A couple of years ago, we talked about the massive global fiscal response to the COVID-19 crisis as a de facto policy experiment in modern monetary theory (MMT). Today, surveying the economic damage, it’s easy to declare that experiment an abject failure.
Easy, yes. And hasty. And oversimplistic.
Yet that’s what the Institute of International Finance did in a recent research note. The Washington-based finance-industry group wrote that 2022 marked “an abrupt halt” to the “illusion” of MMT: that “the ability to run up debt without consequences … is limitless.” The huge expansion of government debt during the pandemic, supported by low interest rates and money creation by central banks, has resulted in the high inflation, soaring interest rates and looming recession.
“The reality is that fiscal space is a scarce and valuable commodity to be used sparingly, the opposite of the MMT zeitgeist that has been so influential in recent years.”
Those with fair minds and a bit of knowledge will tell you that what the IIF describes – a bottomless pit of debt and money creation, without heed of consequences – is a misrepresentation of MMT. Proponents have always recognized that there are limits to their notion that governments have more capacity for spending and debt than they have traditionally been willing to acknowledge or use.
The fiscal experiment that has taken place during the pandemic, far from exposing MMT as an “illusion,” has tested those limits. The “failure” of the experiment, as MMT opponents would frame it, has not marked the death of MMT; rather, it has demonstrated to what extent MMT-like fiscal expansion can be pushed. Perhaps it’s not as far as many MMT proponents had hoped. But it’s no debunking.
As I wrote on this topic in the spring of 2021, MMT argues that the restriction on government spending isn’t a government’s capacity to raise revenue, since it is capable of issuing debt and (through its central bank) creating money to pay for it. Proponents believe that government can and should run larger deficits to fund investments and social programs.
But the caveat is that governments and central banks can only do this so long as it doesn’t fuel inflation. Modern monetary theorists never claimed the capacity to spend and runup debt was bottomless. In practice, an MMT-driven fiscal policy would reduce spending, or, alternatively, increase taxes, at the point where inflation exceeded an acceptable target – just as central banks have long used interest rates to accomplish the same thing with monetary policy.
As I wrote in that 2021 article, government actions in the face of the pandemic had rapidly put many of MMT’s key concepts into action:
“The pandemic demonstrated that, at least over the relatively short term, governments actually can spend as much as they deem appropriate, and they can create the money to do so almost instantly. Central banks, as the agents that issue debt and create currency on behalf of those governments, can do both as much as is necessary.”
What we hadn’t yet seen was the inflationary impact. It’s now clear that the huge global fiscal expansion in response to the crisis, and the money growth at central banks that facilitated it, helped ignite an inflation explosion not seen in decades. Yes, many other factors have contributed to global inflation: supply chain disruptions, massive shifts in consumer preferences, war in Ukraine. Nevertheless, it does appear that MMT-like fiscal policy exceeded its non-inflationary limits.
That doesn’t mean that MMT was a loopy fantasy of hippie-dippie dreamers with no grasp of, nor concern for economic realities. Nor does it mean that the policy measures that were enabled by these fiscal and monetary expansions were failures. Those expansions saved the global economy from collapse, and spared billions of people from desperate hardship. They worked. Pretty much the way MMT proponents said they would.
But so, too, did the consequences. MMT can, indeed, unleash an inflation monster about which critics of the theory had always warned. While no reasonable voice in the debate had ever claimed that debt and money creation was limitless and consequence-free, we have now seen how quickly and easily those expansions can let inflation loose, and how difficult and costly it can be to get it back in its cage.
This experience has also demonstrated perhaps the biggest weakness in MMT-influenced fiscal policy: it is a cumbersome tool to apply to managing inflation. Unlike interest rates, which can be adjusted within a matter of weeks to address inflationary pressures, government fiscal plans unwind over years. As we’ve seen budget deficits reverse, very slowly, back toward (but still nowhere near) precrisis norms, much more nimble central banks have had to jump in to do the heavy lifting on inflation – with rapid and painful interest-rate increases.
We’ve learned that MMT is very real, and can be put to work quickly – perhaps more quickly than its doubters had imagined – to address a severe need. We’ve also confirmed that if taken too far for too long, the inflationary consequences are very real. As policy makers consider how they will address future major economic shocks, those lessons will be invaluable. This wasn’t a failed experiment at all.