The Problem with Modern Monetary Theory

“Modern Monetary Theory,” a doctrine about fiat money, has captured the attention of some reformers and progressives. This doctrine – a set of propositions contrary to logic and evidence – purports to explain why the US and other economies are ailing, but is beset by contradictions with the historic facts and within the doctrine.

For example, The New Inquiry on 11 April 2014 featured an article by Rebecca Rojer on “The World According to Modern Monetary Theory.” The author regards it as a revelation of MMT that the “rules of money are not immutable laws of nature.” Since the science of economics explains the effects of incentives and decisions, evidently these money “rules” are the outcomes of private and governmental decisions, and since the effects are not immutable laws, people can arbitrarily create whatever outcomes they wish. That would indeed be wonderful, to just print money are thereby eliminate unemployment, depressions, and poverty, all without creating price inflation, because the rules of money creation are not immutable, so we can have whatever outcome we wish!

Science is based on logic and evidence rather than “revelations.” It is possible that there have been revelations, but these create religion rather than science, since if an experience or experiment cannot be duplicated, the revelations are not sufficient for scientific warrants. Various religions have had different revelations, and the members do not believe the revelations of the others.

The author provides an example of the MMT doctrine. Suppose there is an island that has minerals. The owner of the mines hires workers and pays them with fiat money, like the paper and bank-account money we have today, i.e. money created out of nothing. But the owner also imposes a tax on the wages of the miners. So evidently this mine owner is a government, and we are not dealing with private enterprise, but a coercive socialist state. The miners work enough to both pay the wage tax and be able to survive.

But a premise of this MMT island example is that prior to the mining, the people were able to hunt and farm without working too hard. So why would anyone work in the mines? The historical explanation is the “enclosures” movement, in which land that was held by small-scale farmers or by villages was forcibly taken by the aristocracy or by the state or by foreign invaders. This is not a money story, but a land-grab story. Another way to get forced labor, other than chattel slavery, is to require the payment of taxes in money, which forces subsistence farmers to work on plantations at least long enough to pay the taxes. That is more a tax story than a money story, since if the government insists on being paid in coconuts, and a farmer does not grow coconuts, he must work on the coconut plantation, get paid in coconuts, and then pay the tax. Therefore the forced labor is based on the government’s restrictions on alternative employment opportunities.

MMT is correct in stating that one way that the government gets people to accept its fiat money is what economists call the “fiscal theory of money,” that the government reinforces its money as a medium of exchange by requiring the use of that money for paying taxes. However, if the government currency is being hyper-inflated, taxpayers would keep their savings in, say, gold, or a stable foreign currency, and then convert it to the fiat money only when a tax payment is due. The fiscal effect only works if the government is not creating too much inflation.

Therefore MMT is incorrect as stating, as a “core building block,” that forcing people to pay taxes with fiat money “gives it its value.” That was not the case, for example, in Zimbabwe, which suffered hyperinflation. One “immutable” economic law of money is that the creation of money, beyond what is needed for transactions, results in price inflation, and the payment of taxes becomes tied to that inflation, via the nominal rise of prices and wages, rather than preventing inflation.

A related fallacy of MMT is that “sovereigns” in general create money by “spending it into existence.” That can indeed happen, as for example in the Zimbabwe hyperinflation, but in the US and most countries today, government spending comes from taxes and borrowing, not money creation. The central bank, such as the Federal Reserve, does not create money by spending it for goods, but rather by buying bonds and then increasing the banks’ reserves or funds to pay for the bonds.

Since the “core” proposition of MMT, that price inflation can be controlled by government’s taxing and spending, is incorrect, the whole superstructure of the MMT doctrine built on it collapses. Actually, MMT does accept the proposition that monetary inflation creates price inflation, but that true proposition contradicts the core MMT premise that tax-paying gives money its value.

A worse MMT fallacy is that the taxes paid to the government destroys money. MMT tells us that governments create money when they spend, and then the money disappears when taxes are paid. But a tax no more destroys money than the dollars used to buy bread. The seller of bread now has the money, and the government now has the dollars paid in taxes, and they then spend that money.

There have been various theories and doctrines on money and banking in the history of economic thought, and in my judgment, the explanations that best fit the facts are a combination of the monetarist and the Austrian schools of thought. The monetarist core is the equation MV=PT, which explains that the quantity of money (M) multiplied by its annual velocity or turnover (V) equals the price level (P) multiplied by the amount of transactions (T) measured in money. Thus high price inflation, a rise in P, is usually caused by monetary inflation, an on-going increase in M.

The Austrian school explains how excessive monetary inflation not only cause price inflation, but distorts relative prices, such as when house purchase prices rise faster than rentals. Austrian theory shows how governmental central planning fails because the knowledge to do so well is always lacking, and that applies to money as well. Hence the Austrians propose free-market money and banking, so that the market sets interest rates and the money supply.

Indeed the Fed failed to prevent the Great Depression of the 1930s and the Great Recession of 2008, and its policies generated high inflation during the 1970s and the cheap credit that has fueled land-value bubbles. MMT cannot do any better, because, as the Austrian theory explains, the optimal money supply is not only not known, but not knowable. The pure free market provides the optimal money supply just as it provides the optimal amount of bread and the optimal amount of shoes.

4 thoughts on “The Problem with Modern Monetary Theory

  1. In reply to some of your criticisims of MMT:

    – You claim it is incorrect that government’s spend money into existence, but rather that money comes into existence when central banks buy bonds.

    In basically every country except the Eurozone ones, the central bank is part of the national government (despite what the Fed conspiracy theorists say…), so buying bonds IS government spending. However, MMT pays much less attention to the supply of cash, and much more attention to the total net financial assets. That being the case, trading bonds for cash does nothing to the net financial assets, and thus relatively little for the economy: there’s still the same amount of opportunities for saving as there were before. Government deficits however create new financial assets (which are not offset by any liability in the private sector, unlike with private asset creation such as bank lending or commercial paper issuance).

    – You claim that it is incorrect that taxing destroys money.

    Functionally, from the point of view of the private sector, taxing destroys money. The government (the consolidated Fed/Treasury/Congress/etc) simply reduces the bank account of somebody in the private sector. As far as the private sector can tell, the money is gone. Due to historical reasons/accounting anal-ness, the government keeps track of how many times it does this (and also how many times it increases bank accounts, AKA spends), to form an accounting history that exists as the Treasury’s account at the Fed. But they could just as easily not do this, and everything would be fine because they are the issuer of the currency. It would not be fine if the bread seller did that: he could choose not to keep track, but eventually he might find that he had no more dollars to spend. Since the government issues the currency, it can’t be in that position: there are always more dollars it can spend if it decides to.

    – You claim that MMT is incorrect to assert that taxes give money value, because hyperinflations disprove this.

    The problem here is that you’re misinterpreting MMT. MMT claims that effectively enforced taxation causes a currency to be accepted in exchange for goods/services, NOT that it stabilizes the exchange value of either those goods/services or of another currency. Even in hyperinflations most of the time the currency continues to be accepted, although sometimes it doesn’t and in almost every one of those times either the tax became insignificant because it wasn’t keeping up with the hyperinflation of prices, or the government simply stopped collecting it.

    – “That would indeed be wonderful, to just print money are thereby eliminate unemployment, depressions, and poverty, all without creating price inflation”…”One “immutable” economic law of money is that the creation of money, beyond what is needed for transactions, results in price inflation, and the payment of taxes becomes tied to that inflation…”

    MMT certainly doesn’t dispute that PY = MV, or that excessive spending in excess of the supply available will lead to bidding up of prices. However, MMT points out that most of the time in the productive sectors of the economy, there is actually more potential supply than demand, resulting in excess capacity: factory equipment sitting idle, and people who want to work but can’t. If this is what the market situation has produced, then only the government can correct it. And furthermore, it can do so without price inflation: if there are people sitting unemployed, then the government can hire them without causing inflation. The unemployed are getting a no-bid from the private sector, so the government employing them just causes a resource that was previously sitting idle to now be doing something.

    Here’s a lot more info:

  2. “Since the government issues the currency, it can’t be in that position: there are always more dollars it can spend if it decides to.” This seems like a distinction without a difference. They can ‘destroy’ the currency then print more to spend? Why?

    There are assumptions about ‘idle workers’ and unemployed that are also assumptions about the private sector and the reasons for unemployment. Barriers to entry (such as high land prices thanks to privatization of land rent) create unemployment. Taxing land rent would therefore open the land to those who are priced out, reducing unemployment significantly.

Please keep it civil

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s