Modern monetary theory (MMT) is controversial. It upsets deficit hawks because it claims that the limits on running a budget deficit for a government that is a “currency issuer” (unlike state governments or members of the Eurozone) are the productive capacity of the economy and inflation. A currency issuer can always make good on debt that is denominated and paid in its own currency. Also, it upsets most mainstream economists with its argument that fiscal policy, rather than monetary policy, should be the main instrument that should be used by governments that are currency issuers to steer the economy to full employment and low inflation.
Stephanie Kelton’s new book, The Deficit Myth, aims to convince interested persons in the correctness of these ideas. It can be easily read by non-economists, but the simplification of the argument does not help it to be persuasive.
The book is at its best when discussing the budget deficit of a currency issuer government. She argues persuasively that analogies to corporations or household budgets are not appropriate.1 Many economists would agree with this, though most would be concerned about the budget deficit when the economy is doing well. Kelton would respond to that criticism by pointing out that the government should not run budget deficits when inflation starts appearing. In the current circumstances, most economists would agree that the large budget deficits of the federal government are necessary.
However, the book is a disappointment. With regard to budget deficits, Kelton does not acknowledge that at some point there could be a lack of confidence in a particular currency, justified or not, which could affect the foreign exchange market and force the government to change its policies.
The most grievous flaw in the book is the brushing aside of institutional detail. The author asserts that the government just issues newly created money to pay its bills and then replaces some of that money with government securities. In the U.S. that is not quite how it works under the current institutional arrangements. The Treasury maintains in effect a checking account at the Federal Reserve. Treasury staff make projections for the months ahead of the amounts of cash that will come into that account and will go out of that account on a daily basis. Then Treasury decides the timing and quantity of its security issuance so that its balance does not go negative. Treasury is prohibited from borrowing directly from the Fed, but an inadvertent one-day overdraft is permitted.
Also, Kelton seems to argue that the government is the sole source of money creation. However, the Federal Reserve controls the monetary base, but it is the banking system that creates money by taking in deposits and lending it out. The ratio of the supply of money (M1 or M2) and the bank reserves that the Fed creates is not constant.2
Another monetary issue that Kelton ignores is the velocity of money, which is the ratio of the GDP to the money supply. That is also not constant.3
MMT proponents do not provide a convincing explanation of the combination of inflation and a bad economy in the 1970s (“stagflation”). They are not alone in not explaining convincingly why this happened, but, since their core argument is that deficit spending is only limited by the productive capacity of the economy and inflation, they need to address it.
Finally, with regard to fiscal and monetary policy, Kelton ignores that the Fed can act very quickly, but Congress cannot. And even when Congress passes appropriation legislation that the President signs, it takes some time for the spending to take place.
The argument that the central bank should be made a bit player and all the action should be concentrated in fiscal policy is not convincing. Kelton surely knows of the issues I have mentioned here, but to simplify her argument she ignores them. If she writes another book, she should address these types of issues and be more explicit about what she is advocating and why she thinks it is practical and feasible, both technically and politically.
The book also addresses Social Security, and I mostly agree with her discussion of this. From an economic perspective, it does not really matter whether benefits are paid from the general fund or the Social Security trust fund, though it matters politically. In this regard, the argument is made by conservatives and others that we should not let the trust funds run down enough that money from the general fund is necessary to make sure that benefits are not cut. This, they say, would make the program subject to politics. This is ridiculous on its face, since Social Security benefits are already subject to politics, as they amply demonstrate by making the argument that future benefits should be cut. They argue that we need to cut future Social Security benefits now in order “to protect” Social Security. From what? Politics?
In another chapter, Kelton argues that the federal government should act as an employer of last resort when the economy is doing badly. The attractiveness of this idea is clear, and to an extent during the Depression, entities such as the Civilian Conservation Corps were set up to provide employment when there were no private sector jobs to be had. However, Kelton underestimates the enormous practical challenges of setting up and administering an agency or agencies that would employ people when the unemployment rate was high. For the idea to be taken seriously, more thought needs to be given about how this would work and what type of jobs would be offered. For example, let’s say that the demand for aerospace engineers collapsed. What would the government employ them to do?
Currently, the U.S. government is conducting a giant economic experiment. It has been spending without regard to the budget deficit, at least until recently when Congress is having difficulty passing legislation to spend more money to help the economy. The Fed has essentially monetized the deficit. While Treasury cannot borrow directly from the Fed, the Fed has been buying up Treasury securities in large amounts in the market, thus replacing Treasury securities with bank reserves. The adherents to MMT and most economists think this is necessary in the situation we find ourselves in. In fact, the well-respected journalist, Sebastian Mallaby, who generally holds more traditional economic views than that of MMT, calls this “the age of magic money.”
In a way then, MMT is being tested, but there may be a return to more traditional ways of thinking once the current crisis is over. MMT cannot be as easily dismissed as Larry Summers tried to do in a March 2019 article for the Washington Post (“The left’s embrace of modern monetary theory is a recipe for disaster”). But it needs more work, and they will have to get into the details of how the monetary system works and how they would reform it in order not to be dismissed as a fringe group, in the manner Art Laffer’s version of supply-side economics is viewed.
Endnotes:
1. In this regard, President Obama was wrong when he said that the government needed to tighten its belt just as families were doing. Precisely the opposite is necessary when the economy is doing poorly.
2. This incidentally is a problem with the monetarism associated with Milton Friedman, which often implicitly assumed that it is constant.
3. Again, the monetarists usually assumed that velocity was relatively constant and that the central bank only had to worry about the amount of reserves it created. Friedman, only half-jokingly, said that we did not need an open market committee at the Fed, a computer could be programed to do this.
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