Mervyn King

The ideological bankruptcy of modern monetary theory

The ideological bankruptcy of modern monetary theory
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If you can’t explain something, try an abbreviation. The latest in economics is MMT — Modern Monetary Theory or, in other words, a magic money tree. It’s a simple idea. It costs almost nothing to print money: the cost of printing banknotes is negligible compared with their face value, and even lower when the Bank of England creates money electronically through its so-called ‘quantitative easing’ programme (QE). That money could be given to the public — either directly or indirectly via the government — to enable people to spend more, so raising output and employment. We are all better off.

Why didn’t we think of this before? Well, of course we did. From Roman emperors through Henry VIII and the Weimar Republic to present-day Zimbabwe and Venezuela, rulers have shown all those clever central bankers struggling to get inflation up to their 2 per cent target how to do it. Unfortunately, they didn’t stop at 2 per cent but ended up in hyperinflations in which prices doubled in a day — equivalent to annual percentage inflation in the many trillions. Needless to say, in such situations the economy tends to collapse. As my wife says when I praise the quality of a bottle of wine and suggest some more, ‘Moderation in all things’.

The problem with the simple idea of MMT is that it belies the context to which it is applied. To be brutally honest, MMT is neither modern, nor monetary, nor a theory.

It is not modern because the ability to print paper (or, today, electronic) money has always raised the question of when to stop. And governments have always used deficit financing to support their wish to spend.

It is not monetary because the relevant questions concern fiscal policy: how should governments finance their deficits and what are the limits to those deficits? If deficits can always be financed by the printing of money by a compliant central bank, then we are in a world of ‘fiscal dominance’, to use the modern jargon. Inflation is then determined by government spending decisions. It was precisely to convince financial markets of the opposite that led to the independence of the Bank of England.

And it is not a theory because the appropriate size of the government budget deficit and how much money to print depend entirely upon the context of the decision. There is no general theory that says printing money or running a government budget deficit is always either good or bad. MMT advocates are correct in saying that the national budget of a country that can print its own currency is different in nature from the budget of a household (as Keynes pointed out in 1936 and others before him). But it does not follow that there is a magic money tree. If the government spends more and finances that by borrowing, the additional debt is a liability of the public sector. If the spending is financed by money printing, that too is a liability of the public sector and can be used, for example, to pay taxes. The smoke and mirrors of MMT violates the only iron law of economics — double entry bookkeeping: for every asset there is a corresponding liability.

To come down from high theory to the terrain of practical considerations, the real weakness of MMT is that it adds nothing to the existing toolbox of policy-makers. The Bank of England already prints money. The government already runs a (very large) budget deficit. MMT is not a new policy tool but simply an encouragement for them to go further. Whether that makes sense depends entirely upon the context in which that advice is given.

Conventional wisdom is to welcome the large injections of created money (QE) made by central banks since the start of this year but to worry about budget deficits and the sharp jump in national debt. The truth may be closer to the opposite.

To suppress the virus, the government shut down parts of the economy. This was a deliberate policy. Irrespective of the merits, it would be odd then to ask another branch of government to try to offset the policy by stimulating the economy, whether by monetary or fiscal means. People would love to spend more but they can’t. While businesses and governments have been borrowing at record levels, households have been saving. The personal sector saving ratio has more than doubled during the course of 2020. Instead of general stimulus, the right response to the pandemic was to support businesses until all the restrictions could be lifted. Only then would we know which businesses have a viable future in the post-Covid world. Broadly speaking, this is what the government has done through the furlough and other support schemes.

The outcome of course is record--breaking budget deficits and a sharp jump in national debt. Many have jumped to the conclusion that we will need increases in taxes and/or further cuts in public spending to ensure sustainability of the public finances. Such a judgment is premature.

Because of fiscal prudence over the past decade, the UK entered this crisis with only a small budget deficit (the so-called primary deficit, after interest payments on the national debt, was less than 1 per cent of GDP). Once we emerge from the epidemic, we could return to that position provided two conditions hold. One is that there are no long-term ‘scarring’ effects of Covid-19 on the productive capacity of the economy. Clearly, some sectors and firms are likely to contract and others expand.

But it is far from obvious that size of the economy as a whole will be permanently affected. The key point, however, is that no one knows today how much permanent damage has been inflicted on the economy. Forecasts based on guesses of the scarring effect are an example of bogus quantification.

The second condition is that public spending is not ratcheted up but returns to its pre-Covid path. Unlikely, perhaps, given the pressures for the government to spend more on all sorts of worthy projects. But there is no need to pre-judge decisions of the next spending review.

The crucial difference between the positions in 2010 and today is the interest rate at which the government can borrow. Back then, the UK government could borrow for ten years at an interest rate of between 3 and 4 per cent a year; today, the interest rate is just above zero. Allowing for inflation, the government can borrow money today at a significantly negative real interest rate.

With a balanced budget — government income equals expenditure — borrowing is required only to pay interest and the national debt expands at the interest rate at which the government can borrow. At present, this rate is clearly well below any plausible estimate of the long-run growth rate of the UK economy. So even with a budget deficit of modest proportions it is likely that the national debt as a share of national income will therefore slowly but steadily fall without any need for 2010-style fiscal surgery.

It would take several, perhaps many, years for debt to return to its pre-Covid level, but what matters is that the trajectory is downward. Outside times of crisis, the aim should be to run a budget deficit small enough to keep the national debt-to-GDP ratio on a declining path.

Since there is enormous uncertainty surrounding what best to do about taxes and spending once we have returned to normality, it would be a mistake to do anything rash now. Higher taxes might be needed to finance extra government spending, but tax raids are not needed to ‘restore the public finances’.

There are no magic money trees and no new theories that eliminate hard choices. But there are good and bad policies. The choice requires careful analysis of the immediate context. The right strategy now is to keep options open. At the end of next year or in 2022 we will be able to assess the appropriate fiscal policy. The 2010s was a time for a degree of fiscal consolidation. Today isn’t.

Written byMervyn King

Mervyn King was Governor of the Bank of England from 2003 to 2013. He is the author of The End of Alchemy (2016) and (with John Kay) Radical Uncertainty (2020).