scanrailFor the last hundred years economists and many politicians have voiced concerns about fiscal deficits—with exceptions made for wartime, the Great Depression, and the recent Great Recession. Today, however, a new branch of economic theory argues deficits may do more good than harm.
Traditional monetary theory maintains that even if a government can print money to pay for debts, the act itself creates inflationary pressures, increases interest rates, and fuels even greater deficits by increasing interest on the debt. If growth cannot match the increase in interest rates, further deficits will be created as tax revenues fail to keep up with expenditures.
At some point, one rarely experienced in the United States, investors may become unwilling to fuel deficits with further loans. The result: a government’s credit rating will decline, fostering an “economic doom loop.” In such times, reductions in government spending or increased taxes in an effort to reduce deficits may just exacerbate the problem.
Conventional economic thinking maintains that fiscal responsibility keeps interest rates and inflation low, fosters investment, and promotes productivity and healthy growth in the economy. The goal is to eliminate deficits and any further growth in the national debt, though this is rarely achieved. Erskine Bowles, co-chair with former Representative Alan Simpson of a 2012 committee charged with coming up with proposals for reducing deficits in the long term, is an advocate of this thinking. As Bowles puts it, “I’m confident many Americans will wonder why didn’t those old guys make some of these tough decisions 20 to 30 years ago.” Michael A. Peterson, president of the Peter G. Peterson Foundation, still believes the federal debt “threatens the economic future of every American.”
MMT's different perspective
Now comes Modern Monetary Theory (MMT), which maintains that the assumptions underlying conventional thinking may have been all wrong these many years. It is based in part on the belief that there may be a disconnect between deficits, inflation, and especially interest rates. Economist Stephanie Kelton argues one reason the disconnect exists is the knowledge that a nation with its own currency can simply deal with deficits by printing more money. Only in extreme cases will this lead to greater inflation if the economy, productivity, and the supply of labor, goods, and services is growing. This has been interpreted by some to suggest that such countries need not worry about deficits.
“Modern Monetary Theory is based in part on the belief that there may be a disconnect between deficits, inflation, and especially interest rates.”
Exhibit A for the argument is what is happening currently in the US. As deficits mount, interest rates remain low in part because of a good credit rating relative to other countries, a strong currency, and the ready flow of capital into the country. Inflation is held down by, among other things, low-cost import competition. In the world of MMT, deficits fuel growth that produces government revenue sufficient for public investment. As long as interest rates remain below the rate of growth—the current US experience—further government borrowing is a good strategy.
MMT fits nicely with the aims of both political parties in America. In a nutshell, Republicans are defending deficits because they fuel economic growth. Democrats are justifying them to foster huge investments in social programs [potentially such as the Green New Deal] that produce social benefits and greater economic equality. This appears to be creating an unusual alliance and mutual lack of concern about greater deficits.
Economists Jason Furman and Lawrence Summers advocate a middle course “that neither prioritizes cutting deficits nor dismisses them. Unlike in the past, budgeters need not make reducing projected deficits a priority. But they should ensure that, except during downturns, when new fiscal stimulus is required, new spending and tax cuts do not add to the deficit… The risks associated with high debt levels are small relative to the harm cutting deficits would do.”
Have we been laboring under incorrect assumptions about the effects of increasing federal debt on such things as interest rates, inflation, growth, and long-term welfare? Is Modern Monetary Theory based on questionable economics? Or is it here to stay? What do you think?
References:
Jason Furman and Lawrence H. Summers, Who’s Afraid of Budget Deficits: How Washington Should End Its Debt Obsession, Foreign Affairs, March/April, 2019, foreignaffairs.com, accessed March 23, 2019.
Neil Irwin, Neil Irwin, How America Learned to Love Deficits, The New York Times, February 24, 2019, p. SR3.
