Modern Monetary Theory

Is Modern Monetary Theory a groundbreaking new economic theory or a false promise?

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Inspired by supply-side economics and the Laffer Curve, the U.S. government under the Reagan administration lowered the marginal tax rate on the highest income earners from 71% to 31%. The Economic Recovery Tax Act of 1981, better known as the “Kemp-Roth Tax Cut,” was designed to increase government revenue through tax cuts, thereby achieving a point where “tax cuts pay for themselves.” However, this policy is still hotly disputed. Reaganomics supporters claim this policy led to economic expansion which eventually paid off while critics argue this actually worsened the government deficits. When George H.W. Bush was running against Ronald Reagan for the Presidential nomination, he even called the idea, “Voodoo Economics.”

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Four decades after the controversial policy, a new heterodox economic theory seems to follow a similar path: Modern Monetary Theory (“MMT”). Fervently supported by progressive congressmen, MMT’s appeal is rapidly gaining momentum. Stephanie Kelton, a professor of Public Policy and Economics at Stony Brook University, has been a vocal supporter of the theory throughout her career, and she also worked as a chief economic advisor for the Bernie Sanders campaign. Along with some post-Keynesian economists like Larry Randall Wray and Warren Mosler, she strongly supports the idea that currency is a simple public monopoly. Kelton has been debating on the validity of MMT with skeptics in academia including Paul Robin Krugman, a nobel laureate and professor of economics at the City University of New York.

The basic idea of MMT is that a government that prints and borrows its own currency, like the U.S. government, cannot default due to its ability to print new dollars. MMTers think the government can regulate the economy more efficiently than banks and financial markets. They believe the government should use fiscal policy to achieve full employment. As opposed to mainstream Keynesian economic theories, MMT encourages printing new money rather than taxing or issuing bonds for government spending. MMT focuses on maintaining the level of spending “at the level that is just compatible with full employment and price stability.”

Representative Alexandria Ocasio-Cortez, a champion of the Green New Deal (“GND”) is very open to the theory as well. MMT supports large government expenditures for stimulus

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packages, and the GND is estimated to cost about 51 trillion dollars, if not more. This massive spending plan has met huge oppositions from those on the other side of the aisle for its unclear source of funding. The fact that Ocasio-Cortez embraces the idea of MMT which states, “the government doesn’t need to balance the budget and that budget surpluses actually hurt the economy” implies how she is planning to pay for her policy proposals.

Numerous economists, who believe government expenditures must be paid through taxes, find this new theory very perplexing. Lawrence Henry Summers, a professor and former president at Harvard University, referred to MMT as a “oversimplified and exaggerated” new idea offered as “the proverbial free lunch.” He claims it is fallacious due to several reasons. First, it assumes that the government can finance its deficits at no cost. Second, creating new money past a certain point can create hyperinflation. Third, it is based on a closed economy which is free of many risks such as capital outflow and exchange rate risk. Most importantly, he thinks the MMT is not qualified to be a theory. “Excessive reliance on inflationary finance” ended up as failure not only in emerging markets but also in developed economies.

Fed leaders also find the new theory dubious. Minneapolis Fed leader Neel Kashkari called it “a political philosophy,” and Fed Chairman Jerome Powell said he has yet to see a satisfying explanation. Just as Krugman and Summers argue, leaders of the Federal Reserve strongly disagree with the idea that “deficits do not matter for countries that can borrow in their own currency.” According to conventional economic theory, rising government borrowing has upward pressure on interest rates as those who buy treasury bonds demand a better return. Kelton claims the opposite: interest rates decrease. She rather criticizes limitations of the conventional IS-LM framework, and writes, “the currency issuer never has to accept market-determined interest rates.”

Given the huge divide between various politicians and members of academia on MMT, the partial agreement of progressives and some financial managers on the theory is very surprising. Paul Allen McCulley, a former chief economist at PIMCO, wrote, using its unconventional approach, he bet successfully that “interest rates would stay low” during the financial crisis. Other chief economists in financial firms such as Goldman Sachs and Nomura also believe there are useful, overlooked insights to be found in MMT. Some money managers credit the theory for their correct prediction of interest rates during the crisis. However, these people do not represent the whole financial sector. BlackRock CEO Laurence Douglas Fink called the MMT “garbage” and asserted his strong belief that “deficits do matter.” He claims deficit spending based on the theory would lead to an unsustainable interest hike just as orthodox economists have noted.

Despite the theory’s rising political stock, its unconventional wisdom that the United States can pay off its debt by printing more dollars has not convinced the majority. Debates on economic models have always been around; for instance, Keynesian economists and Monetarists disagree on how monetary policy works. Through thorough peer review processes, these healthy debates give birth to new, modified ones like the New-Keynesian and Neoclassical economic models. Comprehensive explanation with scientific rigor is required as popularity can sometimes misguide the general public. As politics has become more involved in the conversation, it is easy for people to become attracted to theories with tantalizing prospects. Before we decide which economic model to choose, we should put our best effort to have objective perspective on this issue first.

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