A Simple Explanation of Modern Monetary Theory Inbox

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A Simple Explanation of Modern Monetary Theory Inbox

Economic theories are slow to change, adapt and evolve.  As new theories arrive, it is important to understand new developments and how they differ from established models.  As the government responded to the pandemic with unprecedented stimulus spending, we find ourselves amid a broadening economic experiment with Modern Monetary Theory or MMT.  The ideas are not widely accepted, but certain elements are happening now, and a growing number of policymakers are seeking to learn more.  What is MMT, and how is it different?

The fear of deficit spending 

Carrying out the legislative steps required to address the needs and priorities of the country takes money.  Too often, tax revenues do not cover approved expenses.  To bridge the gap, Congress turns to deficit financing, instructing the Treasury to raise funds in the capital markets.  Generally, both political parties seek to avoid or minimize deficit spending.  Both sides utilize the threat of deficits to impose limitations to proposed policies.  Many of our political differences stem from differing views on whether to cover these gaps with spending reductions or tax increases.

Modern Monetary Theory 

MMT offers a significant shift in perspective.  In the first case, MMT states that fiscal policy measures from Congress are more effective than monetary policy for steering, stabilizing, and managing the economy.  Even the Federal Reserve currently acknowledges limitations of the tools at its disposal.  Second, MMT seeks to dismiss the fear of deficit spending entirely.  Instead, MMT relies on limitations posed by inflation.  MMT would turn a scarcity mindset (fiscal policy limited by deficit spending) into an abundance mindset (fiscal policy limited by inflation), an easy sell after the low inflation over the last 40 years.

Following the $1.9 trillion American Rescue Plan passed in March 2021, Congress is about to begin discussions on an infrastructure bill of indeterminate size.  With inflation as the guardrails, MMT suggests that the primary consideration should be the proposed spending relative to the productive capacity in the U.S. economy needed to implement the bill.

Say the bill projects to spend $1 trillion on airports, roads, bridges, and other needed repairs.  Congress would gather the relevant data to tell them whether we have $1 trillion of available productive economic capacity (i.e., factory production, construction machinery, labor with appropriate skills, etc).    If capacity is determined to be $2 trillion, Congress should pass that bill and give zero thought to resulting deficits.  If capacity is $500 billion, Congress should approve less spending.

When inflation starts rising, incumbent theories require the central bank to raise interest rates to drain money from the financial system.  MMT has a different prescription: raise taxes.  Taxes directly withdraw money from the economy, placing responsibility for inflation-fighting in the hands of elected legislators.

In short, under MMT, government spending injects new reserves into the commercial banking system, and taxes withdraw reserves from the banking system.  The role of central banks is reduced primarily to buying and selling government bonds on the open market to manage liquidity and help fund any deficit financing.

Unanswered questions

MMT leaves several topics unaddressed or addresses them unsatisfactorily.

  • Does it matter if the central bank becomes the primary buyer of our country’s debt?
  • Would Congress be any more willing to raise taxes to head off inflation than the central bank would be to raise interest rates for the same purpose?
  • Who is responsible for calculating the unused economic capacity, a difficult task under the best circumstances?

States are often said to be the laboratories of democracy where innovative ideas and policies get tested before going national.  However, state governments neither issue currency nor do they engage in deficit spending, so the federal level is the only place to test the ideas behind MMT.  Our experiment has begun.

For the record, we don’t agree with the ideas behind MMT, but you can learn more about it here.

Disclosure: https://mitchcap.com/disclosure/

2021-04-09T10:21:38-05:00 April 9th, 2021|Economy, Fiscal Policy, Monetary Policy|0 Comments

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