Modern Monetary Theory: What is it and implications post COVID-19
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On June 18, 2020, the Global Risk Institute (GRI) presented a webinar with David Bezic, who is an independent economic consultant, specializing in the operational aspects of fiscal and monetary policy, and modern monetary theory (MMT). The webinar was moderated by Drew McFadzean, Executive in Residence, and hosted by Vanda Vicars, Chief Operating Officer, GRI.
During the webinar there was strong participation from GRI membership and many questions were submitted which were not answered during the presentation. Below is a list of questions submitted during the webinar that Mr. Bezic has addressed.
It is difficult to draw specific links between MMT and stagflation as MMT does not relate to a particular set of “easy” or “tight” policy settings. Whether government spending and taxation are growing or shrinking depends on the state of the economy (i.e., automatic stabilizers) as well as politically-approved and -motivated programs.
If deficits are growing because of discretionary programs at a time when there is a sizeable pool of unemployed workers and significant spare capacity, the prospects for inflation would be limited. However, if deficits are growing at a time when labour markets and productive capacity are tight, the injection of net financial assets resulting from deficits could raise the possibility of inflation without corresponding growth (i.e., stagflation).
This latter set of conditions has not been apparent in any major economy for decades, which have instead seen persistent unemployment and low growth/low inflation. It is possible for stagflation to result from rising input costs (e.g., oil price spike) but that falls outside the direct influence of fiscal policies, including MMT-influenced ones.
Unlike common economic narratives, which typically view government deficits as “crowding out” private borrowing and lending opportunities, MMT recognizes the fact that these deficits actually add risk-free assets to private sector balance sheets. This is true by the accounting definition, as deficits mean that the government is adding more via spending than it is taking away through taxes.
This net add typically takes the form of new risk-free government bonds, which are issued in amounts (approximately) equal to the size of the deficit. These newly-minted bonds end up on private sector balance sheets, thereby adding to the total supply of risk-free securities available to be lent, repossessed, etc. MMT recognizes that these risk-free assets, particularly US Treasuries, are the most liquid and sought-after form of collateral in the world, and that an increase in their supply thus adds lubricant to collateral-based markets.
An interesting example of the impact that government deficits have on this liquidity was provided by Australia and its budget surpluses in the early 2000s. As a result of these surpluses, the supply of AAA-rated Commonwealth Government Securities (CGS) began to dwindle, creating discomfort for financial institutions and investors who were reliant on these assets for various purposes. This prompted an official Review of the CGS market, and a subsequent decision to continue issuing debt instruments – even in the face of persistent surpluses.
Yes, MMT recognizes this addition of assets as a matter of accounting. When a currency issuer spends, it does so by crediting the bank account of the recipient, be it a household receiving social assistance or a business being paid to build a bridge. This leaves these particular households and businesses with more financial assets than they had before the transaction. The next question is what, if anything, happens to the accounts of other people and firms in the economy?
This depends on how the government “pays for” its purchase or program. If it raises taxes from someone else in an equivalent amount (i.e., runs a balanced budget), then there is no addition to the non-government sector’s holdings of financial assets in aggregate – someone’s gain is another person’s loss.
However, if the government instead chooses to allow the spending to occur without an offsetting collection of tax revenue (i.e., it runs a deficit), then the addition of net financial assets applies not just to the recipient of the spending, but to the entire non-government sector as a whole. It is these accounting dynamics that led MMTers to recognize federal government deficits as net adds to the private sector’s net financial wealth, with budget surpluses having the opposite draining effect.
Note that this injection of financial assets occurs even in cases where the government issues new bonds or bills to cover the deficit “shortfall”. In that scenario, the bond purchaser is just replacing already-existing deposits with newly-issued bonds on the asset side of their balance sheets, thus altering the composition – but not the level – of their financial holdings. The recipient of the government spending, meanwhile, still has their new deposits.
MMTers recognize that, unlike the vast majority of deposit-creating actions (i.e., bank lending), this sequence does not generate a corresponding liability anywhere else in the private sector. Some might argue that it actually does, but that this liability is simply being deferred to future taxpayers. It is hard to square this argument with the fact that Canada has been in a perpetual net deficit position since 1870 – if the debt has not been “paid off” at anytime since then, why should we expect that our kids’ or grandkids’ generations will suddenly be expected to bring its balance to zero?
It certainly could, but this need not necessarily be the case. Recall that MMT does not imply a particular set of policies, but rather highlights the fact that these policies should be set according to targeted societal goals and desired economic outcomes. If inflation is running hot, for example, then higher taxes might be called for. If the goal is to reduce inequality then we might see higher taxes on wealth, but lower ones on general consumption. Key to the MMT framework is its suggestion that the purpose of these taxes should be to promote the chosen objectives, and not to “pay for” things or to reduce debt numbers on a spreadsheet (at least at the currency issuer – i.e., federal – level).
This recognition, coupled with the fact that people presumably prefer keeping more of their money rather than handing it over to tax collectors, suggests that taxes could very well be lower in an MMT-oriented economy. For this to materialize, however, taxpayers would first need to become more aware of the way money works, including MMT’s distinction between currency issuers and users. Armed with this knowledge, taxpayers would then be more likely to put pressure on politicians to deliver on societal goals, rather than on collecting tax revenue in order to keep the debt and deficit “under control”.
A pickup in employment would be welcomed by MMTers, as they see economic growth as the most effective and desirable means to reducing debt burdens. Measures such as debt-to-GDP decline in such environments as automatic stabilizers kick in, with the need for income supports (e.g., employment insurance) declining at the same time that tax revenues pick up. This differs from many conventional frameworks, which focus instead on reducing the numerator via cuts to spending. The flaws inherent in this latter approach were highlighted by the recent experience of Italy, which saw its debt-to-GDP metric actually rise through externally-imposed austerity programs. This was no surprise to those viewing the situation through an MMT lens, as they recognized that the resulting drag on growth would very likely outweigh the “benefits” of fiscal cuts.
Reducing debt through growth is possible so long as GDP is expanding at a faster rate than the average cost of servicing the debt. Or, in economist-speak, so long as “g” is greater than “r”. This has in fact been the historical norm, as confirmed by recent research from the IMF. The potential for the sign on this relationship to flip for extended periods of time is limited in currency issuing nations, given their policymakers’ ability to manage these rates. This could be done, for example, via Quantitative Easing (QE) programs that target particular prices on security purchases rather than quantities. The Bank of Japan’s current yield curve targeting program provides a timely example of this ability.
Worries about the relative size of debt servicing can also appeased by the possibility of having the government “owe” the principal and interest to itself, as is the case when the central bank buys and holds government bonds. These bonds could be bought from market participants via QE programs or directly from the government at primary auctions. Despite fears amongst conventional economists that the latter would be inflationary, MMT recognizes that it simply means the related deficit spending will add deposits to bank accounts, rather than the more typical addition of bonds to brokerage accounts. Experience also provides assurances on this front, as the Bank of Canada has been buying Government of Canada bonds at primary auction for decades (up to 20% of offered supply, increased to 40% more recently as part of the COVID response) without causing a spike in inflation.
So long as a country’s debt is denominated in a currency that it itself produces, MMT’s analysis of currency issuers still applies (assuming that the currency is also not convertible into anything other than itself – i.e., no gold standard – and that the country has a flexible exchange rate). A currency issuer’s ability to service and repay its debt is the same whether the bonds in question are held by a hedge fund in New York or an insurance company in Tokyo. In either case, these credits reside on the same “spreadsheet” over which only the issuing nation has read and write access. The same ability to pay would not be available if the country had instead issued debt in a foreign or external currency, as is the case with Argentina’s USD-bonds or Eurozone nations’ Euro-denominated debt.
This differs from conventional narratives, which often suggest that countries like the US are dependent on the kindness of lenders in other countries (e.g., China) in order to fund their government’s deficit spending. This makes little sense to MMTers, who often like to point out that there’s no US dollar printing press in the basement of the Peoples’ Bank of China. Instead, the ultimate source of the dollars used to buy the Treasuries is recognized as being the US itself. When China buys Treasuries, it is just giving the US back the dollars that it had previously obtained via some other means (e.g., export sales).
Looking beyond ability to pay, the fact that an economy is open and/or has large amounts of debt held by foreigners can impact the analysis. One way this might manifest is via leakages. As noted above, deficits add net financial assets to non-government accounts, possibly including ones owned by the foreign sector. Even if the recipient of the actual spending remains a domestic household or business, the fact that the actual net asset injection shows up on the balance sheet of another countries’ private sector could alter a given policy initiative’s local impact. Another possible avenue is via exchange rates. Even though a sudden decline in foreigners’ appetite for a particular currency issuer’s debt does not alter the latter’s ability to pay, any resultant swings in the exchange rate could alter local inflation rates, competitiveness, etc.
The MMT framework sees the need for fiscal discipline, but for reasons other than the ones typically invoked in conventional economic narratives. MMTers recognize that inflation can result from deficit spending if the associated injection of net financial asset exceeds the economy’s ability to absorb these new assets. As a result, MMTers see productive capacity and potential inflation as the limiting factors when it comes to the size and scope of fiscal programs. This differs from conventional frameworks, which typically view governments’ access to market-provided financing at economical rates as the purveyor of discipline. This makes little sense to MMTers, given that they recognize currency issuers themselves to be the ultimate source and backer of the money being used in these fiscal operations.
Simple observation supports the MMT perspective, with sovereign bond yields seen to have declined to historical lows at the same time that debt levels have risen to all-time highs. Despite these empirical facts, many conventional economists maintain persistent fears of a market backlash “someday”. Rather than lean on vague timelines and unknown catalysts, MMTers would probably suggest that these economists instead question their faith in the so-called bond vigilantes as providers of market discipline. Similar for ratings agencies, whose downgrades of sovereign debt in the US (August 2011) and Canada more recently (June 2020) were met with declines in bond yields.
Note that MMT does see a discipling role for financial markets and credit ratings, but only in the case of currency users such as households, corporations, Canadian provinces and Eurozone nations.
The descriptive elements of MMT do not imply any particular outcome for policy choices. As noted earlier, “optimal” policy is largely a function of the state of the economy (e.g., available capacity, inflation, growth) and society’s identified priorities (e.g., full employment, health, quality infrastructure, etc.).
What MMT does do, however, is encourage policies to be pursued with those factors and objectives in mind, rather than with the goal of limiting debt and deficits. Or, as MMTers like to say, policymakers should be focused on balancing the economy and not the budget. In this sense MMT could indeed be seen as encouraging policymakers to sit on their hands, but only when it comes to placating the ratings agencies and bond vigilantes.
The same sitting-on-hands encouragement, however, cannot necessarily be applied to the pursuit of societal goals. By raising public awareness of the possibilities and opportunities available to currency issuers, the MMT framework would likely make it more difficult for policy makers to respond to demands for action by simply pointing to big debt numbers and suggesting that “sorry, we just can’t afford it”. In such an environment, the policy debate could switch from questions around how things will be paid for to ones asking what will be paid for.
While not necessarily unique to MMT, the framework recognizes that government spending can support production directly via productivity-enhancing investments in infrastructure, education, health, R&D, etc. Contrary to conventional frameworks, MMT notes that these investments do not necessarily “crowd out” the amount of money available left over for private projects, given that we operate in an endogenous money system that finances itself i.e., one where banks create money when they extend loans. MMT does acknowledge, however, that government spending on such projects can crowd out real resources – workers, bulldozers, etc. – and that inflation is the place to look for signals that this may be occurring.
MMT also sees a role for government deficits to support productive capacity indirectly, via the confidence- and demand-boosting effects that go along with adding financial assets to private sector balance sheets. To the extent that the tax cuts and income and revenue supports associated with the higher deficits induce people to spend more than they would have otherwise, a self-reinforcing feedback loop to investment can be triggered.
This view of investment is consistent with John Maynard Keynes’ “animal spirits” concept, which sees confidence and uncertainty around a project’s future ability to generate cash flows as key determinants in whether or not it is undertaken. If customers are not walking through a business’ doors, the business is less likely to invest in expanding production, boosting R&D, etc., even if the project can be financed at zero or even negative interest rates. MMTers have this dynamic in mind when they favor fiscal supports for demand, rather than arms’ length monetary policy measures, as a way to bolster an economy’s productive capacity.
One thing that distinguishes MMT from more conventional frameworks is that it recognizes fiscal levers, rather than monetary ones, as the most relevant policy-driven “money taps” in our economy. Headlines about central banks risking inflation through all their purported money printing fail to recognize that these QE programs (mostly) just change the composition of financial assets in the economy, and not their level. This contrasts with fiscal deficits, which actually add to new financial assets to private sector balance sheets.
Consistent with this view, MMT recognizes that unchecked deficit spending can eventually lead to inflation. For this reason, many of its proponents suggest that automatic stabilizers should be enhanced, which would reduce the need to rely on elected politicians to grow and shrink deficits as required. Suggested improvements include a more thorough assessment of spending and tax programs’ inflationary impact within the budgeting process itself, rather than waiting until later to see if, and how, it shows up in price indices.
Another suggested automatic stabilizer is a Federal job guarantee program that would help anchor a key potential driver of inflation (i.e., wages), while also helping keep otherwise unemployed people working and ready to be hired by the private sector once the business cycle re-accelerates. Such a program would allow productive capacity to expand faster than if previously inactive workers had to be re-trained, while also limiting the incentive for businesses to lure active workers away from their current jobs by offering them higher wages. Both features would help defuse inflationary pressures, as would the fact that the program itself would automatically shrink in size as the economy recovers and unemployment declines.
Independent Economic Consultant, specializing in the operational aspects of fiscal and monetary policy, and modern monetary theory (MMT)