The fiscal theory is not actually that new as its origins can be traced back to the early 1900s and the work of Georg Friedrich Knapp  

As the world’s foremost economic superpower, the idea that the US could suffer from hyperinflation seems preposterous. Hyperinflation is associated with failed states like Weimar Germany, Zimbabwe and Yugoslavia. It would be highly unlikely for any developed economy, least of all the US, to experience a similar fate – but in fact, the US has already suffered at the hands of spiralling inflation.

Some analysts are predicting that we could see a US currency collapse within the next decade

During the American Revolutionary War, the US governing body issued almost $250m worth of a new tender known as the ‘Continental currency’. With little control over how many bills were being issued and lacking the required taxation to take notes out of circulation, the value of this currency quickly plummeted. By 1780, just five years after the start of the war, they were worth approximately one fortieth of their face value.

Of course, the US economy has developed significantly since then, and the likelihood of it becoming caught in an inflationary trap now is much less likely. Nevertheless, some analysts are concerned, predicting that we could see a US currency collapse within the next decade. These fears partly stem from geopolitical factors, although US economic policy is playing a role too.

The rise of Modern Monetary Theory (MMT) has got orthodox economists in particular running scared, because of its suggestion that the US can increase its deficit spending significantly without having to balance its books.

In the past, while MMT remained a fringe view, mainstream economists didn’t have to engage with its ideas particularly closely. However, the theory has gained greater traction of late, especially among prominent left-wing political figures. Enacting a federal jobs guarantee and boosting the resources allocated to public services could certainly prove to be popular policies, but it would take a brave politician to argue that the US could simply issue more currency to pay for them.

In recent decades, governments from across the world have rarely run budget surpluses, frequently increasing spending to pay for things that were deemed to be essential. However, they have always claimed that they intended to cut the deficit eventually. Under MMT that could be about to change – and if it does, the US economy will be entering uncharted territory.

Not so modern
Despite its name, MMT is not actually that new. Its origins can be traced back to the work of Georg Friedrich Knapp in the early 20th century, who posited that banknotes need not be connected to any tangible commodity – say, gold – in order to attain worth. Their value comes from the fact that they are accepted at ‘public pay offices’ – by the state, essentially. Once this fact is acknowledged, theoretically there are no spending constraints for a sovereign state able to issue its own currency.

Russian economist Abba Lerner took Knapp’s work to its logical conclusion with his theories on functional finance, which argued for an interventionist government and focused on policies to reduce unemployment, rein in inflation and encourage appropriate levels of investment. It rejected “completely the traditional doctrines of ‘sound finance’”, contending that there was no need to balance the budget. MMT, a term coined by Australian economist Bill Mitchell in the 1990s, makes similarly bold assertions.

The theory is based on three economic principles that sound simple enough. First, fiat currencies are public monopolies – that is, central banks are the only institutions authorised to issue them. These currencies are also the only accepted payment for taxes. Nations with control over their own floating currencies are not financially constrained because they pay for their obligations with the very currency that they emit and control. Second, governments that sell bonds in a nation’s currency cannot technically default on their debt, even though they may choose to do so. And third, MMT argues that it is normal for governments to run deficits. In fact, every dollar spent by the government that exceeds the money received from taxes is one more dollar for the private sector. In essence, a public deficit is a private surplus.

Despite its name, Modern Monetary Theory is not actually that new

“None of these rather obvious stylised facts [are] part of orthodox economic theory,” said Pavlina R Tcherneva, a research associate at the Levy Economics Institute. “When pressed, mainstream economics would admit that currency is a public monopoly, but this fact is virtually ignored and mainstream theory still talks as though the government has to borrow its own money back from the private sector in order to spend. And outside of MMT, I see virtually no economist who has said that eliminating the deficit means that we are eliminating the surplus of the private sector.

“This is such a basic accounting claim, and yet, mainstream theory continues to argue that deficits crowd-out private spending and investment. In fact, it’s precisely the opposite – deficits provide net financial assets (the surpluses) to the private sector that can be used to finance investment and spending.”

According to MMT, since governments dropped the gold standard in 1971 and switched to fiat currencies, there is no need for them to finance their spending through taxation or borrowing. Instead, as the sole issuer of currency, it can simply create more money. While this could cause debt-servicing costs to increase, in this situation, governments could lower interest rates to make repayments easier. This would also ensure capital costs remained low in the event of investors running scared.

In its current state, the US economy is severely underutilised. Infrastructural projects remain in blueprint form only, minerals are left in the ground, and the country’s employment rate has hovered just below 60 percent for the past decade (see Fig 1). This is all a hugely inefficient waste of resources. Governments should not attempt to balance the budget, but balance the economy instead. It’s a distinction that seems minor on paper but could, if accepted, result in politicians enacting radically different economic policies.

The price of policy
John Maynard Keynes, talking about Lerner’s economic ideas in 1943, said: “His argument is impeccable. But heaven help anyone who tries to put it across.” Certainly, the suggestion that the US Government – or any other government, for that matter – should ramp up its deficit spending is not likely to be much of a vote-winner. Or at least, it hasn’t been until recently – perhaps with the scars of the financial crisis a little too fresh in everyone’s minds.

Today, however, MMT is gaining political traction. Progressive politicians on the left of the Democratic Party, like Alexandria Ocasio-Cortez, have spoken about raising government spending to pay for things like a Green New Deal. Other proponents of MMT can be found all across the world: the first MMT conference occurred in 2017, where a policy was discussed that would provide a job paying $15 an hour for anyone who wanted work. At the conference, economist Larry Randall Wray claimed that such a policy would provide an additional 14 to 19 million jobs, add between $500bn and $600bn to GDP, and add less than one percent to inflation.

In its current state, the US economy is severely underutilised

“MMT has gained… popularity in recent years because it has pointed out some very obvious aspects of public finance and opened up a range of economic possibilities,” Tcherneva told World Finance. “For a very long time, we’ve been told that the government must balance its books like a household, or it can go bankrupt. And therefore, the argument went, in the name of fiscal discipline, we had to sacrifice some policy priorities. Pressing economic problems, like hunger, unemployment, infrastructure degradation, we were told, could not all be financed. None of these claims [are] true.”

Governments often talk about their efforts to balance the books, but in practice, they hardly ever manage to achieve it: over the past 40 years, the US has only once managed to match its spending against tax revenue. In reality, governments find a way to pay for things that they deem to be important, regardless of how big their deficit has become. This could be a tax cut for the rich or a federal jobs guarantee – there is nothing inherently political, socialist or otherwise, about MMT.

“The US Government already enacts MMT,” Tcherneva said. “MMT is not a proposal. The recent [corporate] tax cut is only the latest demonstration that the government funds large-scale » programmes without ‘running out’ of financial resources. The prescriptive part of MMT simply says that since we can already see that there are no limits to government spending, is there a better way to spend? Can we get more bang for our buck, so to speak? What did we get in return for the recent tax cut – more inequality, a share buyback?”

One of the most commonly cited policy proposals among MMT proponents is the implementation of a federal jobs guarantee. The main problem in the US economy today is a lack of demand, in part caused by underemployment. A jobs guarantee would, of course, be hugely costly, but it would also provide citizens with the security and spending power to increase consumption, which would feed back into the broader economy. The guarantee could even turn out to be temporary if the increase in federal spending spurs an uptick in private sector hiring.

Governments often talk about their efforts to balance the books, but they hardly ever manage to achieve it

MMT supporters also rightly point out that the US Government already spends a great deal of money on the unemployed in terms of social support programmes and indirect costs related to crime and mental health. Resources are inefficiently locked up in providing for people who would rather be doing productive work. In this sense, a job guarantee is simply a different form of spending – one that Tcherneva says gives “better bang for your buck”.

A nation’s true wealth is the sum of the real goods and services that it can create. Provided these are being exploited in an environmentally sustainable way, the most efficient use of these resources comes from full employment. If MMT can achieve this, it is certainly better than paying to have people queue up for their social security cheque.

A risky business
MMT can be difficult to process initially – after all, orthodox economics has stressed that if a country increases the money supply too much then inflation will occur, making it more difficult for ordinary people to purchase the goods and services they need. Even worse, hyperinflation could bring an entire economy to its knees.

It is worth remembering, however, that printing money does not necessarily affect the amount of money being spent. And even if it does, MMT also proposes that government funds are allocated to the creation of more goods and services. As long as aggregate demand and monetary supply remain roughly in tandem, then it does not necessarily follow that increased deficit spending will lead to a devaluation of the US dollar. More importantly, MMT has never claimed that deficits are not important, or that the government can spend frivolously.

“There is a widespread misconception out there that MMT proposes running the printing presses,” Tcherneva said. “[It] emphatically [does] not. MMT explains how governments with monetary sovereignty currently spend. MMT explains the financial limits faced by government that do not have their own floating currencies. MMT suggests that we can increase or redirect spending in ways to serve the public purpose. Critics scream: ‘Inflation! Hyperinflation!’ but ignore the core tenet of MMT. The limits to government spending are the real resources, not finance.”

In fact, the finite amount of real resources at a government’s disposal is something that MMT critics have focused on. No one is really sure what would happen if the US Government kept increasing the deficit to pay for things after it had employed every worker and the economy was running at full, or nearly full, capacity. It has been suggested that hyperinflation would take hold.

Of course, MMT proponents argue that such a concern is nothing more than hypothetical posturing. The US is far away from using its full amount of real resources and can always use taxation to curb inflation should it occur. What’s more, much of the developed world has been operating in a low inflation environment for a number of years now. Despite deficits spiralling and years of quantitative easing, inflation has remained stubbornly low (see Fig 2). The threat it poses appears to be exaggerated, for the time being at least.

Times are changing
According to supporters of orthodox economics, MMT could bring an economic superpower to its knees. That appears unlikely at the moment, but significant geopolitical shifts could bring such doom-mongering closer to reality.
First, foreign governments that hold dollar-denominated debt would have to start selling up. Japan, China and a number of other countries keep billions of dollars’ worth of US Treasury holdings, keeping the dollar’s strength up. If economic confidence in the dollar declines, these foreign governments may decide to sell, depressing the value of the dollar further. That is not likely to happen at the moment, as these countries rely on US consumers buying their exports. However, an unforeseen economic crisis could change matters – a move away from the petrodollar, for example, could prove disastrous.

“I think a currency collapse in the US is unlikely,” Tcherneva told World Finance. “I think we need a failed state to see a collapse in the dollar. I cannot imagine a macroeconomic policy we could undertake under current conditions that would bring about a currency collapse. Look at the trillions of dollars we’ve spent for ‘unproductive uses’ – such as financing endless wars. And yet that didn’t cause drastic currency
depreciation or collapse.”

A wholehearted embrace of MMT would no doubt affect how investors view the US

However, a wholehearted embrace of MMT would no doubt affect how investors view the US. Although inflation has remained stubbornly low in the face of huge amounts of government spending, it is possible that this is because there is the expectation that the running up of large deficits was a temporary response to the financial crisis of 2008. In effect, although quantitative easing has been in place for years, there is a belief that it will come to an end.

If the US Government instead decides that it can increase deficits as part of long-term economic policy, businesses might suddenly become concerned. They might start raising prices, and then inflation could set in. While this doesn’t seem like much of a problem at the moment, it could very well rear its head later.

The fact remains that even though governments around the world display little commitment to lowering their deficits, they at least profess to. MMT would mark a departure from this and would likely lead to a substantial increase in deficit spending – in the short term, at least. How businesses and foreign investors would react to such a shift in economic policy is difficult to predict. However, convincing them that a government is not financially constrained by its budget, but by its access to real resources – labour, land and other assets – may be too much to ask.

It is possible that we will find out soon enough. For too long, citizens have been told that the government cannot afford to invest more in education, healthcare, infrastructure and other public services. At the same time, they have seen governments find money to pay for tax cuts, bank bailouts, military activities and other programmes that they likely deem to be less essential.

MMT asks that instead of worrying about their balance sheets, governments start looking at ways to use the resources at their disposal in the most efficient way possible. According to the theory, generating full employment, creating a more equal society and fortifying our education systems are all possible without causing rampant inflation. It is not a question of being able to afford it – it is a question of political will.