In recent years, politicians on the far left have leaned on Modern Monetary Theory (MMT) to justify offering increasingly exorbitant spending proposals without plans to pay for them. Then roughly $6 trillion in deficit-financed stimulus approved by Congress in 2020 and 2021 provided policymakers a natural experiment to evaluate the claims proponents of MMT made. The results exposed the critical flaws in their approach, and rather than being able to take a victory lap, MMT is now on its last legs.
The idea that government should use deficit spending to support an economy in crisis is not unique to MMT – economists across the political spectrum supported an aggressive fiscal response in 2020. The core tenet of MMT is that a monetarily sovereign nation, like the United States, can always simply print however much currency it needs to buy whatever goods and services programs require. This is the lens through which proponents of MMT have argued that the only constraint on deficit spending should be inflation that materializes when the economy is utilizing all available resources.
A new paper published by Dr. Eric Leeper for the Progressive Policy Institute deconstructs the problems with this approach. Leeper writes that the modern financial system rests upon certain norms, namely that 1) government spending is financed by either collecting taxes or debt that will be repaid with revenue from future tax collections and 2) the Federal Reserve will operate independently to fulfill a dual mandate of full employment and price stability. Adherence to these norms is what has allowed to United States to enjoy low borrowing costs, a reliable currency, and robust economic growth.
Proponents of MMT want to turn the system over by having Congress use fiscal policy to achieve inflation and employment goals while monetary policy simply plays a supporting role. In other words, the Fed will keep interest rates low to enable Congress to run large deficits indefinitely – at least, until inflation materializes. In her book “The Deficit Myth,” Dr. Stephanie Kelton, one of the thought leaders behind MMT, writes, “for evidence of overspending, look to inflation.” She goes on to say that below-desired inflation signals insufficient spending while above-desired inflation signals excess spending.
But as Leeper explains, MMT has no comprehensive theory of what determines the inflation rate when the economy operates below its resource limit (as it usually does) nor do its advocates have any actionable proposals for managing inflation that has already materialized. It’s telling that, after a year in which prices rose nearly 7 percent for the first time in decades, no prominent MMT advocates are calling for deficit-reducing tax increases. Perhaps it is because they know that elected officials are loathe to enact the measures needed to rapidly reduce deficits at a time when workers are already seeing their hard-earned wages eroded by inflation.
Kelton has in recent days compared tax increases to “a helmet” – a proactive tool that would prevent inflation from happening, but would have little benefit once inflation has already materialized (without ever producing a model that would plausibly justify the distinction). In a New York Times profile published last weekend, Kelton says that the Congressional Budget Office should “analyze possible inflation ahead of time” and then lawmakers should try to offset the impact of inflation with tax increases. How useful is an economic theory that tells us how to avoid inflation, but has no credible recommendations for reducing inflation once it’s higher than desired?
There is also no reason to believe that advocates of MMT would support such precautionary fiscal restraint. CBO did produce an estimate of the gap between projected and potential economic output in 2021, and it was just one fifth of the size of the $1.9 trillion American Rescue Plan enacted last March. Yet at no point did Kelton or other leading advocates of MMT join the calls of other economists to shrink the bill or propose pairing it with tax increases. In fact, some argued the bill should be even bigger – and they did so without producing any alternative model to suggest CBO was underestimating potential output. Leeper’s paper makes clear that the lack of testable models that can be analyzed and debated is a pervasive problem with MMT.
We now have a scenario in which Congress approved enormous amounts of new spending that was not backed by tax revenues, the Fed supported this debt by creating new bank reserves and keeping interest rates low, and inflation soared as a result. Although most of this spending was essential for enabling the United States to experience a robust recovery from the 2020 recession, the excess came at a cost most Americans were unwilling to pay. Instead of acknowledging those tradeoffs and calling for monetary tightening, as conventional macroeconomists would suggest, or fiscal tightening that is the logical extension of their past statements, advocates of MMT are now proposing to control prices through central planning – an approach that didn’t work in the 1970s and won’t work today. These advocates have faced their first real test and failed miserably.
Until its proponents specify the models underlying their rhetoric and resolve the myriad of practical questions about how to operationalize their proposals, MMT will remain what other critics have likened to “Calvinball” – an incoherent game in which the rules are constantly changing to ensure its creator wins. The past year has proven that policymakers who pursue the misguided prescriptions of MMT advocates without a plan for dealing with the consequences will be following a recipe for economic misery.