The U.S. budget deficit reached $984 billion in 2019. That’s 4.6% of gross domestic product.
Such a large deficit should cause interest rates to rise, according to traditional economic theory, because government debt “crowds out” private sector debt.
Since there is a limited supply of money, the price of borrowing (interest rates) goes up for all borrowers.
This is undesirable because higher interest rates slow economic growth. Fewer people can afford a mortgage or investments become too costly for businesses.
According to Modern Monetary Theory, however, this is not the case.
This theory, commonly called MMT, postulates that countries such as the U.S. that issue their own currencies can simply issue more money to avoid the crowding-out problem.
MMT is drastically different from traditional economic theory and is not well-accepted by mainstream economists.
There are variations to the assumptions behind MMT, but many supporters of this theory see government spending as a way for the government to put money into the economy.
They acknowledge that inflation can accelerate if there is not enough supply or workers to satisfy all the spending.
But the potential acceleration in inflation can be headed off by increasing taxes and thus taking money out of the economy. When there is less money in the economy, the potential for bidding up prices diminishes.
Consequently, it is not necessary for the Federal Reserve to sell government bonds in order to increase or decrease interest rates to stimulate or restrict economic growth as it currently does to carry out its dual mandate of stable inflation and full employment.
Under MMT, the Fed maintains a 0% interest rate, which is neither restrictive nor accommodating to economic growth. Congress and the president take over the dual mandate with their fiscal authority.
In a sense, the role of the central bank and monetary policy would be eliminated under MMT, and fiscal policy would be the only tool to manage the national economy.
Regarding the full employment mandate, rising unemployment rates are the result of the federal government not spending enough and collecting too much in tax revenue.
During times when inflation is picking up and the government needs to raise taxes to slow it down, some people will lose their jobs.
The problem of getting back to full employment is resolved by a job guarantee.
Individuals who can’t find jobs in the private sector would be given a job in the public sector and paid a minimum wage that is managed at the local level but funded by the federal government.
In addition, paying minimum wages helps to keep wage pressures down.
MMT was developed by Warren Mosler, who has a bachelor’s in economics from the University of Connecticut. He worked as a Wall Street trader and later founded a hedge fund. In the 1970s, he began to develop the concepts that underlie this theory. In 1993, he published “Soft Currency Economics” that gained the attention of some economists.
Presidential hopeful Sen. Bernie Sanders and Rep. Alexandria Ocasio-Cortez have further popularized MMT by arguing that their spending proposals will not cause inflation to accelerate under this theory.
To date, MMT is viewed with caution by most economists.
Tim Sablik, an economist with the Federal Reserve Bank of Richmond, wrote in a recent Richmond Fed magazine article how Sebastian Edwards of the University of California at Los Angeles argues MMT had been tried in various Latin American counties with disastrous results.
Sablik also referenced Nobel Prize-winning economist Thomas Sargent of New York University who provided examples from Europe after World War I that resulted in hyperinflation.
In a Bloomberg news article, Federal Reserve Chairman Jerome Powell made it clear that he is no fan of MMT: “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong.”