Modern Monetary Theory is a term that one encounters with increasing frequency. It is often applied to a specific policy, such as advocacy of expansionary fiscal policy. But that’s not a very useful definition. Lots of economists now advocate expansionary fiscal policy in the current environment of very low interest rates and high unemployment.

MMT is more than fiscal stimulus; it is a model of the macroeconomy. In order to better understand the MMT model I’ve been reading “Macroeconomics”, an undergraduate textbook written by William Mitchell, Randall Wray and Martin Watts. While MMT is not my cup of tea, I don’t want to be unfair in my appraisal. Thus I’ll discuss one potential problem here , and try to elicit feedback from MMTers—what am I getting wrong? Am I being unfair? If so, what’s the intuition that I’m missing?

On page 342 they make an assertion that caught my attention:

Monetarists are hostile to the creation of base money to finance deficits because they claim it is inflationary due to the Quantity Theory of Money (QTM). MMT advocates would first highlight institutional practice, namely that net treasury spending initially causes an equal increase in base money.

Second, they would challenge the theory of inflation based on QTM, and argue that if a fiscal deficit gives rise to demand pull inflation, then the ex post composition of  ΔB +  ΔMb in Equation (21.1) is irrelevant. Overall spending in the economy is the driver of the inflation process, and not the ex post distribution of net financial assets created between bonds and base money.

A few initial observations:

1. The first paragraph seems misleading, as it may give students the false impression that the Fed does not determine the stock of base money. But I’d like to focus on the second paragraph.

2. The second paragraph seems to apply to all open market purchases, not just those that occur when market interest rates equal the interest rate on excess reserves (IOER). That’s clear from the rest of the book, which focuses heavily on historical examples from the 1960s, 1970s and 1980s. So for the rest of the post I’ll consider OMOs that occur in a world where nominal interest rates are positive and there is no IOER, i.e. the pre-2008 world. To be sure, I don’t think their claim is even true in a world with IOER, but it’s at least more defensible in today’s world.

3. Most mainstream economists (including John Maynard Keynes) would not agree with the claim that a purchase of interest-bearing bonds with zero interest base money is “irrelevant”.

4. I’m focusing on this point because much of the analysis in this textbook hinges on this claim. If it’s false (and I think it is) then the rest of the book sort of falls apart. For instance, the book assumes that demand management is done by the fiscal authority, whereas in the real world central banks determine aggregate demand (at least when interest rates are positive).

OK, so why do MMTers believe that OMOs don’t matter? Suppose we go back to the economy of the 1990s, when risk-free interest rates were often about 5%. Assume the monetary base is $500 billion (as in 1998). Now consider this thought experiment. The Fed buys another $500 billion in Treasury bonds, paid for with zero interest base money. Is that action actually “irrelevant” because the sum of base money and publicly held debt doesn’t change?

Both monetarists and Keynesians would predict that this action would boost output in the short run, and cause both P and NGDP to double in the long run. Monetarists would point to the creation of huge excess cash balances. Banks would try to get rid of their excess reserves by purchasing assets. Over time, some of the excess reserves would leak out as cash in circulation, but this would cause excess cash balances for the public. Only when the price level doubled would the public and banks be willing to hold $1000 billion in base money, twice as much as before.

Now you might argue that this is the monetarist view, which has fallen out of favor. But Keynesian would make roughly the same prediction.

In the Keynesian model, the huge open market purchase would sharply depress interest rates, to a level far below the natural rate of interest. This would cause aggregate demand to rise sharply. Aggregate demand would continue to increase until the market interest rate was once again equal to the natural rate. But that could only occur when the price level had doubled. Even in the Keynesian model, one-time increases in the monetary base are neutral in the long run.

So what do MMTers think would happen? That’s what I can’t figure out. Here are some possibilities:

1. Maybe the MMT claim that the composition is “irrelevant” is a claim that these assets are close substitutes. Swapping cash for bonds doesn’t matter. Interest rates, output and inflation are not affected. But is this plausible? Why would the Fed’s decision to double the monetary base cause the public and banks to wish to hold twice as much zero interest base money as a share of GDP? For instance, if banks can earn 5% on T-bills and 0% on reserves, why would they choose to hold more excess reserves? Ditto for the public’s holding of cash.

2. Maybe the MMT claim is that the composition does affect interest rates, but not the broader economy. That is, maybe they are claiming that a big open market purchase would drive interest rates much lower, perhaps even to zero, without impacting output or inflation. But how plausible is the claim that in 1998 the Fed could have injected enough base money to drive rates to zero without triggering inflation?

Neo-Fisherians correctly point out that low interest rates are often associated with low inflation. But that’s probably due to reverse causation—the Fisher effect. I know of no case where a central bank injected massive quantities of reserves into an economy with market interest rates well above zero and with no IOER (i.e. an economy like the US in 1998) without triggering high inflation. And I know of many dozens of cases where such a policy did create high inflation.

How plausible does it seem that you could take an economy like the US in 1998, cut Treasury bill yields from 5% to 0% vie OMOs, which would dramatically reduce mortgage interest rates, and not trigger a sharp increase in aggregate demand? I just don’t get what the MMTers are claiming here. If interest rates didn’t fall then you get runaway inflation via the hot potato effect, and if interest rates immediately plunged to zero you’d get a big rise in AD because (unlike in cases like the deflationary 1930s or 1990s Japan) you’d be sharply depressing market interest rates to well below the natural rate for a healthy economy.

What do MMTers think would have happened if the Fed had bought $500 billion in bonds in 1998, and announced that the increase was permanent? And why?

Even if I am misinterpreting their claim and they respond, “Yes, MMTers admit that open market purchases are expansionary”, it would not make me think I’ve wasted my time with this post. That answer would imply that there are other major problems with the textbook, which is mostly written using the implicit assumption that monetary policy does not determine aggregate demand.

I’ll have many more questions on MMT.