It is often said that the 2008 financial crisis led central bankers to believe that money supply no longer mattered. For more than a decade, markets soared on cheap new money, until they were forced to acknowledge the limitations of Modern Monetary Theory (commonly referred to as MMT) after the 2022 pandemic, and that post-COVID inflation would not be “temporary” after all.
MMT in theory
Modern Monetary Theory actually isn’t all that modern, with origins dating back to the early 20th century.
The key tenet of Modern Monetary Theory is that there are no financial constraints on government spending, as long as the country is a sovereign issuer of its currency and does not tie the value of their currency to another (like Canada and the U.S.).
Sovereign issuers are those countries where governments can borrow, interest free, from the domestic central bank and without fear of repayment on demand. Infinite borrowing is possible since countries that issue their own currency cannot run out of money. They simply fire up the printing presses whenever the need arises.
Since the demise of the gold standard, countries with fiat currency no longer face the prospect of not having enough gold to back the paper money they have in circulation, since reserves have to increase anytime the printing presses whirr into action. They’re essentially free to print however much they need.
The only constraint on spending under MMT is inflation, which can rise if the public and private sectors spend too much at the same time. This is demand-pull inflation, when too much money is chasing too few goods.
This is a key objection to Modern Monetary Theory, since its implementation is believed to lead to inflation, or even hyperinflation, which can have devastating consequences for domestic economies.
MMT in action
MMT began receiving widespread attention in the 21st century, particularly as government spending increased dramatically following the 2008 financial crisis and then again amid the COVID-19 pandemic — raising concerns about how we’d pay for this heightened spending.
The pandemic ushered the economy into uncharted waters. The Bank of Canada (BoC) printed billions of dollars to purchase government bonds in the secondary market in order to lower interest rates and help stimulate economic activity at a time of unprecedented uncertainty for many households. This took quantitative easing (QE) to another level, as the BoC transitioned from buying on the secondary market to their first ever direct purchases of government bonds.
Efforts to support the economy and consumers during the pandemic led to the BoC and other central banks creating more money than was necessary given the level of economic activity. This in turn led to the highest inflation in 40 years.
Implementations of MMT in Latin America and Greece resulted in runaway inflation and a marked decline in living standards in those regions. Only time will tell what transpires in North America and Western Europe.
Modern vs traditional
MMT clashes with the traditional view that raising and lowering interest rates is the best way to manage economies, largely because MMT proponents believe the interest rate should be zero wherever fiat money is in use.
Modern monetary theorists assert that economies should be guided by fiscal policy, namely government spending and taxation. Ideally, taxes exist mainly as a means to keep inflation under control, which could be achieved if they diverted just enough money from consumers and businesses to keep total spending from becoming excessive.
What the MMT critics say
MMT contradicts much of the mainstream macroeconomic theory and has been heavily criticized by many traditional economists. Traditional monetary policy theorists vehemently disagree with the notion that more money can fix an economy’s woes. It’s very far removed from the monetarist doctrine of Milton Friedman and the Chicago School of Economics, who frequently expounded that only money matters.
While creating copious amounts of money tends to be extremely popular with politicians, the markets and voters, there isn’t much real-world evidence that central banks could actually create huge sums of money without inflation or other adverse effects on their economies.
Post-pandemic, it seems we have real-world evidence that there are indeed financial constraints on government spending. How we end up paying for this – and how dearly it ends up costing us – remains to be seen.