Groucho Marxism

In recent years there has been a burst of interest in Modern Money Theory, or MMT. The essence of MMT is that sovereign currency-issuing governments, with flexible exchange rates and without foreign currency debt, are financially unconstrained and do not need collect taxes or borrow from financial markets to finance spending. This view, counter-intuitive as first seems, is nonetheless steadily accumulating adherents. MMT is not without its critics however. One particularly vocal opponent is the American economist Thomas Palley, who has recently devoted an entire series of academic articles to debunking MMT. In this blog post I will respond to some of the points made in Palley’s most recent article in this series, published in 2020.

According to Palley, a sovereign currency-issuing government’s ability to create money to finance spending has “long been widely recognized by all economists” – including, presumably, Palley himself. Thus Palley does not object to the central claim of MMT, only to the idea that it is new. Personally, though, I don’t care whether the claim is new or not; I only care about whether it is true. The fact that a vehement critic of MMT such as Palley willingly accepts this claim can be taken as strong evidence that it is correct. Palley does however object to the claim made by proponents of MMT that the public cannot pay taxes until government has first spent it into existence, arguing that it is the central bank, not the government, that is the source of state money.

Palley’s argument here rests on the independence of central banks. But are central banks really independent of government? The short answer is: no. Take for example the Bank of England, the central bank for the UK. Whilst nominally independent of government, the Bank of England is not really independent in any meaningful sense. Indeed, it has been wholly owned by the government since 1946. Although the government granted the Bank of England some operational independence in 1997, it kept a right of veto over everything it does: the Bank of England Act of 1998 provides a Chancellor with the option of overruling any decisions made by the bank. In practice, therefore, the Bank of England is independent of the government only as long as it does what the government wants.

Palley argues that although in theory governments can create money at will to finance spending, in practice they are constrained by macroeconomic factors. In particular, he argues that any significant money-financed government spending without a concomitant increase in taxation will result in inflation, which in turn will cause long-term interest rates to rise. The reason for this is that lenders will only give out a loan if they think they can make money out of doing so. And they can only do that if the interest rate they receive on loan is higher than the rate at which the value of the loan depreciates in value, which is determined by the rate of inflation. Hence, higher inflation generally means higher long-term interest rates.

There are a couple of ways to respond to this critique. One is to point out that MMT is a theory how government spending, taxation, and borrowing work in practice, rather than a theory of what governments should or shouldn’t do. MMT does not say that sovereign currency-issuing governments should run a money-financed budget deficit, just that there is nothing stopping them from doing that if they want to. You might wonder why a government would willingly choose to do something that will result in higher inflation and higher interest rates. But there might be case for doing that in situations where the alternative is worse – for example, if the economy requires a fiscal stimulus to avoid a recession.

Another response is to point out that budget deficits do not necessarily lead to inflation (as I pointed out in a previous blog post). There is certainly a risk that running a persistent budget deficit will create inflation, which in turn will probably result in a rise in long-term interest rates. The risk of inflation alone might be enough to cause long-term interest rates to rise even if inflation does not actually occur in practice. But we cannot be sure that this will necessarily happen just because the government runs a budget deficit. There are many examples of countries running budget deficits for years without any significant increases in inflation (e.g. Japan). Inflation is a complex social phenomenon and assuming that ‘budget deficit = inflation’ is extremely reductive.

Palley raises more points against MMT in his article, but I will leave responding to these to a future blog post.