A number of clients have recently asked us about Modern Monetary Theory (MMT). As an evolving theory, there are several different interpretations, but one of the overriding tenets is that a sovereign nation can’t default if it is issuing debt in its own currency and has a floating exchange rate. More specifically, it suggests that expansionary fiscal policy can be financed by monetary policy, thereby providing more options to achieve full employment.
It is quite a challenge to orthodox economic theory, as proponents of MMT believe that limits to government spending should not be constrained by budgets but by considering any resultant inflation. In turn, they believe that any inflation above acceptable levels can be managed by higher taxation.
Why is MMT being increasingly discussed? A lot has to do with the post-Great Financial Crisis (GFC) experience. From a policy perspective, there is a growing belief that current policy frameworks are failing: interest rates remain close to zero, growth is stalling in a number of major economies, inflationary pressures are far from evident globally and many are talking about the next round of QE. On that latter point, a leap to MMT, or something like it, is much less of a leap as policy makers have already made the philosophical jump to QE.
Furthermore, the sensitivity to higher levels of government debt has fallen over recent years. More governments are running higher levels of debt as a percentage of GDP when compared to pre-GFC levels, but without the usual side-effects, such as sovereign bond sell-offs, currency sell-offs and debt restructuring programmes; take the US, the UK and Japan, as significant examples. Indeed, bond vigilantes have been largely absent in their role of applying a market discipline to government debt levels. There is good reason for this: central banks have capped rates along the curve and thereby helped to limit the cost of debt. In short, there is less of a concern around debt sustainability, as material debt is more widespread, not isolated to a small number of ‘basket cases’, and central banks have their backs.
Let’s not forget that economics doesn’t operate in a vacuum though. Politics and society are also important contributors as to why MMT is rising in popularity. Populism and inequality are both applying pressure for new solutions, questioning the effectiveness of the widespread austerity programmes which have seen inequality broadly stagnate and government debt as a percentage of GDP rise in many cases. Indeed, a number of US Democrats have proposed a Green New Deal (GND), with a nod to Roosevelt’s “New Deal”, which was a response to the US depression in the 1930s. The GND is a radical stimulus proposal designed to address climate change and inequality, and has added to the interest in MMT, as it has been put forward as a way to fund the GND.
In short, there is good reason to question the validity of the current policy framework and look for something new. That said, there are some risks to MMT that should be mentioned. An obvious one is the rising risk of currency devaluations when printing money. Secondly, it seems to be exacerbating moral hazard, as well as reducing the independence of central banks. It’s also important to consider where it might be more relevant. For example, potentially less so in economies which are close to full employment and full capacity (say the US), versus economies that aren’t (say the Eurozone).
Importantly though, MMT doesn’t need to be embraced in its entirety to argue, for example, for increased public investment in infrastructure. Indeed, how the fiscal spend is generated is important but so is the investment target. For example, productive infrastructure versus “roads to nowhere”, or rather, making sure there are decent multiplier effects across the economy.
In some ways, MMT can be seen as a natural progression from QE but a big obstacle will be political, specifically the dominant narrative around austerity. Indeed, many policy makers have a preference for small governments, well captured by Ronald Reagan all the way back in the 1980s, when he said, “Government is not a solution to our problem; government is the problem”.
What does this all mean for us? Well, the “if or when” of MMT is not a material driver of our thinking currently but it is more evidence of the move towards more aggressive and experimental policy. We don’t believe that inequality and populism are going away anytime soon but we think it would take something like a recession, or a systemic threat to the financial system, to drive these types of policies up the political agenda.
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