What Economic Theory Caused the Global Recession
During the pandemic, officials around the world tested the provisions of modern monetary theory in practice. Tests fail, leaving regulators to deal with rising inflation and pressure on the economy.
Modern Monetary Theory (CMT) is a relatively new approach to economic regulation. It appeared in the early 1990s and suggests that the state can issue a sovereign currency without regard to negative factors for the economy.
Supporters of the MMT claim that, if properly regulated, an increase in the money supply will not cause inflation and a deterioration in the economic condition of the country. However, in practice it turned out that the theory does not work as its adherents expected.
Modern monetary theory
The authors and supporters of modern monetary theory are predominantly left-wing figures. The essence of the theory is that the state, being the source of all existing fiat money in the country, cannot experience a true budget deficit, since in case of a shortage of funds it has the ability to start a printing press.
At the same time, the only restriction on the emission of money is the availability of real resources - for example, labor, building materials, etc. If government spending is divorced from the real state of the economy, from how much money it can use, the risk of increased inflation increases. Proponents of the theory note that such an outcome is extremely unlikely, and its negative effect can be leveled due to additional regulation.
The theory is used as an argument in favor of launching expensive government programs such as public health insurance. According to supporters of the theory, you should not be afraid of a budget deficit and an increase in public debt, because public debt is money that the state invests in the economy and does not require back in the form of taxes. On the contrary, one should be wary of a small deficit, and even more so a budget surplus, as this will lead to a recession.
According to the SMT, taxes are a withdrawal of funds from the economy in order to reduce the purchasing power of citizens and prevent inflation, and government bonds are not a loan of money from the population, but a way to get rid of surpluses in order to achieve key rate targets.
Creators and critics
The financier Warren Mosler created the theory. He first came up with the idea for CMT in the 1970s while working as a Wall Street trader and running his own hedge fund.
It was in the foundation that Mosler tested his theory in practice. In the early 1990s, investors feared that Italy might default. Mosler, relying on his theory, considered that there could be no default, and his hedge fund became the largest holder of bonds denominated in lira outside of Italy.
The bet turned out to be correct and brought in a profit of $100 million. In the academic world, Mosler was mostly ignored, but gradually supporters began to gather around him. In 1993, Mosler released his policy essay “The Economics of Soft Currency” as part of a financial email newsletter, and Australian economist Bill Mitchell was among those who agreed with his theses. Later, it was Mitchell who became the author of the term “modern monetary theory”, the co-author of its provisions and an active promoter of the CMT in academic circles.
The popularity of CMT has continued to grow along with the spread of the Internet: theorists, economists, in countless blogs and posts in simple words explain the advantages of CMT over the usual behavior of regulators around the world. In the 2010s, politicians such as Alexandria Ocasio-Cortez and Bernie Sanders began to turn to modern monetary theory.
The founder of the theory is still alive, but has retired from actively promoting the theory. The current face of CMT is Stephanie Kelton, author of The Scarcity Myth. Kelton served as an economic adviser to Sanders during the 2016 presidential race. She became acquainted with Mosler’s theory at the same time as Bill Mitchell, in the mid-1990s.
Supporters of the so-called mainstream monetary theory argue with the supporters of the CMT. They call opponents “naive and irresponsible.” Thus, for example, the American economist Thomas Pally called the MMT “a political controversy for difficult times.” According to him, the thesis that central banks around the world should keep the key rate around zero does not apply in the case of Mexico or Brazil, and the proposal for super-soft monetary policy does not take into account the political context in each individual country.
Nobel Prize-winning economist Paul Krugman believes US finance officials have a lot in common with MMT’s views on the public debt. At the same time, Krugman is an ardent opponent of Mosler’s theory and believes that following her advice threatens hyperinflation, which will lead to a record decrease in demand for US government bonds.
Finest hour
Formally, no government has adopted CMT as a direct guide to action, but in fact, large-scale field-testing of the theory began at the time of the announcement of lockdowns around the world. Governments, imposing virtual bans on the work of entire sectors of the economy, in return distributed material assistance and increased public debt in the national currency.
According to SMT, this was exactly what should have been done. Moreover, proponents of the theory have criticized governments for not being aggressive enough. In their opinion, it was necessary to impose even more severe restrictions on the economy and pump even more borrowed funds into the “social program”.
According to mainstream theory, the rising public debt was only “life on loan from the future”. The money borrowed during the days of the pandemic will have to be returned - in the form of increased taxes, or inflation, or default.
At the beginning of the pandemic, events unfolded exactly according to the MMT: governments increased public debt to allow the economy to survive the period of hibernation, while key rates remained close to zero, and inflation did not grow. On the back of the success of Mosler’s theory, Stephanie Kelton became a popular guest in the financial media and released a podcast on Bloomberg, How CMT Won the Debate and Fiscal Policy.
Time of death
The death of SMT began to be talked about in 2022, when it became clear that the consequences of a shutdown of the global economy due to attempts to cope with the coronavirus were not at all what Mosler’s supporters predicted.
In early 2022, rising U.S. prices became hard to ignore, and Kelton began making excuses. In a January blog post, she pointed out that ramping up non-inflationary deficit consumption had to be coupled with a careful assessment of the state of the economy. As soon as the government did not do this, then their failure to deal with inflation cannot be a low estimate of the theory.
The further the world economy deteriorates, the more disillusionment becomes. In November, the Institute of International Finance released a survey titled “The End of the CMT Illusion.”
“The illusion of boundless fiscal space has ended abruptly in recent months. The UK’s attempt to drastically increase debt issuance ended in market turmoil. The limitation of the Bank of Japan’s yield led to an unprecedented devaluation of the yen. Italy’s growing dependence on the ECB is another example of the same. Fiscal space is a scarce and valuable resource that should be used sparingly.
Paul Donovan, chief economist at UBS Global Wealth Management, agrees with the landmark role of the UK case. “The end of SMT flirting is a major message for the international community after what happened in the UK. Now populists who sell dreams of impunity for uncontrolled printing of money and loose fiscal policy will have to face the British precedent,” Donovan writes.
Stephanie Kelton, however, believes that in the case of the UK, officials were let down by the implementation of the planned “mini-budget” and its information support. “Given that energy subsidies, coupled with a reduction in the tax burden on part of the population, would almost certainly lead to increased inflationary pressure, the Bank of England should have been even more aggressive in the government bond market,” Kelton told MarketWatch. According to her, the main mistake of Liz Truss was the lack of coordination with the financial regulator and a crumpled explanation of the need for such reforms.
What’s next
“SMT was empty as long as it was a theory. Now that regulators around the world have tried it, the officials remaining at the helm are forced to deal with the negative consequences of SMT,” Simon Lack, managing partner at SL Advisors, wrote in early 2022.
The reaction to the “death of SMT” could be a sharp reversal to the opposite point of view in its extreme manifestations, although economists advise not to go to extremes. Financial Times writer Robin Wigglesworth writes : “I can’t help but feel that, just as CMT supporters were too radical in the era of low interest rates, so CMT opponents are now too eager to arm themselves with simplistic slogans about vigilant handling of bonds and adhering to fiscal honesty.”
Seeking Alpha’s Jeremy Bloom notes that with the failure of MMT amid rising inflation, rising unemployment and the key rate, investors may once again turn their attention to long-term investment vehicles such as bonds.
Among other attractive instruments, Bloom names the securities of companies that set their own prices for their goods, residential, but not office and commercial real estate. “If SMT is not dead, then it must be. The theory failed wherever it was used. Most likely, we will see an extended period of rising inflation, the last time this happened in the US in the 1970s. Then the Fed was forced to raise the key rate to 20%. In my opinion, today this indicator will not be raised so high - up to a maximum of 5%. This will slow down the economy, but will help to cope with inflation and other negative consequences of the use of MMT,” Bloom wrote in early 2022.