit of cheaper imports more than it values employment in a particular industry. Similarly a nation overly dependent on imports may face a supply shock if the exchange rate drops significantly, though central banks can and do trade on the FX markets to avoid sharp shocks to the exchange rate.
Foreign sector and governmentEdit
MMT argues that as long as there is a demand for the issuer's currency, whether the bond holder is foreign or not, governments can never be insolvent when the debt obligations are in their own currency; this is because the government is not constrained in creating its own currency (although the bond holder may affect the exchange rate by converting to local currency).
MMT does agree with mainstream economics, that debt denominated in a foreign currency certainly is a fiscal risk to governments, since the indebted government cannot create foreign currency. In this case the only way the government can sustainably repay its foreign debt is to ensure that its currency is continually and highly demanded by foreigners over the period that it wishes to repay the debt – an exchange rate collapse would potentially multiply the debt many times over asymptotically, making it impossible to repay. In that case, the government can default, or attempt to shift to an export-led strategy or raise interest rates to attract foreign investment in the currency. Either one has a negative effect on the economy.
Economist Stephanie Kelton explained several policy claims made by MMT in March 2019:
- Under MMT, fiscal policy (i.e., government taxing and spending decisions) is the primary means of achieving full employment, establishing the budget deficit at the level necessary to reach that goal. In mainstream economics, monetary policy (i.e., central bank adjustment of interest rates and its balance sheet) is the primary mechanism, assuming there is some interest rate low enough to achieve full employment. Kelton claims that cutting interest rates is ineffective in a slump, because businesses expecting weak profits and few customers will not invest at even very low interest rates.
- Government interest expenses are proportional to interest rates, so raising rates is a form of stimulus (it increases the budget deficit and injects money into the private sector, other things equal), while cutting rates is a form of austerity.
- Achieving full employment can be administered via a federally funded job guarantee, which acts as an automatic stabilizer. When private sector jobs are plentiful, the government spending on guaranteed jobs is lower, and vice versa.
- Under MMT, expansionary fiscal policy (i.e., money creation to fund purchases) can increase bank reserves, which can lower interest rates. In mainstream economics, expansionary fiscal policy (i.e., debt issuance and spending) can result in higher interest rates, crowding out economic activity.
Economist John T. Harvey explained several of the premises of MMT and their policy implications in March 2019:
- The private sector treats labor as a cost to be minimized, so it cannot be expected to achieve full employment without government creating jobs as well, such as through a job guarantee.
- The public sector's deficit is the private sector's surplus and vice-versa, by accounting identity, a reason why private sector debt increased during the Clinton-era budget surpluses.
- Idle resources (mainly labor) can be activated by money creation. Not acting to do so is immoral.
- Demand can be insensitive to interest rate changes, so a key mainstream assumption, that lower interest rates lead to higher demand, is questionable.
- When the economy is below full employment, there is a "free lunch" in creating money to fund government expenditure to achieve full employment. Unemployment is a burden; full employment is not.
- Creating money alone does not cause inflation; spending it when the economy is at or above full employment can.
MMT claims that the word "borrowing" is a misnomer when it comes to a sovereign government's fiscal operations, because what the government is doing is accepting back its own IOUs, and nobody can borrow back their own debt instruments. Sovereign government goes into debt by issuing its own liabilities that are financial wealth to the private sector. "Private debt is debt, but government debt is financial wealth to the private sector."
In this theory, sovereign government is not financially constrained in its ability to spend; it is argued that the government can afford to buy anything that is for sale in currency that it issues (there may be political constraints, like a debt ceiling law). The only constraint is that excessive spending by any sector of the economy (whether households, firms, or public) could cause inflationary pressures.
MMT economists advocate a government-funded job guarantee scheme to eliminate involuntary unemployment. Proponents argue that this can be consistent with price stability as it targets unemployment directly rather than attempting to increase private sector job creation indirectly through a much larger economic stimulus, and maintains a "buffer stock" of labor that can readily switch to the private sector when jobs become available. A job guarantee program could also be considered an automatic stabilizer to the economy, expanding when private sector activity cools down and shrinking in size when private sector activity heats up.
Comparison of MMT with mainstream Keynesian economicsEdit
|Funding government spending||Advocates taxation and issuing bonds (debt) as preferred methods for funding government spending.||Advocates creating new money; emphasizes that taxation and debt issuance are not required to fund spending.|
|Purpose of taxation||Fund government spending and address inequality.||Prevent inflation, by taking money away from private sector, a form of austerity; and address inequality.|
|Achieving full employment||Main strategy uses monetary policy; Fed has "dual mandate" of maximum employment and stable prices, but these goals are not always compatible. For example, much higher interest rates used to reduce inflation also caused high unemployment in the early 1980's.||Main strategy uses fiscal policy; running a budget deficit large enough to achieve full employment. Economist Paul Krugman explained that expansionary fiscal policy may be required to achieve full employment when monetary policy is constrained by the zero lower bound on interest rates, but isn't required while the Fed has room to lower interest rates.|
|Inflation control||Driven by monetary policy; Fed sets interest rates consistent with a stable price level, sometimes setting a target inflation rate.||Driven by fiscal policy; government increases taxes or issues bonds to remove money from private sector|
|Setting interest rates||Managed by Fed to achieve "dual mandate" of maximum employment and stable prices.||Creating money increases supply of bank reserves, which lowers interest rates to "near-zero", as explained by economist Stephanie Kelton. Krugman claimed MMT does not have a compelling argument for this mechanism.|
|Budget deficit impact on interest rates||At full employment, higher budget deficit can crowd-out investment.||Creating new money can drive down interest rates, encouraging investment and thus "crowding-in" economic activity, as explained by economist Stephanie Kelton. Krugman claimed MMT does not have a compelling argument for this mechanism.|
|Automatic stabilizers||Primary stabilizers are unemployment insurance and food stamps, which increase budget deficits in a downturn.||In addition to the other stabilizers, a job guarantee would increase deficits in a downturn.|
A 2019 survey of leading economists showed a unanimous rejection of assertions attributed to modern monetary theory in the survey: "Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt. [...] Countries that borrow in their own currency can finance as much real government spending as they want by creating money". Directly responding to the survey, MMT economist William K. Black said "MMT scholars do not make or support either claim". Multiple MMT academics regard the attribution of these claims as a smear.
The post-Keynesian economist Thomas Palley argues that MMT is largely a restatement of elementary Keynesian economics, but prone to "over-simplistic analysis" and understating the risks of its policy implications. Palley denies the MMT claim that standard Keynesian analysis does not fully capture the accounting identities and financial restraints on a government that can issue its own money. He argues that these insights are well captured by standard Keynesian stock-flow consistent IS-LM models, and have been well understood by Keynesian economists for decades. He also criticizes MMT for essentially assuming away the problem of fiscal - monetary conflict. In Palley's view the policies proposed by MMT proponents would cause serious financial instability in an open economy with flexible exchange rates, while using fixed exchange rates would restore hard financial constraints on the government and "undermines MMT’s main claim about sovereign money freeing governments from standard market disciplines and financial constraints". He also argues that MMT lacks a plausible theory of inflation, particularly in the context of full employment in the employer of last resort policy first proposed by Hyman Minsky and advocated by Bill Mitchell and other MMT theorists; of a lack of appreciation of the financial instability that could be caused by permanently zero interest rates; and of overstating the importance of government created money. Palley concludes that MMT provides no new insights about monetary theory, while making unsubstantiated claims about macroeconomic policy, and that MMT has only received attention recently due to it being a "policy polemic for depressed times".
Marc Lavoie argues that whilst the neochartalist argument is "essentially correct", many of its counter-intuitive claims depend on a "confusing" and "fictitious" consolidation of government and central banking operations.
New Keynesian economist and Nobel laureate Paul Krugman argues that MMT goes too far in its support for government budget deficits and ignores the inflationary implications of maintaining budget deficits when the economy is growing. Krugman described MMT devotees engage in "calvinball", which is a game in the comic strip "Calvin and Hobbes" where the players may change the rules at whim. Austrian School economist Robert P. Murphy states that MMT is "dead wrong" and that "the MMT worldview doesn't live up to its promises." He observes that the MMT claim that cutting government deficits erodes private saving is true "only for the portion of private saving that is not invested" and argues that the national accounting identities used to explain this aspect of MMT could equally be used to support arguments that government deficits "crowd out" private sector investment.
The chartalist view of money itself, and the MMT emphasis on the importance of taxes in driving money is also a source of criticism. Economist Eladio Febrero argues that modern money draws its value from its ability to cancel (private) bank debt, particularly as legal tender, rather than to pay government taxes.
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