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The Pandora’s box of modern monetary theory

|January 26, 2023
The Pandora’s box of modern monetary theory

Some believe we are living in a simulation—whether that’s true, it’s difficult to prove. Similarly, some regard currency as a fiction. Rather than reflecting an underlying intrinsic value, it’s simply the math we use to track transactions and measure performance. For governments, it’s a tool to adjust the economy by controlling the money supply. Think of the new money infused into the economy by quantitative easing deployed in the 2008 recession, and the significant government funds spent on pandemic relief programs.

The pandemic also brought Modern Monetary Theory (MMT) into the conversations about how to best manage the economy. MMT was first coined by Bill Mitchell, a professor at the University of Newcastle in Australia, and is an extension of some of the ideas put forward by John Maynard Keynes (The Deficit Myth by Stephanie Kelton provides a great explanation). Simply put, it posits that countries that issue sovereign currency, like the U.S. and Canada, can print as much money as is needed to fund public programs. The debt a government owes in its own currency should not be a concern as it can be paid back using the money it creates.

While seemingly a new concept, a form of MMT has been the current practice in many countries—even if the language around it has viewed the deficits created as problematic as personal debt. However, does openly adopting MMT as a strategy remove any prudence governments should have in applying it?

Without significant government intervention, the 2008 recession and the pandemic economic impact would likely have escalated into full-blown 1930’s-style depressions. The Canadian Emergency Wage Subsidy (CEWS) supported the income of millions of Canadians. Still, the estimated two-year $110 billion price tag exceeds that spent on child benefits, health care transfers and equalization payments. In addition, the Canada Emergency Response Benefit (CERB) paid to individuals was estimated to be $71 billion. Arguably these large amounts were necessary to address the impact of the pandemic. However, MMT admits that government overspending can create inflation. Also, MMT-created money should be applied to productive investments, not create asset bubbles.

In the aftermath of the pandemic (or almost), we face high and persistent inflation and record house prices. Other factors were at play in driving inflation growth—such as supply chain issues and the war in Ukraine. However, the increased money supply, and some of that money being applied to asset purchases rather than production, was also a factor.

As an economic theory, MMT embraces the concept of money as a fiction. By deploying a generously flexible currency, an interventionist government can create a society with full employment, fully funded social programs, and support initiatives such as carbon neutrality. This intervention also puts governments into the role of central banks, which makes a faithful application of the theory problematic.

An elected politician has little difficulty in announcing new funding for programs, especially when it creates more voter support. However, it would be difficult for most politicians to make an announcement, as Bank of Canada Governor Tiff Macklem did, that some Canadians would face hardship because of the Bank’s programs to rein in inflation. Freely creating money without taxing or raising rates to control a surplus can create hyperinflation.

Even if we are living in a simulation, we still need to ensure that we apply a real-world approach to keep the economy on track.