Modern Monetary Theory, Part 2: Will MMT hold down taxes?

As government expenditures associated with the COVID-19 crisis continue to mount, and as government tax revenues decline along with economic activity, so does the government’s fiscal deficit increase.

Less well-recognized, however, is that direct and indirect loan guarantees extended by the government to business and household borrowers can also contribute to larger government deficits in the future, if some portion of the government guaranteed loans winds up in default. In this regard, Prime Minister Trudeau recently said that the government is considering extending lower (than market) interest credit directly to consumers.

However necessary and well-designed the government’s responses to the COVID-19 crisis, the larger associated government deficits must be addressed in the future, as will the debt burden governments carried before the COVID crisis. In “conventional” economic models, government borrowing (including interest on borrowing) is ultimately paid for through future taxes levied on businesses and households. So as the government debt burden increases, Canadians should also expect their future tax payments to increase.

But why can’t governments, including Ottawa, just borrow ever more money to retire maturing government debt and to pay interest on outstanding debt? In fact, wasn’t the federal government doing this before the COVID crisis? No one likes paying taxes, so why not keep kicking the tax can down the road and have the government borrow however much it needs to fund “necessary” government expenditures, including interest on the government’s outstanding debt? If deficit-financing was a good idea before COVID-19, why should any additional deficit-financing related to the crisis make it a bad idea, especially given the current (and prospective) relatively low real interest rates on Canadian government debt instruments?

If the government tries to borrow more money from domestic lenders, it must compete with borrowers in the private sector for available domestic savings, which will drive up domestic interest rates at some point. As a result, companies will do less investing, and households will invest less in consumer durables such as housing. In effect, higher interest rates associated with government borrowing act like an implicit tax by reducing the amount of privately supplied goods and services that companies and households can afford to buy.

So why not borrow in the international capital market where the volume of available funds to borrow is much greater?

In fact, the Government of Canada has an excellent credit rating and would have no difficulty borrowing money in international capital markets to fund any additional deficits related to the COVID crisis or to other government programs over the foreseeable future. It could also presumably borrow internationally to pay interest on previously issued debt.

However, at some point, even government borrowers with good credit ratings may face growing reluctance on the part of foreign lenders to buy ever-larger quantities of their debt instruments, as did various European governments in the aftermath of the 2008-2009 financial meltdown. Default risk and exchange-rate risk increase for foreign lenders as they increase their holdings of any individual government’s debt, even governments with good credit ratings.

What if the government could find a lender who was unconcerned about risk and charged no interest rate?

According to Modern Monetary Theory (MMT), the Bank of Canada can be that lender. As discussed in an earlier blog post, the government can sell bonds directly to the Central bank, which in turn can create money to pay for the bonds it buys. This action creates increases reserves in the commercial banking system, which enhances the ability of commercial banks to make additional loans to the private sector as well, unless the Bank of Canada discourages incremental commercial bank-lending to the private sector by increasing the interest rate on the reserves that banks keep on deposit at the Bank of Canada. But the central bank is not obliged to pay interest on commercial bank reserves.

It would therefore seem that by implementing MMT, the government could kick the tax can down the road into eternity. In fact, scarcity will still rule. Given that production capacity in the economy is constrained by scarce inputs such as skilled labour, if government borrows and spends more, it must bid away production capacity that would otherwise produce goods for the private sector. The government does so by paying higher prices for the goods and services that employ scarce inputs for their production.

The resulting increases in prices across a broad range of goods and services in the economy is an indirect tax on the private sector, similar to higher interest rates, since it means businesses and households will experience reduced purchasing power and, therefore, a reduced financial ability to buy the intermediate and final goods and services they desire.

Proponents of MMT acknowledge that direct financing of government by the central bank could drive up prices or, equivalently, create inflation. However, they believe that worry about inflation is overblown and point to current and persistent low rates of inflation in developed economies as evidence. They also argue that if inflation does appear to be a potential problem in the future, the central bank could reduce its direct financing of government borrowing.

Are proponents of MMT correct to argue that overblown fears of inflation should not prevent the implementation of a policy tool, which seemingly allows government to borrow money without imposing direct or indirect taxes on the private sector? Future blog posts will address this question.