Mar 18, 2019

5 Problems with MMT

These Are the Biggest Weaknesses of Modern Monetary Theory
Patrick Horan Program Manager

“Modern Monetary Theory” (or MMT) is a new approach to monetary policy that advocates argue justifies massive government spending programs, including “Medicare for All” and the “Green New Deal.”

But what is MMT, exactly?

The core proposition of MMT is that a government that issues its own currency can always fund itself with that currency. Therefore, a government does not need to worry about accumulating large debts. The only potential downside is that government spending could lead to higher inflation.

While MMT proponents are technically correct that a government with its own currency can print money to pay its bills, that isn’t the end of the story. In our recent Mercatus policy brief, Scott Sumner and I criticize the stronger claims of MMT and identify five major weaknesses with the idea.

1. MMT has a flawed model of inflation that overestimates the importance of economic slack.

MMT argues that “slack,” the amount of resources not being used at a given time, is what determines inflation. This is partly based on an economic model called the Phillips Curve, which argued there is a tradeoff between inflation and unemployment (more of one will lead to less of the other). However, simultaneously high inflation and unemployment in the 1970s showed that this model was flawed. Rather, it is monetary policy, not slack, that determines the path of inflation.

2. It overestimates the revenue that can be earned from money creation.

A government can earn revenue from printing money if the cost of printing is less than its value. For example, if a $100 bill costs roughly six cents to print, then it yields a $99.94 profit. However, assuming the government does not pay interest on that money, it will be quickly spent by the public. The result is high inflation for not much added revenue. In fact, one study found that the maximum sustainable amount of revenue from money creation is roughly four percent of GDP, which would generate annual inflation at 266 percent!

3. It overestimates the potency of fiscal policy while underestimating the effectiveness of monetary policy.

MMT argues fiscal policy is more important than monetary policy in determining inflation, so raising taxes is the solution to high inflation. However, this is not the experience of the United States. In the 1960s, President Lyndon Johnson followed this logic by raising taxes and balancing the budget, but high inflation persisted. In fact, inflation only fell in the early 1980s when Fed Chair Paul Volcker reduced the growth of the money supply, despite high budget deficits under President Reagan during the same period.

The fiscal policy explanation for inflation is true in places like Venezuela and Zimbabwe, where the central bank’s monetary policy decisions are highly political. However, in these places, the government is so wasteful and irresponsible that monetary policy has to support fiscal policy.

4. It overestimates the ability of fiscal authorities to control inflation.

Politicians, who are charged with determining fiscal policy in most countries, adjust tax and expenditure policies in response to their constituents’ interests. How likely does it seem that Congress and the president would be likely to raise taxes during a period of high inflation when the public is already upset at rising prices? Not very likely, especially given the political gridlock in Washington, DC.

5. It contains too few safeguards against the risks of excessive public debt.

Debt that might look manageable in one economic environment may become unsustainable in another, as Greece learned during the Great Recession. While the United States is unlikely to default on its debt, high debt can cause other problems, including either higher taxation or higher inflation in the future. Either of these problems can stifle future growth and prosperity. Furthermore, while the US is not in danger of becoming like Greece in the near future, history tells us that circumstances change. If the US continues to accumulate massive amounts of debt, there is no guarantee we will always be able to easily pay it off.

Photo credit: Senate Democrats/Flickr

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