Economics,  Investing,  Markets,  Politics

Why treating a government like it’s a household is simply wrong

Conventional economics is having a really hard time explaining what’s going on in much of the world today: how can we have such low inflation when interest rates are at record low levels? How can some governments consistently run deficits, that look for all the world like they could never be repaid, and yet their bond yields are going down, not up? How come those economies where central banks have been pumping in stimulus for years, are still showing sluggish rates of growth?

The same questions have left many investors perplexed as asset prices stay high while they read about a range of risks.

It makes sense that if conventional thinking can’t explain what’s going on, then it’s time to look elsewhere. There is one school of economic thought that’s been talking about the inevitability of declining inflation and interest rates for years. It has not just a plausible, but also logical, explanation for many of the conundrums that leave orthodox economists scratching their heads.

However, that school of thought is so unconventional, and requires such a radical change to long-accepted wisdom, that those orthodox economists, including some of the best known names in the industry, have been lining up to ridicule it. But the most common criticisms sometimes show at best a lack of understanding, and at worst, an unwillingness to think differently.

That new school of thought is known as Modern Monetary Theory, which is commonly abbreviated to MMT. The first problem MMT has is its name, which is simply not a good description of what it is.

While it is indeed modern, having been developed in the early 1990s, it could easily be mistaken as a new version of ‘monetarism’, which was the economic theory developed by Milton Friedman and the Chicago School back in the 1960s that advocated, amongst other things, that markets are best at determining the optimal allocation of resources, so the role of government should be minimised and indeed fiscal spending is not only ineffective but irresponsible, because the resulting government borrowing will end up increasing interest rates, inflationary expectations, or future taxation in order to fund it.

But if that thinking’s right, then how is it that Japan and the US, both with massive government deficits, can reduce tax rates and have falling inflation and interest rates?

MMT is, in fact, the antithesis of monetarism, arguing governments must spend in order to achieve full utilisation of an economy’s resources. In that sense, it’s closer to Keynesianism. Finally, it’s not really a ‘theory’, it’s actually a straight up application of accounting rules to explain how money works in an economy where the government controls its own currency, in other words, an economy like Australia’s.

One of MMT’s most controversial insights is that such a government cannot be insolvent, that is, it can never run out of money, however, it can go broke. How that works is a government creates brand new money whenever it injects more in fiscal policy that it takes back in taxes, so, by logical extension, it can never run out.

However, that money is effectively backed by all the resources of the economy: all the workers, machines, factories and farms. If every single one of the workers suddenly disappeared, so there’s nobody left to run the machines, then the economy’s stuffed and the money is worthless. The government would be broke.

In this sense, one of the hardest lessons to get your head around that MMT teaches us, is that treating a government like it’s a household is fundamentally wrong. A household doesn’t control its own currency, so it can easily become both insolvent and broke. If a household spends more than it earns, or takes on too much debt, it’s in big trouble.

Because a government can create money at will, MMT points out that government spending is not constrained by a lack of funds. This is where conventional economists yell indignantly that MMT is preposterous: telling a government it can spend as much as it wants is a sure-fire recipe for inflationary disaster, and they’ll often refer to Venezuela, Zimbabwe or the Weimar Republic of the 1930s as examples of what happens when governments spend money as if there were no limits.

But MMT explicitly acknowledges the existence and risks of government deficits and inflation. What it says though, in a very simplified example, is imagine the economy is like a giant department store where both the private sector and the government sector shop for the things they need, everything from hospitals, to cars, workers, or soldiers. If some of the stock is not being bought by the private sector, that means there’s excess capacity and you’d expect prices will not be rising. It follows the government is able to go to the store and keep buying things with its printed money until all the stuff in the shop is being sold before you’d expect prices to rise.

One of the critical things to remember about MMT is it’s not a policy framework, it’s simply a model of how money works in a modern economy. This has been a very brief and broad-brush overview of what is a complex and sophisticated body of work that’s gaining increasing traction as the most logical explanation of a variety of situations that conventional economics is at a loss to explain.

In part two, we’ll look at why the world’s central bankers are wittingly, or unwittingly, becoming advocates for MMT.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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