Modern Monetary Theory: Lessons for Fiscal Policy
Proponents of the so-called Modern Monetary Theory (MMT), also known as neo-chartalists, build on a chartalist theory of money to present a new perspective on the role of fiscal policy. The debate on the origins of money is a point of disagreement among economists. On the one hand, mainstream economists believe that money was created by the market in a barter economy, i.e. a cashless economic system in which goods and services were traded for other goods or services. To overcome the inefficiencies caused by this ‘double coincidence of wants’, such as high transaction costs, the time-consumption and the inconvenience of finding another person who would be willing to trade, money arises as a spontaneous solution from the market to lubricate trade.
On the other hand, neo-chartalists (or MMTers) argue that there is no evidence that such a barter system has ever existed. They argue, in fact, that money is a ‘creature of the state’ and not a commodity from the market. Money does not have any intrinsic value, such as gold or silver (i.e. commodity money), and it can be made of anything – e.g. clay, glass, paper, etc. In the current modern society, governments issue currencies that are not backed by any other commodity, which are known as ‘fiat currencies’, with no intrinsic value. And this money may take many other forms: coins, notes, and bank deposits (digital money). But if money does not have any intrinsic value, how do governments create a demand for their fiat currency?
According to MMT, taxes have several functions in the economy – discouraging certain behaviours (e.g. sugar consumption, smoking), improving income distribution, and reducing inflationary pressures. MMT, in particular, stresses that taxes also have another very important role: to create demand for state money. The fact that companies and individuals in our society need to pay taxes to the government creates incentives for them to produce and work to get hold of the money on which taxes must be paid. Thus, the demand for money is not driven by its intrinsic value, but by the power of money to discharge debt obligations to the government – that is, taxes.
Mainstream economic theory argues instead that taxes are simply the source of government revenue. In a famous quote from Margaret Thatcher, the former UK prime minister: “[…] Let us never forget this fundamental truth: the State has no source of money other than money which people earn themselves. If the State wishes to spend more it can do so only by borrowing your savings or by taxing you more.” In that sense, the mainstream theory presents the opposite argument to MMT: the state needs taxpayers’ money to finance their spending. And this perspective leads to policy recommendations that limit the role of the government in the economy. According to most mainstream economists, the main objective of fiscal policy is to attempt to balance the government budget. They should interfere as little as possible in the economy, leaving room for the private sector to grow, while they should aim to keep a low debt-GDP ratio. Such an understanding of the role of the government in the economy leads to the implementation of policies that we have seen, for instance, in the Global Financial Crisis in 2008, as austerity and massive cuts to welfare benefits.
The pandemic, however, has posed a challenge to this longstanding dominant perspective. Governments across the world played an essential role in keeping low unemployment levels and the economy running while providing health assistance to the population. Modern Monetary Theory does not imply, however, that there are no limits to government spending. Inflation is a real danger. This theory simply argues that countries with monetary sovereignty do not need to rely on taxing or borrowing to finance their spending. It proposes to replace the fear of debt with functional finance, an idea put forward by Abba Lerner in which the government should use fiscal policy to achieve goals such as full employment and low inflation.