Modern Monetary Theory, and why it matters
In the last few years, I’ve heard the term “Modern Monetary Theory” more frequently.
It’s an economic theory that has gained popularity, and we may be approaching a time when the theory will be tried out in the real world.
Modern Monetary Theory is favoured by many of the U.S. Democrats who want to run for President next year, and by some of the left-leaning populist parties across Europe. It might well have an impact on the value of your investments over the next few years.
According to Modern Monetary Theory (MMT), a country with its own currency, such as the U.K., doesn’t have to worry about borrowing too much money because it can always print more money to pay interest. After all, paper money isn’t backed by anything tangible (the Gold Standard is a thing of the distant past).
This means that the only constraint on spending is inflation, caused when the public and private sectors spend too much at the same time.
As long as there are enough workers and equipment to meet growing demand without creating high levels of inflation, the government can spend what it needs to achieve its goals.
MMT has some similarities to Keynes theories, including his “paradox of thrift”.
Keynes concluded that the balance sheet of a person and the balance sheet of a country are two entirely different things. While you can personally dig yourself out of a hole by cutting spending when your income falls, a country cannot.
At the level of a country (or broader economy), one family’s spending is another’s income, so if everybody cuts back, there is less income too. That leads to an economic depression.
Only a government can resolve this, as it prints money and spends freely, which means that household income matches expenditure again, and so the economy gets back on track.
A key element of MMT is the idea of a government-funded job guarantee.
When unemployment increases, the government will employ more people, paying them with the money its central bank has created. As employment increases, the government reduces the number of people it employs, with the private sector taking up the slack.
Nowadays, economists tell us that the raising and lowering of interest rates should be used to control the economy. MMT states that this is wrong and that the natural rate of interest is zero.
MMT suggests that there is no point in tweaking interest rates because businesses make investment decisions based on prospects for growth, not the cost of money.
In a world of MMT, fiscal policy (government spending and taxation) are used to control the economy.
When a government needs money, its central bank creates it in a few clicks on a computer. When the government spends more, the private sector gets the money and puts it in the system.
With more money in the system and no increase in demand for it, interest rates will tend to fall, not rise, according to MMT.
The primary purpose of tax is to keep inflation under control; tax is used to drain just enough money from consumers and businesses to avoid excessive total spending in the economy, and thus keep inflation to an acceptable level.
In a world of MMT, inflation isn’t primarily the result of excessively strong growth; instead, it is caused by businesses’ excessive pricing power. The way to prevent high inflation is to break up monopolies and regulate big business.
MMT does seem to explain a few things, and some of it can be used to make sense of what has happened since the banking crisis of 2007/08.
Why do we have full employment in the U.K., but little price or wage inflation? Why isn’t borrowing higher when interest rates are so low? And why hasn’t Quantitative Easing resulted in high inflation, when it was just a new way of printing money?
But MMT doesn’t seem very modern in many ways.
In the modern world, with its globally connected economies, a government doesn’t have that much influence over its own economy, perhaps except for the USA, and, maybe in the future, China.
In the U.K., domestic economic decisions are usually outweighed by what happens on the global stage.
In the past, when governments have printed money, it usually hasn’t ended well. And MMT doesn’t help when a country doesn’t have control of its own currency, so it shouldn’t work in the Euro-zone.
It may be that we never see MMT in action. But, if there is an MMT influenced Prime Minister here or President in the White House soon, we may need to understand and deal with its consequences.
We’ll be keeping an eye on the progress of MMT, and working out what our clients should do if it does look like the reality of the future. It’s likely that, as usual, diversifying your investments will be the best solution, but this time the flavour of diversification may need to be different.The term Modern Monetary Theory has gained popularity in recent years. We may be approaching a time when the theory will be tried out in the real world. Click To Tweet