-A A +A
July 11, 2019

Opinion: If you think governments allocate resources better than markets and massive increases in money supply can be non-inflationary, talk to a Venezuelan

Modern Monetary Theory (MMT), once a relatively obscure branch of macroeconomics, has recently gained star status. It is riding high in the popular press in the U.S. and has been endorsed by many in the left wing of the Democratic party as a way of financing massive spending programs such as the “Green New Deal” and “Medicare for All.” MMT holds that a country with its own currency doesn’t have to worry about accumulating government debt: it can always print money to service the interest on its debt and pay down the principal. If this seems like magical thinking, it’s probably because it is.

MMT’s basis is that fiscal policy is the key to achieving full employment, using the printing of money to finance government spending. (“Printing money” is a metaphor, of course: these days expansion of the money supply works via the creation of chartered bank deposits at the central bank.) According to the theory, inflation comes from total spending rising above the economy’s productive capacity. Any concern about government deficits is allayed by the fact that governments have a monopoly over their currency and can print all the money they need to pay off their debts. MMT supporters don’t worry that printing money will cause inflation: governments can adjust taxes to keep total spending just shy of productive capacity.

Let us count the ways this theory fails.

The advocates of MMT draw an analogy between the spending programs they favour and the original New Deal in the U.S. But while unemployment exceeded 25 per cent during the Great Depression, it is currently near its all-time lows. So spending on the Green New Deal would be less about new jobs for the unemployed and more about reallocating labour and capital from currently productive uses to uses government prefers. The U.S. economy would become a largely command economy, with direct government interference in many markets and, very likely, rationing and price controls.

MMT is wrong that inflation is related only to excess demand for total output. Financing spending by printing money expands the economy’s money stock. While the short-run relationship between money and total spending can be fairly loose, the long-run relationship is incontrovertible: a higher stock of money sooner or later means higher prices, even if taxes are fine-tuned to keep a lid on spending.

Nor can the money supply affect full-employment output, which in the long run is determined by market forces, including people’s willingness to work at different wage rates, that are beyond the control of the central bank — barring, that is, massive direct government interference in the functioning of markets (think the Soviet Union or Venezuela).

MMT also holds that deficits financed by printing money will keep interest rates low. The reasoning is that if the money supply increases relative to the demand for money, the cost of holding money (the short-term interest rate) must fall. Then, as long as economic growth exceeds the interest rate, the cost of servicing the debt has to go down as a fraction of GDP. But this view is also naive in the extreme. Nominal interest rates contain two components: the real rate of return and expected inflation. If massive increases in the money supply lead to expectations of high inflation — as they probably will, since most participants in financial markets don’t yet believe in MMT — nominal interest rates will rise, increasing the costs of servicing the government’s outstanding debt and potentially leading to a vicious circle in which higher debt servicing leads to printing more money, which leads to a higher cost of debt servicing, and so on.

Historical examples of large government deficits financed by printing money include the Weimar Republic in the 1920s, Hungary after the Second World War, and (more recently) Zimbabwe and Venezuela. Carried to extremes, money-printing leads to hyperinflation, as it did in these four cases. The counter-argument that those governments made the fatal but avoidable error of not soaking up enough money through taxation but “this time will be different” is similar to the argument that “true” socialism has never really been tried before, but this time will be different. No candidate for high office, either in Canada or the U.S., has been talking about the need to mop up excessive overall demand with higher taxes.

Finally, MMT assumes that the central bank and the government work together, with the bank agreeing to finance the government’s deficits via the use of the printing press. Central bank independence, widely thought to be a necessary prerequisite for sound money and the control of inflation, goes right out the window.

Bottom line? If you believe governments allocate resources more efficiently than markets and massive increases in the money supply can truly be non-inflationary, then MMT may be for you. But before signing on for good you should talk to a Venezuelan or Zimbabwean.

MMT will likely figure prominently in the debates leading up to the U.S. elections in 2020. As usual, it may only be a matter of time before this theory leaks north of the border and is used to justify ambitious new deficit-financed government programs. While it all sounds great in theory, the evidence both historical and present should give serious pause.

Steve Ambler is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute and professor of economics at the School of Management (École des sciences de la gestion), Université du Québec à Montréal.

Published in the National Post