Difficult times make for questionable thinking. So soon you might be hearing a little more about Modern Monetary Theory (MMT) – a slippery body of theory which has emerged from the low interest rate environment which followed the 2008 global financial crisis. It’s hard to pin down but at its heart is the belief that modern governments which can print their own money have fewer constraints on increasing spending and raising public debt levels than suggested by conventional economists and central bankers. MMT is finding popularity on the left wing of America’s Democratic Party as a painless way to pay for renewable energy and state-run healthcare.
The latest person to say we should take this seriously is Mr Ray Dalio, an American billionaire who opines on public policy (his full argument is here and a Bloomberg summary is here). Mr Dalio thinks that interest rates and inflation will remain low; central banks, unable to cut interest rates below zero, will run out of ways to stimulate the economy with monetary policy; and fiscal policy will step into the gap in imaginative ways (for example, printing money to finance state spending, buying assets, writing off debts or even cash handouts).
As is often the case with this sort of thinking, there is a body of truth providing the seedbed from which the theory grows. This can make it more tricky to distinguish sound conclusions from flawed. So it’s noteworthy that MMT has caught heavy duty flak from both ends of the political spectrum. Take the following analyses from economists Paul Krugman and Scott Sumner – who have clashed ferociously on almost every aspect of economic policy over the last ten years.
A Nobel prize winner of the centre-left, Mr Krugman is just the man MMTers would like on their side. He was a strong proponent of the inadequacy of monetary policy both during and after the 2008 global downturn, and a leading advocate of fiscal expansion. But he is very clear on the parameters of this policy and in this column he makes equally clear that he thinks many of the claims for MMT are based on defective reasoning. An example of his customary trenchancy: “So let’s be clear here: Are MMTers claiming … that there is only one deficit level consistent with full employment, that there is no ability to substitute monetary for fiscal policy? Are they claiming that expansionary fiscal policy actually reduces interest rates? Yes or no answers, please, with explanations of how you got these answers …”.
On the other side of the fence, Mr Sumner is a market monetarist theorist (note – different sort of MMT). His thinking runs in a line from Milton Friedman and Anna Schwartz’s pioneering work in the 1960s on the monetary history of the United States. He believes monetary policy should be more market and less model based in order to keep inflation low and better manage unusual demand shocks like the 2008 slump. The key variable is using interest rates to keep nominal GDP growing at a stable rate.
In his assessment of MMT, he says that mainstream economists (read Mr Krugman) are sometimes a little sympathetic towards its claims when the economy is depressed and interest rates are zero, because they think monetary policy may not work and fiscal policy is more powerful. Mr Sumner has no truck even with this carefully-circumscribed sympathy. His view: “In 2013, we saw how even at the zero bound for interest rates, monetary policy is still more powerful than fiscal policy. A dramatic $500 billion reduction in the budget deficit did not lead to the growth slowdown predicted by many Keynesian economists. It was fully offset by expansionary Fed actions and much more aggressive forward guidance.”
Lacking Mr Krugman’s or Mr Sumner’s qualifications, a lay observer with a moderate historical knowledge might ask if Mr Dalio is really wise to assume that the world is stuck in a permanent cycle of low inflation and interest rates. It’s true, as Mr Dalio points out, that Japan has been there for several decades now and has successfully run up a huge government debt of 250% of GDP. But this has been possible because Japan’s numerous old people like cash savings and are happy to lend to their government at screamingly low nominal (and real) interest rates. The government has recycled those savings into spending on schools, police and, with some irony perhaps, pensions. All very neat so far. But bear in mind that there is a commitment – eventually – to repay those resources – say if a grandparent wanted to help a son buy a house or help a granddaughter pay for her education. If this were to happen on any scale, the government will have to divert real spending to do this. Or find a creative way of writing down its obligations.
Nor is Japan’s approach to the current economic climate the only option. Switzerland faced roughly similar circumstances but its government reduced debt to less than 30% of GDP. New Zealand also lowered its government debt to GDP ratio, but its businesses and consumers borrowed heavily at low real interest rates to invest in highly productive assets like dairy farms or rental housing. This has been a great trade – so far. But if there is a change – as yet unforeseen – in global savings, consumption and investment patterns, we could see higher global real interest rates (remember how high rates were needed to defeat inflation in the 1980s and 1990s?). Some NZ investment decisions might then look a bit silly with hindsight. And MMT will certainly be much less appealing (no doubt its supporters will transition smoothly to making the case for capital and interest rate controls).