16 Apr 2019
Article | 05 April 2019 | Sebastian Mackay, Fund Manager, Multi Asset
Most mainstream economists have been quick to dismiss Modern Monetary Theory (MMT) but with interest rates close to zero in much of the developed world, policymakers will need to move beyond the existing toolkit in the next recession. Monetary financed fiscal expansion may be one of the only effective options available.
The key principle of MMT is that a government’s budget is fundamentally different to that of a household because a government will never run out of currency. The central bank is the monopoly supplier of currency that is needed by households and companies to pay their tax liabilities. As a result, government spending is not constrained by taxes or government debt; a government can spend what it needs to, and the central bank will ‘print’ enough currency to pay its bills.
Proponents argue that a government should spend enough to ensure full employment and that, instead of worrying about deficits and debt, we should be concerned that underspending by a government is creating idle resources and unnecessary unemployment.
MMT would entail a radical change in the institutional framework that most developed economies have adopted over the last forty years, including independent central banks focussed on targeting inflation. But, before we throw up our hands in horror, it’s worth remembering that the current set-up has presided over the most severe financial crisis and deepest recession since the 1930s.
At the same time, the monetary policy-focussed response has resulted in a significant disparity between rampant asset price inflation and depressed real income growth. Moreover, private sector debt remains as high as on the eve of the Global Financial Crisis. Perhaps it is time to think again about the macroeconomic policy framework.
Monetary alternatives to traditional policy that have been considered (and in some cases implemented) in the past include quantitative easing, guiding down future interest rate expectations and a ‘helicopter drop’ of money. The latter might entail a broad-based tax cut financed by central bank money printing and shares some characteristics with MMT.
Both are financed by central bank money creation but a critical difference is that while the beneficiaries of a helicopter drop might choose to save some or all of their additional post-tax income, MMT involves the government spending whatever is necessary to achieve full employment.
The experience of the last ten years suggests that monetary policy alone is just not adequate to deal with a balance sheet recession. If the relief in interest costs from lower rates is insufficient to restore private sector balance sheets to health, then private sector deleveraging and growth are mutually exclusive.
The government needs to take the other side of private sector retrenchment to sustain growth. MMT provides a framework for thinking about how fiscal policy can be used to jolt an economy out of a post balance sheet recession equilibrium of low growth and inflation.
A common objection to MMT is that it will crowd out the private sector by using scarce resources and by pushing up interest rates. MMT proponents contest both these points. If government spending were directed towards infrastructure that would increase the supply capacity of the economy, creating room for stronger private growth. With respect to interest rates, MMT argues forcefully that they would fall not rise in response to monetary financed government spending because there is an increase in the money supply. Indeed, bond issuance may be necessary to prevent interest rates falling to zero!
Another popular concern is that because MMT involves an increase in the money supply, it would be inflationary, but a feature of balance sheet recessions is a collapse in the velocity at which money circulates around the economy. As a result, monetary financed government spending would simply be offsetting the overwhelmingly disinflationary force of private sector deleveraging.
There are some unanswered questions about MMT, perhaps the most critical being whether it could work outside the United States, in countries without reserve currency status. However, limited monetary policy options and evidence that monetary policy alone is insufficient in a balance sheet recession means that policymakers are likely to seriously consider monetary-financed government spending in the next recession.
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