Modern Monetary Theory – or Practice?

Mariano Torras General Leave a Comment

March 20, 2021

It is time to make good on an earlier promise. In earlier posts (e.g., here), I hinted that I would, in the future, post more on Modern Monetary Theory (MMT). Well, economic and political events are rapidly making a proper understanding of MMT more urgent. Indeed, in large part due to recent Fed largesse, the question becomes whether we should be talking about Modern monetary theory or practice?

The premise behind MMT is that governments, unlike businesses or households, can never “run out” of money. As a last resort they are always able, by decree, to increase the quantity of money in circulation. This much is well recognized and understood. But to MMT proponents, governments’ unique position in this regard implies that it is free to “print” money as needed to fulfill its obligations. That is, without restriction. And what is even better, with no debt.[1]

Originally dismissed as a fringe idea, it would now be imprudent to ignore it. You might ask if inflation wouldn’t then rear its ugly head. But not so fast. The logic, to be sure, is straightforward. Flood the economy with money, make money less scarce, hence less valuable. If money is worth less than before, prices go up. In itself not necessarily a major problem. The real crisis occurs when expectations set in and spending increases, setting in motion a vicious cycle.[2]

But an under remarked fact is that logic does not always tell the whole economic story. To be sure, logic alone often misleads. Significant inflation is seldom if ever a problem in a slack economy. In fact, absence of inflation in the face of heavy and repeated money printing is usually a good sign that the economy is flagging. Remember that next time someone tells you that the U.S. economy was approaching full employment just before the pandemic.

I know, the unemployment rate was low. But as I have noted previously, this headline statistic seriously misleads, and even more so in crisis times. The Federal Reserve’s asset position is at historical highs, a clear signal of excess money printing. Yet no inflation.

MMT, originally a nonmainstream perspective held by a handful of “fringe” economists, is increasingly being given a second look by economists and politicians alike. True, Alexandria Ocasio-Cortez is one of the most prominent supporters, and credentialled economists like Paul Krugman, Larry Summers, and Ken Rogoff, among others, are its most vocal critics. But events increasingly appear to favor MMT’s supporters.

When first conceived, MMT was meant to offer innovative policy advice. It has been slow to stick, with much mainstream opposition to this day. And realistically, it seems that the idea of leading with untrammeled growth in the money supply is politically unpalatable to too many policymakers and therefore a non-starter.

Yet as is the fate of many economic theories, MMT may yet serve to explain economic phenomena post hoc. I mean really, elite economists’ opposition notwithstanding, the MMT experiment is being conducted as we speak. If things continue as they have since more or less the end of the 2008-9 financial crisis, MMT proponents are likely to find themselves vindicated.

For most of the past decade, deflation has been feared more than rapid inflation – despite massive money printing (see Chart 1). The Fed has increased the asset side of its balance sheet since 2008, both in absolute dollars and in relation to GDP. And notice than in the past year both have spiked. In simple terms, the Fed increases assets when it buys Treasury bonds – and, increasingly, corporate bonds – with the money that it prints.


Federal Reserve Assets refer mostly to government Treasury bonds, but also (increasingly) corporate bonds and other corporate assets.
Source: Federal Reserve, St. Louis.

But the aggressive money printing has not, contrary to conventional theory, provoked significant inflation (Chart 2). If anything, the opposite is the case, as the percentage increase in average prices has been on a downward trend over the past decade. And this despite rock-bottom interest rates during this time.


The Fed funds rate refers to the Fed’s target overnight rate, and most interest rates move with it. Inflation is measured by the change in the consumer price index (CPI).
Source: Federal Reserve, St. Louis.

How can we explain all this? My thinking is that assets like stocks and bonds represent a substitute good or commodity that one could purchase with the Fed money infusions. In other words, far from encouraging the “real” economic spending that tends to cause inflation, the bulk of the monetary stimulus has been parked in illiquid financial assets like stocks and bonds. Consequently, both stock and bond prices have enjoyed a flourishing bull market. Asset price inflation has, therefore, come to substitute for goods price inflation.

I have serious doubts that the Biden’s $1.9 trillion “rescue” package will do much to change things in this regard. It might, one must hope, improve conditions for the poor and middle class. But do not expect rapid inflation. We should probably, however, expect much hullaballoo about a mild uptick in inflation, which is likely.

You might be thinking: What if this economic generalist guy has no idea about what he is talking, and the economy does actually heat up, causing rapid inflation? Of what avail, then, would MMT be? I did not discuss it earlier, in part because full employment seems so remote. But the theory is clear. In the event that the economy heated up sufficiently to provoke inflation, the solution would be to tax surplus money out of circulation.

The wealthy would not be happy, since the lion’s share of that burden would be on them. But note that, with Biden even saying so in a recent interview, there are signs that his Administration is serious about this option. The Democrats are surely not getting their marching orders from MMT theorists. There may, however, be a day in the near future when we will be writing about MMP – modern monetary practice.

[1] Or at least that is the theory in a nutshell. A lengthier and more technical treatment will need to wait a bit longer (sorry). For those who cannot wait, a good source can be found here.
[2] I can hear some of you objecting: But higher prices would lead to less spending, not more. But if you’ve taken an introductory microeconomics class, a quick review of the difference between demand and quantity demanded should shed light. (I know that these sound like the same thing but trust me). If not, consider that if people expect inflation, they are more likely to buy now instead of in the future when the price is even higher.

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