Modern Monetary Theory

Modern monetary theory (MMT) is a new approach to macroeconomics. To call this monetary theory modern is to assume that it is a better theory, built on better, more recent evidence than old-fashioned economics, such as Keynesian economics. However, this is presumptuous. MMT has many critics.

Part of the increased recent interest in MMT is that some people view MMT as a way to help the poor and the middle class without increasing taxes, simply by increasing the money supply and paying for increased benefits with seigniorage, the profit from creating money.

Many of the ideas of MMT overlap with that of functional finance, an economic theory proposed by Abba P Lerner. Functional finance argues that prosperity is more important than balancing revenue and spending. Fiscal policy and taxes should be based on improving economic output, not simply as a means to raise revenue. The appropriate size of the budget deficit should be large enough to ensure full employment.

Foundation of Modern Monetary Theory

Modern monetary theory is somewhat nebulous, with different people having different ideas about what it is. Modern monetary theory was pioneered by American economist and theorist Warren Mosler in 1992, along with Bill Mitchell, a university professor based in Australia, a key developer of the theory.

MMT proponents argue that the issuer of the currency faces no financial constraints, since it can always print more money, so it can never become insolvent in its own currency. A country that prints its own currency can pay for a significant portion of its liabilities by printing more money. The only constraint on spending is inflation. Governments could control inflation by spending less or taxing more.

MMT proponents argue that hyperinflation occurs when too much money is printed compared to economic capacity, such as what happened with the Weimer Republic of Germany after World War I, when that economy was destroyed by World War I, or Zimbabwe during the 1990s, when the government pushed out white farmers who knew how to farm and replaced them with soldiers who did not know how to farm, leading to starvation and economic depression. However, these are extreme forms of hyperinflation.

Certainly, the money supply can be increased substantially under certain circumstances without significantly increasing inflation. For instance, Japan has a deficit of 240% of GDP, yet it has little inflation. Indeed, as of 2021, Japan had a negative inflation rate of – 0.29%. Likewise, Denmark, Sweden, Switzerland, and countries of the euro currency area imposed negative interest rates, to promote lending, and printed $2.5 trillion of new money, but without significant inflation.

Another sign that increasing the money supply does not necessarily increase inflation is that inflation spiked only temporarily after a big increase in the money supply after the Great Recession. In the United States, the amount of cash in circulation increased from about $1 trillion in 2008 up to $4 trillion in 2014, then declined to about $3 trillion by 2019. Inflation increased substantially at 1st, but then subsided to less than 2%.

MMT proponents also argue that fiscal policy should have a greater role in guiding the economy, rather than relying exclusively on monetary policy. The main function of taxes, they argue, is to lessen inequality and to control inflation by taking enough money from the economy to prevent excessive spending. The government can increase economic output by spending freely, since it does not have to worry about debt.

Employment could be stabilized by adding a federally funded, locally administered job guarantee, where the government would employ more people during economic downturns and fewer people in economic upturns.

Contrary to the assumptions of classical economics, MMT posits that increasing budget deficits will not raise interest rates necessarily, since increased government spending increases the money held by banks, which would lower interest rates if there were no increased demand for money. Government deficits are the private sector’s surplus, because if the government did not borrow, then that money would have to be collected as taxes from the private sector. Tweaking interest rates is ineffectual, since businesses select projects based on growth potential, not the cost of money.

What Causes Inflation?

Inflation is complex. Although many factors affect inflation, the direct cause of consumer inflation is businesses raising prices, because this is what the government measures when it measures consumer inflation.

There are 2 types of inflation: cost-push inflation and demand-pull inflation. Cost-push inflation is caused by price increases in supplies or other business inputs, often caused by shortages or bottlenecks in production. It can also be caused by monopolies or oligopolies taking advantage of their market dominance by increasing prices to maximize their profits. It can also be caused by corruption, such as by hoodwinking consumers into overpaying or buying products or services that are not needed or do not convey the advantages advertised.

Demand-pull inflation is caused when aggregate demand, the total demand by an economy, exceeds the optimal economic output. This is the type of inflation increased by a greater money supply. The optimal economic output is the maximum amount an economy can produce without straining resources, such as not having to make major capital investments or paying overtime to meet the increased demand. But if the economy is producing less than the optimal output, then an increase in aggregate demand will not increase inflation until the economy reaches its optimal output. But if the economy is already producing at the optimal output, then increasing aggregate demand will increase inflation significantly.

Diagram showing how increases in economic output becomes less for the same given change in aggregate demand as real GDP approaches, then exceeds, potential GDP.

Diagram showing how increases in aggregate supply and economic output becomes less for the same given change in aggregate demand as real GDP approaches, then surpasses, potential GDP. (P = Price, AD = Aggregate Demand)

Macroeconomists often divide the aggregate supply curve into 3 sections.

  1. The 1st section is the fixed price level range, where quantities can be increased without increasing inflation, since the economy is below its potential output. (Example: AD1 to AD2 in the diagram.)
  2. However, as potential output is approached, then prices start rising faster as quantities are increased further. (Example: AD3 to AD4 in the diagram.)
  3. Prices rise fastest and real GDP grows slowest, when economic output exceeds potential output. The economy can temporarily produce more than its potential output, by investing more capital, by running factories longer, and by increasing overtime, but it will eventually return to its equilibrium state of potential output. Hence, this part of the curve is vertical, where increasing aggregate demand simply results in greater inflation. The cost of raw materials and labor rises steeply, forcing businesses to raise their own prices. (Example: AD5 to AD6 in the diagram.)

Moreover, whether an increase in the money supply will increase aggregate demand will depend on who gets the increased money supply. Because lower income people have a larger marginal propensity to consume, meaning that they will spend a larger proportion of any additional income they receive, income to this group will more likely be inflationary. Wealthier people, on the other hand, will invest more of their additional income, which will be less inflationary, at least for consumer goods and services.

Economic growth also limits inflation. The economy grows over time, as technology improves and knowledge increases, which leads to greater competition, which lowers prices or minimizes increases in price.

So increasing the money supply will not necessarily lead to inflation if the economy is operating below its optimal output or if more of the new money goes to the wealthy or if the new money is increased only as much as required by the growing economy. However, continually increasing the money supply cannot fund the whole government or even most of it.

Criticisms of Modern Monetary Theory

Fiscal policy can be a great way to maximize the economy. The main problem with using fiscal policy to control the economy is that the politicians have complete control over fiscal policy, and there is little chance they will give that control up. After all, voters are most concerned about taxes. Major political donations are given to support lower taxes on the wealthy. Therefore, politicians are not going to set fiscal policy to maximize economic output or to increase equality; instead, they will try to lower taxes on the wealthy, which does not help the economy at all, though many wealthy people argue otherwise. Because politicians are concerned about being reelected, they will set fiscal policy to increase the likelihood of being reelected, and since it takes much money to get reelected, many politicians will choose to cater to special interests, to receive their large political donations.

Another major problem with using the printing press to pay for government is that politicians will resort to it continually, regardless of inflation, hoping to kick the can down the road, hoping to leave the inflation problem to their successors, as is often done when politicians try to solve problems.

And because printing money is politically safer for politicians than raising taxes, this is what politicians will naturally do, but continually depending on an increased money supply to fund government will most certainly lead to higher inflation, if not immediately, then later on. Once money is printed, it will remain in the economy, causing inflation now or later. While central banks can sell government debt to reduce the money supply, these purchases come mainly from the wealthy or from investment funds, which is money that was not being spent for consumer goods and services anyway and, therefore, will have little immediate effect on inflation.

This is why most economies depend on monetary policy set by central banks, which have some political independence, allowing them to set monetary policy according to the needs of the economy rather than to the whims of politicians. Voters are also less concerned about monetary policy. Few people have a view on what interest rates should be, but everyone has a view on what tax rates should be: lower!

Hence, expecting politicians to set fiscal policy to maximize economic wealth is just unrealistic. While there are some ways of setting rules that would change tax rates based on automatic triggers, most politicians would probably not support that, since most major political donations are given for preferential treatment of the donors, the wealthy.

The primary problem with using inflation triggers to limit further increases in the money supply is that inflation significantly lags an increase in the money supply. Therefore, monitoring inflation is not an effective method to base decisions on how to control the money supply.

Inflated money will also have less value in the international markets. Imports will become more expensive. Indeed, if rampant inflation is expected to continue, other countries may not want to accept inflating fiat currency; they may start to demand gold again.

MMT does not believe that the economy should be cooled or stimulated by raising and lowering interest rates, since the natural rate of interest for fiat money is 0; setting it higher benefits the investor class. Tweaking interest rates do not work because businesses decide on investments based on their prospects for growth, not the cost of money.

However, money has time value and opportunity costs. Interest rates on loans provide a measure to decide whether to borrow or not. Borrowing money instead of printing money will be less inflationary. Indeed, since non-wealthy people tend to borrow more, and pay higher interest rates, higher interest rates on loans will help to keep inflation down. Money does have an opportunity cost, so if lenders cannot earn interest, then they would not lend. Furthermore, it helps to determine the best uses of money. For instance, growth prospects are not the only thing that businesses consider in investments. They also consider the cost of capital, the cost of money they would need to borrow to pay for their projects. If the net present value of the project is positive, meaning that the expected return of the project exceeds its cost of capital, then the project is worth considering further. However, since businesses can only do so many projects, calculating net present value can help determine which projects would be most worth doing.

MMT argues that the economy can be stimulated or cooled by increasing employment when the economy is suffering and decreasing employment when the economy is optimized.

The problem with the government employing people directly is that whatever work they do will be temporary, and what would they be doing? How much will they pay the workers?

A better way is to spend more money on projects that need to be done. By using businesses to increase employment, businesses can hire the required people when necessary or lay them off if work slackens. A good use of spending is to increase scientific research, which yields many dividends. Scientific research has great economic usefulness, and spending more on research will help to draw intelligent people into more valuable fields, such as science, and away from fields that, while they may pay well, do not have much economic worth, such as legal services. Another benefit of research is that it can help to increase efficiency for businesses and other organizations. The Internet is a great example of new technology that greatly reduced the cost of many services and provided many new services that did not exist before, and this technology was initially funded by the government.

Other methods to increase employment include eliminating artificial barriers to entry, such as the many local licensing requirements for simple professions, such as for barbershops or beauty salons. Many of these licensing requirements were lobbied for by these professions to limit competition in their fields, enabling them to charge higher prices. Anticompetitive contracts, such as not allowing people to work for other competitors, should also be eliminated by outlawing such provisions.

As far as increasing employment, the federal government should target the most valuable industries, then spend more money in research in those industries, which would increase overall economic wealth by the most compared to spending the money elsewhere.

A Better Solution

There is no simple proportionate relationship between the quantity of money and the general level of prices. However, no simplicity does not mean no relationship, for hyperinflation proves that there is, indeed, a relationship, where at some point, increasing the money supply will increase inflation.

There is no question that the money supply can be increased under certain circumstances to partially fund the government, but it cannot replace taxes, and it certainly cannot be used to reduce inequality. Having a better, fairer tax policy can go a long way toward achieving a more equitable society. Because the marginal propensity to consume is inversely proportional to wealth, the economy can be best stimulated by reducing taxes on the poor and the middle class, who will spend most of their money. Lower taxes on the less affluent will maximally stimulate the economy. Inflation can then be better controlled by adjusting interest rates because central banks will not have to resort to zero or negative interest rates. A more progressive tax rate will form a floor of support for the economy, making it easy to control inflation with higher interest rates.

A diagram illustrating the consumption function, how consumption varies with the marginal propensity to consume and disposable income.

Note how the propensity to consume varies with income. At low-income levels, all increases in income are spent (#1 in the diagram: C = I), while at higher incomes (#2), consumption is less per unit increase in wealth (C < I). Although this diagram is schematic, it does comport with the fact that, per unit of wealth, wealthier people save more and consume less.

The marginal propensity to consume is also illustrated by the higher economic growth in poorer countries than richer countries. Economies grow much faster in emerging markets because the people have so little to begin with, so the marginal propensity to consume is high, while the marginal propensity to consume is much lower in wealthier nations, which is 1 reason why the growth rate of any economy starts leveling off as the wealth of its citizens increases.

The tax rate may also be set to increase when inflation increases, which will help to dampen any inflation, but politicians are unlikely to allow this. Government can be funded by increasing taxes on the wealthy, which can be done without hurting the economy. Bill Clinton raised taxes on the wealthy during his last term as President, even as the economy boomed, which was the only time since Ronald Reagan when the federal government had budget surpluses.

We read every day that the top 1% are receiving an ever-increasing share of the wealth that the economy produces. The primary reason why the wealthy are receiving more of the wealth is because they decide how it is distributed and many of the wealthy have decided to keep more of it for themselves. A simple example illustrates this. Many CEOs of major companies are receiving an income hundreds of times greater than their average worker. Is it because they are hundreds of times better than their workers? Of course not. They either determine or significantly influence their compensation directly, and since everyone works in their own interest, they decide to compensate themselves more rather than less. Of course, since businesses only earn so much revenue, that leaves less to distribute to the workers. On top of that, they get to pay less taxes on their income, because much of their compensation is in the form of stock options, allowing them to pay the lower long-term capital gains rate and to avoid paying employment taxes on that income.

Allowing the wealthy to pay an overall lower tax rate on their income means that lower income people must pay higher taxes to compensate the government for receiving less tax revenue from the wealthy. The wealthy pay much less tax as a percentage of the wealth, because income earned from investments or received as an inheritance was taxed considerably less than income received from work. And since investment and gratuitous income accrues mostly to the wealthy, they are the main beneficiaries of the lower tax rates on nonworking income. This is much easier to see with a simple example. Imagine that an economy’s tax base consists of 3 people: the worker, the investor, and the beneficiary. Now imagine that the government needs $3000 of tax revenue. With 3 taxpayers, it can collect $1000 from each taxpayer to get the revenue it requires. However, if the beneficiary does not pay any taxes, then the other 2 taxpayers will have to pay $1500 each, since the government’s need for revenue does not decline because it decides not to collect taxes from the beneficiary. And if the investor does not pay any taxes, then the worker will have to pay the entire $3000. But note that the worker will have to pay more even if the other 2 taxpayers do pay some taxes, but at a lower rate.

The biggest problem with funding government is that the wealthy pay politicians to keep their taxes low. This is why work is the most highly taxed form of income, while investments and gratuitous transfers are taxed much less. The problem with not increasing taxes on the wealthy is that, as they accumulate more and more of the wealth, more of the economy’s wealth will be subject to lower tax rates, thus reducing potential revenue to the government, even as government expenses continue to increase. As their wealth increases, the wealthy will have to pay more and more of the taxes, and if they do not, then the government will not be able to fund itself. It is a simple as that.

In 2020, the United States federal government received about $600 billion of seigniorage, and that amount will continue to increase with the economy. However, the government spends more than $4 trillion annually, so it cannot be used to solely fund the government. Taxes cannot be avoided; taxes must provide the bulk of the revenue for the government. Furthermore, the interest paid on federal government debt according to Government - Interest Expense on the Debt Outstanding was $522,767,299,265 in 2020. In 2021, it will significantly exceed this because of the government stimulus checks and other expenses due to the Covid-19 pandemic. If the government did not have to pay this interest, then that money could be used to fund other major government expenditures, which would allow for lower taxes.

When you consider that the marginal utility of money is considerably less for the wealthy than it is for the poor or middle class, there is no reason why the wealthy cannot at least be paying the same tax rate on all of their income as the rate assessed on working income, including employment taxes. And indeed, if all income were taxed the way work is taxed, then the government would have plenty of money.

So there is nothing new about modern monetary theory. It simply presents a different point of view about seigniorage, taxes, and inflation. Although some of its policies would work under certain circumstances, a better policy for a more equitable society would be applying a progressive tax rate to all income, then using monetary policy to control inflation. Lowering taxes on the less affluent would provide a floor for economic activity and output, making it easier to control inflation with monetary policy.