Modern Monetary Theory

A modern economy has 2 main authoritative components, a Treasury and a Central Bank.

Typically, a Treasury’s role has been to raise money through tax and borrowing to pay for public services – this is called Fiscal Policy. The constraints of Fiscal Policy include the rate at which it can levy taxes without causing economic damage, and the interest rate at which it can borrow. As every Government would ideally like to spend more money, these constraints end up as the perennial debate between political parties, particularly so since the financial crisis. It is also highly likely this will be a flashpoint in all Western political systems in the aftermath of the COVID crisis.

The Central Bank in a modern Western economy is independent from the Government. It is responsible for setting interest rates and maintaining orderly financial markets. It does this to maintain low inflation, usually around 2%, and keep unemployment low. It can do this in two ways. The first is by setting the Base Rate of interest at the bank, which is then passed into the economy as the rate typically found on instant cash accounts (such as current accounts for savers). The second is that it can then influence interest rates through Quantitative Easing (often called money printing). Although it sounds complicated, in very simple terms it is in essence the Central Bank creating money and purchasing Government Debt to increase demand and reduce the amount of interest payable. In reality, it is a complicated mechanism, however the purpose is simple – to reduce interest rates on issued debt by the Government which then has a knock-on effect of reducing interest rates for businesses and stimulating the economy. It is often referred to as money printing as the money to buy this Government Debt comes out of thin air (in actual fact, no new bank notes are printed and it is all done digitally).

In recent times, as our public finances have become ever more stretched, a new economic theory has been circulating as a way to get around this constraint. What if the Central Bank simply directly financed the Treasury and removed the problem of tax raising and borrowing?

It has been floated before, under the guise of People’s Quantitative Easing. The Central Bank opens an account for the Treasury and credits the account with all of the spending requirements for the year. Or perhaps just enough to pay for infrastructure improvements or the health service.

A massive influx of money into the economy, and no need to pay it back or take it in tax.

What is the downside?

In one word, inflation. Cash is an asset like any other and its value is determined by supply and demand. If the quantity of money in the economy increases, or its supply, and the amount of goods that money can buy does not, then the value of the cash is worth less. The way this manifests is through higher prices. So, what use would all this extra money be in the economy if prices rose, in effect wiping out the gains? This is the problem (amongst others) which Venezuela and Zimbabwe have experienced in the past.

However, the proponents of Modern Monetary Theory say that in a modern economy, this will not happen. For example, Japan has had ballooning debt, significantly increased money supply and the Central Bank has practiced a much higher level of Quantitative Easing than the US or UK (on a relative basis), and yet its inflation continues to be below 2%. Equally, look at the Eurozone. The European Central Bank has been purchasing tens of billions of Euros of EU governments debt for several years, and yet it does not have the kind of inflation the traditional theory would have predicted.

This argument goes back and forth, with reason and evidence on both sides. Maybe the strongest argument against it is that it simply sounds too good to be true. Nothing is free.