The latest fashion that’s captured the political left is Modern Monetary Theory (MMT). Once a quiet idea resting in the annals of academia, it is now taken up by the likes of Rep. Alexandria Ocasio-Cortez and Bernie Sanders’s adviser, Stephanie Kelton. It’s still an unpopular theory among economists—and for good reason.
MMT extrapolates from a series of accounting identities with reckless abandon. By leveraging America’s infinite ability to print its own currency, MMTers think they can sidestep the need to balance budgets. They are wrong. Modern Monetary Theory is one of those ideas that mathematically holds together but utterly fails once you’ve incorporated actual economics.
How Monetary Policy Now Works
To understand how MMT fails, it’s important to understand how it should work, beginning with the system it yearns to replace: conventional monetary policy.
Figuring out how much money to create or delete in order to achieve the delicate balance of stable prices and economic growth is very difficult.
Here’s how monetary policy works now. If a central bank, such as the US Federal Reserve (the Fed), thinks interest rates should be lower to encourage economic growth, it creates money at the push of the button. It uses this newly created money to buy government bonds from private banks. These banks, now flush with cash, are willing to lend at a lower interest rate, encouraging consumption and investment.
If the central bank fears inflation because there’s too much money in the system, it sells government bonds to banks and deletes the money it collects. It should be noted that figuring out how much money to create or delete in order to achieve the delicate balance of stable prices and economic growth is very difficult.
Money, Money Everywhere
MMT transfers these difficult monetary decisions to Congress. The Fed still creates money, but Congress, by passing legislation, determines how much they create. New money doesn’t flow through banks but through the recipients of various spending programs.
Once you’ve considered actual incentives, it’s clear that implementing Modern Monetary Theory doesn’t avoid the (hyper)inflation problem at all.
Inflation is the natural concern of all this money creation, and MMTers have an answer: taxes. In the MMT world, taxes are not used to raise money for future spending. Taxes are used to destroy money to balance out previous spending. Tax revenue collected is money deleted.
In an interview with NPR, Kelton likens the economy to a sink. The money supply is like water flowing from the faucet, which, in the MMT world, is spending. If there’s too much water, the sink overflows (inflation), but have no fear: the government’s ability to tax is like the drain. As long as money flowing in from the faucet is balanced by money flowing out through the drain, there’s no inflation. The result is limitless funding with no downside.
If you think that’s too good to be true, you’re right. Once you’ve considered actual incentives, it’s clear that implementing Modern Monetary Theory doesn’t avoid the (hyper)inflation problem at all.
The Faucet Is Stuck, and the Drain Is Clogged
Politicians have little incentive to restrain spending.
There’s a reason modern economies establish a firewall between their elected officials and their central bank: printing money to fund spending is much more politically tempting than raising that money with taxes.
Politicians have little incentive to restrain spending. Spending generates political benefits in the short-term (before the election) at a long-term cost (after the election). There’s an endless number of ways to spend money and, as evidenced by persistent government deficits, every incentive for politicians to fulfill those requests. It would be naïve to assume that politicians will restrain their spending even if they know they should. They already don’t.
Nor is there reason to assume politicians will raise taxes to balance their spending. Taxes remain wildly unpopular; their presence can even derail support for popular policies. For example, support for Medicare-for-All plummets when pollsters note that it could come with higher taxes. Taxes to fight the distant and abstract concept of inflation will surely be even less popular. Why would any politician increase taxes to fight a problem voters have trouble even acknowledging?
Even if an MMT regime reliably used taxes to fight inflation, it would be completely impractical. The Fed meets eight times a year to evaluate how it should adjust the growth of the money supply. An MMT government would have to do something similar about its taxes and spending.
Countries that subject the power to printing money to political pressure inevitably create price instability.
We would never stop talking about taxes. The 2017 tax reform took months to negotiate and incorporated a menagerie of conflicting interests, each pulling the tax code to a preferred policy outcome. Expecting lawmakers to also carefully consider how much money they’re leaving in the economy is ludicrous.
The myopic attitude of politicians is why strong economies establish central bank independence. Countries that subject the power to printing money to political pressure inevitably create price instability. Under Modern Monetary Theory, we will end up with the same result we have now—spending will far outstrip taxes—but now with hyperinflation.
There Is No Infinite Power to Tax
Even if somehow the political will to use taxes to offset spending is achieved, the government’s infinite ability to create is not matched by an infinite ability to destroy. Taxes are avoidable, something Canada has recently re-discovered, so the government’s ability to reduce the money supply through taxes is actually quite constrained.
High taxes generate little revenue because high taxes reduce the incentive to do whatever is taxed. It’s much like how high prices reduce revenue by discouraging customers. A high income tax discourages working, a high sales tax discourages buying, and a high capital gains tax discourages investment. High taxes can even move activity to the untaxable informal sector, a phenomenon common in underdeveloped countries. There’s a limit to how much money the government can tax out of the economy.
Consider taxes on the rich, which are typically the most popular kind. The rich don’t need additional income as much as the poor, which is both the reason people like taxing them and why taxing them doesn’t raise much revenue. The rich can most easily retire early, turn down work, and demand forms of non-monetary (and thus untaxable) compensation. You can’t balance unlimited spending by only taxing groups that are best at avoiding taxes.
Spending will be high. Tax revenue destruction will be low. Inflation, and then hyperinflation, will follow.
Since you can’t balance unrestrained money creation by only taxing the rich, politicians will be forced to fight inflation with higher taxes for everyone else, threatening to cancel out the benefits government spending sought to impart.
Just like the rich, everyone else will respond accordingly. Voters will demand more spending, and special interests will want tax exemptions. Even more than it does now, federal spending will epitomize Bastiat’s insightful description of government: “the great fiction through which everyone endeavors to live at the expense of everyone else.” Spending will be high. Tax revenue destruction will be low. Inflation, and then hyperinflation, will follow.
A House (and Senate) of Cards
Modern Monetary Theory advocates argue governments have monetary policy exactly backward. Taxes don’t fund spending, they say. Spend first and use taxes to fix it later.
They forget that tax revenue doesn’t fund spending now, as evidenced by persistent government deficits. If taxes can’t offset spending when politicians are supposedly constrained, taxes won’t offset spending when politicians are explicitly handed the power of the printing press. Implementing MMT—even seriously discussing implementing MMT—would create a disaster that no plumber could fix, drowning us all in a tidal wave of hyperinflation.