Understanding Modern Monetary Theory: Part 2
By Scott Sumner
In my previous essay, “Understanding Modern Monetary Theory: Part 1,” I explained how adherents of Modern Monetary Theory (MMT) overestimate the role of fiscal policy because they underestimate the role of monetary policy. MMT denies that monetary policy determines the path of aggregate demand, rendering it pointless to give central banks an inflation target. In this essay, I show where MMT fits on the ideological spectrum, relative to other schools of thought. On a wide range of issues, MMT occupies a position on one extreme of the ideological spectrum, where Chicago school economists such as Milton Friedman are at the other extreme. Finally, I examine why MMTers have difficulty communicating their ideas to other economists.
Putting MMT onto the ideological spectrum
One way to understand the views of MMTers is to compare their beliefs about a wide range of issues with those of mainstream economists, as well as those on the other end of the ideological spectrum. First, a word of caution; not all MMTers hold the same views.
As an analogy, most Keynesians are left of center, but Martin Feldstein was a relatively conservative Keynesian, as is Gregory Mankiw. While Keynesians often favor government spending during a slump, the basic Keynesian model also suggests that tax cuts can provide economic stimulus when demand is depressed. Similarly, not everyone who is skeptical of the efficacy of monetary policy is left wing.
Nonetheless, MMTers do tend to be left of center on a wide range of issues. There are a striking number of examples where the MMT view is almost the exact opposite of the “Chicago school” views of economists, such as Milton Friedman. Here are a few examples:
1. Chicago school economists see the supply and demand model as applicable to a wide range of industries- even many industries that are less than perfectly competitive. MMTers tend to be skeptical of the usefulness of supply and demand models, whereas mainstream economists are somewhere in between the two extremes.
2. Chicago school economists favor free market policies in the overwhelming majority of cases. Mainstream economists believe that free market policies are often appropriate. The MMT textbook written by Mitchell, Wray, and Watts (MWW) is highly skeptical of “neoliberalism” and suggests that free market ideology has become a sort of religion, accepted as a matter of faith. Many MMTers advocate a more activist government, including a guaranteed jobs program.
3. Chicago school economists do not believe there is much value in talking to bankers when trying to understand how monetary policy works. In their model, an injection of reserves into the banking system leads to changes in a wide range of asset prices, which indirectly lead banks to engage in more lending. MMTers believe that knowledge of the nuts and bolts of the banking industry is highly important when trying to understand monetary policy. Because bankers report that the availability of reserves is not a constraint on lending, this makes MMTers skeptical of the efficacy of monetary policy.
4. Chicago school economists believe that the concept of opportunity cost is extremely important, and applies to almost all policy debates. Mainstream Keynesians believe that opportunity costs are often an important consideration. In contrast, MMTers believe that the economy is generally well below full employment and thus there is no opportunity cost to additional government expenditure.
5. Chicago school economists are extremely skeptical of the “Phillips curve” approach to business cycles and inflation. Milton Friedman developed a model of the natural rate of unemployment where there was a short run tradeoff between inflation and unemployment, but no long run trade-off. Mainstream economists mostly agree with Friedman, but allow for the possibility that there might be some long run trade-off due to the effect of unemployment on job market skills and employability. This idea, termed ‘hysteresis’, suggests that on some occasions the actual rate of unemployment can get stuck well above the natural rate.
MMTers are at the other extreme from the monetarists. In their view, aggregate demand determines the unemployment rate, even in the long run. They are quite skeptical of claims that unemployment will automatically adjust back to the natural rate once inflation expectations adjust to actual inflation.
6. Chicago school economists favor employing monetary policy to control nominal spending, and are highly skeptical of the efficacy of fiscal policy. Mainstream economists favor of mix of the two, whereas MMTers prefer fiscal policy and are skeptical of the efficacy of monetary policy.
7. Chicago school economists argue that it is most useful to treat money as exogenous, i.e. under control of the central bank, at least under a fiat money regime. Mainstream economists treat money as endogenous in short run models with interest rate targeting, and exogenous in long run models trying to explain large changes in the trend rate of inflation. MMTers treat money as being almost completely endogenous.
8. Chicago school economists believe that changes in interest rates primarily reflect the income and Fisher effects. Thus, falling interest rates are usually an indication that money has been tight in the recent past. Mainstream economists view interest rates as being heavily influenced by monetary policy (the liquidity effect), but also reflecting the income and Fisher [Irving Fisher] effects, especially in the long run. MMTers see interest rates as almost entirely reflecting monetary policy, at least under a fiat money regime. They mostly ignore the income and Fisher effects, and reject models of the “natural rate of interest.”
9. Chicago school economists see investment being determined by savings rates. Mainstream economists see investment as being determined by savings rates during normal times, but also worry about a “paradox of thrift” when interest rates are extremely low. In this view, an attempt by the public to save more may end up depressing national income, and in the end neither saving nor investment will increase. MMTers see the paradox of thrift as being the norm, even when interest rates are positive.
10. Chicago school economists believe high inflation to be caused by excessive money growth. Mainstream economists see high inflation as being caused by a mix of monetary policy and supply shocks. MMTers see high inflation as mostly reflecting aggregate supply problems.
MMT tends to have more appeal to non-economists
During my three decades of teaching economics, I often encountered students who were confused by certain economic theories. For instance, students would often have trouble understanding how the income and Fisher effects impacted interest rates, as they were so used to thinking in terms of interest rates being set by the central bank. I would frequently find myself in a position of needing to correct these “myths” about monetary economics. That same student would likely be much more open to the MMT view of interest rate determination, which focuses almost exclusively on the role of the central bank
Non-economists often see Japanese monetary policy as being highly expansionary because interest rates in Japan have been close to zero for the past quarter century. Mainstream economists would generally attribute those low interest rates to the negative impact of extremely low rates of growth in prices and output. In contrast, MMTers often point to Japan as a sort of success story, demonstrating that a central bank can arbitrarily hold interest rates down to zero for an extended period of time.
But if Japan is an MMT success story, it is a very peculiar one.1 Since the mid-1990s, Japan has seen by far the weakest growth in aggregate demand of any major industrial economy—perhaps the slowest growth in modern history. Some conservative economists don’t see that as a big problem—after all, Japan has fairly low unemployment—but MMTers view growth in aggregate demand as the sine qua non of a healthy economy. Thus, it is odd to single out a “success story” that achieved low interest rates by an extraordinarily slow rate of growth in nominal spending.
Mainstream economists often complain that MMT theories are difficult to understand. Previously I discussed their odd definition of “net saving”; but there are other communications barriers as well. Paul Krugman compared debating MMTers to playing Calvinball—just when you’ve addressed one issue you are told that they are actually making a different point. Here Paul Krugman tries to get a prominent MMTer to answer some specific questions on monetary and fiscal policy:
- Are MMTers claiming, as Kelton seems to, that there is only one deficit level consistent with full employment, that there is no ability to substitute monetary for fiscal policy? Are they claiming that expansionary fiscal policy actually reduces interest rates? Yes or no answers, please, with explanations of how you got these answers and why the straightforward framework I laid out above is wrong. No more Calvinball.2
And here’s how Stephanie Kelton responded:
- Quick responses first, followed by explanations behind my thinking.
- #1: Is there only one right deficit level? Answer: No. The right deficit depends on private behavior, which changes. MMT would set public spending always to the level required to achieve full employment, and then accept whatever deficit may result.
- #2: Is there no ability to substitute monetary for fiscal policy? Answer: Little to none. In a slump, cutting interest rates is weak tea against depressed expectations of profits. In a boom, raising interest rates does little to quell new activity, and higher rates could even support the expansion via the interest income channel.
- #3: Does expansionary fiscal policy reduce interest rates? Answer: Yes. Pumping money into the economy increases bank reserves and reduces banks’ bids for federal funds. Any banker will tell you this.3
Here it seems like Kelton has not understood Krugman’s questions. In context, it is clear that she thinks the answer to the first question is “yes”, and yet she says no. Indeed, she wrongly believes the first question is actually two separate questions. Then she responds to the question about fiscal policy as if Krugman had asked about monetary policy.
On Twitter, Paul Krugman offered a point by point rebuttal, and then concluded as follows:
- Sorry, but this is just a mess. Kelton’s response misrepresents standard macroeconomics, my own views, the effects of interest rates, and the process of money creation.
- Otherwise I guess it’s all fine.
- See what I mean about Calvinball?4
Because MMTers define terms such as “saving” and “monetary policy” and “fiscal space” in a way that is radically different from the definitions used by mainstream economists, it is difficult to engage in a fruitful debate on these issues. It is as if claims must be translated from French into English before their validity can be evaluated.
As a theoretical model, MMT is clearly not ready for prime time. That does not mean that MMT will have no policy impact. Over the past 40 years, the natural rate of interest has been declining steadily in all major economies. This makes deficit spending much more attractive than during the 1980s, and hence it is quite possible that the world will see larger budget deficits and near zero interest rates for an extended period of time.
To mainstream economists, those large budget deficits will represent a sensible response to new economic conditions. To MMTers, the low interest rates and large deficits will be seen as proof of the validity of their model, indeed they often cite the example of Japan. On closer inspection, however, the Japanese case is actually at odds with much of what MMTers have been advocating. Between 1993 and 2012, Japan saw no growth in nominal GDP, despite some of the largest peacetime budget deficits in world history:
During that period, Japan’s gross government debt rose from below 100% to nearly 240% of GDP.5 When Prime Minister Abe took office at the beginning of 2013, Japan switched to a policy regime combining fiscal austerity and monetary stimulus. After the beginning of 2013, Japan’s nominal GDP finally began rising, even as the national debt leveled off.
This pattern is exactly the opposite of what the MMT model would have predicted.
Modern Monetary Theory adopts some of the ideas of traditional Keynesian economics, including the advocacy of fiscal stimulus in a depressed economy and skepticism about the efficacy of monetary policy. They push this idea much further, however, even questioning the potency of monetary policy in an economy with interest rates well above zero.
Given that my own views on macroeconomics are in some respects out of the mainstream, I do not automatically reject a theory just because it is unconventional. Even if some of their non-traditional claims are valid, however, MMTers are likely to remain a fringe group unless they are able to present their ideas in a way that is intelligible to mainstream economists who might be receptive to some of their policy proposals, especially Keynesians like Paul Krugman. Thus far, they have been unable to do so.
 Ben Dooley, “Modern Monetary Theory’s Reluctant Poster Child: Japan,” The New York Times. June 5, 2019 .
 Stephanie Kelton, “Paul Krugman Asked Me About Modern Monetary Theory. Here Are 4 Answers.” StephanieKelton.com. Previously published at Bloomberg, March 1, 2019.
 Paul Krugman on Twitter. Thread available at “Stephanie Kelton responds — and I feel a sense of despair 1/”.
 While some measures of net debt are considerably lower, even that figure rose sharply. In addition, there are also large future pension obligations in Japan, so all of these estimates are imprecise.
*Scott Sumner is Professor Emeritus in Economics at Bentley University in Waltham, Massachusetts, and Research Associate on monetary policy at the Mercatus Center. He earned his Ph.D. in economics at the University of Chicago in 1985. He blogs both at EconLog and also at his personal blog at The Money Illusion.
For more articles by Scott Sumner, see the Archive.