TheMarketForIdeas

A new economic theory – “modern monetary theory” (MMT) – has been enjoying lately a great success in the USA and is also often invoked in Europe. It is supported especially by left-wing politicians and economists, who advocate for the further increasing of the budget deficit, financed more by the creation of currency, rather than by issuing government securities. The argument is that by these means the state’s financial deficit is more easily covered. 

The Modern Monetary Theory (MMT) is often mentioned in the latest economic debates, especially in the USA, where it is supported by some (left-wing) candidates of the Democratic Party to the Presidential elections of 2020 and their economic advisers. Recently, a first edition of a macroeconomics manual with over 600 pages, where this theory is presented, was rapidly sold out[1]. The explanation for this bookstore success resides in the fact that the new theory seems to provide governments with economic policy tools susceptible to be used when the interest rates are very low or even zero and will, probably, remain so in the near future.

The MMT representatives are deeply inspired by the Keynesian economic theory, which assigns a great importance to state intervention in the economy through fiscal policy. By giving the impression that, through investment, the state can obtain the wanted economic growth and eliminate unemployment, the Keynesian theory has largely opened the door to inflation.

Although it arguably advances some solutions, which are nevertheless difficult to implement into practice or even detrimental to economic freedom, the MMT suggests some interesting ideas regarding the possibility of improving the tools of economic policy. Therefore, these ideas are taken over by some European political and economic leaders, who have their own reasons to wish to give up on austerity policies and to increase the public spending[2]. Also, they began to appear in the public discourse in Romania, where some politicians, economists and journalists try to give credit to the idea that the increase in public debt observed in the last period is not a problem, but is the result of a well-founded economic policy from the theoretical point of view and which is also applied in many countries[3]. 

Monetary financing of the budget deficit 

The MMT postulate is that a sovereign state can never reach the point of inability to pay in its own currency, because it is always able to honour its commitments by creating the needed currency for the payment of the public debt service (interest + maturity rates). Here, the only risk is the inflation. But, if the respective country has enough unused labour force and an adequate infrastructure, the increased demand can be satisfied without inflation. As a result, the state can spend as much as needed to reach its goals: for example, to revive economic growth and reduce unemployment.

The MMT representatives are deeply inspired by the Keynesian economic theory, which assigns a great importance to state intervention in the economy through fiscal policy. By giving the impression that, through investment, the state can obtain the wanted economic growth and eliminate unemployment, the Keynesian theory has largely opened the door to inflation. This is because the state is not only a user but also a currency creator. By modifying the quantity of currency, it influences its value.

Examples of successful implementations of these policies are found especially in the US economic history of the 1930s and 1940s.

The modern banking systems – consisting of central bank and commercial banks with fractional reserves – allows sovereign states to create any quantity of currency they want[4]. However, by acting this way, the state creates inflation, leading to currency depreciation and losing the trust of international markets in the respective national currency. As a result, even if it has served in the past as an international currency, the respective national currency loses this role and, thus, can no longer be used to pay the external debt.

Such a phenomenon took place at the end of the 1960s and the beginning of the 1970s in the USA, whose national currency – the dollar – constituted the key-currency of the Bretton Woods (1944) international monetary system. The US Government was involved at the same time in a costly war (Vietnam) and in the implementation of ambitious internal programs, all without imposing on the population the necessary fiscal effort (taxes). Therefore, it resorted to loans from the Central Bank, which led to a large-scale creation of currency, and the US domestic prices increased markedly, with the dollar losing much of its purchasing power. In addition to this – but it is obvious that the two phenomena are closely linked – there had been a radical reorientation of international flows of capital. Thus, in the past there were usually important spontaneous capital inflows into the US, which allowed the country to record surpluses of the balance of payments, despite the high volume of investment made abroad and the economic, political and military aid granted to foreign governments. In the late 1960s and early 1970s, a significant capital mass has begun to leave the USA towards Western Europe and Japan, causing a significant deficit in the US balance of payments. As a result, the dollar depreciated greatly, not only in relation to the domestic goods, but also towards gold and those currencies that were more likely to be revalued.

This “mix” of economic policies involves, among other things, the establishment of automatic ceilings for budget revenues and expenditures, which requires a greater responsiveness of the government and a closer collaboration between policy makers and economic analysts.

Under these circumstances, the US Dollar was not and it could no longer have been a proper instrument of international reserve, and the Bretton Woods principles could no longer be applied. The Central Banks, instead of expressing satisfaction that their foreign exchange reserves in dollars were increasing, had begun to worry about this phenomenon and tried to limit it by adopting some measures to discourage floating capital inflows of dollars. Therefore, some Central Banks had forbidden the domestic commercial banks to pay interest on non-resident deposits held on call (Eurodollars), others had instituted “negative interest rates” (taxes) for these deposits, and others – most of them – had decided the increase of the mandatory reserve rates, thus immobilizing a part of the funds that were available to the commercial banking system. Also, some Central Banks (the Bank of France, the National Bank of Switzerland) demanded the conversion to gold of the dollars they held, in accordance with the Bretton Woods agreements (at a fixed price of 35 dollars per ounce, rather than the much higher prices on the free market, further pressuring the US). After numerous delays, the US met some of these conversion demands, and, as a result, the US gold reserves dropped to the worrying level of USD 10 billion, considered by the US government as an intangible stock in case of war.

Following these phenomena, during the first months of 1971, the dollar had basically lost its status as a key-currency of the international monetary system, the Central Banks of the participating countries making every possible move to prevent the entry of the US currency into their international reserves. However, if some Central Banks continued to accept the increase of their foreign exchange reserves in dollars, they did so either because they could not act otherwise, constrained by the political pressure exerted by the US government, or simply because there was no other international reserve asset. Other Central Banks (the Bank of France, the National Bank of Switzerland), however, made use of their right to demand the conversion of dollars into gold, which led to the depletion of the US gold reserve. However, an enormous amount of dollars continued to exist in the world, representing floating capitals (easily recoverable short-term investments) in search of speculative earnings and especially reaching the most economically prosperous countries (West Germany and Japan). All the conditions of a large international crisis were, therefore, met. Without going into the details about the phases and consequences of this crisis, we only mention that it finally led to the abolition of the gold convertibility of the US dollar (August 15^th, 1971) and to the abandonment of the Bretton Woods monetary system.

The MMT is interesting, because it reveals how a theory based on somewhat similar principles to the planned economy can lead to re-examination of the instruments of state intervention in the economy.

Currently, the US dollar seems to be in an invincible position, at least as long as other countries and the population continue to purchase US government securities. However, the question arises – what will happen when other currencies (for example the Chinese renminbi) will become a strong competitor against the US dollar in the role of international currency, as happened in the past with the German mark and the Japanese yen? Will a similar crisis to the one that led to the cancellation of the dollar’s convertibility to gold and the change of the international monetary order set up at Bretton Woods be triggered? 

Maintaining a very low interest rate for a long time 

Placing the above rationale in an economic context characterized by the very low interest rates presently and in the predictable future in the developed countries, the MMT advocates recommend the use of budgetary tools as a stimulus for the economy.

In the past, interest rates fluctuated greatly, and the state’s budgets were rather fix and rigid; currently, in the USA, Japan and in some EU countries, the interest rates are quasi fixed at zero level, or close to zero. As a result, the MMT representatives argue that a much more dynamic budgetary policy is needed, which is likely to comply with this static monetary policy.

Nevertheless, the problem of applying a flexible economic policy, like the one recommended by the MMT advocates, arises in completely different terms for most countries of the world – for the simple reason that their currency is not an international currency like the US dollar.

In practice, the assenting of the budgetary policy is done by the purchasing of government securities on the part of the commercial banks, refinancing these banks at the Central Bank (through open market operations, lending facilities, redemption, etc.) and using the newly created currency to lend it to the economy. The advantage is the possibility of relatively accurate orientation of the creation of currency process and of the lending towards economic sectors that are considered important and directing the additional monetary inflows directly towards the targeted categories of economic agents[5].

Examples of successful implementations of these policies are found especially in the US economic history of the 1930s and 1940s. Starting from these cases, the MMT followers propose the use of the unemployed in state organized productive activities – instead of granting them unemployment benefits without doing anything. The advantage is that the persons in question remain in the productive circuit and, thus, can more easily return to the private sector, when this will start to create new jobs. This is, obviously, a solution inspired by the “New Deal” policies carried out in the USA between 1933 and 1936 by the administration of President Franklin Delano Roosevelt. However, the question arises in identifying the economic sectors in which the state creates new jobs, as well as establishing the adequate wages. Because, if the salaries in the public sector are too high or too low compared to the ones on the labour market, the private sector will surely suffer. It also raises the question of the extent to which this policy can be applied to other economic-social contexts than the one existing in the USA during the 1930s.  

Interest rate control, quantitative easing and flexible economic policy 

To simplify, the literature distinguishes between three types of monetary policies:

1) conventional policy: the Central Bank’s influence on the interest rates of the economy;

2) Quantitative Easing: the purchase of government securities by commercial banks, and in last resort, by the Central Bank, which leads to currency creation;

3) flexible economic policy: the coordination of monetary and fiscal policy.

The first two types seem indeed to have reached their limits, given the fact that the respective policies have had poor effects in some countries with increased structural unemployment and a slow economic growth. Thus, it is found that these policies did not lead to an increase to the desired extent of the volume of bank credit granted for financing economic activities, rather favouring the growth of large assets and of speculative investments (for example in the real-estate sector), not in the sectors that were declared as priorities (education, research and development, etc.). 

In order to replace these policies and to take into account that the effects of budgetary policy are transmitted into the economy at a very slow rate, the MMT followers propose a system of flexible economic policies, that allow the modulation of the fiscal burden according to the economic performances: lower taxes during the recession phase, higher taxes during the breakthrough phase – somewhat similar to the way the mechanism of transmission through the interest rate channel has worked so far[6]. This “mix” of economic policies involves, among other things, the establishment of automatic ceilings for budget revenues and expenditures, which requires a greater responsiveness of the government and a closer collaboration between policy makers and economic analysts. Also, it is necessary, as we have shown, to assent to currency creation through the purchasing of government securities by the banks.

The MMT is interesting, because it reveals how a theory based on somewhat similar principles to the planned economy can lead to re-examination of the instruments of state intervention in the economy. The aim of the followers of this theory is to increase the effectiveness of the instruments of economic policy, but the consequences of its application is the decrease in the degree of generality. In any case, the historical examples are abundant in these types of analysis – from imperial China and the “New Deal” to the red mandarins’ China and today’s USA – and the list can go on. 

The possibility of applying the MMT in the emergent economies 

Nevertheless, the problem of applying a flexible economic policy, like the one recommended by the MMT advocates, arises in completely different terms for most countries of the world – for the simple reason that their currency is not an international currency like the US dollar.

Thus, in the case of EMU countries that face difficulties in managing their public debt, such as, for example, Greece and Italy, the Euro is not their national currency and, therefore, it does not confer such advantages like those that the use of the US dollar at international level provides for the USA. Besides, the single European currency is bound by the constraints represented by the convergence criteria and the “Stability Pact” – budget deficit of less than 3% of the GDP and a public debt of less than 60% of the GDP –, which allows the Eurosceptics to affirm that monetary unification is the main reason that prevents the European peoples to know an eternal economic prosperity! Moreover, this is a well-known refrain of anti-Europeans from the former communist countries, including Romania[7].

The situation is even more complicated in the case of countries with an emerging market economy, such as, for example, Romania, which can create national currency (leu) at its discretion, but cannot use the currency for the payment of the external debt service, because the national currency has no international circulation. In the following, we will deal with the latter case, as it is the one that most interests the Romanian reader.

The main difference between the countries with an emerging economy and the USA and the other developed countries (other than those of the Eurozone, which have a special situation), is that the first ones cannot place denominated (expressed and payable) governmental bonds in their national currency on international financial markets.

In the light of the problem discussed here, the main difference between the countries with an emerging economy and the USA and the other developed countries (other than those of the Eurozone, which have a special situation), is that the first ones cannot place denominated (expressed and payable) governmental bonds in their national currency on international financial markets. This circumstance create a complex interaction between the public debt and the position of the balance of payments, interaction that leads to the occurrence of “twin deficits”, domestic currency depreciation, inflation and accumulation of debt in foreign currency[8]. As a result, the countries with an emergent economy, which, as a rule of thumb, are heavily indebted in foreign currency and have a limited access to the international financial markets, face the problem of public debt sustainability. In addition, in the case of Romania, there is another restriction, valid for those countries that belong to the “European System of Central Banks”: the prohibition by law, even from the beginning, of the government receiving credit from the Central Bank.

By definition, the public debt of a country is sustainable if the current applied budget policy can be maintained without the need of excessive adjustments in the future. The sustainability of the debt implies, first of all, that the state is considered to be solvent, which means that the creditors positively evaluate its ability to pay off its long-term debt. Secondly, sustainability implies that the state is liquid, meaning that it can procure the necessary payment means in order to settle its matured debts. Both elements are largely based on the confidence of the creditor and the credibility of the authorities.

It is proven that a state is solvent if the updated primary surpluses are equal or higher than the initial public debt[9]. However, it should be mentioned that the analysis of the solvency of a state falls within a legal framework which is different from the one valid in dealing with the solvency of a private enterprise, in which it is possible to liquidate the assets through a bankruptcy procedure. In case of sovereign states, such a procedure does not exist, because other principles of law are applied: the intangibility of the state and the imperceptibility of state property.

However, like any economic agent, the state is subject to inter-temporal budgetary constraints[10]. These constraints flow from the necessity to respect a series of public debt balance ratios, which reflects the existing links between the interest rate, the long-term economic growth rate and the future updated primary surpluses. In these equations, two variables are essential:

1. a) the primary surplus, which allows the state to release the necessary resources to face the reimbursement demands;
2. b) the interest rate, which is an important part of the financial burden on the public debt[11].

The solvency criterion is, however, a theoretical concept, with limited practical significance. Indeed, it does not allow the univocal determination of a reference debt threshold: in theory, whatever the level of public debt at any given moment, the budgetary constraint can be respected. Besides, solvency is a concept whose dynamics are little taken into consideration in an uncertain environment: a solvent state in a certain period can become insolvent due to various shocks. Conversely, a state can remain solvent, although its debt is unsustainable, provided that the authorities can change their budgetary policy.

In practice, the assessment of the sustainability of public debt is done by evaluating the state’s ability to stabilize the share of short-term debt in GDP: if this ratio can be stabilized, the debt is considered sustainable. Conversely, a continuous increase in public debt share in the GDP can cause a crisis of investor confidence in the public credit securities issued by the respective state[12]. So, the mistrust in a particular state may limit its ability to withstand the budgetary effort necessary to create future primary surpluses and to transfer these abroad[13].

In the case of a state which strongly indebted in foreign currency, stabilizing the debt needs the integration of the effect of the depreciation of the domestic currency, because this evolution of the exchange rate imposes an increase of the primary surplus needed to support the debt.

Thus, in the case of a state which strongly indebted in foreign currency, stabilizing the debt needs the integration of the effect of the depreciation of the domestic currency, because this evolution of the exchange rate imposes an increase of the primary surplus needed to support the debt[14]. But, the depreciation of the currency determines an increase of domestic prices, which leads to the evaporation of the primary surpluses constituted by the state, as well as the savings made in the respective country (by the population and enterprises). This temporarily registers as a surplus of the balance of payments, but the international reserves constituted in this way disappear rapidly, that is, the speed of their disappearance rises the slower the economy’s adjustment goes. Finally, the monetary mass from this country increases as a result of the monetization of the foreign currency obtained though the surplus of the balance of payments, so that, in the new position of long-term equilibrium of the balance of payments, the domestic currency supply is bigger, according to the increase of currency demand determined by the mentioned increase of domestic price levels[15].

The issue of liquidity resides in the fact that a state with an emergent economy has to have at the right time the required currency to pay the external public debt service; a liquidity crisis can occur, therefore, even without the solvency of the respective state being questioned. However, as the public debt crises of the last decades show, it is difficult to distinguish ex ante situations of insolvency from the actual liquidity crises.

These events show however that the main factor determining the moment of the liquidity crisis’ occurrence is the perception of the foreign investors. The debt crisis is triggered, usually, by a liquidity crisis manifested through the difficulties encountered at the refinancing of the due debt by issuing new government securities and placing them on the international markets[16].

The refinancing of the external debt faces, therefore, the same problem of the unavoidable connection between the trust in the authorities of a state and the image of solvency of the respective state: a foreign investor will only lend the government of a country to the extent that it evaluates the capacity of the debtor state to reimburse its long-term loans as positive and to have the necessary foreign currency to ensure the external debt service.

Finally, the emergent countries face the risk of the occurrence of an imbalance between the domestic resources in national currency – constituted through the achievement of primary surpluses – and debt in currency (currency mismatch)[17]. This risk discourages the monetary authorities from reducing the interest rate during the recession, fearing that further currency depreciation and chained bankruptcies will occur. It also induces in them the “fear of flotation”, making countries choose a currency regime which is unsuitable in the light of their long-term interest[18].

Compared to the USA and the developed countries, the emerging countries, therefore, face specific problems which are numerous and complicated. The sustainability of the public debt of these countries does not depend on their ability to issue national currency, which, as in the case of all sovereign states, is theoretically unlimited, but on their access to refinancing from international markets, which is often reduced and intermittent[19]. In the case of this large group of countries, there is a “vicious circle”: the liquidity crisis can lead to a currency crisis, which in turn can trigger a public debt crisis and so on. Therefore, the countries with an emergent economy can experience both a crisis caused by the unsustainability of the public debt and one caused by the scarcity of foreign currency at state level.

All of these phenomena have nothing to do with the states’ ability to create domestic currency in unlimited quantities, which is the main fact on which the validity of the MMT depends. Moreover, these states often use this possibility similarly to developed countries, which have practiced what is called “quantitative easing”. The essential difference is that, for the reasons shown, financing the budget deficit by creating currency causes hyperinflation and mass unemployment. The latest striking examples are Zimbabwe and Venezuela, and the chaos in these countries should be the most effective counter-argument.           

Final remarks 

Speaking in the US Senate about the new economic theory, Federal Reserve President J. Powell said: “The idea that deficits are of no importance to countries that are able to borrow in their own currency is, in my view, wrong”[20]. He added that US debt is already at too high a level relative to the GDP and, even more problematic, it grows more rapidly than it should. The solution recommended by MMT followers is even more debatable in the case of the Eurozone countries that deal with a high public debt. In the case of these countries (Southern Europe), MMT advocates recommend reducing the budget deficit by increasing taxes, not by reducing expenditures (especially the civil servants’ salaries), in order to not affect the economic growth. But the increase of taxes is not a more feasible policy than reducing budgetary expenditures.

The MMT is the manifestation of a statist and populist ideology. Curious is that, despite repeated failures of these experiments, the temptation of dirigisme has not disappeared.

Finally, the MMT is clearly denied by the observed facts regarding the emerging countries. A study by A. Alesina and A. Ardagna, from Harvard University, which analyses 107 austerity plans applied in different countries for the past 30 years, show that the most effective solutions are those that imply reducing of public expenditures without the raising the taxes[21]. A similar conclusion was reached by a team of IMF researchers: reducing the public expenditures and structural reforms (diminishing the social spending, liberalizing the labour market, privatization, etc.) are the only ways to sustainably reduce a country’s public debt[22].

The MMT is the manifestation of a statist and populist ideology. The way it treats the problem of public debt is the symptom of an anti-capitalist mentality, which undermines the political philosophy of individual rights and economic freedom, envisaging a dirigiste conception, very similar to that experienced in the past by the communist countries and the Third World countries with Marxist regimes. Curious is that, despite repeated failures of these experiments, the temptation of dirigisme has not disappeared.

Timișoara, July 25^th, 2019

(The Romanian version of this article is scheduled to appear in the Œconomica journal, issue 3 / 2019.)

Notes:

[1] W. Mitchell, L. Randall Wray, M. Watts, Macroeconomics, Macmillan, London, 2019,https://www.bloomberg.com/news/articles/2019-05-31/a-600-page-textbook-about-modern-monetary-theory-has-sold-out.

[2] Economists bolster Salvini in dispute over Rome’s spending,

https://www.ft.com/content/28666e56-8154-11e9-9935-ad75bb96c849.

[3] S. Cerna, Datoria publică și iluzia keynesiană,

http://www.contributors.ro/economie/datoria-publica-%c8%99i-iluzia-keynesiana/.

[4] S. Cerna, Băncile în economie, Revista Română de Drept Privat, nr. 2/2017, Issue 2, p. 46-52, http://www.rrdp.ro/articole-revista/917.

[5] Idem.

[6] S. Cerna, Politica monetară, Editura Academiei Române, București, 2014, p. 136-145.

[7] S. Cerna, Mentalitatea anticapitalistă: o mare problemă a României,

http://www.contributors.ro/economie/mentalitatea-anticapitalista-o-mare-problema-a romaniei/.

[8] S. Cerna, Deficitele gemene și viabilitatea politicii economice,

http://www.contributors.ro/economie/deficitele-gemene-si-viabilitatea-politicii-economice/; B. Eichengreen, R. Hausmann, Exchange Rates and Financial Fragility, NBER, Working Papers, 7418, 1999.

[9] P. Agenor, P. Montiel, Development in macroeconomics, Princeton, New Jersey Princeton University Press; 1996; N. Roubini, Debt sustainability: how to assess whether a country is insolvent, 2001, http://pages.stern.nyu.edu/~nroubini/referen.htm.

[10] S. Cerna, Deficitele bugetare și inflația, Economistul, nr. 29-30, 31 august 2015, https://www.researchgate.net/publication/334535711_DEFICITELE_BUGETARE_SI_INFLATIA

[11] S. Cerna, Politica monetară, ed. cit., p. 118-123.

[12] N. Chalk, R. Hemming, Assessing Fiscal Sustainability in Theory and Practice, IMF, Working Paper, 81, April 2000.

[13] N. Roubini, op. cit.

[14] S. Cerna, Monedă și finanțe internaționale, Editura Universității de Vest, Timișoara, 2012, p. 78-83.

[15] Idem. p. 133-135.

[16] H. Cole, T. Kehoe (1998) Self-Fulfilling Debt Crises, The Review of Economic Studies, Vol. 67, No. 1, Jan., 2000, pp. 91-116; M. Chamon, Can Debt Crises Be Self-Fulfilling?, IMF, Working Paper, 99, June, 2004.

[17] M. Goldstein, P. Turner, Controlling Currency Mismatches in Emerging Markets, Peterson Institute for International Economics, 2004.

[18] Idem.

[19] Ilustrative în acest sens sunt cazurile următoarelor țări: Venezuela (1998-2019), Rusia (1998), Ucraina (1998, 2000), Pakistan (1998), Ecuador (1999), Peru (2000), Republica Moldova (2001), Argentina (2001) etc.

[20] https://www.c-span.org/video/?458249-2/federal-reserve-chair-powell-testifies-day-capitol-hill&live=

[21] A. Alesina, S. Ardagna, Large Changes in Fiscal Policy: Taxes Versus Spending, NBER, Working Paper, 15438, 2011.

[22] P. Maoro (ed.), Chipping Away at Public Debt: Sources of Failure and Keys to Success in Fiscal Adjustment, IMF, 2011.