A hot debate has erupted over “Modern Monetary Theory”, which is alleged by its promoters as justifying a sizable rise in government deficit spending to pay for the Green New Deal and various programs. The government would issue as much debt as needed to raise the funds and the Fed would buy the debt by printing the money. The theory claims there would be no adverse consequences since the debt is denominated in dollars and the Fed can print as many dollars as required. This discussion notwithstanding, the economy continues to roll along without any obvious need for incremental stimulus.
One of the more vocal and visible promoters of MMT is Stephanie Kelton, former chief economist of the Senate Budget Committee for the Democratic minority staff, a former senior advisor to Bernie Sanders and currently a professor of economics at Stony Brook University. Kelton has argued that any country engaged in MMT doesn’t have a deficit problem unless it has an inflation problem. According to her, running very large deficits does not lead to rising inflation. Kelton notes that since the U.S. government can print its own money to meet any obligation (the Fed would do the printing and buy the Treasury’s newly issued debt), it is not possible for the U.S. government to ever become insolvent. This last statement is true. But there are dire consequences to just printing money.
Kelton’s argument builds from the view that government spending to fight high unemployment, even when it runs a deficit, is desirable. This view is shared by Keynesians and been mainstream for many years. But Kelton goes much further. She maintains that there is seemingly no limit to the budget deficit as long as there is no inflation problem. And she sees no link between too much Federal spending and inflation. She calls such a link “hard to believe”. Well, believe it. MMT misses the inevitable link between too much Federal spending, printing money, and inflation.
Numerous governments have tried to print money to pay their bills and, in every case (with one possible exception) the result was rising inflation. Two egregious examples include the Weimar Republic and its hyperinflation in Germany in the 1920s and Zimbabwe in the 2008 – 2009. Both printed unlimited quantities of money but paid for this behavior with runaway inflation. More moderate versions of this behavior occurred in Italy and France when they had their own currencies and both economies suffered from higher inflation than the rest of Europe. Their higher inflation rates weakened their currencies to maintain competitiveness. And when their governments pegged their currencies to rest of Europe, rising inflation killed their competitiveness and they suffered high unemployment even when they chose to run large government budget deficits. Some of the Latin countries also chose to fund budget deficits and to print money to pay for their spending, such as Argentina and Brazil. These episodes also ended badly, especially when foreign investors became unwilling to buy the bonds they issued. We even experienced a deficit induced surge in inflation in the 1960s in the U.S., when Lyndon Johnson sought to finance his “guns and butter” budget spending on the Great Society programs at the same time he was paying for a war in Vietnam.
The notable exception to deficit spending without rising inflation is Japan, where the debt to GDP ratio is about 2.5, well above the ratio for the U.S. of about 1.0. Yet Japan has been in recession or experienced rather little growth for more than two decades. It also has a shrinking population and a highly acquiescent population that seeks order and favors existing institutions. Workers don’t strike for higher wages. Redundant workers aren’t fired; they are given dead end jobs with nothing to do. It isn’t clear anyone else could mimic the Japanese economy, assuming they wished to do so.
Kelton’s argument seems to be based on the observable fact that the U.S. government is running a large budget deficit today without experiencing worrisome rising inflation. But MMT doesn’t seem to offer any explanation of what does cause inflation and she rejects outright the possibility that inflation may increase in response to large budget deficits albeit with a lag. MMT adherents also claim that if inflation were to increase, then government could prevent a surge by raising taxes at that time. That may be true in theory, but in practice, governments have proven time and time again they raise or lower taxes when such action is politically expedient, not necessarily when it is the most appropriate policy for the economy.
Inflation results when demand for goods and services exceeds supply, so rising prices are required to offset the difference. If there is demand for $20 trillion of goods and services, but only $19 trillion is being produced, there are two possible outcomes. The first is that the economy will expand more quickly so output will rise to meet that higher level of demand. This is feasible when there are enough unemployed workers who can be hired to increase output. In this case, deficit spending may be desirable. Indeed, this is precisely when Keynesians argue fiscal stimulus should be used to help the economy get back to full employment more quickly following a recession.
The second possibility is for such deficit spending to drive up inflation. Printing money to pay for new government programs does NOT work when unemployment is already low, as it is today. An increase in government deficit spending adds to demand, but increasing the supply of goods to meet that higher level of demand runs into bottlenecks because labor is already scarce. In this case, excess demand can only be met by marking up the price of supply—inflation—so that demand can match up with demand once again. This is precisely why many economists criticized the Administration’s late 2017 tax bill, because it injected more spending when unemployment was already low. But this does not mean inflation will surge immediately. These things take time. So the risk today is for inflation to increase because of this deficit spending. And this would occur whether or not the increased supply of bonds is bought by the Fed.
Proponents of MMT probably take comfort from the very fact that government deficit spending has increased and inflation has not increased significantly, as yet. Some of the credit for that surely goes to the Fed, which has been quite vocal about keeping inflation around its 2% target and its high level of credibility. But Fed officials understand perfectly well that an unemployment rate that is already below what they thought to be full employment could cause higher inflation at any time. In this politically charged environment, Fed officials are reluctant to raise interest rates until higher inflation becomes visible. If they did raise rates to prevent rising inflation, critics will argue they are preventing growth from continuing. President Trump has criticized Fed Chair Powel for raising rates over the past year and MMT proponents are also critical because they’d like to finance their social programs. The Fed will get little credit for inoculating the economy against a problem that isn’t visible, as yet. So the Fed has acquiesced and will tolerate some rise in inflation at least until everyone sees higher inflation as an emerging problem.
Looking ahead, the ongoing decline in the unemployment rate will create ever more bottlenecks in the economy that will lead to higher inflation. Standard neoclassical economic theory, which is accepted by the overwhelming consensus of economists, is extremely clear on this point, even if it is incapable of providing much insight with regard to timing. Assorted pressures are likely to keep the Fed from acting in anticipation of such an outcome. And the fact that some Fed officials would prefer a period of inflation above 2% to make up for a period of inflation below 2% insures that the Fed will not react either preemptively or quickly to a rise in inflation. MMT is bad policy and its advocacy could lead the nation to experience more inflation than we would otherwise.
In the meantime, the fear mongering case for recession took a direct hit from the latest employment report. It’s hard for the economy to lapse into recession when 196,000 jobs are created in a month, an average of 180,000 net jobs over the latest three months and businesses are trying to fill 7.5 million job openings. (A job openings report is scheduled this week.) Unless there’s some sort of sizable unexpected economic shock, we expect the economy to continue to roll along.