Desperate times call for desperate measures. Policymakers in the developed world have been left gasping amidst the ruins of slow economic growth, high youth unemployment and rising income inequality. Such conditions are usually the perfect breeding ground for heterodox economic ideas.
The contemporary avatar of such an idea is the sensational modern monetary theory (MMT). In the frenzy of hope that this theory will provide the panacea for all ills, the conspicuous fact has been overlooked that MMT is not modern but a resurrection of an old failed idea.
The origin of MMT
MMT proposes that a State which issues its own currency cannot go bankrupt or default as it can always print currency to settle all obligations. Thus, rather than worrying about "arbitrary" fiscal deficit targets or spiralling public debt, the State should spend to ensure full employment in an economy. MMT says that there is only one constraint to the State's expenditure - inflation, and not taxes or public debt.
MMT is a synthesis of ideas which can be traced back to at least a century ago. The theory assimilates ideas from the work of primarily Georg Friedrich Knapp, John Maynard Keynes, Abba Lerner and Hyman Minsky. Since the 1990s, a group of "post-Keynesian" economists have further developed and propagated the idea in academic circles and the blogosphere. The primary economists in this group are Warren Mosler, L. Randall Wray, Stephanie Kelton and Bill Mitchell.
A good place to start unravelling MMT is Knapp's 1905 publication The State Theory of Money. MMT's conception of money parallels Knapp's hypothesis that money is a "creature of law" rather than a commodity which independently sprang up in a market. As per Knapp, money is what the State decrees as money. More specifically, only that commodity or token can serve as money which the State accepts in settlement of taxes (this approach to money is called the "Chartalist" approach).
The Chartalist notion of money is different from the "Metalist" approach which links the value of money to a precious metal or to it being scarce. The Metalist view says that money originated independently as that commodity which served as a common medium of exchange, like precious metals, irrespective of any State decree.
Under Knapp's "state theory of money", it is not required that money should be converted into a precious commodity. This is because as a "creature of law", the decree of the State is sufficient to ensure that any token which the State declares as money will act as the predominant medium of exchange.
It is important to understand the link between Knapp's Chartalist approach to money and MMT. As the State is central to the creation of a monetary system, the State is also responsible for taking full cognizance of its discretionary powers over money supply to ensure full employment.
If this entails printing currency for State expenditure to ensure full employment, so be it. This ties closely with Abba Lerner's doctrine of "Functional Finance"- the forerunner to the contemporary MMT thought, which we examine next.
Abba Lerner, a Russian born British economist, in his popular 1943 paper titled 'Finance and the Federal Debt' suggested that since the State does not have any constraints on currency issuance, fiscal policy should be evaluated only by what effects it has on the economy and not by pre-conceived notions of sound finance. Thus, the only criteria for evaluating fiscal policy is the function that it plays in promoting employment and income.
Lerner's functional approach to finance, flowing from the "state theory of money" was premised on the fact that a government which issues debt in its own currency can never go bankrupt and has full discretion on printing currency. Lerner wrote that "Functional Finance rejects completely the traditional doctrines of 'sound finance' and the principle of trying to balance the budget over a solar year or any other arbitrary period."
Lerner sought to take the idea of fiscal deficit further from where Keynes left it. Keynes opened the window for the government to actively use fiscal policy for the management of aggregate demand. During the Great Depression of the 1930s, the prolonged economic slowdown provided Keynes with the impetus to challenge the classical economics bedrock of balanced budgets and he actively advocated for the use of fiscal policy to manage aggregate demand.
Lerner felt that the right lessons were not learnt from Keynes' breakthrough. Even after the popularity of Keynes' ideas, the argument remained that "the government merely had to get things going and then the economy could go on by itself."
Thus, deficits were only to be run during recessions or depressions, and in normal times, the government should balance its budget or run fiscal surpluses. Lerner countered this in his famous "steering wheel" hypothesis which stated that the control of the steering wheel for the economy should permanently rest with the State.
In his Functional Finance paper published in 1943, Lerner emphasized that "there is no reason for supposing that the spending and taxation policy which maintains full employment and prevents inflation must necessarily balance the budget." Lerner stated that no matter what "unimagined heights" the national debt might reach, no danger to the society is presented as long as the government maintains total demand equal to that of current output.
Also, as long as the public is willing to lend to the State, there is no threat of a burgeoning national debt, irrespective of "how many zeros are added to the national debt." When the public becomes reluctant to lend, the State can always print money.
Another key figure on whose shoulders MMT stands is Hyman Minsky, an American economist. Echoing Lerner's functional finance approach, Minsky wrote that "in developed Western economies, the national debt is unique among all income-earning assets, for there is no default risk attached to this asset." Minsky's "financial instability hypothesis", which predicts the crisis-prone nature of capitalism also fits neatly in the MMT framework and justifies the government having a seat at the "steering wheel" of an economy.
It is important to note how similar the contemporary MMT thought is to the doctrine of Functional Finance. In fact, most commentators hark back to Lerner's work while discussing MMT. Paul Krugman, the Nobel Prize winning economist, writes that "MMT seems to be pretty much the same thing as Abba Lerner's "functional finance" doctrine from 1943". Kelton says that MMTers, like herself, have "rediscovered old ideas and assembled them into a complete macroeconomic frame."
The heydays of Functional Finance
It is easy to see why the idea of Functional Finance was popular in the first half of the twentieth century. The Great Depression of the 1930s was the perfect stage for the Keynesian revolution, and from Keynes, moving on to Lerner was only a jump.
The 1940s witnessed the Second World War and the only way that the government could meet war expenses without resorting to high taxation and borrowing was by printing money. The popularity of Functional Finance in that era can be gauged from the fact that the Chairman of the Federal Reserve Bank of New York, Beardsley Ruml said in 1946 that raising "taxes for revenue are obsolete".
The abandonment of the Gold Standard by revoking domestic convertibility of dollar to gold in 1933 by Roosevelt set the stage for the ascendancy of Functional Finance. In 1971, Nixon scrapped the convertibility of dollar for international payments as well, sounding the final death knell of the Gold Standard. The breaking of the link between the dollar and gold marked an important step in the evolution of Functional Finance and removed an important constraint on printing currency for financing government expenditure.
Knapp's foresight that money does not need the backing of a precious metal proved prophetic. The post-war world had fully moved towards a paper-based "fiat" currency system. As described by L. Randall Wray, the development of a non-convertible paper currency system "came nearly three-quarters of a century after Knapp's book was first published (1905), he had recognized that the money of a state does not derive its value from metal, and indeed, that no metal is needed domestically."
Once the State is free from convertibility of its issued currency to a precious metal, its spending is not constrained by either the stock of precious metals or taxes. Thus, as dictated by MMT, why should the fiscal policy be bound by notions of sound finance or a balanced budget when the State can never run out of money or default?
The turning of the tide
During the 1950s and up to the mid-1960s, Functional Finance was humming on smoothly. Post-war reconstruction required an expansive fiscal policy which the Federal Reserve was willing to accommodate. The relationship between the Federal Reserve and the governments of Eisenhower and Kennedy was amicable. As inflation was calm, the Federal Reserve was willing to keep a loose monetary policy even though the government was pump priming the economy.
Things changed in 1964 with the government of Lyndon Johnson. The Johnson administration believed that "allowing a modest amount of inflation to reach low unemployment was not risky; as long as the economy had not reached full employment, it would have enough slack to keep wage pressures in check. And if inflation did emerge, they believed fiscal policy, rather than the Fed, was the most effective tool to manage it." This prescription has Lerner's Functional Finance written all over it.
The views of the Federal Reserve had however changed due to its anticipation of rising inflationary pressures in the economy. In 1965, the Federal Reserve increased interest rates under the Chairmanship of William McChesney Martin Jr, much to the chagrin of Johnson. From this point onwards, things went on a downhill. The co-ordination between the monetary and fiscal policy broke down.
In 1969, inflation in the US hit an eighteen year high of 5.75 per cent. Martin's term was set to end in January 1970, and he did not expect it to be renewed given the election of Richard Nixon. Nixon was uncomfortable with Martin's hawkish streak on inflation and appointed Arthur Burns as his replacement. Before assuming the Chairmanship of the Federal Reserve, Burns served as Nixon's White House adviser. The appointment was perceived as a political move to provide Nixon's administration with a less hostile monetary policy.
The consequence of a more malleable Federal Reserve became evident. The entire 1970s witnessed a stubbornly high inflation refusing to lie low, earning the moniker of the "Great Inflation". It was only after the appointment of Paul Volcker in 1979 and his ruthless monetary tightening that tamed inflation and brought an end to America's worst inflation episode since the civil war.
The stagflation of the 1970s sounded the death-knell of Functional Finance. The world was once again reminded of the pernicious effect of inflation, something which had eclipsed from the memory of the public in the post-war era. The mood during the 1980s took a complete U-turn. The governments of Margaret Thatcher in the UK and Ronald Reagan in the US rolled back government and ceded a larger space for the private sector to operate.
The stagflation era saw Milton Friedman's doctrine of Monetarism overshadowing Functional Finance. Monetarism's emphasis on removing the State's discretion over money supply was directly in opposition to Functional Finance's doctrine of the State enjoying a seat at the "steering wheel" of the economy.
Freidman wrote that "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth."
Both Lerner and Minsky revised their views on Functional Finance
So severe and persistent was the "Great Inflation" that even the father of Functional Finance, Lerner, had second thoughts on the practicality of his theories. During the 1970s, Lerner adopted views in favour of Monetarism - not because he feared that the State would default on its debt but because of concerns on inflation.
The stagflation episode convinced Lerner that his earlier "steering wheel" argument ignored institutional aspects of the economy and focused too much on the macro. Even before the stagflation episode, Minsky was of the view that Lerner's "steering wheel" hypothesis was too mechanistic. Minsky rightly felt that rather than target aggregate demand in general, fiscal policy had to be "directed" towards certain segments of the economy based on institutional realities.
Some of Minsky's post-1990 writings have arguably deviated from the core principles of Functional Finance. Minsky emphasized that rather than total government spending, it mattered what the government spent on. He also spoke about how the quality of the fiscal deficit post the Reagan-era had deteriorated and the need for the government to "validate" its debt through taxation.
Minsky's financial instability hypothesis also highlighted the risks of an aggressive fiscal policy. He wrote, "The 1960's witnessed the apparent victory of Keynesian policy. However, the successful application of Keynesian policy may result in an economy that is inherently unstable. This instability is not the result of a tendency to stagnate or enter into a deep depression state; rather it is due to a tendency to explode." Thus, mechanistic pump priming of the economy could lead to instability and an eventual crash (popularly referred to as the "Minsky moment") in the financial markets with severe spill-over repercussions to the real economy.
What explains the current popularity of MMT?
We can trace two events which have played a large part in the resurrection of the old Functional Finance ideas in its new avatar of MMT. First is the disappearance of the inflation problem in the developed world. In Japan, the persistent economic problem post the real estate crash of 1989 has been fighting deflation. Even after several rounds of fiscal stimulus (leading to one of the highest public debt to GDP ratio in the world) and extraordinarily loose monetary policy, Japan has struggled to fight deflation.
Similar has been the story in the Euro region and the United States post the Global Financial Crisis of 2007. Both the European Central Bank and the Federal Reserve have engaged in large scale monetary easing which has substantially increased the size of their balance sheets. Yet the dreaded monster of inflation did not rear its head.
The last few decades of benign inflation have put the memory of the "Great Inflation" squarely behind us. The low inflation in the developed world has lulled us into believing that being a hawk on inflation is also akin to being a dinosaur. In this environment, a policy which advocates taking the limits out of fiscal expansion not only sounds appealing but logical.
Ideas are creatures of their times and the current economic predicaments demand heterodoxy. The world is yearning for a new paradigm as nearly every arrow in the policymaker's arsenal has been deployed- a new paradigm which challenges existing doctrines and, more importantly, which says that there is still hope.MMT has provided hope that the intractable economic problems can indeed be solved if only we look at things in a "new" light. Blinded by this hope, the fact that MMT is not "new" and has been tried in the past has remained hidden. A true evaluation of MMT should ground its theories in history to contextualize its prescriptions. Else, in the not so far away future, we may be forced to unwillingly recollect, "Those who cannot remember the past are condemned to repeat it."
(The author is CFA, is Member, CPD Committee, CFA Society India.)