This article was published in the Australian Financial Review on 29 January 2020.
Conventional economics has struggled to explain much of what’s happening in the world today: how can we have record low inflation and interest rates at the same time? How can some governments continue to increase their deficits and yet their bond yields go down and currencies go up? How on earth can you justify negative bond yields?
There is one school of economic thought that purports to have at least some of the answers, and in fact has been talking about the inevitability of declining interest rates and inflation for years. It uses iron clad rules of accounting to offer not just plausible, but logical, explanations for many of the conundrums that leave orthodox economists scratching their heads. However, much of what it says is so radically different to what we’re used to that those same orthodox economists have lined up to ridicule it. That school is Modern Monetary Theory, also known by its handle of MMT.
One of MMT’s biggest problems is its name, which is simply not a good description of what it is.
While it is indeed modern, having been developed in the 1990s, it could easily be mistaken as a new version of ‘monetarism’, the economic theory developed by Milton Friedman and the Chicago School back in the 1960s which advocated, amongst other things, that markets are best at determining the optimal allocation of resources, so the role of government should be minimised and indeed fiscal spending is not only ineffective but irresponsible. Its focus on letting markets run free has become the norm across most of the developed world.
MMT is, in fact, the antithesis of monetarism, arguing governments must spend in order to achieve full utilisation of an economy’s resources. In that sense, it’s closer to Keynesianism. Finally, it’s not really a ‘theory’, it’s actually a straight up application of accounting rules to explain how money works in an economy where the government controls its own currency, in other words, an economy like Australia’s. It’s not unlike how the ‘theory’ of gravity is simply an application of the rules of physics.
Critically, MMT is not a policy prescription and nor is it politically aligned, it is absolutely indifferent as to who holds the purse strings, it simply explains the mechanics of what happens in the economy when they tighten or loosen them.
The first counter-intuitive point MMT makes is that government spending comes first and tax revenue flows from that. This can be tough to get your head around, but if you think about it, there has to be money already out in the economy before you can tax anything (remember, you don’t just go and issue a whole bunch of notes and coins to kick things off because they are a tiny fraction of the total amount of money in an economy). So a government creates money by paying things like pensions, unemployment benefits, or spending on infrastructure.
If the government isn’t injecting newly created money into the economy, the only other way it can grow is by people borrowing. MMT recognised ages ago that as people borrow more and more, the only way growth would be supported is through lower and lower interest rates, courtesy of central banks. But at some point, people reach their borrowing limit and then it’s up to governments to create the growth.
Another of MMT’s most controversial insights is kind of in two parts: first, since it’s governments that create money they can never be insolvent, which means they are never financially constrained. Second, they are, however, very much constrained by the resources available in the economy.
This usually sends conventional economists into apoplexy, who get stuck on the first part crying a government that thinks it can spend money at will is a recipe for fiscal disaster and a sure-fire way for an economy to end up crippled with inflation, like Venezuela or Zimbabwe. The problem is, those economists don’t stop to think through the second part.
MMT explicitly acknowledges the existence and risks of government deficits and inflation. What it says though, in a very simplified example, is imagine the economy is like a giant department store where both the private sector and the government sector shop for the things they need, everything from hospitals, to cars, workers, or soldiers. If some of the stock is not being bought by the private sector, that means there’s excess capacity and you’d expect prices will not be rising. It follows the government is able to go to the store and keep buying things with the money it creates and once the thing it’s bidding for in the shop is sold out (which could be labourers, or cement, or widgets) you’d expect its price to rise and it’s time for the government to back off.
Probably the most important thing MMT teaches us is it doesn’t make sense to treat a government as if it’s a household. While it’s intuitively appealing to think a responsible government should live within its means, the reality is the government’s ‘means’ are nothing like a household’s because a family can’t print its own money. Instead its means are limited by how much it earns and what it can afford to borrow, whereas a government’s means are limited by what’s available in the entire economy.
A third insight MMT offers that conventional economists struggle with is government deficits simply represent money the government has put into the economy that year which hasn’t been taken out by taxes. Deficits don’t actually accumulate to become a burden on future generations with crushing interest rates or catastrophically weak currencies. You just have to look at the US and Japan for confirmation of that.
When conventional thinking can’t explain something, it makes sense to think unconventionally. In many ways MMT sounds like stepping through the looking glass, but that’s because for almost 50 years we’ve become conditioned to think of our government as facing the same budget constraints we do. MMT not only provides a logical explanation of what’s happening in the world, but with Australian households up to pussy’s bow in debt, it offers a sobering perspective on the Morrison government’s insistence on balancing the budget.