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Modern Monetary Theory (MMT)

MMT suggests that countries and governments controlling reserve currencies can borrow and spend as much as they need to achieve employment, and later, create more currency to repay their debt...Modern Monetary Theory or Modern Money Theory (MMT)

 

The Modern Monetary Theory is an alternative to the traditional macroeconomic theory. Generally, MMT suggests that there is no limit to the quantity of money that can be created by a central bank. The only limit comes from the impact of inflation.

In short, MMT suggests that countries and governments controlling reserve currencies can borrow and spend as much as they need to achieve employment, and later, create more currency to repay their debt.

 

MMT Economists are focused on fiscal policies

According to MMT, governments can create new money through their fiscal policy. The government’s fiscal policy is focused on budgeting and includes:

  • Taxation
  • Government spending, and
  • Transfer payments

The MMT theory proposes high government spending towards:

  • Funding for essential government programs (education, infrastructure, etc.)
  • Full employment
  • Full economic capacity
  • Strong private sector

According to MMT economists, countries suffering from high unemployment are countries whose governments spend less than they should. Governments should spend as much money as they should achieve the full employment of the population.

 

Creating money to deal with unemployment (until infinity)

Until 1971, there was the Gold Standard. The Gold Standard was a monetary system that directly linked national currencies and paper money to gold. This meant, that the central banks of the participating countries were obligated to limit the quantity of new money. Nowadays, there is no obligation or international rule that limits the quantity of new money.

MMT suggests that there should be no limit to the quantity of money that can be created by a central bank. Governments should create and spend as much money it is needed to cope with unemployment. The only limit is the long-term impact on inflation.

■ Higher unemployment → The government borrows and spends more money

According to MMT, this money will be paid by the creation of new money from the central bank.

■ Repay debt → Central bank creates new money

Ultimately, the above situation creates inflation. At this point, the government increases taxes in order to limit consumption and control inflation.

■ Inflation unfavorably rises → Increase the level of domestic taxation

 

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The Unfavorable Impact of Government Deficit & Inflation

Government spending leads to government deficits. According to MMT theory, this is not an economic problem, as the government's deficit equals the private sector's surplus.

On the other hand, economic stimulus leads to higher inflation. When inflation rises in unfavorable levels, governments may increase taxes or lower the level of government spending (economic tightening).

If we look at history, the best indicator that signals the shift from economic stimulus to economic tightening is the price of energy prices and the price of industrial metals.

  • The price of Oil and Natural Gas
  • The Price of Industrial Metals (NOT precious metals)

 

Quantitative Easing Programs -The New Paradigm

After the financial crisis of 2008-2009, central banks around the globe have been buying huge amounts of government bonds from the private sector, in order to deal with deflation and stimulate the economy. These are the so-called “Quantitative Easing” (QE) programs.

The US Quantitative Easing Program of 2020

In Mach 2020, the Federal Reserve announced that they would purchase government debt bonds and mortgage-backed securities from domestic financial institutions, worth 700 billion US dollars. The Size of FED’s Balance Sheet:

  • March 11, 2020, 4.3 trillion USD
  • August 31, 2020, 7.1 trillion USD

The European Central Bank (ECB) Quantitative Easing Program of 2015

The ECB started its quantitative easing program in March 2015. By buying assets from commercial banks the target was to help the euro area return to inflation levels below, but close to, 2%.

However, history has taught us that Quantitative Easing Programs don’t work as efficiently as they should. Increasing the money supply doesn't necessarily lead to inflation. During economic turmoil, people prefer to save, so consumption and inflation don't increase.

 

Modern Monetary Theory (MMT)

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More Economic Theories: ► Triffin Dilemma | ► Purchasing Power Parity (PPP) | ► Portfolio Balance Approach | ► Interest Rate Approach ► Balance of Payments Approach | ► Monetary Exchange Rate Model

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