Functional Finance Roots Of MMT

I have been writing online for over six years. and my experience is that almost all of the discussion around Modern Monetary Theory (MMT) involve basic principles of Functional Finance. Functional finance was a school of thinking within early post-World War II Keynesian economics. For a number of reasons (mainly political), Functional Finance disappeared from discussion -- until proponents of MMT revived the ideas. The online debates (including opinion pieces from mainstream academics) bounce around Functional Finance ideas. This is somewhat unusual, as the theoretical dissent around the basic Functional Finance concepts used is not very strong.

Most critiques of MMT take the form of a critic asserting "MMT says X." The response from MMT proponents is that MMT most definitely does not say "X".  This situation is obviously confusing. This article attempts to explain why the online debates are confusing (and pointless).

(Note: This is the second article in a sequence of articles on fiscal policy and MMT (link to first). These articles are drafts that are expected to form a chapter in an eventual intermediate introduction to MMT. This article is somewhat of a diversion, but it reflects the reality that most online debates about MMT are confused.)

Really Short Version of Functional Finance

For the purposes of deciphering online wrangling about MMT, the most important principle of Functional Finance is as follows:

For a floating currency sovereign, the only negative economic consequence of loose fiscal policy is a loss of purchasing power of the domestic currency ("inflation").

There is more to Functional Finance than that, but it is what matters to us right now. (I have a longer tutorial on Functional Finance here, and it is the core of Chapter 7 of my book Understanding Government Finance.)

One immediate thing to keep in mind is that I wrote "floating currency sovereign," and so this is ruling out situations like the Gold Standard, euro area, etc.

One consequence of this statement is non-intuitive: the role of taxation is inflation control, not to raise money. ("Taxes for revenue are obsolete.*") Put another way, we cannot attempt to line up "tax dollars" to "spending dollars" on a one-to-one basis. (Since the expected state of affairs is a public debt growing in line with GDP, it is obvious that we cannot line up spending to taxes.) This perspective is definitely not the "common sense" view, and creates a great deal of consternation.

Note that this rules out the following things floating currency sovereigns allegedly need to worry about.

• Running out of money.
• "Bond vigilantes."
• The debt-to-GDP ratio hitting some magical barrier.

There are good faith critiques of Functional Finance doctrines, but they are fairly narrow and tend to be arcane. My experience is that 99% of critiques of MMT are not referencing these legitimate critiques. When I turn to discussing the MMT academic literature, I will discuss those critiques as they come up.

Is MMT Confusing?

The idea that the only limit to government spending is its inflationary consequences is a radical departure from the usual framing, which uses the language of households -- "how are we going to pay for the programme?"

For example, why cannot the government of a large country promise to give everyone a free pony? Very simply, because there are not enough ponies available on the market. The government would drive up pony prices to a spectacular level, and the monetary flows would likely cause inflationary pressures elsewhere. 

This also explains war-time finance. The United States (and other countries) employed rationing and price controls to allow the central government to run fiscal deficits that were much larger than what is normally seen in peacetime. It would not have been enough to just spend money to buy war matériel, extensive interference in markets was needed to displace private sector demand for goods and services.

The main academic proponents of Modern Monetary Theory targeted the misleading household analogies used in popular discourse, and have deliberately written statements that appear quite provocative. This certainly helped "market" MMT, but it obviously confused at least some people. (To a certain extent, some of the confusion was the result of prominent MMT critics deliberately mis-stating MMT positions in an effort to discredit it.)

This confusion is regrettable, but it also creates space for me to sell books. I am not interested in dissecting the wording of other MMT treatments, rather explain it to the best of my abilities.

The Widowmaker and Intellectual Evolution

The basic proposition that inflation is the main (or only) constraint on government spending has largely become a consensus view among well-informed observers by a process of attrition. The idea was hotly contested earlier, but embarrassing forecast failures by prestigious institutions and highly-credentialed individuals has culled the weak ideas from the herd.

The first area of failure was the Widowmaker Trade -- based on the belief that the fiscal position of Japan "unsustainable."  Many investors placed short positions in the Japanese Government Bond (JGB) market, and they discovered that Japan's fiscal position was a lot more "sustainable" than their negative carry positions. I started as a rates analyst in the late 1990s, and by then, it was largely people who had no expertise in government finance who argued that the JGB market was doomed.

The final nail in the coffin for competing views was the aftermath of the Financial Crisis. Prominent commentators argued that the United States "would be the next Greece," and that is exactly what did not happen.

I will not say that there is no dissent now, but most of it consists of weasel-worded empty statements, like "government finances are on an unsustainable trajectory." If pushed as to what the consequences of this "unsustainability" are, eventually inflation comes up.

Not Much Good Theory for Dissension

The reason why there is not a whole lot of detailed dissension against the view that inflation is the ultimate constraint on government finances is the general lack of theory supporting alternative viewpoints.

For example, if we examine benchmark DSGE models, we see that there is no attempt to model governmental default, nor is there even a term premium. As such, the only side effect of fiscal policy is the effect on aggregate demand. There is the vexed question of the "governmental budget constraint," but even that is not particularly satisfying. (It will be discussed separately, as it is a fairly arcane topic.)

In order to develop side effects of fiscal policy, new models have to built -- which are designed from the ground up to get the desired results. Whether those models fit reality is another question, and would have to be discussed when I move to the more advanced topics.

Concluding Remark

One of the basic premises of MMT is that the government only needs to worry about the inflationary consequences of its fiscal policy, not the nominal amount of debt it has outstanding. So when a critic argues that "MMT will lead to hyperinflation!," they are literally agreeing with the base theory. At most, they can debate whether any particular policy proposal will lead to higher inflation -- but that necessitates digging into the policy proposal.

With this diversion out of the way, later installments will turn to the question as to what the MMT academic literature actually says about fiscal policy and its limits.

Footnote:

* Ruml, Beardsley. "Taxes for revenue are obsolete." American Affairs 8.1 (1946): 35-39.

(c) Brian Romanchuk 2020