Modern Monetary Theory: A Solid Theoretical Foundation of Economic Policy?

Prinz, Aloys L.; Beck, Hanno Article — Published Version Modern Monetary Theory: A Solid Theoretical Foundation of Economic Policy? Atlantic Economic Journal Provided in Cooperation with: Springer Nature Suggested Citation: Prinz, Aloys L.; Beck, Hanno (2021) : Modern Monetary Theory: A Solid Theoretical Foundation of Economic Policy?, Atlantic Economic Journal, ISSN 1573-9678, Springer US, New York, NY, Vol. 49, Iss. 2, pp. 173-186, https://doi.org/10.1007/s11293-021-09713-6 This Version is available at: https://hdl.handle.net/10419/287014 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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AloysL.Prinz1 · HannoBeck2 Accepted: 4 May 2021 © The Author(s) 2021 Abstract This paper shows that so-called modern monetary theory (MMT) lacks a sound economic foundation for its far-reaching policy recommendations. This paper’s main contribution to the literature concerns the theoretical foundation of MMT. A simple macroeconomic model shows that MMT is indistinguishable from the Keynesian cross model, as well as a neoclassical macroeconomic model, even when taking account of money in the sense of MMT. This result is in stark contrast to the claims of MMT proponents. Accordingly, it is asserted that MMT is a fundamentally new theory of money and monetary economics. However, MMT is admittedly based on the functional finance concept of the 1940s and money is modelled as an accounting identity. In addition, the fundamental connection between government expenditures for goods and services and the steady state equilibrium value of the national income, the so-called fiscal stance, is a well-known result that is not only consistent with MMT. The interpretation of the fiscal stance, in combination with the accounting identity for money, is a major issue because an equilibrium condition should have a certain causal direction of effects. Based on this reading of the equilibrium condition, policy recommendations encompass the fiscal dominance of monetary policy via monetization of public debt, a job guarantee by the state, along with a so-called Green New Deal. According to the results of this paper, these policy recommendations cannot be justified with MMT. Supplementary Information The online version contains supplementary material available at https:// doi. org/ 10. 1007/ s1129302109713-6. * Aloys L. Prinz alo[email protected].de 1 Institute ofPublic Economics, University ofMuenster, Wilmergasse 6-8, 48143Muenster, Germany 2 University ofApplied Sciences Pforzheim, Tiefenbronner Straße 65, 75175Pforzheim, Germany / Published online: 25 May 2021 Atl Econ J (2021) 49:173–186 1 3 Keywords Modern Monetary Theory· Keynesian cross· Public budget deficits· Fiscal policy· Monetary policy JEL B59· E42· E52· E62· H63 Introduction Recently, a macroeconomic theory, modern monetary theory (MMT) (also dubbed modern money theory), has become a hot topic in United States (U.S.) politics. Stephanie Kelton, a proponent of this theory, was among the advisers of Bernie Sanders in the 2016 U.S. presidential campaign. Her contemporary, Alexandria Ocasio-Cortez, a popular member of the Democratic Party in the U.S., seems to also adhere to MMT. MMT offers politicians what they want most: a simple justification for policies they want to carry out. A case in point is active U.S. labor market policy. The U.S. public expenditures in this policy area are very low in comparison to all other countries of the Organisation for Economic Co-operation and Development (OECD) (Council of Economic Advisers,2016). After the near meltdown of the financial system and the economic fallout of the coronavirus pandemic, attitudes towards active labor market and social policies might have changed. Therefore, MMT may provide a welcome academic justification for these policies. Moreover, the popularization of MMT through the blogosphere may have a profound effect on U.S. politics and economic policy in the 2020s and 2030s (Brady2020). A special feature of MMT and its policy recommendations is public debt. According to MMT, public expenditures can be financed by public debt or even by printing more money without negative economic side effects such as inflation, crowding-out of investments or national insolvency (Forstater1999; Mosler 1998). The only precondition is that the respective state has its own currency. This is the most provocative conclusion of MMT proponents. MMT is not a new theory that emerged from the financial crisis of 2008. Most of the policy recommendations can be found in the work of Lerner (1943, 1944, 1951), dubbed functional finance, as also mentioned by MMT proponents. The theory itself is Post-Keynesian and monetary. Post-Keynesian economics (Arestis 1996; Lavoie 2009) is the general heading for very different economic concepts and theories that rely on Keynesian economics, but that do not accept New Keynesian concepts (Dixon and Rankin,1995). Meanwhile, economists of this tradition formed a group whose common feature is a socalled coherent financial stock-flow accounting framework (Godley and Lavoie, 2012, p. 12, who also sketch the development of MMT; Nikiforos and Zezza, 2017). As will become clear in the following, ex post accounting identities play a crucial role in MMT. 174 Prinz A. L. , Beck H. 1 3 Literature Review Although there are a number of recent assessments of MMT, these contributions either do not contain a formal analysis (Brady2020; Coats2019; Epstein2020; Hartley2020; Newman2020; Palley2015a; Skousen2020) or the formal analysis is a bit too sophisticated to isolate exactly where the theoretical foundation of MMT fails (Palley2015b). Palley (2015a) discussed the elements of MMT with Tymoigne and Wray (2013) concluding that what MMT adds to old Keynesian economics is wrong. Similarly, Skousen (2020) investigated the macroeconomics textbook on MMT by Mitchell etal. (2019) concluding that MMT is dangerous as its policies may provoke runaway inflation, and that it is not required as countries can reduce unemployment substantially without applying MMT policies. Brady (2020) summarized five cornerstones of MMT concerning the sustainability of very high public debt and refuted them with results from old and contemporary economic literature. Coats (2019) studied MMTs free-borrowing hypothesis for governments and argued that this radical view was based on the critical assumption that the natural rate of interest is zero. Hartley (2020) found that MMT might be a political movement rather than an economic theory, as long as there is no empirical evidence for its propositions on government debt and inflation-free money creation. The MMT critique of Epstein (2019, 2020) is related to the existing institutions that are responsible for monetary and fiscal policy. According to Epstein, this institutional setting and the functioning of modern financial markets may seriously limit the implementation of MMT’s policy recommendations. Kashama (2020) assessed MMT from the viewpoint of macroeconomic stabilization in the eurozone. His conclusion was that the policy assignment to the governments and the central bank, with the central bank responsible for price-level stability, should not be changed, in stark contrast to MMT. Compared to these papers, this short contribution relates to the theoretical foundation of MMT at a very fundamental level. This paper most closely resembles Palley (2015b). Palley provided a sophisticated theoretical analysis of MMT from a Keynesian viewpoint. He demonstrated very clearly the basic Keynesian approach of MMT and argued that nothing of relevance was added that would justify the term MMT. In contrast to Palley (2015b), this paper takes MMT seriously in the sense that a simple version of MMT is used to prove that it is identical to the Keynesian cross model. In the model, MMT’s approach of financing government expenditures by money creation is applied, showing that MMT’s interpretation of money does not change anything. MMT does not present a new theory of money, but only accounting identities. Moreover, the fundamental flaw in MMT is a misreading of the equilibrium condition of the underlying macroeconomic system. Far reaching policy recommendations, such as financing large-scale social policy expenditures by public deficits or printing money, do not seem to be justified on the basis of MMT. Moreover, information in the Online Supplemental Appendix shows that even in MMT, ex post Ricardian equivalence must hold true. This implies that money is neutral in the sense that it does not eliminate or mitigate the fiscal burden of government expenditures. 175Modern Monetary Theory: A Solid Theoretical Foundation 1 3 Simplest MMT Model: SIM The following presentation of MMT in the simplest version (SIM) is based on Godley and Lavoie (2012, pp. 61–72). SIM is interpreted as the basic model of MMT. Moreover, all subsequent extensions of the model inherit the characteristics of SIM. The notation in this presentation is somewhat modified (without any content change) to make it easier to compare SIM with the simplest Keynesian model in the next section. The disposable income of households, Yd , is given by: where W is wage, LS is labor supply, and T is tax payments of households. Note that firms are not modelled explicitly, as is quite usual in very simple macroeconomic models. Implicitly, firms employ labor services of households to produce goods and services and they pay wages to the households as remuneration of labor services. SIM has two behavioral equations. The first one is the tax function, T, defined by the government: where t is the tax rate of a proportional wage tax. The second behavioral equation is the consumption function, C, of households: where 𝛼,𝛽 are coefficients and MHH−1 is money stock of households from the previous period. The consumption function in Eq.(3) depends on the disposable income, with α as the marginal propensity to consume and β as the influence of the money stock households hold from previous periods. Money is created by the government via the public budget deficit: where MG(MG−1) is money creation of the government in the current (previous) period and G is government expenditures for goods and services. Equation(4) can be understood as the monetization of debt (Protopapadakis and Siegel, 1986; Thornton 2010). Instead of I-owe-you’s (IOUs), the government buys goods and services by creating its own money, also called outside money (Wray2014). Money is defined here as an accounting measure, or “as a two-sided balance sheet phenomenon” (Bell 2001, p. 151). Therefore, it cannot be said whether it is an asset or only a numeraire (for a discussion of the latter, see Otaki 2012). Households adjust their holding of money as follows: i.e., the difference between disposable income and consumption is equal to the change in money holding. Obviously, the difference between disposable income and consumption must be equal to households’ savings, S (note that S is not (1) Yd=W ⋅ LS−T, (2) T=t ⋅ W ⋅ LS,t<1, (3) C( Yd,MHH − 1 ) =𝛼⋅Yd+𝛽⋅MHH − 1,0<𝛽<𝛼< 1, (4) ΔMG=MG−MG−1=G−T, (5) ΔMHH =MHH −MHH−1=Yd−C(=S), 176 Prinz A. L. , Beck H. 1 3 included in SIM). National income is given by the production of consumption goods and public goods: Note that Eq.(6) is an ex post identity. Therefore, it is neither right nor wrong. In addition, there are no investments. The proceeds are distributed to the factor of production, i.e., the labor services of households: Y =W⋅LD⇒LD= Y W , where LD is labor services demand. Since the money created by the government (money supply) must be equal to the money holding of households (money demand), the public budget deficit is equal to the change in the stock of money and, hence, savings: Put differently, this means (not contained in the SIM presentation of Godley and Lavoie,2012): Equation(8) is the implication of a standard economic circular flow model with government, where S=I+(G−T) , if there are no investments (as is the case in SIM), i.e., I=0 . Obviously, the equality of savings, money creation and public budget deficit is a consequence of the descriptive circular flow model of the economy. This demonstrates that no new theory of money is presented with SIM and, hence, MMT. Instead, Eqs.(6,7, 8) are ex post identities. In a (long-run) steady state equilibrium, government expenditures must be tax financed in order to avoid so-called Ponzi-games: with Y* as the steady state equilibrium national income. Rearranging the terms in Eq.(9) yields: Equation(10) is called fiscal stance. Godley and Lavoie (2012, p. 72) emphasized the importance of the fiscal stance as follows: “It [i.e., G/t] plays a fundamental role in all of our models with a government sector, since it determines GDP (i.e., gross domestic product) in the steady state.” In MMT, the expression G/t (government expenditures divided by the tax rate) is considered causal for the equilibrium national income, Y*. Even in a larger model with government money and portfolio choice (Godley and Lavoie, 2012, p. 99), the steady state solution collapses to Eq.(10) if the average interest rate on all government liabilities is zero (Godley and Lavoie, 2012, p. 115). A further implication (not mentioned) of SIM is again an ex post identity: (6) Y=C+G. (7) ΔMG=ΔMHH ⇒ G−T=Yd−C(=S). (8) S=G−T. (9) G= T = t⋅W⋅L ∗= t⋅Y ∗ , (10) Y ∗= G t . (11) G−T=0 ⇒ Yd−C=0 ⇒ S=0. 177Modern Monetary Theory: A Solid Theoretical Foundation 1 3 This implication is consistent with the circular flow model of the economy since there are no investments in SIM: I=0 ⇒ S=G−T,G=T ⇒ S=0 . To summarize, the simplest model containing the main elements of MMT is based on the descriptive circular flow model of an economy, combined with a tax function defined by the government, and a consumption function. However, the conclusion suggests that government expenditures (in combination with the income tax rate) causally determine the equilibrium national income.1 To understand SIM better, it is compared with the simplest Keynesian model (KEYSIM) in the following. SIM Versus theKeynesian Cross, KEYSIM The Keynesian cross model, or KEYSIM, can be considered the simplest Keynesian model of an economy. It can be found in any introductory macroeconomics textbook (Beck and Prinz, 2018, p. 145–156). The KEYSIM is also based on Eq.(6), i.e., that national income can be used for private consumption, C, or public expenditures for goods and services, G(Y=C+G) : Moreover, the consumption function is given by: i.e., consumption consists of an income-independent element, C0, and depends on disposable income, Yd, with α as the marginal propensity to consume. Disposable income is given by total income, Y, minus savings, S, and tax payments, T: Yd=Y−S−T , whereby the tax is again a proportional income tax: Furthermore, in equilibrium, all government expenditures are financed via taxation so that G=T . Finally, since there are no investments, the circular flow model implies that savings are zero ( S=0 ). Therefore, combining Eqs.(6, 12, 13) gives: Solving Eq.(14) for the equilibrium national income, Y, yields: Equation (15) deviates from Eq. (9) ( G=T=t⋅Y∗=t⋅W⋅L∗ ) that also determines the equilibrium value of government expenditures. According to Eq.(15), the (12) C=C0+𝛼Yd, (13) T=t⋅Y. (14) Y=C+G=C0+𝛼(Y−T)+T=C0+𝛼(Y−tY)+tY. (15) Y −𝛼Y(1−t)−tY =C0,⇒Y∗= C 0 ( 1 −𝛼)( 1 − t ). 1 The Online Supplemental Appendix shows in a two-period variant of SIM that in MMT ex post Ricardian equivalence must hold true. The reason is that government expenditures use real economic resources that must be transferred from private households to the state. The instrument to carry out this transfer is called taxes. 178 Prinz A. L. , Beck H. 1 3 value of government consumption is given by: G =t⋅Y∗=t⋅ C 0 ( 1 −𝛼)( 1 − t ) . In SIM, Eq.(3) says C( Yd,MHH −1) =𝛼⋅Yd+𝛽⋅MHH −1 . For sake of simplicity, let which is that part of consumption that is independent of current income. Note that the term 𝛽 ⋅ MHH−1 in the consumption function is the only innovation in SIM, in comparison to KEYSIM. Accordingly, Eq.(14) holds also in SIM: The long-run steady state equilibrium national income with a balanced public budget reads according to Eq.(15). There is also no contradiction to the long-run steady state equilibrium of SIM in Eq.(10) ( Y ∗= G t ) since this also implies in SIM: which is identical to the value of government consumption in KEYSIM, as can be seen by multiplying Eq.(15) with the tax rate, t. Hence, up to this point, SIM and KEYSIM are indistinguishable. However, the Keynesian cross is an oversimplification of the Keynesian model. In this paper, only the short run is considered. Extending the model requires the incorporation of price-wage adjustments with Philips-curves. In such an extended model, price-wage dynamics will lead back to the long-term equilibrium. In contrast, MMT models do not contain pricewage adjustments. It is unclear what role money would play in MMT concerning pricewage adjustments. In this respect, MMT cannot be compared with a Keynesian model as applied here. In addition, even in a neoclassical world with fully flexible wages and prices, the equilibrium condition (that may be written as Y∗=Y ) will hold. Nevertheless, in neoclassical theory, supply determines equilibrium output. Moreover, with fully flexible prices and wages, monetary policy determines nominal variables in equilibrium. Fiscal policy may change the composition of demand and the distribution of income as fiscal stabilization is not an issue. Hence, in effect, the above analysis is not only compatible with MMT and Keynesian theory, but also with neoclassical macroeconomic theory. Consequently, SIM (and MMT) is not wrong. Where then does MMT get it wrong? Misreading theEquilibrium Condition The key to understand MMT is reading the equilibrium result in Eq.(18). By simple algebra, this equation can be written as: As an equation, it can be interpreted in several ways: (16) 𝛽 ⋅ MHH−1=A=C0, (17) Y=C+G=A+𝛼(Y−T)+T=C0+𝛼(Y−tY)+tY. (18) G =T=t⋅Y∗=t C 0 ( 1 −𝛼)( 1 − t ), (19) Y ∗=G t= C 0 ( 1 −𝛼)( 1 − t ) = 𝛽M HH−1 ( 1 −𝛼)( 1 − t ) . 179Modern Monetary Theory: A Solid Theoretical Foundation 1 3 (1) National income, Y*, is determined by the government via choosing expenditures, G, and tax rate, t. (2) National income, Y*, is determined by the income-independent part of consumption, C0=𝛽MHH−1 , the marginal propensity to consume, α, and the tax rate, t. (3) National income, Y*, is the result of the aggregate demand in an economy. (4) The production side of national income, Y*, determines private and public consumption. (5) Aggregate production and aggregate demand are equal at the equilibrium national income of Y*. All of these versions are of necessity correct, or at least not wrong, because there is no causality involved. Since both models share the same bases (i.e., the circular flow model of an economy, a tax function and a consumption function) and the same equilibrium condition (aggregate supply is equal to aggregate demand), they are indistinguishable. Moreover, it is clear that both models are of Keynesian origin because the supply side reacts passively to changes in aggregate demand. By assumption, aggregate demand determines (is causal for) national income. The claim of MMT that government expenditures, financed by running a public deficit via the creation of money, determine (causally) national income constitutes a misreading of an equilibrium condition (i.e., reading the equation from right to left). However, an equation simply equates two sides of the equation and nothing else. The causality is externally added by the reader, as it were. Figure1 shows SIM in a circular flow diagram. According to MMT, government expenditures for goods and services, G, in combination with a public budget deficit financed by creation of additional money, ΔMG (i.e., that part of G not financed via taxation with the tax rate, t), determines national income, Y*. However, as Fig.1 demonstrates, all causal explanations of Y* are circular. The model contains not one, but two decision making units: the government and households. Therefore, both are causal (in an interdependent way) for the size of national income. Moreover, the model is built on ex post identities (i.e., on accounting identities) as Fig.1 demonstrates. Another proposition of MMT can be clarified with Fig.1. According to MMT, it is neither taxes nor borrowing that finance public expenditures, but the creation Fig. 1 Fiscal stance and national income determination. Source: Own depiction 180 Prinz A. L. , Beck H.