Like It or Not, We’re All on Board the MMT Train — and the Train Has No Brakes

By John Banks

Modern Monetary Theory, or “MMT” for short, is a hot topic — or at least it was before 2020 exploded.

Prior to the pandemic, there was a lively, ongoing debate about whether MMT was a good thing or a bad thing; whether MMT makes sense, or whether it’s a bunch of nonsense; and how soon deeply indebted Western governments might implement variations of MMT.

As of June 2020, we can say that MMT is no longer a hypothetical. It is already here.

To put it another way, the whole world is now on the MMT train — and the train has no brakes.

A popular nickname for MMT is “Magic Money Tree,” because some view MMT as a license to spend without limit. For example, governments guided by the principles of MMT could, in theory, spend enough money to guarantee jobs for everyone, and never have to worry about recession or default risk.

The basic idea behind MMT is that, if a government issues its own currency, and has no meaningful debt burden in someone else’s currency, there is no hard limit to the amount that the government can spend.

If a government wants to spend more — to give everyone jobs, for instance — it can simply create currency to pay for such measures directly, with no need to issue debt or raise funds through taxes.

Proponents of MMT do acknowledge that, if a government spends too much or too recklessly, inflation could become a problem. They further argue that taxes are a means of solving the inflation problem.

In the view of MMT, taxes are unnecessary as a means of funding — the government can simply fund itself — but remain useful as a policy tool for managing overall inflation levels.

If inflation is making an economy run too hot, the government can — again, according to MMT — raise taxes for the express purpose of cooling things down and reducing monetary velocity. MMT views taxation as a control mechanism, not a funding mechanism.

We think of MMT as a train with no brakes because of the folly in the tax idea.

In the real world, the hypothetical ability to raise taxes would not prove much of a brake at all.

A government experiencing high inflation could hypothetically jack up tax rates until the inflation goes away — but in practice that would never actually work.

For one thing, politicians would never accept a sharp increase in taxes every time inflation became a problem. Constituents would never stand for it. Then, too, if the tax rate moved around with the inflation data, it would wreak havoc on the financial planning process for businesses and consumers alike.

Worse still, because changes in tax policy would hit the economy with a lag, policy makers would always be stuck behind the curve, responding to conditions that are out of date.

But there is a far worse problem with using taxes as a form of inflation control: In terms of slowing down a too-hot economy, raising tax levels would be an incredibly, brutally blunt instrument — akin to striking a cow with a sledgehammer. With minimal force comes minimal (if any) results. Anything greater causes lasting damage.

Needless to say, swinging a sledgehammer at a living creature would be inhumane and insane — but that is the point. So, too, is the MMT idea of slowing down an economy via tax policy. In the event of an inflationary spike, policy makers would have no idea how much force to apply or where. Real people and businesses would be badly hurt as a result.

There are many other problems with MMT, too many to discuss or even list here. The inability to control inflation through their proposed method (raising taxes) is just one of the big ones. 

Another problem with MMT is that, when a government creates too much currency, or otherwise deploys huge amounts of currency in a wasteful or foolish way, it is not just inflation that threatens to become a problem. An even worse problem is a loss of confidence in the currency itself.

There is a big difference between lowering one’s preference for holding a currency due to inflation and losing faith in the integrity of a currency as a store of value or medium of exchange.

The MMT theorists have an answer to this objection, too: They argue that a government-issued currency will retain its value if the currency is required to pay taxes.

To put it another way, the U.S. dollar has a mandated use case that is backstopped by force. U.S. entities require U.S. dollars to cover their tax obligations, and tax compliance is enforced by law (if you don’t obey the state, the state can seize your assets or throw you in jail).

But the taxation argument is problematic, too, because even with a tax mandate, users of a currency do not have to hold that currency in between tax payments.

If consumers and businesses decide to shun their home currency for whatever reason, they can hold their funds in some alternative vehicle on a day-to-day basis, swapping into the necessary currency only at the point of transaction, and only in the exact amount needed to cover the tax payment. The need to pay taxes thus would not stop a currency’s downward spiral if a loss of faith kicked in.

Modern Monetary Theory is correct in a technical sense: It is true that, in terms of the mechanics and the plumbing, there is no requirement for a government to issue debt or gather revenue prior to spending.

A government can, in fact, create money from thin air and then spend it.

The Federal Reserve is not allowed to create currency — technically speaking, they are only allowed to buy or sell debt securities — but the Bank of England (BOE) can create currency directly, and in response to the pandemic, they actually did.

“The U.K. has become the first country to embrace the monetary financing of government to fund the immediate cost of fighting coronavirus,” the Financial Times reported in April, “with the Bank of England agreeing to a Treasury demand to directly finance the state’s spending needs on a temporary basis.”

What “monetary financing of government” means is that, rather than raising funds by issuing government debt — the typical thing that happens — the BOE simply created British pounds electronically from thin air, and sent them to the U.K. Treasury to cover stimulus-related costs.

What the BOE did was a literal interpretation of MMT, in the most direct sense. A government can spend without collecting revenue or issuing debt. In the U.K., they just did it.

Now, there is a reason governments never do it this way under more normal circumstances.

If a central bank can create currency at will at the Treasury’s request, it becomes very hard, if not impossible, to know how much currency is being created, or when a new batch of currency is due to be created, or how much. The normal guardrails and constraints disappear, which is unsettling for those who are expected to hold the currency as a store of value or default medium of exchange.

The more standard and accepted way of creating currency — through the official issuance of debt, which is then swapped out for currency — is a deliberately political act, because the issuance of debt is itself a political act. This means that, at least in theory, democratically elected policy makers are subjected to a measure of accountability via the ballot box, which restrains how much debt they issue.

And so, under the normal, non-MMT way, the Treasury issues new debt in a process that is authorized by elected leaders (Congress in the U.S. or Parliament in the U.K.).

That debt may be sold to the private sector, or bought by the central bank to turn it into currency if need be, but the point is that elected representatives authorized the debt issuance, and there is a way to track the debt, and how much of it exists, and what happened to it.

Fiat currency, by the way, is the other side of the debt coin because currency is another form of government obligation, i.e. debt — just read the fine print on any dollar bill.

If you think of the Federal Reserve as a bond trader, and imagine dollars as zero-maturity bonds, it makes sense: The Fed can swap, say, newly issued 10-year treasury notes for zero-maturity dollars, because they are just two different forms of debt.

So MMT is right that governments can skip that whole debt issuance thing, and we know this because two months ago, the BOE actually did it.

The problem is that the MMT way — just creating currency outright — also skips the inherent connection between trackability (as to how much debt or base currency there is) and election-based accountability (linking the country’s finances to a democratic process).

To understand why direct currency creation (the MMT way) is dangerous, imagine if the BOE and the U.K. government went even further than it did in April, and did so with arrogant abandon.

Picture the Bank of England and U.K. Treasury saying something like: “From now on, we’re not issuing any more gilts (the U.K. version of bonds) at all. No more debt. We’re just going to create British pounds from thin air and tell you about it later. And by the way, we are retiring all of the existing debt.”

If this happened, the British pound would be subjected to a catastrophic loss of faith. Corporations and savers would not wait around for stagflationary downstream effects to ravage the pound. Instead they would drop the currency like a hot potato, only re-engaging with it for tax payment purposes at the point of transaction.

A cliff dive in the pound’s value would then likely trigger a dramatic rise in import costs and a nasty spike of inflation, or worse yet, stagflation (the presence of inflation without growth) — and in this situation, the MMT solution to paring back inflation, “raise taxes,” would just worsen the catastrophe. 

Meanwhile, in the United States, we are seeing a kind of “de facto” version of MMT — also as a result of the pandemic — in the form of monetary policy and fiscal policy landing at the same time.

As mentioned, the Fed does not have the same leeway as the BOE. The current rules do not let the Federal Reserve create currency directly.

But to the extent the Fed can unleash multi-trillion lending programs in conjunction with the U.S. Treasury, even as the Treasury enables “helicopter drop”-style cash infusions for hundreds of millions of Americans, the result feels very much like MMT in terms of its electrifying effects.

Central bank liquidity actions are the “monetary” part; free money from the government is the “fiscal” part; put them together and it feels very much like a straight-to-the-vein MMT injection, even if Congressional debt issuance is still technically involved.

This fiscal-monetary combo is, in part, how the Frankenstein stock market rally originated. As the Federal Reserve backstopped every credit facility in sight, the U.S. government transferred hundreds of billions of  dollars (via stimulus checks) directly into the bank accounts not just of those who needed the money, but many who didn’t need the money — and thus used the funds to buy stocks. 

This is all likely to end badly, if not catastrophically — but we may be closer to the beginning than the end.

Government programs that are “temporary” tend not to be temporary, but permanent, and government programs that are “small” tend to grow large over time.

It is likely to play out in similar fashion with MMT-style experiments on both sides of the pond.

When the economy slips back into a downturn, or even just starts to look weak again due to exploding debt levels and below-trend growth, another nip of MMT juice will feel irresistible. And then another, and another, and another, until the government requires the MMT version of Alcoholics Anonymous. 

Over the long run, this will ultimately be a path either to inflation, or something that looks and feels like inflation, but is actually far more devastating — an utter loss of faith in the integrity of the currency itself, with a persistent erosion trend that moves past the point of no return.

And, as mentioned, the supposed braking mechanism that MMT recommends — raising taxes — will prove to be no brake at all, because raising taxes in a stagflationary environment (inflation plus low or no growth) is a good way to kill an economy, and because the notion is politically untenable.