In a rapidly changing world, ways of thinking which served us well in other eras, become obstacles to understanding, and reacting appropriately to change. Traditional economic theories, currently being taught all around the world,blinded economists to the possibility of the global financial crisis.The Queen of England went to London School of Economics to ask why “no one saw it coming?”.The US Congress appointed a committee to study why economic theories “dismissed the notion that a financial crisis was possible”. At the heart of this failure arewrong ideas about the role of money in the economy. All major schools of macroeconomics currently being taught around the globe teach that the quantity of money only affects the prices, and does not have any other effects on the real economy. Economists write that “money is a veil” – it hides the workings of the real economy, but does not play any role in it. Economists were blindsided by the crisis because models currently in use for policy making do not have a role for money, credit, banking, and debt, even though these were the factors responsible for the Global financial crisis.
The crisis made clear to all and sundry the vital role of money in the economy. Surprisingly, the mainstream economics profession has been extremely resistant to change. The same textbooks, theories and models which failed so drastically, continue to be used in teaching and policy making throughout the world. However, the space for unorthodoxy has expanded substantially, and a lot of new theories of money have emerged to challenge mainstream views. Among these, Modern Monetary Theory, which provides a radically different perspective on money, has emerged as a strong contender. This article aims to summarize some of the key insights of MMT, which creates new ways of looking at the world of fiat money that we live in today.
The starting point of MMT is that our thinking about money is conditioned by the view that money is based on gold, which leads us to ignore the radical differences between gold-backed money and “fiat” money, which comes into existence by government decree, and does not require any backing. With a gold-backed currency, the concept of a government deficit makes sense – the government must have gold, in order to spend it. However, with a fiat currency, a deficit must always be self-imposed; the government chooses not to print money in order to pay its obligations.The idea that the government does not have money to fund social welfare or investment is wrong, because the government creates money by sovereign fiat, and can always print as much money as it likes. MMT raises the question of why the government should impose taxes on citizens to generate revenue – why not just print the money instead? Readers who have been conditioned by economic theories will eagerly proffer the standard answer: because this will lead to inflation! But this answer is neither sufficient, nor satisfactory.
Based on his experiences as Governor of the New York Federal Reserve Bank, Daniel Tarullo has written that at present we do not have a working theory of inflation. Similarly, Joseph Stiglitz has written that the stable relationship between money and inflation broke down in the 1980’s, leaving us with no reliable guide to monetary policy. The Quantitative Easing program that was adopted in major world economies after the Global Financial Crisis involved printing huge amounts of money. However, to the surprise of economists, no inflation resulted, in conflict with standard theories of inflation. So, the idea that if the government prints money, inflation will necessarily result is not credible.
As experience of the past few decades has shown, there is no automatic relationship between printing money and inflation. A more sophisticated analysis is needed. MMT provides rather different answers to when and whether governments should print money, as well as the why of taxation. First let us consider the printing of money. Whether or not it is inflationary depends on how the printed money is used. For instance, if it is deposited in the accounts of billionaires and adds to their financial wealth, without being used for any other purpose, then it will not have any inflationary effect. If the money is used to purchase goods in a sector where the economy has excess capacity for production, then the demand stimulus will create an expansion, with increase in employment and in production. This is the Keynesian phenomenon – in a recession, where economy is below it peak production capacity, a monetary stimulus can create increases in employment without inflation. If the money is used to buy goods in sectors where economy is at peak productive capacity, then it will create inflation in the short run. What happens in the long run depends on whether the industry can expand to meet the excess demand.
Against this Keynesian possibility where printing money increases production and employment, there are many possible ways that money creation can harm the economy.If money is spent on land and stocks, this will lead to inflation in their prices. Money can also be used for purchase of luxury foreign goods, or transferred abroad in various forms. In such cases, increased demand for dollars would lead to depreciation of the exchange rates. Keynesian economists have suggested that dropping money from helicopters would be a useful policy to reduce unemployment in recessions. Modern Monetary Theory tells us that we need to be more discriminating in targeting the printing and distribution of money. If money goes to sectors of the economy where there is excess capacity, it will stimulate production and employment, without causing inflation. If it goes to domestic sectors operating at peak capacity, it will lead to domestic inflation. If it is exchanged for dollars and flows out of the country, it will lead to depreciation.
One of the key resulting insights is that the “deficit” numbers by themselves – whether in percentages of GNP or in absolute quantitative terms – are meaningless. The government can “sustain” any amount of deficit by printing money to pay its obligations. Of course, this is not a license for irresponsible spending. Creation of money, and its utilization in ways which do not enhance productive capacity of the domestic economy are sure to cause harm to the economy. Rather, MMT provides us with a license for responsible spending. If there are worthwhile projects which will utilize resources currently lying idle, then there is no need to be scared of the deficit numbers in spending on these projects. Viewed in this light, the project of building a million houses is not constrained by the budget of the government. Rather it is constrained by the availability of resources which are required for this purpose. If there is idle productive capacity in terms of labor, land, and materials, spending is this area will utilize them to the maximum. If the capacity does not exist, then a carefully balanced spending strategy, which builds capacity in a way coordinated with the increasing demand for utilization of this capacity, can be funded by deficit financing, without causing harm to the economy. Of course, it goes without saying that this requires skillful management and planning.