The seductive utopia of Modern Monetary Theory
Modern Monetary Theory (MMT) is a controversial topic in the
economic-political debate. In essence, it is a discussion within the
Keynesian school of thought about the specific role of monetary and
fiscal policy. MMT focuses on fiscal policy as the main policy
instrument, while monetary policy serves to finance deficits.
However, MMT is also often used to create the illusion that there
are actually no hard budgetary constraints. After all, central banks
can finance all kinds of projects through the money printing press.
The icing on the cake is that this could even be possible without
derailing inflation. However, entrusting a significant part of
financing fiscal policy to the central bank creates a huge moral
hazard problem for fiscal authorities. In practice, this will
inevitably lead to derailing inflation. After all, even in the world
of MMT, there is no ‘free lunch’ and we still have to make political
choices about how scarce economic resources should be allocated.
There are currently a number of ongoing public discussions on policy
proposals that could sometimes have large budgetary implications. One
example is the international climate debate. There is also the
proposal for a ‘Green New Deal’ by the US Representative
Ocasio-Cortez, which includes a number of far-reaching social and
climate-friendly measures. Of course, this raises the question how
these plans could be financed if they were to be approved.
Some supporters of such policies rely explicitly on central banks
for such financing. In support of this line of thought, reference is
made to the so-called ‘Modern Monetary Theory’ (MMT). In itself, this
framework is not new, but the proposals to implement its
recommendations in practice are more recent. The principles of MMT go
back to the so-called ‘chartalism’ of the beginning of the twentieth
century. In short, it is a forerunner of the concept of fiat money. In
this view, money has no intrinsic value, but derives it from the fact
that it is a legal tender and that it is necessary to pay taxes owed
to the government. Money is by definition a short-term debt of the
government, and the central bank, as part of that government, can, in
theory, issue such securities without limits. This also means that a
government with its own currency can always formally repay its debts
in that currency if it so wishes. The purchasing power of this
repayment is, of course, another matter.
What role should monetary policy play ?
The academic debate on MMT mainly focuses on the interrelationship
between fiscal and monetary policy. Following the experience of
inflation in the 1970s, there was a broad consensus in most developed
countries that the central bank should be independent and, first and
foremost, ensure price stability (i.e. low and stable inflation). As
long as price stability is assured, monetary policy has room to help
stabilise the business cycle. The US central bank is to some extent an
exception because of its dual mandate of price stability and maximum
sustainable employment (together with moderate long-term interest
In general, therefore, business cycle stabilisation was mainly left
to fiscal policy. Any budget deficits should be financed through bonds
or loans and not through central banks, because sooner or later, this
would inevitably jeopardise the desired price stability.
However, the necessary consolidation of public debt increasingly
constrained the fiscal policy instrument. As a result, its role as a
business cycle stabiliser increasingly transferred to the central
banks. For example, the ECB had to bear a large part of the burden of
the Great Recession and even of the sovereign debt crisis from 2010
onwards. Figure 1 illustrates that the ECB was forced to exceed by far
the once sacred boundary between monetary and fiscal policy. The fact
that the ECB is the central bank of many (fiscally) sovereign Member
States makes this evolution even more complex and controversial.
Figure 1 - Blurred separation between monetary and fiscal policy (public debt held by ECB, in % of outstanding debt, end of 2018)
In the academic debate between, for example, Keynesians Stephanie
Kelton (advocate) and Paul Krugman (critic), MMT pushes this trend to
its extreme. In MMT, the budget balance is the central policy
instrument used to stabilise the business cycle around an unemployment
rate target. The actual budget balance mechanically derives from this.
The task of monetary policy is then to finance any deficits that may
occur. In MMT, budget deficits as such are irrelevant as long as the
country issues its own currency (see above) and inflation does not
rise excessively as a result. In order to keep inflation under
control, MMT proposes to remove any excess liquidity from the economy
by means of additional taxes or bond issuance.
No one disputes the fact that monetarily financed public expenditure
can stimulate economic growth, especially when there is still unused
production capacity. In 2003, for example, the then Fed governor and
later president Bernanke proposed that Japan should be able to tackle
its growth and deflation problems in extremis in exactly that way, on
a temporary basis. His message was that this is some kind of ultimate
However, it is dangerous to generalise such an emergency scenario.
It creates a huge moral hazard problem for governments. In the short
term, the fiscal authorities may avoid necessary policy choices, as
central bank financing is always secured. This temptation would now be
particularly strong due to the currently extremely low inflation
(expectations). The associated risks have not disappeared but will
only occur in the longer term. So a short-sighted government can chose
to ignore them for a while.
The experience of the 1970s also shows that the monitoring of price
stability should be entrusted to an independent authority. Which
politician will raise taxes (or issue bonds to slow down economic
growth) just before elections if inflation risks are building up?
Moreover, even with such political discipline, the process of levying
new taxes is likely to take far too long to allow for quick and
efficient reactions to price shocks.
Money creation is also an arbitrary and non-transparent form of
taxation. It particularly affects those parts of the population that
are least able to protect themselves against money slowly losing its
value. This is not a socially responsible policy.
The academic debate on MMT will undoubtedly continue for some time
to come. It questions economic taboos, but that doesn’t make it
nonsensical by definition. In practice, however, MMT would quickly hit
operational limits, almost certainly causing inflation to derail.
After all, history teaches us that the temptation of the money
printing press is too great.