Modern Monetary Theory Makes Back-Door Entry Into Policies

Blu Putnam, Chief Economist and Erik Norland, Senior Economist, CME Group

Originally published in the April | May 2020 issue

Governments and central banks around the world are backing into Modern Monetary Theory (MMT), not by embracing a new theory of economic policy but by the sheer necessity of swiftly repairing the economic damage from the Covid-19 pandemic. At its heart, MMT is about the fusion of fiscal and monetary policy. It does not worry about fiscal budget deficits, but cares about how the government spends money. It links fiscal to monetary policy by using the central bank to buy the debt the Government issues via Treasury securities when it chooses not to use tax revenues to fund new spending. The limits of fiscal spending and central bank debt purchases are guided mainly by whether too much inflation is created.

The economic crisis stemming from the global pandemic of 2020 quickly exposed the limits of traditional monetary policy acting in isolation from fiscal policy. Lowering short-term interest rates to near zero would clearly not be enough to limit the economic damage from a cascading collapse of the economic network, akin to a disequilibrium phase transition in physics1. Central bank purchases of government bonds (i.e. Quantitative Easing or QE) was unlikely to help much either, given that this approach had failed to generate additional economic growth or inflation when tried in an aggressive fashion by the central banks in US and Europe during the economic expansion of 2010-2019. Arguably the Bank of Japan’s (BoJ’s) even more extreme version of QE, which took its balance sheet to over 100% of GDP and, unlike Europe or the US, also included buying large quantities of corporate debt and even equities via exchange traded funds, provided a very slight boost to Japanese inflation through the transmission mechanism of depreciating the yen in 2013 and 2014. Once the yen depreciation was capped and then reversed, though, the BoJ’s aggressive QE had no further impact on growth or inflation.

In addition to monetary policy, many countries around the world, especially the US, Europe and Japan, embraced the idea that massive fiscal stimulus would be required to deal with the cascading collapse of the economic network. Many central banks responded to the fiscal stimulus by committing to expand their asset purchases in new directions, including corporate and local government debt.2 Voilà, the active collaboration of fiscal and monetary policy by way of MMT was implemented, not by choice, but by necessity.

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