Modern Monetary Theory (MMT) has exploded onto the political and economic scene this year. Politicians in the US have called for it to be part of the ‘broader conversation’ on how governments could finance their policy goals.

The theory also has some academic support, including Stephanie Kelton from New York’s Stony Brook University – a former Bernie Sanders economic adviser – as well as former IMF chief economist Olivier Blanchard, who has recently expressed views consistent with MMT.

Equally loud though has been the opposition to the theory. New York Times columnist and Nobel Prize winner Paul Krugman bemoaned his attempts to debate with MMT advocates, ‘with the rules constantly changing; every time you think you’ve pinned them down on some proposition, they insist that you haven’t grasped their meaning’. Former chief economist of the World Bank Larry Summers called MMT ‘voodoo economics [that] takes ideas that have a little bit of validity and extends them to a grotesque point’.

Despite the name, MMT isn’t actually that modern. The idea can be traced at least to early twentieth-century economist Georg Friedrich Knapp and certainly to Abba Lerner’s 1943 ‘functional finance’ doctrine.

MMT advocates contest that for a government that creates and borrows its own currency (such as the US, UK or Australia), its spending is not limited by how much tax it collects. It can always take on more debt to finance more spending without necessarily having to increase taxes. Even if the rest of the world stops lending to such a country (or starts charging prohibitive interest rates), the central bank can hold all the government’s debt.

Not only does this mean such a government can always ensure their economy runs at full employment, it also means such a government can never go broke – it can simply create more of its own currency. It’s their currency after all.

The only limit on government spending, according to MMT, is inflation. If government and private sector (businesses and households) spending combined exceeds the economy’s ability to meet that spending with goods and services, inflation rises.

This is where MMT places the role of taxes. Not as a means for the government to ‘afford’ what it spends, but to shrink the private sector sufficiently to ‘accommodate’ what the government spends.

Of course this means the size of the economy is also a limit on MMT. Venezuela has just demonstrated this with abundant clarity. Its government’s central bank-financed spending became bigger than the entire economy itself, resulting in hyperinflation. This is something that no increases in tax levels and shrinking of the private sector could fix.
So, as long as the government is effective enough at moving taxes up and down to manage inflation, and it doesn’t become bigger than the economy itself, there is no limit to how much debt it can take on in its pursuit of full employment and whatever pet policies it desires. 

If MMT sounds to you like just a creative way of stating the blatantly obvious, you’d be right – like saying ‘you can eat all the chocolate cake you like and not put on weight...as long as you cut back on everything else.’

MMT is also rife with pitfalls.

Firstly, the public sector is not as efficient, productive or as innovative as the private sector. Trusting the government to contain its own size has always been a big ask. Trusting it to do so under the belief that it can keep spending more, as long as it keeps shrinking the private sector, is an even bigger ask. An ever-expanding government imposes costs on macroeconomic efficiency, productivity and innovation – costs that are then limited only by political ambition (that is, not limited at all).

Secondly, the debt accrued by an MMT government still has to be paid back (even if just to its own central bank). It’s future generations that will have to do this, and given the government’s tendency towards inefficiency, MMT will only increase this burden. The total debt burden would be larger, as would the share of non-performing debt where the benefits of having incurred that debt for investment purposes get smaller the more the government crowds out the private sector.

There’s also the counter-intuitiveness of giving control of the central bank’s monetary policy toolkit back to government, or of the ineffectiveness of past (and current) governments in controlling inflation when it was their responsibility. Governments all too often have the incentive to spend more and tax less. Add this to the administrative logistics problems of frequently having to change tax levels to manage inflation (compared to simple changes of central bank interest rates), and trust is hard to justify.

MMT may be a reaction to the failed austerity economics of the post-GFC era. There is certainly capacity for fiscal policy to better complement monetary policy during economic downturns, but MMT is not the solution. 

Thomas Devitt is HIA Economist