Modern Monetary Theory: A Working Theory Out of Control

Some time ago, we reviewed a seminal book on Modern Monetary Theory by Stephanie Kelton.   As an aid to Senate Democrats, Bernie Sanders, and Elizabeth Warren, she has achieved wide influence within the Democrat Party. See the archives for November 25, 2020, The Deficit Myth – Modern Monetary Theory and the Birth of the People’s Economy: A Review

Monetary theory is difficult to understand and explain, but we will do our best to explain it in a short essay. In the necessary compression of these ideas, we will do some injustice to them but it cannot be avoided.  However, the takeaway for the reader is mainly the policy problems present today in the economy.

Given the wild budget proposals of the Biden Administration, it is evident that most party functionaries buy into her theory. The Wuhan virus crisis gave advocates the perfect opportunity to not only increase deficit spending but also to pass out money directly to the public directly in the form of checks.  As a result, M2 money supply (a key determinant of inflation) has been soaring.

Well, hardly a year into the Biden Administration, inflation has become a serious problem. Yes, we know about supply chain issues from China, the cost of shipping, and the hundreds of ships that can’t get into port. That might explain part of it, but we don’t get our food and fuel from China and these are items going up the most.

Besides, Biden has overstimulated an economy that was already starting to come back from the stupid and flawed lockdown policy to deal with the virus. This was followed by massive injections of money directly to the public and unemployment benefits so generous it has created a labor shortage. This has even some left-leaning economists like Jason Furman and Lawrence Summers concerned.

The inflation problem has everything to do with printing excessive amounts of money and then heaping on regulatory and Wuhan virus policies that stifle production and work.

Without delving into granular detail into the theory of MMT, which we have done elsewhere, the theory basically posits that deficits don’t matter, that printing money does not cause inflation, and that if inflation does become a problem, it can be dealt with by raising taxes.

For the moment, if we accept their premises, faulty though they may be, we can demonstrate the theory still does not hold together from an operational point of view. It might operate successfully under a dictator, but it is dysfunctional in a constitutional republic that has dispersed centers of power, a central bank with nominal independence, and still large elements of operationally free markets.

For example, money creation is largely a purview of the Federal Reserve, which bows to politics on occasion, but on occasion is also independent. They create money when they buy government debt. Money is also created when banks make loans, which low-interest rates encourage and said rates are largely under Fed control. Interest rates are a function of both free-market forces and Fed policy. The excessive deficits we suffer from, are not yet causing rates to rise markedly yet, because the FED buys the bonds before they ever come on the market. Where did the FED get the money to buy them? Well, they created the money out of thin air.

However, the deficit is under the control of Congress and the Fed may or may not monetize all of it.

If the Fed decides to reduce its bond purchases, or in today’s parlance “taper”, rates will start to rise against an enormous debt bubble supporting overinflated equity prices.

For some time the growth of banks reserves did not cause excessive consumer price inflation because the money stayed largely within the banking system and elevated financial assets like stocks and real estate. However, MMT advocated the direct injection of money to consumers which began under Trump and has followed in spades on under Biden.

A good working definition of inflation is too much money chasing too few goods. When you print vast amounts of money and then shut production down through stupid Covid policies, you have set up a perfect storm of more money, fewer goods.

Under the theory of MMT, when inflation becomes a problem, the excess money thus created can be sopped up by raising taxes. Even within the confines of this theory, things can’t work out if taxes are not raised.

What if Congress runs up huge deficits, those deficits are monetized (the FED buys them), but then the Congress can’t see its way clear to raise taxes?

Is that not where we are right now? The Congress spent the money and sent out checks to anyone who can fog a mirror, demand is surging, the FED is monetizing, supply is constrained, but suddenly a few Democrats like Manchin and Sinema, have second thoughts about crushing taxation.

Understand, we side with Manchin and Sinema, we just want to point out their theory said inflation can be stopped by raising taxes. What if Congress gets cold feet? They are already getting significant political blowback on inflation, Biden is tumbling in the polls, and now politicians are supposed to raise taxes and suffer the political fallout from that? This may not be smart given elections for Congress are next year.

In short, the theory did not appreciate that FED printing and Congressional tax-raising might be hard to coordinate as easily as the theory suggests. It is not as if Stephanie Kelton is the pilot flying something as complex as the economy, who can just pull levers at will. Competing agencies are working, political log rolling is going on, and the opposition party in Congress is only behind by a few votes. One or two Democrat defectors, and the taxes don’t go through.

So, what if MMT sets loose inflation in the land but the government cannot take the steps to reign it in?

Moreover, the government is not in charge of what elements of the free market that are still free and left to operate. Consumers for example, if they feel prices will be going higher, start buying in advance of inflation, hoping to acquire goods before they go up further in price. Businesses may want to accelerate inventory accumulation, buying needed goods and components before they too go higher in price. Lenders and savers may require higher interest rates because present rates provide negative rates, well below the rate of inflation. All the aforementioned steps by private actors are a rational response to a government deliberately funding itself through currency inflation. Once this psychology takes hold, it is extremely difficult to break.

In terms of mainline monetary theory, free-market forces (the willingness to lend and borrow) can influence the money supply, the psychology of investors, consumers, and entrepreneurs can influence the velocity of money turnover. When inflationary psychology takes hold, prices can race upward because the velocity of money rises somewhat independently of its quantity. People want to spend the money before it loses further value. A given quantity of money will turn over faster and faster.

Now, what happens to the elegant  MMT theory?

It is evident that even within the schema set out in MMT, it cannot work in a constitutional republic where both houses of Congress can act independently, the Fed can act somewhat independently, the Executive can act independently, the bureaucracy can act independently, and what is left of free markets can act independently.

MMT advocates actually use the metaphor of monetary sink filling with money. When it starts to overflow, simply drain excess money through taxation. Well, what if the drain clogs due to politics and turf disputes between independent agencies and branches of government? You then get serious inflation. The implementation of MMT policies only could work if there was a dictator and no free market. Are we supposed to give up our constitutional republic and prosperity so their theory can have a chance at working?

MMT then runs into the “information problem” Hayek and other Austrian economists have pointed out. How much should the money supply grow, what is the right level of inflation, what is the correct level of interest rates, how many cars should be built, how much oil should be pumped, or how much corn should be grown?

In the absence of a free market, politicians can only guess, and they are truly guessing because the only right price and right quantity are those that will allow the market to clear. Otherwise, you wind up with shortages or surpluses. In the absence of free markets, how could one know?

This is the internal hubris of MMT. It supposes that experts can know these things, and secondly, it posits that having this knowledge, politicians and appointed bureaucrats can pull levers and spin dials as if the political system is some unitary and coordinated mechanism.

That is certainly not how things work in a democratic system with dispersed power among both agencies and branches of government.

MMT was wrong in its economic assumptions and terribly wrong in its description of how the system would be implemented and controlled in the real world.

Unfortunately, it appears our government is enthralled with this flawed and naïve theory.

Central planning has never worked. Not under communism or fascism.

Finally, it is worthwhile to reiterate the flawed assumption of MMT insofar as its effect on citizens.

Having once started inflation under their theory, the answer is high taxation. That leaves the citizen in the difficult position of suffering the confiscation of his wealth either through taxation, or inflation, or both.

Frankly, we would like the opportunity to avoid choosing any of those outcomes.