Modern Monetary Theory says deficits do not matter, and 2022 answered it

There is a theory in economics that says a country can never run out of money, only out of patience. Its supporters add that the patience runs out at inflation. Its critics reply that they have just described the problem and called it a solution.

I want to give the theory the treatment it deserves, which means stating it at its strongest, in the words of the people who advance it, and then answering it with the record. The record is not a distant one. It is the price of groceries between 2021 and 2023.

Define the theory

Modern Monetary Theory, abbreviated MMT, is a school of macroeconomics associated with academics and writers including Warren Mosler, L. Randall Wray, Bill Mitchell and Stephanie Kelton, whose 2020 book The Deficit Myth brought the ideas to a general audience. It is not one single claim but a set of connected ones. I will state them as its advocates do.

One: a government that issues its own currency is not like a household. A household or a business must earn or borrow money before it can spend. A national government that creates its own money, and borrows only in that money, is the issuer of the thing it spends. It cannot be forced to default on debts denominated in its own currency, because it can always create more of the currency to pay them.

Two: taxes do not fund spending in the usual sense. In the MMT account, a government spends first, by creating money, and taxes later. Taxes serve to create demand for the currency, because people need it to pay what they owe, and to remove money from the economy to control inflation. Borrowing, in this view, is not necessary to finance spending. It is a way of swapping the form of money, from reserves to interest-bearing bonds, and a tool for managing interest rates.

Three: the deficit is the private sector's surplus. This is an accounting identity: when the government runs a deficit, the private sector, taken together, receives more than it pays in taxes. A larger deficit means more net financial assets in private hands. A government that insists on a balanced budget, on this account, forces the private sector to run down its savings.

Four: the real constraint is inflation, not solvency. MMT advocates do not say there is no limit. They say the limit is the economy's real capacity, its workers, factories and materials. When spending pushes demand past what the economy can produce, prices rise. So the deficit that matters is the one that exceeds the economy's ability to absorb it. Policy should aim at full employment and use taxes, interest rates and regulation to cool the economy when prices climb.

Five: a job guarantee as a stabilizer. Many MMT advocates propose a federal job guarantee, offering a public-sector job at a fixed wage to anyone who wants one, which would act as a buffer stock of employment and help hold prices steady.

That is the theory in its own words, as I understand them, and I want to say that it is more careful than its critics usually allow. The sectoral balances identity is true as arithmetic. The point that a country borrowing in its own currency faces no default risk of the type that Greece or Argentina faced, in debts they owed in euros or dollars, is also true. A reader who thinks MMT is only a license to print is mistaken. Its advocates say plainly that inflation is the limit.

So the argument is not about whether there is a limit. It is about where the limit is, how fast it arrives, and who is able to act when it does. That is where 2021 and 2022 come in.

The test the theory set for itself

The theory makes a prediction. It says deficits are safe until the economy hits its capacity, and that inflation is the signal. It also says the tools to respond are available: raise taxes, trim spending, adjust interest rates. If the theory is right, a country can run large deficits, notice rising prices and then correct, with limited pain.

In March 2021 Congress passed and the President signed the American Rescue Plan Act, a $1.9 trillion spending law, on top of earlier large relief packages in 2020, at a time when the Federal Reserve held its policy rate near zero and was buying securities on a large scale. Consumer demand recovered fast. Supply chains, still disrupted, could not keep up. And prices began to rise.

The Bureau of Labor Statistics reported that the consumer price index, which had risen modestly through 2020, climbed rapidly through 2021 and reached an annual increase of 9.1 percent in June 2022, the highest reading in about forty years. I analyse the competing explanations for that surge, including supply shocks, energy prices and the war in Ukraine, in what caused the inflation of 2021 to 2023, weighing the honest evidence. I do not claim fiscal policy was the only cause, and no honest economist does. What I claim is narrower and enough for this argument: the theory said inflation was the limit, and the limit arrived while the deficits were still large, and neither the theory nor its institutions had a ready answer.

The Federal Reserve responded in 2022 by raising its target for the federal funds rate from a range of 0 to 0.25 percent before its first increase in March 2022 to a range of 5.25 to 5.50 percent by July 2023, one of the fastest sequences of increases in modern history. That is the tool the theory expects to be used. And look at what it did to the government's own balance sheet, which brings us to the third point below.

The steelman, once more

Before I answer, let me put the best MMT reply in its best form. An MMT advocate would say: you have confirmed our argument. We said inflation is the constraint, and inflation arrived. We never said deficits were harmless at all times. We said the right response is to tax or tighten, and the Fed did tighten. The system worked as described. And we would add that a deficit that fills a gap in demand during a deep downturn, such as 2020, is exactly what the theory recommends.

That is a fair response. Here is mine, in numbered points.

The answer, in numbered points

One: the limit arrived fast, and the warning system was late. The theory counts on policymakers noticing the signal in time and acting. In the data, prices were rising through 2021, and the official view for much of that year was that the increase was transitory. A theory that treats inflation as the only brake needs a driver who sees the corner. If the driver does not see it until the car is in the curve, the theory has not shown that deficits are harmless. It has shown that the cost of being wrong is large and arrives with a delay.

Two: raising taxes to cool an economy is a political act, and politicians will not do it on time. The theory's remedy for inflation is to take money out of the economy through taxes. But taxes are voted on by elected representatives, who must face the voters. The theory assumes a government that spends freely when demand is low and taxes heavily when prices are high. In practice, the spending half of that bargain is popular and the taxing half is not. The first can be done in a week, and the second is a campaign. A rule that is sound only if politicians do the unpopular thing at the right moment is a rule that will fail on the day it is most needed. The record of Congress suggests that the other tool, the Fed, bears the burden by default, which means interest rates carry the full weight of the adjustment.

Three: higher rates make debt more expensive, and the bill lands on the government. The theory says the interest rate is a policy choice, and so it is. But the choice made in 2022, to raise rates sharply to cool prices, meant that the government's interest bill on a very large debt rose too, as old debt was refinanced at higher rates. I show the mechanism by hand in do the arithmetic on $40 trillion and the interest bill it carries: each point of average interest on $40 trillion is about $400 billion a year. The theory says the government cannot go bankrupt in its own currency. It does not say the interest cannot crowd out other spending, and it does. A government that cannot go broke can still be unable to afford its priorities.

Four: inflation is itself a tax, and it falls on the people least able to bear it. A deficit financed by money creation, or by borrowing that the central bank effectively monetizes, transfers purchasing power from savers and wage earners to the government. The families hit hardest are those on fixed incomes and those who spend most of their paycheck on necessities, a point I work through in inflation hurts the poor most, and the arithmetic of a fixed paycheck. A policy that is fine unless it produces inflation is a policy that gambles with the grocery budget of ordinary people.

Five: history has a long list of money-financed deficits, and the list is not encouraging. The classic case is Weimar Germany, where the government financed its deficits and war-related obligations in 1921 to 1923 by creating money, and the exchange rate collapsed until it took trillions of marks to buy a dollar by November 1923. The American Revolution gave us the Continental dollar, issued in such quantities that its value collapsed and the phrase "not worth a Continental" entered the language. The Great Inflation of the 1970s, which I discuss in The Great Inflation of the 1970s was a policy choice, not bad luck, took a decade and a painful interest rate shock to end; the federal funds rate rose above 19 percent in 1981 before prices were tamed. Zimbabwe in the 2000s and Venezuela in the 2010s are more recent episodes of hyperinflation, and economists who study the long record have traced most hyperinflations to government deficits financed by creating currency.

An MMT advocate will answer that none of these governments was running a disciplined MMT policy, and that the inflation in each case came from supply collapse, war or foreign-currency debts and not from deficits as such. There is something to that. But the reply proves my point from the other side: the line between a sound deficit and a ruinous one cannot be drawn in advance by any formula. It is drawn after the fact, by prices, and by the people who pay them.

Six: the Founders knew paper money, and they feared it. They had lived through the Continentals. In Article I, Section 10, the Constitution says that no state shall "emit Bills of Credit" or "make any Thing but gold and silver Coin a Tender in Payment of Debts." In Article I, Section 8, Clause 5, it gives Congress the power "To coin Money, regulate the Value thereof." The design of the monetary clauses reflects a generation's distrust of governments that create money to pay for themselves. I look at those clauses in Coin Money and Regulate the Value Thereof, the Founders' Monetary Clauses. You can disagree with their remedy, and the modern dollar is a fiat currency in a way the Founders did not imagine. But their instinct, that the power to create money must be restrained, is the one the 2022 data supports.

What MMT gets right

I promised fairness, so let me give credit where it is due. The theory is correct that a country borrowing in its own currency does not face the same kind of default risk as a country borrowing in someone else's. It is correct that the sectoral balances are an identity. It is correct that the real constraint is the economy's productive capacity. And it is right to say that a government that talks about its budget as though it were a household budget misleads the public.

What it gets wrong is the emphasis. A limit that is "only" inflation is not a small limit. Inflation is the limit that every voter feels in the checkout line, and the correction, higher interest rates and a squeeze on the economy, falls on workers and borrowers. A conservative case for deficit restraint does not rest on a fear that the Treasury will run out of dollars. It rests on a view that spending drawn from the economy by borrowing or by creating money is spending the people have not agreed to pay for, and that the bill arrives as higher prices, higher interest costs, or higher taxes. I discuss some of the myths that cover this over in Seven myths about the national debt that Washington finds convenient.

The verdict

The theory said: watch inflation. In 2021 and 2022 the country watched it, and what it saw was a rate of price increase that no one in power had expected, a monetary response that was sharp and painful, and a federal interest bill that rose with it. That is not a proof that deficits are always ruinous. It is a demonstration that the limit the theory identified is real, that it arrives quickly, and that the institutions responsible for acting on it are slower than the theory assumes.

A free people should not hand its government a theory in which the only restraint is a price signal the government itself controls the response to. Restraint belongs earlier, in the budget, where it can be debated, voted on and held to account. You can follow the votes at the oversight page and see the debt itself on the national debt clock.

The case in brief

1. MMT says a government issuing its own currency cannot be forced to default in that currency, that taxes and borrowing do not fund spending in the household sense, and that inflation is the real constraint.
2. Those points are partly true, which is why the argument must be about where the inflation limit sits and how fast it arrives.
3. In 2021 and 2022 the limit arrived: consumer prices rose 9.1 percent over twelve months to June 2022, and the Federal Reserve raised its target rate from near zero to 5.25 to 5.50 percent.
4. The remedy MMT proposes, taxes to cool prices, is politically hard and slow, and higher rates raised the cost of the debt itself.
5. History, from the Continentals to Weimar Germany, shows that money-financed deficits end in inflation, and the Founders built the monetary clauses on that lesson.

What you can do: read Article I, Section 8, Clause 5 and Section 10 on the Constitution page, then ask your representative in writing what rule, short of a price spike, should tell Congress to stop borrowing.