Question

Does Modern Monetary Theory prove that budget deficits are not of concern to the longterm health of the economy? Explain.

Answer 1

Modern Monetary Theory adopst an older view, known as the endogenous money theory, that rejects the idea that there’s a supply of loanable funds out there that private businesses and governments compete over. Instead, they believe that loans by banks themselves create money in accordance with market demands for money, meaning there isn’t a firm trade-off between loaning to governments and loaning to businesses of a kind that forces interest rates to rise when governments borrow too much.

MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players.

A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannotdirectly pay for spending. Instead, the government creates money whenever it spends.

The purpose of bond issuances is to prevent interest rates in the private economy from falling too low. When the government spends, they argue, that adds more money to private bank accounts and increases the amount of “reserves” (cash the bank has stocked away, not lent out) in the banking system. The reserves earn a very low interest rate, pushing down interest rates overall. If the Fed wants higher interest rates, it will sell Treasury bonds to banks. Those Treasury bonds earn higher interest than the reserves, pushing overall interest rates higher.

But the basic upshot of all this is that taxing less than the government spends, and issuing bonds in tandem, isn’t a problem under most prevailing circumstances, per MMT. The main constraint on government deficits is inflation, but at a time like now when inflation is low, that’s not a serious concern.

When the US is importing more stuff than it exports (as is normally the case), and the domestic US economy is overwhelmed with debt that it’s trying to get rid of (as was the case after the 2008 crash, as private homeowners and others were left underwater), the government, as a matter of arithmetic, has to run deficits if it wants to help the private sector recover. the 2001 recession was the result of the US fiscal surplus at that time forcing the private sector into deficit: “In most advanced economies, sharp, severe economic downturns typically follow a period when fiscal surpluses are accompanied by large private sector deficits.

In the long term,the only sustainable position is for the private domestic sector to be in surplus. As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.