In Part I of this four-part series, we introduced this report and discussed the origin narratives of Modern Monetary Theory (MMT). This week, we will examine the principles and consequences of the theory.
Principles of MMT1
MMT begins its analysis with a focus on macroeconomic identities and flows.2 The theory states that the creation of money begins with government. The government buys goods and services and injects money into the economy. That money goes into the private sector through the banking system and is either spent or saved by households and firms. To prevent the money supply from becoming excessive, the government taxes households and businesses or issues bonds that absorb cash and, in return, become financial assets.
These macroeconomic identities all balance to zero, as referenced below in our WGR series from May 2017.
The government runs deficits most of the time. For most of the postwar period, the household sector was a saver, although households did dissave toward the end of the housing boom. Business tends to be a dissaver. Until the early 1980s, the U.S. mostly had a balanced current account; a current account deficit, the broadest measure of foreign flows, including trade and remittances, started to turn negative after 1980. A current account deficit is positive in the above chart because it is essentially importing foreign saving.
Note that business dissaving expanded when the Federal government ran a modest surplus in the late 1990s. Much of this dissaving supported investment in technology and triggered a bubble in equities.
Although these identities always balance, there is nothing, in theory, to determine the direction of causality. On any given day in the financial media, one will hear the statement that the U.S. undersaves and thus we run a trade deficit. However, it is equally possible that foreigners oversave and, since the U.S. economy has both open current and capital accounts, that foreign saving must be accommodated through dissaving by either government, households or businesses. The fact that the U.S. runs a trade deficit with low interest rates and a stable to strong currency would suggest that the reason for the importation of foreign saving is that it wants to come here, not that we need it. If we needed the saving, one would expect a weaker dollar and higher interest rates. And so, as foreign money flows into the U.S. economy, domestic net savings has to adjust. In the last decade, it adjusted mostly by household dissaving, which led to more borrowing and a housing bubble.
From the macroeconomic identities, MMT works if the sovereign currency is non-convertible. In other words, the government does not guarantee that the money it issues can be converted into gold or any other commodity. Although it isn't essential, a floating exchange rate gives policymakers less constraint on fiscal and monetary policy. If the sovereign currency has a fixed conversion rate to a precious metal or other commodity, or can be directly converted at a guaranteed rate for a foreign currency,3 then MMT doesn’t hold. In fact, under conditions of convertibility, the orthodox model of money holds. However, there is no developed nation on earth that has a convertible currency. Therefore, the primary condition of MMT does appear consistent with how developed economies manage their currencies.