Exciting new research is making economists and policymakers rethink much of what they thought they knew about fiscal policy. The findings are compelling, theoretically robust, empirically sound, and accepted by many of the world’s leading economic thinkers.
No, it’s not the increasingly popular notion of “modern monetary theory.” The research I am referring to was carried out by Jason Furman, Larry Summers, Olivier Blanchard and other leading economists. It shows that the costs typically associated with an increase in government spending or cuts in taxes don’t necessarily apply in a world of low inflation and low interest rates. That might sound a bit like modern monetary theory, but it fits much better into the world we live in.
We know that an increase in government spending has consequences if interest rates are anywhere above zero. The government’s increased demand for goods, services, workers and capital causes inflation to rise. Its demand for funds to cover the extra spending means it must sell bonds, pushing up interest rates at the same time the central bank is increasing rates to cool the demand-driven inflation. The value of the local currency then rises, making exports more expensive — and less attractive — than those from other countries.
Of course, government spending has benefits, too. If done well, it improves people’s lives, boosts productivity, gives dignity to the vulnerable and produces a more equal, harmonious society. Policymakers must carefully balance these benefits against the costs of increased spending.
Or must they? Furman, Summers and Blanchard’s research shows that, in a world of low inflation and low interest rates, the costs of increased spending are much less of a constraint. A government can lift its spending with little or no impact on inflation, interest rates or the exchange rate. It can spend more money on worthwhile projects without facing the usual economic costs.
Enter modern monetary theory, which pushes these conclusions well beyond theoretical and empirical plausibility. Economics Nobel Laureate Paul Krugman has recounted his struggle to get its advocates to spell out exactly what they’re arguing. From what I understand, the idea is that governments can increase their spending until full employment has been achieved, regardless of whether interest rates and inflation are low, and that they can finance the extra spending by directing the central bank to “print” new money.
There are several problems with this.
First, modern monetary theory looks like a solution in search of a problem. If its stated objective is to achieve full employment, then it appears unnecessary. In Australia, for example, we generally regard an unemployment rate of around 5 per cent as full employment, given that there will always be a degree of joblessness because of temporary mismatches of skills and people moving between jobs. With unemployment currently at 5.2 per cent, it’s difficult to argue that such a radical approach is warranted in order to knock 0.2 per cent off the rate.
Achieving an unemployment rate below the current level of full employment would be lovely, but that will come with productivity growth rather than by printing money.
Second, increasing government spending is sensible if real interest rates are at zero and employment is far from full. But if interest rates are higher than zero, an increase in spending comes with trade-offs: higher inflation, increased interest rates and an appreciated exchange rate. These, in turn, hurt growth, investment, consumption and exports.
The idea that this increase in spending should be financed by printing money is particularly problematic. During the global financial crisis, when real interest rates were zero, the central banks in many countries, including the United States, purchased government bonds while the government undertook fiscal stimulus. To some, this may look like modern monetary theory in action: the central bank financing government spending. But this is coincidence, not coordination. The US Federal Reserve bought government bonds when the economy was weak in order to get inflation back up to its 2 per cent target, not to do Barack Obama a favour. Once inflation and interest rates were rising again, it stopped buying bonds.
It stopped because, in a world of above-zero interest rates, financing government spending by printing money would deliver a triple whammy of inflation: inflation from increased government spending; inflation from the central bank expanding the money supply; and inflation from the central bank abandoning its inflation target (since its objective is now financing government spending), causing inflation expectations from wage bargainers, businesses and consumers to skyrocket, as they did in the 1970s.
Modern monetary theory argues that governments can eliminate these consequences, particularly all this inflation, by raising taxes on their citizens. This is too simplistic. Constantly changing tax rates is a very blunt instrument for controlling inflation, to say the least, and would (much like rampant inflation) make the economy a much less desirable place for investment.
Taxes also come with costs. Taxing labour reduces incentives to work, taxing savings reduces incentives to save, and taxing investment reduces incentives to invest. Although these costs can be minimised by making taxes as efficient as possible, they shouldn’t be ignored, and this is to say nothing of the political difficulties of constantly raising taxes on voters.
But the third, and biggest, blind spot of modern monetary theory is how it would work in an open economy, like Australia, that trades with the world and relies on foreign savings to finance investment to sustain its standard of living.
Modern monetary theory relies on the assumption that the rest of the world is happy to lend to us in our own currency. But as soon as inflation, interest rates, the exchange rate and our business environment start to deteriorate, the world becomes less accommodating. In truth, modern monetary theory only approaches plausibility if it is undertaken in an economy that is in a state of autarky (meaning zero trade or foreign investment) and has no private sector. Indeed, this is the sort of economy that modern monetary theory would likely move us towards, if it were implemented in Australia.
If none of these arguments convinces you, then remember that Britain pursued modern monetary theory in the 1970s. The consequences were as described above. Advocates of modern monetary theory might say that Britain didn’t do it properly, but that would be persuasive only if Britain were the sole example. Modern monetary theory is alive and well in Venezuela today, as it was in Zimbabwe in 2008, Yugoslavia in 1994, Italy in the 1970s, Hungary in 1946, Greece in 1944, Weimar Germany in 1923, and so on.
Worst of all, modern monetary theory is a distraction. It is a distraction from the measures suggested by Furman, Summers and Blanchard’s robust and nuanced research, which highlights the circumstances under which worthwhile projects could be funded by an increase in government spending. •