Modern Monetary Theory (MMT)

Bankruptcy is terrifying. It’s bad when a household goes bankrupt and even worse when a business goes bankrupt, but that pales in comparison to the total and absolute devastation experienced by a country when its government goes bankrupt. So a fear of too much government expenditure and a worsening deficit is understandable. But is this fear justified? Modern Monetary Theory (MMT) says our fear of crippling government debt is overblown, and here’s why.

It’s easy to compare governments to households. Governments, like households, have a source of income through taxation. Governments, like households, borrow money and have debt. If governments, like households, can’t pay back their debt, they go bankrupt.

MMT tells us to stop comparing governments to households for one reason: governments can print money (in reality, change numbers on a spreadsheet). But why don’t governments create money all the time? Wouldn’t this help solve issues like climate change, poverty and homelessness? 

Traditional economics says we can’t print money because of inflation. Inflation is when money decreases in value and general prices rise. When governments print currency, more money floats around in the economy. And as more money is created, the value of each dollar decreases, so inflation occurs. So by shoveling more money into the economy, everyone actually becomes poorer.

This isn’t quite the case. A major cause of inflation is when overall demand in the economy exceeds overall supply. Businesses see this and raise prices to increase their profits, and soon prices have risen for everyday goods, from food and clothing to rent and utilities. Because of this overall price increase, the value of money has actually decreased - $100 buys less now than what it did previously. This is called demand-pull inflation.

When governments print a whole lot of money and give it away, people feel richer and spend more in the economy, thereby increasing overall demand. If this new level of overall demand exceeds overall supply, inflation will occur. But if the new level of overall demand is matched by overall supply, inflation will not occur.

It’s hard to understand, mostly because it is so ingrained within us that printing money is bad for the economy because it will cause inflation. But as long as there is enough aggregate supply, enough goods, services, resources and assets that can support the subsequent increase in demand from printing money, inflation will not occur. 

Here’s a more basic way of looking at it. Money is a technology that is used to help societies exchange goods and services. Printing money is not objectively bad - governments had to print money in the first place in order to help the exchange of goods and services. Through printing more money, governments boost an under-performing economy by allowing previously poor consumers to buy from sellers with excess stock. 

 

I really want to make sure that you understand this, so here’s another way of looking at it, especially if you like maths. Some economists like to use this equation to model inflation: MV = PQ

• “M” is the amount of money in the economy

• “V” is the velocity of money, or the rate at which people spend money in the economy (essentially demand)

• “P” is prices (so if P increases, inflation occurs)

• “Q” is the quantity of goods and services in the economy (essentially supply)

If we rearrange the equation, we get: P=MV/Q. But what does this equation mean for us? 

During the pandemic, because of low consumer confidence, disruptions to supply chains and the fact that we were literally trapped inside our own homes, we bought less stuff, so V decreased. But the pandemic did not drastically affect supply, so Q stayed the same. This means that we can increase M by printing money and not see any significant increase in prices. In other words, the government can create money without causing inflation as long as there is stuff to spend it on.

Are you confused yet? Let’s look at MMT through the perspective of unemployment. The unemployment rate is the number of unemployed people expressed as a percentage of the labour force (which is employed + unemployed). There are three main types of unemployment. Frictional unemployment is experienced by workers moving between jobs. Structural unemployment is experienced by workers who are outpaced by technology or a changing economy (ie Luddites). Cyclical unemployment is when workers lose their jobs due to the natural cycle of booms and recessions.

In the short term, the government can’t do anything about frictional and structural unemployment - that’s why there will always be some unemployment in the economy. However, the government can do something about cyclical unemployment - they can inject money into the economy, increasing consumer demand and therefore encouraging businesses to ramp up production by hiring these cyclically unemployed workers. If all the cyclically unemployed people in Australia’s economy found jobs, the economy would be operating at full employment. In other words, when the unemployment rate only consists of structural and frictional unemployment (known as natural unemployment), the economy is meeting its current productive capacity. This is why many MMT supporters support a policy that gives anyone looking for work a low-wage government job (usually doing community work like building roads and houses) - it helps the economy reach its productive capacity. 

So what does this mean for us? Right now, most of the world is recovering from the recession caused by the Coronavirus pandemic. Because of lockdowns and general uncertainty, this recession was caused by a sharp decline in overall demand, so businesses have had to reduce workers’ hours or let them go entirely, causing cyclical unemployment. If the government printed some money and injected it into the economy, overall demand would recover. Businesses would see this and start hiring the cyclically unemployed to help boost overall supply, and the economy would be back to full swing.

 

Let's get back to the idea of government debt. If lenders (bondholders) know that the government can always create money to pay back its debt, interest rates will be very low as there is almost no risk of default. But hang on, if governments can print money, why should they borrow in the first place? Issuing bonds would be a smart policy choice for two reasons: to use excess funds in the economy (borrow money from rich people at a low interest rate) and to manipulate the overnight interest rate (have influence over interest rates in the economy).

 

Critics of MMT cite stagflation as a reason why it doesn't work. Stagflation is when rising unemployment meets high inflation (it’s very bad). This in itself is unusual, as traditional economics states that unemployment and inflation have an inverse relationship (if one goes up, the other goes down, and vice versa). MMT critics say that if governments create money, inflation will occur, and because of this inflation businesses will try to cut costs by letting go of employees, thereby increasing unemployment too. Of course, this increased inflation coupled with increased unemployment would cause stagflation.

But is this really the case? The US experienced stagflation in the 1970s. Using the two graphs below, can you figure out why the US had high inflation and high unemployment?

 

Crude Oil Prices

Inflation

If you guessed that oil prices had something to do with inflation, you’d be right! And since oil is used in practically everything (most importantly in energy and transport), if the price of oil is rising, businesses need to pass this to consumers in the form of rising retail prices - hence inflation. Of course these graphs don't perfectly match as there are other factors affecting inflation, but the general trend of inflation in this example, including the two peaks in 1974 and 1980, is reflected in the crude oil prices.

 

What does this tell us? Stagflation is not caused by printing money, it is caused by a slowing economy and a rising cost of supply.

But what happens if, in the extreme, the government accidentally prints too much money and overheats the economy? For this to happen, more money would have to be printed and be in use than what the economy could supply. Overall demand would exceed supply and demand-pull inflation would occur. How can governments stop this? The answer is simple: increasing taxes. By increasing taxes, the government is taking money out of the economy, lowering the money supply. Consumers have less money, so they spend less, and therefore overall demand falls. Supply can meet this lower level of demand, and therefore inflation is curbed.

For those who are still in doubt about MMT, it is technically already in use. The amount of US dollars has increased by over 40% since 2019, yet annual inflation currently under 2% (as of February 2021). Many developed economies, including Australia, the US and Britain have already employed Quantitative Easing (creating money in a complicated way) in the wake of the pandemic.

 

US money supply (in million USD)

Despite this, we haven’t fully embraced MMT, and nobody quite knows what will happen if we do. I might not know much about economics, but the only real argument I see against MMT is that corrupt politicians might print money to make themselves more popular, and they could be unwilling to implement higher taxes if they create too much money. But with issues like climate change, homelessness, and poverty looming over us, I think MMT is worth a shot.

It is a pretty radical idea, though, so if you have any concerns, let me know in the comments!