Understanding Modern Monetary Theory (MMT)
By: Tony Yiu
Tags: Money, Editors Pick, Business, Economics, Popular

Photo by Erik Mclean on Unsplash

Understanding Modern Monetary Theory (MMT)

I hear a lot of MMT references on podcasts or randomly on finance Twitter. For the longest time I didn’t know what it was, but then I dug a bit into it and found that economic policy makers today are running financial markets with monetary policy that smells a lot like MMT.

What’s MMT?

MMT stands for Modern Monetary Policy and is a relatively new belief about how the economy and money work (and interact). Paraphrasing Wikipedia, the major tenets of MMT are:

Governments (that issue their own currency)

Can pay for stuff without needing to first tax their citizens or issue bonds. Can’t default on debt because they can print the currency needed to repay that debt. The only limit of printing and spending is inflation. Can manage inflation via changing tax rates. Government debt does not impact the supply of private savings and the ability of the private sector to access those savings.

What Are The Implications Of MMT’s Tenets?

The first four sound a lot like a rationalization of post 2008 monetary policy. Quantitative Easing (QE) is often referred to as money printing because it sort of is. Central banks engaging in QE create money (by recording a liability on their balance sheet) and use that money to buy bonds from banks.

You can think of the bonds as an investment that banks are happy to sit on because they earn interest. However, once those bonds have been replaced with cash (since the Fed buys up the bonds and effectively locks them away), two things happen:

First, the supply of safe investments like bonds goes down, so bond prices go up and bond yields (and expected returns) go down. This pushes up the prices of risky assets by making them look more attractive relative to low yielding bonds.

And secondly, it gives banks more cash to make loans with. In practice, the desired effect of QE seems to be the reduction in long duration interest rates along with the increase in prices of risky assets. Central banks pay a bit of interest on bank reserves to reduce the desire for banks to lend out the cash they get from QE (from selling their bonds). But if necessary, all that cash could also be pushed into the economy as loans to increase spending, investment, and growth (possibly at the expense of inflation and a weaker currency).

If you want to know more about QE, I wrote a three part primer on it here:

So at a very high level QE is basically creating money to spur economic growth. MMT is very similar. It also focuses on the belief that governments can spend as if they own a money printer.

MMT appears to build its argument as follows: currency, like bonds, is a liability (a.k.a. debt) of the government that issues it. And since governments can issue (print) as much currency as they desire (with inflation as the only limiter), it’s impossible for governments to default. Therefore, government debt doesn’t matter — as much debt as there is, they can always repay it by creating even more currency.

Thus, in the absence of inflation, governments can spend to their heart’s content. And that spending will be the catalyst for full employment and economic growth.

In the MMT world, government spending, taxes, and government bonds have a very different purpose/interpretation:

Government spending (using printed money) is the primary lever for injecting money into the economy. Higher government spending increases bank reserves that can then be lent out. This increases private sector credit growth and therefore economic growth. The reverse outcomes occur when government spending is reduced. Taxes serve two purposes. They serve as a secondary lever for removing money from the economy, which reduces bank reserves and private sector credit growth, and ultimately economic growth. The point of slowing things down is to reduce inflation, the main limiter of government spending and growth in the MMT world. The other purpose of taxes is that it creates demand for currency amongst a country’s citizens. It’s notable that, under MMT, funding government spending is not one of the purposes of taxation (as governments can just print the money to spend). Government bonds are another mechanism for removing money from the economy. Selling bonds replaces lendable bank reserves with government bonds. Similar to taxation, government bonds are exclusively a monetary policy mechanism and not a financing mechanism for government spending.

So What?

So what are the implications if more policy makers either adopt or come from the MMT school of thought? The obvious one is ballooning fiscal deficits as government consistently spend in excess of what they receive from taxation and bond issuance. Government spending would become the primary lever for boosting the economy during recessions and economic slowdowns would create ever expanding fiscal deficits.

If taxes are the main mechanism for controlling inflation, then above average inflation will probably be tolerated. Political appetite for raising taxes (in order to lower inflation) is generally pretty low, assuming politicians desire reelection. Politicians prefer the subtle tax of inflation to the obvious tax of higher tax rates. Keep in mind that currency is a liability of the government — thus, inflation which reduces the value of that currency, is a subtle and gradual way to reduce that liability over time.

I’m by no means an expert on MMT, but the whole thing sounds like a slippery slope to me. Giving governments a blank check is dangerous, rarely have governments proven to be optimal capital allocators.

It’s true that countries whose debt is primarily denominated in their own currency can’t technically default, but they can definitely devalue their currency by printing too much. And currency devaluation, especially entrenched expectations of currency devaluation, would have material negative impacts to peoples’ net worth and the economy. People with fixed salaries, large cash savings, and bonds would suffer, especially relative to those that own hard assets or stocks of companies with pricing power. It would exacerbate the gap between the haves and the have-nots as well as unfairly penalizing the elderly retired who have no choice but to allocate significant money to bonds (due to their lower tolerance for volatility).