Challenging the Orthodoxy: What is Modern Monetary Theory?
Updated: Oct 25, 2020
The COVID-19 pandemic has ended Australia’s record of 29 years of economic growth, bringing the country into its first recession since 1991, or as then Treasurer Paul Keating called it, “the recession we had to have”. This has caused the federal government to spend an unprecedented amount of money on an economic stimulus, most notably in the form of the JobKeeper program and temporary supplements to existing welfare payments. Consequently, the federal budget is projected to be in a $85.8 billion deficit in 2019-2020, and $184.5 billion in 2020-2021. Additionally, it is estimated that this financial year alone net government debt will increase to a new record high of $507 billion or 26% of GDP. These are the largest budget deficits in commonwealth history and the highest deficit to GDP ratios since the Great Depression.
Federal Treasurer Josh Frydenberg at the Economic and Fiscal Update expressed that “during this crisis fiscal support will be a primary contributor to GDP” One new macroeconomic theory, known as Modern Monetary Theory or MMT, is challenging the traditional schools of economic thought. These are strange times, and proponents of Modern Monetary Theory say now is exactly when we need to adopt bold and radical ideas to combat the economic challenges of the 21st century. But what exactly is Modern Monetary Theory, and why is it gaining traction but also controversy? Modern Monetary Theory is inspired by several economic theories, especially Keynesian Economics. While the Keynesian school of thought proposes governments should stimulate the economy through debt-induced deficit spending when needed, proponents of MMT suggest that countries that have a monopoly on their currency can deficit spend by simply printing more money. Immediately, anyone who has attended an economics class would raise a few questions; won’t printing more money cause inflation? Well, MMT argues that when an economy has spare productive capacity, that is there is still room for supply to increase in response to greater demand, then printing more money will not actually cause inflation. It is only when an economy’s productive capacity has nearly reached its limits that inflation becomes an issue. For example, after the First World War, Germany’s productive capacity was severely damaged, and printing money only made economic conditions worse, causing hyperinflation. Zimbabwe is a contemporary example of hyperinflation because it has a significantly reduced productive capacity due to bad governance, which was only exacerbated through the irresponsible printing of money. However, developed countries like Australia, that have spare productive capacity, especially during this recession, where an effective unemployment rate of more than 11% indicates a significant volume of labour is not being utilised. The Reserve Bank of Australia could potentially issue more currency for the federal government to deficit spend the economy out of recession without the risk of inflation.
The official unemployment rate of 7.4% excludes those who have given up looking for work and those who are on JobKeeper but have zero hours However, as noted earlier, this can only be done by governments who have a monopoly on their currency. This means countries in the European Union cannot so easily adopt MMT because they share a common currency that is issued by the European Central Bank in Belgium, and neither can state governments because they are currency users, not currency issuers like federal governments. The benefits of MMT for Australia would potentially involve social services like education and healthcare being fully funded and a stronger social safety net to reduce the rate of poverty. Additionally, it would help achieve the Reserve Bank of Australia’s goal of full employment by stimulating economic activity through deficit spending. This introduces us to what proponents of MMT call a Federal Jobs Guarantee, in which the public sector absorbs excess labour (those who want to work but cannot find any) that is not being utilised by the private sector and allow this labour to retrain to work in public sector jobs like healthcare or in public works such as infrastructure. These public sector jobs would be managed on a decentralised basis so that this labour can be allocated most efficiently; allowing workers who would otherwise be unemployed to continue to have a source of income and carry out work that is valued by the community. While this sounds amazing in theory, many may doubt it could work in practise and would argue we are yet to see a scenario where printing more money has not caused inflation. But as a matter of fact, central banks around the world already use MMT in the form of quantitative easing. As a form of monetary policy, this involves the central bank increasing liquidity in the short-term money market by printing more money, or as is done today, moving the decimal point a few places on a computer screen. While Australia’s RBA has not yet used quantitative easing, it was used by the Federal Reserve in the United States during the 2009 Great Recession and is being used today to combat this COVID-19 induced recession by pumping $1 trillion per day of liquidity into the short-term money market during March, in addition to another $1 trillion every week. This hasn’t caused inflation because the additional liquidity is being used for productive purposes in an economy with spare productive capacity. However, like any idea, MMT is not perfect and is criticised by some economists. Australia’s RBA Governor Dr Phillip Lowe says there is no need to adopt MMT because the government is “not out of options” and “has no trouble accessing finance” as they can issue bonds at record low yields of 0.25%. In addition, he is worried that if the government starts to rely on the RBA to access funds, then “the confidence that has been built up around our institutional arrangements would weaken and that would be bad for confidence, investment and jobs over time." Critics are concerned that if the central bank issues more currency for the government, then this removes the scarcity of public funds and can cause policymakers to recklessly spend, creating no accountability, and without budget constraints cause public expenditure to be exceedingly high. This would increase the rate of inflation beyond the target goal of 2-3%, risking hyperinflation. But proponents of MMT argue the solution to this is that the central bank provide a limit on the amount of funds it will provide the government each financial year to spend, so as to maintain the existence of budget constraints and prevent undesirable levels of inflation. It is not likely that Modern Monetary Theory will become part of the policy mix anytime soon, but it is an interesting idea that should be welcomed into the national conversation. By emphasising that governments are not like households when it comes to debt, perhaps MMT can shift the Overton window to encourage policymakers to be more willing to deficit spend to help achieve macroeconomic outcomes and improve the social safety net. After all, the Australian federal government still has $130 billion sitting in the Reserve Bank waiting to be spent, $50 billion of which is from government bonds issued virtually for free.
RBA Governor Dr Phillip Lowe says the government’s deficit spending “is entirely manageable and affordable and it’s the right thing to do in the national interest” So while governments are not going to rely on central banks to access more public funds, MMT may play an important role in an economic environment with record low interest rates, and in countries like Australia with a AAA credit rating and relatively low levels of net debt. The federal government should take advantage of this situation to continue to deficit spend, and perhaps even more aggressively, to lift our economy out of recession sooner and improve national outcomes in the long-term through intelligent and targeted public investment.
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