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A modern money perspective on deficit spending [1]

Lars Syll

What Modern Monetary Theory (MMT) does is more or less what Knut Wicksell tried to do more than a hundred years ago, when in 1898 he wrote about ‘pure credit systems’ in Interest and Prices (Geldzins und Güterpreise). The difference is that today the ‘pure credit economy’ is a reality and not just a theoretical curiosity — and MMT describes a fiat currency system that almost every country in the world is operating under.

In modern times legal currencies are totally based on fiat. Currencies no longer have intrinsic value (as gold and silver). What gives them value is basically the simple fact that you have to pay your taxes with them. That also enables governments to run a kind of monopoly business where it never can run out of money. A fortiori, spending becomes the prime mover, while taxing and borrowing are relegated to secondary operations which follow the spending. If we have a depression, the solution, then, is not austerity – it is spending. Budget deficits are not a major problem since fiat money means that governments can always operate them, and increase them if necessary.

In the mainstream economist’s world, we don’t need fiscal policy other than when interest rates hit their lower bound (ZLB), and in normal times monetary policy suffices. According to the mainstream narrative, it suffices for the central bank to simply adjust the interest rate in order to achieve full employment without inflation. And if governments in that situation take on larger budget deficits, these tend to crowd out private spending and interest rates increase.

What mainstream economists have in mind when they argue this way, is nothing but a version of Say’s law, basically saying that savings have to equal investments and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity, there is, of course, nothing to say about the law, but as such, it is also totally uninteresting from an economic point of view. What happens when ex-ante savings and investments differ, is that we basically get output adjustments. GDP changes and so makes saving and investments equal ex-post. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

MMT rejects the traditional Phillips curve inflation-unemployment trade-off and has a less positive evaluation of traditional policy measures to reach full employment. Instead of a general increase in aggregate demand, it usually prefers more ‘structural’ and directed demand measures with less risk of producing increased inflation. At full employment deficit spending will often be inflationary, but that is not what should decide the fiscal position of the government. The size of public debt and deficits is not — as Abba Lerner argued with his ‘functional finance’ theory in the 1940s — a policy objective. The size of public debt and deficits are what they are when we try to fulfill our basic economic objectives — full employment and price stability.

Governments can spend whatever amount of money they want. That does not mean that MMT says they ought to — that’s something our politicians have to decide. No MMTer denies that too much government spending can be inflationary. What is questioned is the mainstream assumption that government deficits are necessarily inflationary.

Contrary to mainstream theory, finance in the world of MMT — and people like Keynes and Minsky — precedes investment and saving. What is ‘forgotten’ in mainstream theory, is the insight that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

All real economic activities depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channelling money/savings/credit — are more or less left in the dark in modern mainstream formalizations of economic theory.

Source: RWER blogs, 15 Sept 2021
1. Original title: MMT and the deficit myth)


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