EC MMT Heaven And MMT Hell For Chinese Investment And U.S. Fiscal Spending

Modern monetary theory (MMT) isn’t discussed much in Chinese universities as far as I can tell, except by a few of my Chinese friends and former students who mostly work in banking and finance. Analysts abroad often claim that China is somehow proof that MMT “works,” but to me and most of my Chinese friends, this statement is either unintelligible or just wrong.

Every Sunday afternoon, a few of the brightest math, finance, and economics students from Peking University converge on my courtyard house for an informal seminar on debt-related issues. For our first meeting of the new school year, I had them read up on MMT and research the MMT debate so that we could work out how it might apply to their own thinking.

From these readings (including a 1943 piece on “functional finance” by economist Abba Lerner), we assume that the key insight of MMT is not that debt doesn’t matter, as mistaken stereotypical views seem to assume, but rather that governments that issue their own fiat currency have no funding constraints insofar as they do not need to issue debt or raise taxes to spend money. They simply budget the expenditure, and then go ahead and spend the money.

There is a lot of confusion about this. A January 2019 Financial Times article had this to say:

Advocates for modern monetary theory argue that, for a sovereign country with its own currency, there is no inherently unacceptable level of government debt—that country does not automatically begin to collapse when debt reaches 90 per cent of GDP, or even 200 per cent of GDP. The country appropriates what it believes is necessary for domestic programs, regardless of revenue.

This, however, is almost certainly an unfair caricature of MMT. It assumes that if a country increases debt to fund spending until the economy is at capacity, it will cause the country’s debt-to-GDP ratio to rise. But if government spending directly or indirectly causes productive investment to rise in line with the debt, this kind of spending increases both debt and GDP, so neither the debt ratio nor the debt burden changes.

It is only when money is borrowed (or created) and spent in ways that do not cause GDP to rise that the debt burden rises. For that reason, a rising debt-to-GDP ratio over the medium term is almost prima facie evidence that the government should cut back its spending (over the short-term there can be timing differences between when an investment is made and when it starts to pay off). This is also true of inflation: if the government “prints money” to spend on projects that reduce excess capacity or employ workers productively, the result will not be inflationary to the extent that the increase in demand caused by printing the money will be matched by an increase in supply.

What MMT actually does say is that governments must issue debt or raise taxes if either is necessary to control the potentially adverse economic impact of the additional demand created by spending the additional money. As Lerner puts it:

The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that the taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend. By these means total spending can be kept at the required level, where it will be enough to buy the goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced.

Lerner points out that this idea, “like almost every important discovery,” is very simple (albeit counterintuitive), to the point that when academics understand it, they often dismiss it as “merely logical.” He goes on to explain:

An interesting, and to many a shocking, corollary is that taxing is never to be undertaken merely because the government needs to make money payments. According to the principles of Functional Finance, taxation must be judged only by its effects. Its main effects are two: the taxpayer has less money left to spend and the government has more money. The second effect can be brought about so much more easily by printing the money that only the first effect is significant. Taxation should therefore be imposed only when it is desirable that the taxpayers shall have less money to spend, for example, when they would otherwise spend enough to bring about inflation.

This seems to be where much of the confusion lies. One of the main criticisms of MMT is that it seems to imply to some people that governments can spend on any project they like without worrying about the consequences. By extension, these critics also assume that for this reason there are no effective limits to government borrowing: debt can always be serviced by creating additional fiat money for the sole purpose of servicing the debt.

To sort through these various claims, our seminar decided to concentrate on the conditions under which there are no intrinsic constraints on government spending, a state that can be called MMT heaven. We also considered the conditions under which there are constraints, in which case governments would have to raise taxes to balance the government expenditures. To simplify matters, we decided that the government could basically spend the money in three ways:

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ANG Traders 1 year ago Contributor's comment

Thank you for the clear explanation.

Alpha Stockman 1 year ago Member's comment

Yes, a great read.

Gary Anderson 1 year ago Contributor's comment

I agree, but I don't understand what he means by pure debt free money creation unless he is talking about the Fed expanding its balance sheet which would not add to the national debt. But that is more like helicopter money than MMT.

Howie Sandberg 1 year ago Member's comment

Good point.

Gary Anderson 1 year ago Contributor's comment

Must read. Doesn't answer all my questions about MMT but certainly it is helpful.