Modern Monetary Theory: What should the EMU make of it?

In 2020, governments all over Europe and beyond have enacted unprecedented fiscal stimulus to keep their economies afloat amidst the pandemic. By the end of the year, a country like France will have engaged or guaranteed at least 300 billion Euro in 2020, the equivalent of four years of income tax receipts. Institutions of the European Union also rightly stepped up to the challenge. Most notably, the European Central Bank launched several bond-purchasing programmes to absorb the rising public debt on its balance sheet.

Should the public debt sitting on central banks’ balance sheet be considered a burden or an unfortunate tab that a country can get away with? This is in essence the question that Stephanie Kelton, one of the leading progressive voices in American academia, raises in her book The Deficit Myth (2020). Kelton’s book, meant to serve as a manifesto for the ‘Modern Monetary Theory’ (MMT), primarily considers the nexus between fiscal and monetary policy in the specific context of the United States. In the wake of the Covid-19 pandemic however, Kelton’s ‘deficit myth’ has, gained traction in the EU too. Notably with some policymakers who see MMT as a way to ‘cancel’ public debt. 

A misnomer rightly debunking misconceived views on fiscal policy

As Kelton herself acknowledges (2010), Modern Monetary Theory is a ‘misnomer’. MMT is indeed not a theoretical but rather a descriptive approach, which largely builds on the work of economists such as Georg Friedrich Knapp, John Maynard Keynes, and Abba Patchya Lerner. MMT primarily focuses on the role of fiscal policy in achieving macroeconomic objectives – such as full employment, low inflation, and lower inequalities – with monetary policy supporting these objectives in the background. 

In The Deficit myth, Kelton’s argument relies on the following main claims: 

1. There are neither financial nor monetary constraints for sovereign countries. Kelton primarily focuses on the United States as a country issuing fiat money (government-issued currency that is not backed by a physical commodity such as gold), in a floating exchange rate regime where its currency is internationally accepted. In this context, governments can never default since central banks can always credit the accounts of banks holding public bonds. Accordingly, governments don’t need taxes or borrowing to fund their expenditures. 
2. Fiscal policy should help balance the economy, not the budget. Kelton rejects the widespread view of the state’s finances as equivalent to those of private households: borrowing, like taxes, is not there to fund public expenditures, but to attain targeted objectives in the economy, including achieving full employment, controlling inflation, or altering the distribution of income. Efficiency should be measured against the objective of bringing about policymakers’ goals rather than against the ability of correcting market failures. In that spirit, Kelton proposes introducing a federal job guarantee scheme, which would create a market for jobs linked to building a care economy.
3. The real constraint is not deficit, but inflation. Kelton clearly acknowledges that while deficit may not be a constraint on government expenditure, inflation is one that needs be taken seriously. Rather, productive resources are the real constraint as inflation will kick in when aggregate demand is higher than productive capacity. This kind of ‘demand-pull’ inflation, she argues, should be dealt with by raising taxes or cutting spending to reduce the available money in the hands of the taxpayer. A federal job scheme would also help reduce inflationary pressures by stopping companies from bidding up wages to attract workers.

Essentially, Kelton advocates for the use of fiscal policy to address macroeconomic issues and to “shift away from the current reliance on central banks to deliver on the twin goals of full employment and price stability”. This approach may be seen as a welcome call to move away from technical monetarism in the EMU. Yet one should also be careful not to throw out the baby with the bathwater and consider how best to address the negative externalities created by monetary financing. 

Moving away from technical monetarism

Kelton’s The Deficit Myth undeniably has the merit of bringing back the instrumental role that fiscal policy can play in achieving macroeconomic objectives citizens actually care about. In the same vein, another major contribution of MMT is the rejection of technical monetarism (Constâncio, 2020), which basically sets the view that governments should keep the money largely steady and price stability be some sort of a totem for which objectives as legitimate as full employment can be politically sacrificed.

A modern criticism of the neoclassical paradigm is particularly relevant in the light of the original EMU institutional design. From the years following the adoption of the Maastricht Treaty to those of the Great Recession, EMU rules and their interpretation undeniably reflected the dominant ideology at the time when the Treaties were signed which coincided with the supply-side revolution in economics. the monetarist design of the European Central Bank (ECB) and its focus on keeping inflation (well-)below the 2 per cent target was often achieved at the price of high levels of unemployment. To that extent, pre-‘whatever it takes’ ECB monetary policy did represent a case example of Kelton’s criticism of a theory that promotes precisely this approach, namely: the non-accelerating inflationary rate of unemployment (NAIRU). 

The EU’s response to the pandemic however does constitute a sea-change in economic and monetary governance to the extent that it was described as “Modern Monetary Theory in action” (Bofinger 2020). Of particular importance has been the response of the ECB which launched several bond-purchasing programmes of a total value of 1.85 trillion Euro (the equivalent of the yearly economic production of a country like Italy). By buying bonds in exchange of so-called ‘central bank money’, the ECB notably allowed governments with higher debt servicing and refinancing costs to benefit from its own credibility as lender of last resort. A good example is Portugal’s 10-year bond yield which, in November 2020, fell, for the first time, below zero. 

As of January 2021, a substantial and increasing amount of government debt is sitting on the ECB’s balance sheet. In light of the global macroeconomic environment, scholars have highlighted the benefits in the ECB engaging in at least some kind of temporary monetary financing (Blanchard and Jean Pisani-Ferry 2020). Yet, as any short-term remedy, monetary financing also comes with some long-term side-effects that will need be mitigated.

Remaining challenges ahead: inflation, financial stability, and inequality

Given the universal claims made by Kelton in some parts of the book and, above all, its reception in some countries like France and Italy as a kind of new ‘general theory’ in the making, it is surely fair to address some of the apparent limits standing in the way of MMT if it is to foster the kind of paradigmatic change it aspires to trigger. 

The first issue relates to inflation. Today, chances of inflation hitting EU economies for a sustained period are undoubtedly low. Yet this does not mean that they are inexistant. What if, indeed, a ‘demand-pull’ inflation spiral did unleash as a result of the EU’s bazooka in more than a temporary rebound? What if a ‘cost-push inflation’ was triggered by other long-term trends, be it deglobalisation or demographic ageing (Goodhart and Pradhan, 2020)?

Kelton’s argument largely relies on the assumption that inflation may be addressed more effectively from the fiscal than from the monetary side. This assumption, however, appears fairly naïve politically, economically, as well as socially: politically, ‘internal devaluation’ strategies, usually associated with spending cuts, lower wages and labour market flexibilisation, are usually more perceivable (and hence politically contested) than interest rates hikes. Economically, this strategy risks proving less effective in calming down inflationary expectations, potentially costing precious time for policymakers seeking ways to preserve the value of their currency. And socially, addressing inflation through tax hikes or spending cuts (especially) could have a particularly damaging distributive impact given that the most vulnerable generally rely the most on public assistance.

The second issue is linked to the negative externalities that are associated with a situation of permanently low interest rates. While MMT surely helps to revive the role of fiscal policy in macroeconomic stabilisation, the role that monetary policy can play in this area seems overly downplayed. Low interest rates can disincentivise policymakers from making the kind of long-term reforms that help improve the productivity of their economy. As shocks hit, these trends can in turn expose countries to risks of capital flights and create immense socioeconomic challenges especially in those countries where years of neglect and underfunding have undermined the institutional capacity. Advocates of the MMT are right to point out that central banks will have to integrate issues such as climate change or the rise of inequalities. Yet overburdening monetary policy with issues of a more fiscal nature could largely constraint its capacity to help trigger the kind of change it aspires to propel. 

Not only does cheap money artificially keep zombie firms alive, preventing the emergence of more sustainable business models. Latest exercises of quantitative easing also led to a major rise in the value of financial assets, far from reflecting developments in the real economy. There are risks that the status quo further exacerbates the gap between asset-rich and asset-poor individuals, as well as countries.

Making common fiscal capacity work

In The Deficit Myth, Stephanie Kelton’s main insight is essentially that economic instruments should remain means to pursue political goals. Recently, much debate has focused on the extent to which the MMT Kelton advocates for in the US should also be considered to change the course of the ECB’s monetary policy. This however is questionable in a context where governments effectively borrow at negative interest rates from financial markets with practically “no fiscal cost” (Blanchard 2020). As we have shown, several issues also remain to be cleared for the MMT’s monetary policy prescriptions to be considered politically, economically, and socially desirable.

Today, there are in turn reasons to believe that the novelty of the latter argument should not blind us to what is certainly the most decisive reminder of the MMT approach: namely that fiscal policy should be used as a force for short-term stabilisation, long-term development, resources allocation and distribution, and employment maximisation.

On 10 December 2020, EU member states have adopted a 750 billion Euro recovery fund, which includes both grants and loans funded by common borrowing – a historical breakthrough for the EU. The economic rationale of an EMU fiscal capacity has been repeatedly stressed (see e.g. Pasimeni, 2015) and progressive voices have been advocating for years for precisely for such kind of common fiscal capacity to see the light of the day. Now, the challenge will be to demonstrate that sharing fiscal capacity not only has purpose, but also provides genuine added value to member states’ expenditures, and that it is effectively spent too. 

In short, the main policy implication of Kelton’s Modern Monetary Theory should be to make this common fiscal capacity work. This approach will surely have more value than raising the flag of a distant, obscure, and possibly unnecessary government debt cancellation by the ECB.