Modern Monetary Theory, Part 4: MMT and quantitative easing

Participants on both sides of the Modern Monetary Theory (MMT) debate acknowledge that there’s no “free lunch” when a country’s central bank buys government debt directly and charges no interest on the debt. As explained in previous blog posts, having the central bank effectively print money to finance government expenditures does not eliminate competition for resources between the private and public sectors.

While it mitigates the need for government to compete with the private sector for financial capital, competition for real resources (e.g. labour and capital used to produce goods and services) occurs when government spends the money (in the real economy) that it receives from central bank purchases of its debt.

As Milton Friedman explained many years ago, the cost of government is measured by the goods and services that are foregone by the private sector as a result of government expenditures. If government does not reduce private-sector expenditures through higher taxes or by crowding out private investment through higher interest rates, it must do so by paying more than private-sector participants are willing to pay for the goods and services it purchases. Inflation is the outcome of this dynamic.

Proponents of MMT acknowledge the potential for increased inflation if MMT is pursued aggressively, but they argue that the potential is an exaggerated concern. There are several components of this argument.

First, since the 2008-2009 financial crisis, central banks in Canada and elsewhere have pursued a policy called quantitative easing (QE), whereby central banks have purchased government bonds to help finance government deficits. Specifically, Canada (and other developed countries) have consistently run government deficits since the financial crisis while the Bank of Canada’s holding of Government of Canada bonds has approximately doubled since 2010. Yet the annual inflation rate in Canada since 2010 has averaged well below the Bank of Canada’s target of 2 per cent per annum.

It should be noted that QE is conceptually different from MMT, although both involve central bank purchases of government bonds. Under QE, the expectation is that the central bank will sell the government bonds it buys before they mature, so that the government will need to raise money (ultimately through taxes) to pay its debt to private holders of that debt. Effectively, central bank assessments of a temporary need for money-creation to address short-run economic circumstances have driven QE.

Under MMT, the central bank simply creates money for the government with no expectation of being paid back. The latter action is proverbial “helicopter money” equivalent to the central bank dropping money from the sky onto the lawns of Parliament for politicians to spend at will. MMT can therefore be seen as an ongoing policy to fund government with the central bank effectively accepting a funding obligation role with funding obligations essentially dictated by government.

The expansion of the money supply by permanently implementing MMT clearly raises more of an inflation risk than does QE. Still, proponents of MMT offer a second reason for being sanguine about the risk. Namely, an aging population increases the propensity of society to save, as individuals build savings for their projected retirement. The demographic phenomenon is being augmented by the economic uncertainty created by the COVID-19 crisis. Households and businesses save more during periods of uncertainty. An aging population and economic uncertainty suppress the growth of private-sector consumption.

The resulting inference drawn by MMT proponents is that there will be a fair amount of future “spare capacity” in the economy, so that increased government spending financed by helicopter money need not drive up prices of domestic goods and services. Furthermore, they argue that government spending on things such as infrastructure, education and public health increases the future capacity of the economy to produce goods and services, which serves as an additional constraint on inflation going forward. These assertions are, at best speculative, especially given the emerging outlook for disruptions of global supply chains and increased economic nationalism.

To be sure, MMT proponents acknowledge the potential for capacity constraints to lead to inflation at some point in the future. Therefore, a key component of the MMT argument is that to the extent that helicopter money does eventually lead to inflation beyond some “acceptable” level, private-sector spending can by reduced through increased taxation. Whether politicians would see imposing higher taxes as being less damaging to their reelection prospects than tolerating faster inflation is an issue that, to my knowledge, has not been addressed by MMT proponents.

It might be noted that a leading advocate of MMT, Professor Stephanie Kelton, is serving as an advisor to Joe Biden, the presumptive Democratic Party nominee in the 2020 U.S. presidential election. Hence, one might expect MMT to become an issue in the U.S. election. If so, the underlying tenets of the case for MMT will come in for much closer scrutiny, which, in turn, might help inform debates elsewhere about adopting this policy.

A bit of history should be kept in mind as debates unfold. Under the Johnson and Nixon administrations, the U.S. Central Bank was successfully pressured to forego tightening monetary policy as government spending on domestic programs and the Vietnam War increased dramatically. Double-digit inflation was the consequence, and interest rates in the U.S. under Paul Volcker, President Reagan’s Federal Reserve Chair, rose above 20 per cent per annum before the inflation rate was brought under control. This experience was, and remains, an important reason for why most economists favour central bank independence from the directives of politicians.