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Modern Monetary Theory (MMT) and the Federal Deficit

I recently finished reading “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy“.

The Deficit Myth: Modern Monetary Theory and the Birth of the People's Economy

As the subtitle says, this book is focused on Modern Monetary Theory (MMT). Please read the book for a much better explanation but here’s the short version:

  • There is an important difference between currency users and currency creators.
  • Currency users are entities like provinces, people or businesses. That is, to get $1 it has to come from somewhere via revenue, taxes, salary, debt etc.
  • The Federal government of a country with high monetary sovereignty (U.S., Canada, U.K.) is very different – it creates money when it spends. It does not tax or borrow to spend.
  • The Federal government has a monopoly on creating dollars and can therefore not run out of dollars.
  • This is where most trivial inspections of MMT stop, people jump to the conclusion that this implies there are no limits and the Federal government can spend whatever it wants and then they declare MMT crazy.
  • What MMT actually says is that the amount of deficit doesn’t matter. The actual limit is the productive capacity of the economy. When the economy is operating at full capacity, prices will go up and therefore the limit of deficit spending is when inflation starts to rise instead of an arbitrary attempt to balance spending with taxation.

Try this simple thought experiment. Consider the economy as two buckets. The bucket on the left is the Federal government and the bucket on the right is the rest of the economy (businesses, people, etc). Remember, only the Federal government can create dollars.

What happens to the balance between these two buckets when the Federal government balances its budget? The amount spent from the left bucket into the right bucket balances equally with the amount taken out of the right bucket and put back into the left bucket via taxation. In this case the right bucket (economy) stays the same size.

Now consider the situation when the Federal government runs a surplus. Now the amount of money moving from the left bucket into the right bucket is lower than the amount of money moving from the right bucket to the left. That is, the amount of money available to businesses and people has been reduced.

The obvious third scenario is the Federal government running a deficit. That is, spending more than it takes in via taxation. In this scenario, the size of the right hand bucket (businesses, people) grows because less money is taken out by taxation than is being added by deficit spending.

That’s right, the non-government economy grows by Federal deficit spending. Think about it, if only the government can create dollars (it’s the law), which it does by spending, then how else could the rest of the economy grow?

The logic is very simple but it goes against all of our conditioning to think of Federal finances as a currency user but the reality is, the Federal government is a currency creator.

Given the role Federal financing plays in dealing with the pandemic and the attention the Federal deficit will get going forward, now is a good time to at least acquaint yourself with the concept of MMT. I promise the explanation of MMT in the book is better than mine.

Overall, this book is well worth your time and is very timely having come out during the pandemic. The only negative is that I feel it gets a little squishy and utopian with some of the implications of this powerful idea.

After reading this book I have a few questions on what MMT means to how we structure government:

  • MMT gives the Federal government more leeway with spending but doesn’t imply the same for provinces (they are currency users). What does this mean for the somewhat arbitrary division of responsibilities between the Federal and Provincial governments? For example, in Canada, health care is a provincial responsibility and is a huge part of the provincial budget.
  • MMT says that the real limit is not the deficit or debt but inflation. As long as inflation isn’t going up, more spending is fine. Would setting spending limits based inflation require a more fine grained way to measure inflation? The Federal government may need to be careful to not spend too much into one area. For example, if the Federal government decided it was going to double the amount of passenger trains or subways in the country but there is limited supply of trains, this would create great inflation in train costs and therefore reduce the effectiveness of the spending. Do specific targets like that require a ‘micro-inflation’ measure?

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