• Rose Poyser

Modern Monetary Theory: An Imprudent Alchemy

Modern Monetary Theory (MMT) gained traction due to its claim that there is no limit on government debt when the government operates a sovereign currency. When a government issues debt in its own currency, if the creditors come knocking, the government can always print money to pay down the debt.

I will not patronise our readers with examples of Hungary, Venezuela, and the Weimar Republic to demonstrate the inflationary dangers of paying off debt with the printing press. Needless to say, that strategy does not have a good track record.

This danger is all the more serious when the policy proposals that often accompany MMT are taken into consideration. Proponents of MMT often cite full employment as their ultimate policy goal. A jobs guarantee programme, universal basic income and a Green New Deal would require the printing presses to work just as hard as they have done recently for QE, if not more so- the difference is that these proposals, unlike QE, demand direct cash injections straight into the hands of consumers, not just the hoarding of new money in savings and assets. This means that, while QE has little effect on the velocity of circulation, programmes like the Green New Deal would increase both the monetary base and the velocity of circulation, resulting in a much higher possibility of inflationary consequences [1].

This criticism of MMT has been repeated many times, so it is covered only briefly here. Instead, this article will go on to focus mostly on a more overlooked aspect of MMT: its advocacy of the abandonment of interest rates as a means to control the money supply, and the use of taxation to replace it.

Proponents of MMT disregard interest rates as a monetary control mechanism; instead, they favour the use of taxation to control inflation. Interest rates only set the price of money; only indirectly can they control the quantity of money in circulation [2]. However, taxation directly drains bank reserves, allowing the government greater control over the amount of money circulating in the economy. Interest rates, they argue, are messy, indirect [3], and result in unnecessarily high unemployment- an unacceptable price to pay for low inflation [4].

This reliance on taxation implies that either the government or the central bank will have to monitor inflation and correspondingly raise taxes (or at least signal willingness to do so) in response to changes in price indicators. There seem to me to be two key problems with this strategy: its speed, and the blurring of the roles of the central bank and the government.

Firstly, rate of response brought about by an increase in is clearly a problem. To respond to rising inflation, taxes would have to be increased, a duty currently carried out through the budgetary process and legislation. This is a lengthy and difficult process, unlike the management of interest rates which can be raised quickly and with minimal fuss. Time lost raising taxes allows inflationary expectations to set in and the wage-price spiral to be aggravated, increasing the size of the inflationary problem and potentially rendering taxation measures, once passed, less effective. This is especially true of economies approaching full employment- which would be the constant state of the economy in an MMT, jobs-guarantee world.

Some like to believe that a progressive rate of taxation, where taxes automatically increase the more people begin to earn, will work as a sufficient automatic adjustor against rising inflation- once wages start to increase the rate of taxation should rise, and more money should be taken out of circulation. This, they say, should help to curb inflationary pressure in a way similar to interest rates.

This may help partly to address the issue of the speed of response, although one does wonder what the distortionary impact of a very progressive, high rate of taxation would be on the economy. It is also unclear whether progressive taxation left to its own devices would be enough to prevent inflation from occurring.

More worryingly, the suggestion that taxes should be used as an instrument of monetary policy risks blurring the line between the duty of the central bank (namely, ensuring monetary stability) and the democratically-grounded role of the government.

Currently, the central bank, a politically neutral body, sets interest rates. The reason for this is that raising interest rates has adverse consequences for many members of the electorate, and so a government may be reluctant to raise rates when necessary. As a result, independent banks are more reliable than governments when it comes to raising rates when necessary.

Ultimately, the logical end-point of the rejection of interest rates as a monetary tool is either that government takes on the mandate of the central bank, or the central bank takes on the ability to change rates of tax. The former suggestion is clearly prone to abuse; the latter is a recipe for instability.

Government has a bias towards inflation. Tax cuts and government spending are popular and therefore favoured by a democratic system; inflation erodes government debt and thus could be abused by governments as a tool to escape the consequences of borrowing. Depending on government to control inflation is likely to lead to weak implementation of inflation targets.

Knowing this, investors, employers and speculators may build inflationary expectations into their forecasts of the future. As any economic historian could tell you, these expectations can become self-fulfilling, further fuelling the wage-price spiral [5].

This option is clearly untenable, leaving us with the second option: allowing the central bank to control taxation. This may seem a preferable alternative- central banks are independent and thus not subject to the same populist inflationary bias as governments.

The mandate of the central bank is to protect price and financial stability. Taxation, however, is a clumsy tool for these ends. Almost any tax is likely to be distortionary- while raising income or corporation tax may help to curb inflation, distortionary effects on employment, investment and growth may arise as a consequence, creating more problems than the tax initially solved.

Of course, the central bank could move to devote more resources to devising disinflationary tax policy and implementing it; it could expand its mandate to cover more policy objectives, making it less likely that adverse consequences of their taxation are overlooked. Thus we would ultimately end up with two bodies competing over the shape of policy on taxation: an undemocratic central bank aiming to drive down inflation, and a populist government freely using the printing press and pushing the economy towards full employment. It is not hard to see to where this leads- a high tax, high spend economic picture, with constant upwards pressure on inflation, and an unelected body constantly hiking up taxes in order to compensate for the spending of an irresponsible government.

The more the government would spend, the more the central bank would need to increase taxes; the more taxes would increase, the more governments would need to increase spending in order to appease a frustrated and over-taxed working population. A dire picture for investment and growth, further worsening the UK’s need to strengthen competitivity and productivity.


[1] In accordance with the equation of exchange: M V = P Q

[2] http://moslereconomics.com/wp-content/uploads/2018/04/Soft-Curency-Economics-paper.pdf

[3] http://bilbo.economicoutlook.net/blog/?p=1961

[4] https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained

[5] https://www.brookings.edu/blog/up-front/2020/11/30/what-are-inflation-expectations-why-do-they-matter/