Is Inflation Disproving Modern Monetary Theory?

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Economic events sometimes have a way of discrediting popular economic theories. The Great Depression of the 1930s challenged many neoclassical economic ideas and encouraged Keynesian thinking. In turn, the stagflation of the 1970s challenged many Keynesian ideas and helped popularize Milton Friedman’s brand of monetarism. Today, some economists are trying to use the current inflation to discredit a newer theory with Keynesian roots, the Modern Monetary Theory (MMT) championed by Stephanie Kelton and others. In this case, however, the theory under attack can hardly be said to have been tried, so the rumors of its failure or demise may be greatly exaggerated.

The argument we now hear goes something like this: MMT is distinguished from mainstream economic theories by its higher tolerance of federal budget deficits. The Biden administration has been running large deficits, so its policies are a test of MMT. The recent surge of inflation is an ill effect of those policies, so that provides evidence of failure for both deficit spending and the theory that encourages it.

In this vein, Karl W. Smith writes:

In response to Covid, the federal government spent trillions of dollars on relief, and the Fed pushed interest rates to zero. The idea was that these policies would be short-lived. But as the pandemic wore on, they were kept in place.
In effect, America was putting MMT into practice. Congress borrowed and spent with little concern for long-term limits, and the Fed supported that borrowing by keeping interest rates at zero. As a result, MMT proponents are fond of pointing out, the U.S. economy bounced back stronger than any of its peer nations.
Yes, they admit, the U.S. has also had stronger inflation. But MMT proponents note that they had always acknowledged that possibility, and that inflation was more a result of the unusual circumstances of a pandemic than of any particular aspect of MMT.
Both of these answers are unsatisfying. In truth, MMT is failing precisely as its more sanguine critics predicted.

Furthermore, critics like Clive Crook complain that MMT “offers no plausible solution” to inflation, since it rejects the most orthodox solution of interest-rate hikes by the Federal Reserve.

Although these concerns about Modern Monetary Theory are certainly worthy of debate, I believe that they exaggerate some features of the theory while almost completely overlooking others.

MMT’s tolerance of deficits

The part of this popular critique that contains the most truth is that MMT is indeed unusually tolerant of federal budget deficits. Orthodox economic theories have at most a grudging acceptance of deficit spending to stimulate a sluggish or recessionary economy. And yet, the federal government has run a deficit almost continuously for the past fifty years, only balancing the budget between 1998 and 2001. Is that a policy mistake, or an implicit recognition that deficits help stabilize the modern capitalist economy most of the time?

MMT’s understanding of deficits is based on “flow-of-funds” accounting that distinguishes three economic sectors: the public sector, the private domestic sector, and the foreign sector (our trading partners). The key point is that a deficit in any one sector is balanced by a surplus somewhere else, and vice versa. MMT economists reason that the U.S. must run a deficit at least as large as its current account imbalance with its trading partners (that is, the foreign sector surplus); otherwise, the domestic private sector has to be in deficit instead. Its total income will be less than its total spending, and its financial assets will decline relative to its debts. This makes the economy more vulnerable to financial crises resulting from boom-and-bust cycles, as it was in the housing boom and bust of the 2000s. The recommended course of action is to run a government deficit even larger than any current account imbalance, to give the private sector added protection against economic downturns. “In the long term, the only sustainable position is for the private sector to be in surplus. An economy can absorb deviations from that position but only for short periods” (Mitchell, Wray and Watts, Macroeconomics, p. 89).

In The Deficit Myth, Stephanie Kelton argues that a government that controls its nation’s currency does not have to budget like a household, that the national debt is as much a private asset (held in treasury bonds) as a public liability, and that the country has no good reason to pay it off. She says that “a government that borrows in its own sovereign currency can always maintain the critical condition for sustainability,” which is that the interest rate on the debt is no greater than the growth rate of the economy. But these views do not sound fiscally responsible to economic traditionalists.

MMT’s view of inflation

What MMT most certainly does not say is that the government can spend as much as it likes without worrying about the inflationary consequences. On the contrary, it says that the possibility of inflation, rather than the budget deficit itself, is exactly what the government should be worried about. While rejecting as a myth the idea that “deficits are evidence of overspending,” Kelton immediately adds, “For evidence of overspending, look to inflation.” And later, “Once the economy exhausts its real productive capacity, the only way for the government to get the construction workers, architects and engineers, steel, concrete, paving trucks, cranes, and so on that it needs is to bid them away from their current use. That bidding process pushes prices higher, giving rise to inflationary pressures.” Few economists would argue with that.

The key phrase is “once the economy exhausts its real productive capacity.” The classic definition of inflation—too much money chasing too few goods—reminds us that inflation is a relationship between monetary demand and real supply. MMT is especially interested in cost-push inflation, when shortages of key resources push up prices. It attributes the high cost of gas partly to our failure to develop alternative energy sources, the high cost of housing partly to our failure to build enough of it, the high cost of food partly to production interruptions from war and pandemic, and the high cost of labor partly to shortages of qualified workers (and of the child care they need to take jobs). Although government spending can stimulate the demand side of the economy, it can also address shortages on the supply side, helping to keep costs down. To the extent that government invests in expanding the nation’s resources along with the nation’s money supply, it is acting responsibly and working against inflation.

What kind of deficit?

This line of reasoning implies that all deficits are not equal in their inflationary impact. It matters what specific fiscal policies are creating the deficit.

Since the budget deficit is the gap between revenue and spending, critics of the deficit could just as well complain about “deficit revenue” as “deficit spending.” Economists who blame the deficit for inflation should question President Trump’s tax cuts as well as President Biden’s stimulus checks. In truth, Modern Monetary Theory is not enthusiastic about either tax cuts or stimulus checks, since neither is sufficiently targeted to expand the productive capacity of the country. When Karl W. Smith characterizes MMT as “a school of economics that advocates the kind of policy that has brought the U.S. economy to this point,” he is overlooking most of what economists like Kelton would really like to see done. One cannot have it both ways, attacking MMT as a dangerous new theory and then claiming that it’s already established policy.

One Biden initiative that does appeal to proponents of MMT is the infrastructure bill. Improvements in things like transportation and the energy grid can help grow the economy while cutting costs for producers and consumers. When the government offsets that kind of spending not with taxes, but with sales of treasury bonds, it is not acting irresponsibly, but just asking the public to invest in the nation’s future. Democrats managed to pass the infrastructure bill with support from only 12% of Congressional Republicans. Biden’s “Build Back Better” proposal, which has been called a “human infrastructure” bill, has not passed. It contains initiatives in the areas of preschool education, family and medical leave, health care, affordable housing, and clean energy, all of which are arguably relevant to developing our national resources. The great majority of Republicans opposed both bills, attacking the first for adding to the deficit and the second for raising revenue by rolling back some of the Trump tax cuts. MMT may be having some impact on the administration’s thinking, but it remains to be substantially implemented.

Modern Monetary Theory tries to broaden our conception of fiscal responsibility by considering not only how to pay for programs but what the programs actually accomplish. Deficits that serve to expand the country’s resource base are not as inflationary as deficits that just put more money in people’s pockets. But fiscal policy still has limits, since the resource base is not infinitely expandable, especially in the short run. Kelton says:

To be clear, MMT is not about removing all limits. It’s not a free lunch. It’s about replacing our current approach, one obsessed with budget outcomes, with one that prioritizes human outcomes while at the same time recognizing and respecting our economy’s real resource constraints. In other words, MMT redefines what it means to engage in fiscally responsible budgeting…“It’s the economy’s real resources, stupid!” We are a nation rich with real resources—advanced technologies, an educated workforce, factories, machines, fertile soil, and an abundance of natural resources.

MMT’s budget priorities

When asked in a recent interview for her number-one policy recommendation, Kelton said:

It has to be climate. I don’t see a bigger threat challenge before us than climate change… Climate change is gonna massively disrupt life in so many ways, right? It is going to be an irritant. It is going to be a hardship. People are going to be feeling pain in ways they haven’t even imagined in their lives, in their pocketbook as a result of climate. So again, I think, you know, the kind of inflation we’re dealing with now is mild in comparison to what lies ahead, if we don’t get our arms around this.

When faced with such a serious challenge, responsible budgeting requires more than just deficit reduction. It demands spending what we need to in order to develop alternative energy resources, so that we can avoid the catastrophic costs of environmental damage and energy shortages. We can, of course, include taxes on fossil fuels to encourage the transition, if we can summon the political will to pass them. But we can also do what we’ve done in time of war, sell more treasury bonds and rely on a growing economy to keep the debt manageable.

Another budget priority for MMT—although one that’s a harder sell—is a federal job guarantee for workers who are otherwise unemployed. Many politicians and orthodox economists reject it out of hand as another costly program the country cannot afford. But MMT theorists point to the enormous costs imposed on the country by chronically high unemployment, especially in poor communities. Leaving people who would like to work unemployed is counterproductive, since the longer they are without work, the less qualified for work they become. The well-documented damage includes not only loss of relevant skills, but poor health, psychological harm, social isolation, antisocial behavior, and deterioration of family life. Greater investment in human capital development through health and educational programs can help, but acquisition of good work habits and job skills through actual employment is essential.

MMT argues that a federal jobs program could help stabilize the economy by counteracting fluctuations in private employment. In times of economic contraction, the government wouldn’t just give out money, but hire more workers and produce some useful services for the money it spends. That would be the alternative to—in Kelton’s words—“pulling out the bazooka, the money bazooka, and just spraying it across the economy and saying, we gotta blow a bunch of money into people’s hands because we don’t know what else to do.” In times of economic expansion, the private sector could draw on a larger pool of experienced workers, so that the cost of hiring good workers wouldn’t rise so quickly. Economists might not have to assume that getting unemployment below 5 percent or so is impossible without triggering inflation.

Fighting inflation

So, how would Modern Monetary Theory respond to the current inflation? Admittedly, the theory is less focused on immediate measures to control prices than on long-term investments to develop resources and reduce costs. Public policy may be able to address some current supply problems, such as shortages of baby formula or supply-chain bottlenecks. More comprehensive measures, like developing more of the country’s human capital, will take much longer.

MMT does not deny that raising interest rates can fight inflation from the demand side by discouraging borrowing and spending. However, it is a crude instrument that may slow overall economic growth. raise unemployment, and risk recession. That’s why the stock market reacts so badly to the slightest hike in rates. To the extent that federal budget deficits are contributing to inflation, some fiscal tightening may be called for. That has the advantage of being able to target particular forms of taxing or spending, making changes that do less harm than others. Most MMT proponents would rather raise taxes on millionaires than eliminate spending on new energy initiatives. But MMT’s focus on fiscal rather than monetary policy is hardly without impact. The federal deficit, which was 12% of GDP in 2021, has already come down to about 5% due to a winding down of emergency stimulus programs.

In general, MMT has more to say about preventing future inflation than curing existing inflation. Its general message is the optimistic one that economic growth with price stability is possible if the country makes wise investments in resource development and management. MMT’s support for public spending is admittedly an easier sell when the market economy is faltering and Keynesian stimulus measures are on the table. Once the economy is growing again, conventional economists turn their attention to moderating demand, while MMT recommends continued attention to expanding long-term supply. This does not have to be an either-or proposition; the interest in one does not preclude or invalidate the interest in the other.

To say that Modern Monetary Theory has failed is grossly misleading. For the most part, it has yet to be tried. Maybe we would have a more productive and less inflation-prone economy if it were.

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