Stephanie Kelton, who achieved notoriety as a proponent of Modern Monetary Theory, has written a book that debunks some of the common misconceptions about public finance while unfortunately introducing some misconceptions of her own. Her book is The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy.

The Deficit Myth correctly points out that some accounting measures that receive public attention are merely sources of confusion. The Social Security Trust Fund is one example. The deficit in the balance of trade is another.

The most striking claim of Modern Monetary Theory is that government spending does not need to be constrained by the need to raise taxes. As Kelton puts it:

[Modern Monetary Theory] decouples spending from the prior need to raise money by taxing or borrowing. The question is, How do we want the federal government to use its great power. How much should it spend? What should it fund? What about inflation? And taxes?

How can we tell when the government is trying to spend too much? The accounting approach to answering this question would say to look at the budget deficit. Kelton instead says that the right indicator to watch is inflation. She believes that the government could run a much larger deficit without triggering inflation, and she argues that a large deficit today poses no special risk for the future. I see these arguments as central to her thesis, and I find them unpersuasive.

In examining the limits of government spending, Kelton wisely directs us away from looking at accounting measures to instead focus on real resources.

Once the economy exhausts its real productive capacity, the only way for the government to get the construction workers, architects and engineers, steel, concrete, paving trucks, cranes, and so on that it needs is to bid them away from their current use. That bidding process pushes prices higher, giving rise to inflationary pressures….

As long as we have health providers and facilities to meet demand, Medicare will be sustainable in the only terms that matter—our nation’s real productive resources.

I would phrase this as “all costs are opportunity costs.” When the government directs resources into one area, the benefits of its spending should be measured against the opportunity cost of those resources. Kelton judges that the benefits of more government-provided health care, green energy projects, education, and infrastructure would be high. She believes that, short of full employment, the opportunity cost of such spending would be low.

One of Kelton’s main proposals is a government jobs guarantee, which she sees as a solution to the otherwise intractable problem of unemployment.

The federal government would commit to funding jobs that are aimed at caring for our people, our communities, and our planet. This effectively establishes a public option in the labor market, with the government fixing the hourly wage and allowing the quantity of workers hired into the program to float. Since the market price of an unemployed worker is zero, that is, no one is currently bidding on them—the government can create a market for these workers by setting a price that it is willing to pay to hire them. Once it does, involuntary unemployment disappears.

It seems reasonable to me to measure the cost of a federal jobs program as opportunity cost rather than budgetary cost. If the government jobs enable workers to produce more in value than the opportunity cost of their time, then it is a worthwhile program. Otherwise, it is not.

It is indeed correct to say that when the government is bidding for resources, the risk of inflation is low if those resources are idle. It is also correct that unemployment is an indication of idle resources. But just because some resources are idle does not mean that the government can spend wherever it would like without affecting prices. The government would have to be an especially perspicacious and adroit entrepreneur to advance its priorities while only using idle resources.

Kelton does not explain why she believes that those currently without jobs would be a good match for her spending priorities. But without the ability to wave a magic wand to instantly transform the unemployed into teachers, skilled health care workers, and engineers specializing in energy alternatives, more spending in these areas would compete for scarce workers rather than soak up idle ones.

Deficits and Inflation

Conventional wisdom among economists links inflation to the money supply. Implicitly, the government can finance a deficit through borrowing without causing inflation. But Kelton describes government bond issuance this way:

It chooses to offer people a different kind of government money, one that pays a bit of interest. In other words, US Treasuries are just interest-bearing dollars.

I think that she is correct to view government debt, especially short-term debt, as similar to money. This implies that a sufficiently large government deficit will indeed lead to inflation, no matter how it is financed.

Kelton wrongly accuses inflation of having one kind of harm.

People worry about inflation because it can eat away at their real standard of living. You might have no trouble affording the typical basket of goods today, but if the price of that fixed basket starts rising, you may discover that you can no longer afford to buy it. It depends what’s happening to your income. If the price of the basket keeps going up by 5 percent each year while your annual earnings rise by just 2 percent, then in real (inflation-adjusted) terms you’ll be 3 percent worse off each year.

No. We can have falling real incomes without inflation, and we can have inflation without falling real incomes. People do blame “inflation” when the prices of what they buy rise by more than the price of what they sell, but economists refer to such a phenomenon as a relative price shift, not general inflation. General inflation is defined as an equal rise of all prices, including wages.

The problem with inflation is that it introduces uncertainty into the metric of money as a unit of account, complicating calculations about transactions. Instability in the purchasing power of a dollar is like instability in the definition of a kilometer, a volt, or any other unit of measure.

Suppose that you offer to pay me $1000 to deliver 100 tons of steel to you in six months. I might agree to that offer, but not if there is a risk that between now and then a “ton” is going to be redefined to be 2500 pounds instead of 2000 pounds. That sounds like an absurdity, but inflation that reduces the value of $1000 by 25 percent between now and then would have the same effect.

When inflation is low and steady, people can rely on a price quoted in currency units for a transaction involving future delivery. When inflation is high and variable, it greatly complicates our lives, like living in a world where kilometers or volts are subject to redefinition.

Moreover, a sudden, surprise bout of high inflation can wipe out hard-earned savings. If a household has a lot of its wealth tied up in bonds that pay a low interest rate, then by the time the bonds mature, the value of the principal may have been mostly eroded by higher prices.

Finally, there is the problem of hyperinflation. When the government keeps running deficits and printing money to finance them, prices start rising so rapidly that people try to spend money as fast as they can, before their currency depreciates. This raises prices rapidly, forcing the government to print money even faster to finance its spending.

If the dollar’s value can change with inflation, then why do people accept money as payment in the first place? Kelton argues that the government makes money useful by specifying it as a means for paying taxes: “Taxes are there to create a demand for the government’s currency.”

In fact, the bills in your wallet contain the inscription “legal tender for all debts, public and private.” What this means is that not only must the government accept currency as payment for taxes; all private creditors must do so as well. If I owe you $1000, and I “tender” you fifty $20 bills, you have no choice but to accept my offer. Legally, the debt has been discharged, whether you accept those bills or not.

Kelton writes, “taxes can be used to get resources without using force.” That makes government sound like a charity. A charity could issue currency and create demand for that currency by accepting donations in the currency.

A better way to describe the phenomenon of fiat money is to start with the proposition that government has a monopoly on the legitimate use of force. It uses that monopoly to conscript resources. It also uses that monopoly to enforce the legal tender status of money. The public then accepts, more or less willingly, government currency to settle debts.

Even though fiat money has legal status, we are still able to defend ourselves against inflation. We can take actions today in anticipation of price increases tomorrow. If we believe that the prices of what we buy tomorrow are going to rise, then we need to raise the price of what we sell today.

Because inflationary psychology is self-fulfilling, the belief in Modern Monetary Theory is inherently self-refuting. 

Kelton argues that under a gold standard, government spending is limited by the need to be able to back government liabilities with gold. This constraint goes away with fiat money. But by the same token, inflation is anchored in a gold standard, because people know that the value of money is defined in terms of gold.

Kelton seems to believe that in a fiat money regime inflation only appears when the economy is at full capacity, with no unemployment. But we know from the experience of the 1970s that this is not the case.

With a fiat money regime, there is no anchor for prices. Instead, the value of a dollar depends to a large extent on habits and beliefs. Many mainstream economists hypothesize that the central bank can anchor beliefs simply by announcing an inflation target. Instead, I think that the public forms habits and expectations based on recent experience. But these habits can change. As people become conscious of currency depreciation, they will take steps to protect themselves—and those steps will accentuate the depreciation.

Ultimately, inflation has an important self-fulfilling social psychological element. If people believe that the prices of what they buy will remain steady, then they will be inclined to hold the prices of what they sell steady, which in turn will tend to stabilize prices. But if they believe that prices for what they buy are going to rise, then they will raise the prices of what they sell in order to compensate.

Because inflationary psychology is self-fulfilling, the belief in Modern Monetary Theory is inherently self-refuting. Once people believe that the government is not constrained by deficit concerns in its issuing of paper claims (low-interest bonds or money), they have to be alert to the possibility that the government will at any point drastically devalue the monetary unit. To protect themselves, people will raise the prices of what they sell. This will devalue the monetary unit.

To put this another way, expectations of inflation have to be anchored in some way. The doctrine that the government can spend whatever it wants without regard to the size of the budget deficit undermines any reason to believe that inflation will remain low. It removes the anchor that arises from our current monetary and fiscal norms.

In 1971, President Nixon ended the Bretton Woods agreement, and he thereby changed the monetary and fiscal norms. This removed the link between the dollar and gold, which had become increasingly untenable in part because of the deficits of the Vietnam War era. Notwithstanding the price control regime that the Nixon Administration put in place as it abandoned Bretton Woods, what followed was the highest-inflation decade of the last hundred years. Perhaps this was coincidence. But perhaps we need to be wary of the effect of any new monetary/fiscal regime on the anchoring of price expectations. This is a significant gap in Modern Monetary Theory.

Deficits and Savings

Another misconception that Kelton proffers is that government deficits create savings, so that deficits do not crowd out investment. But her argument rests on a confusion between gross saving and net private saving. Gross saving is the amount that households and businesses save. Net private saving is gross saving minus private investment.

It is true as a matter of accounting that in a closed economy, the net savings of the private sector rise to absorb any increase in the government deficit. But the accounting identity can be satisfied in a variety of ways. It is possible for gross saving to rise by the amount of the deficit, so that investment need not fall. But it is also possible for private sector savings to remain constant, with the increase in net private sector savings coming from a drop in investment. Kelton here is making an elementary mistake that is difficult to excuse.

Deficits and the Future

Most economists believe that the government debt plus its unfunded obligations to future recipients of Social Security and Medicare make for a dire outlook. Kelton argues instead that the ability of the government to issue money to discharge these obligations means that there is no need to raise taxes, cut entitlements, or reduce other spending.

Those of us who believe that entitlement programs have to be cut tend to focus on the fact that people are living much longer than when those programs are first enacted, and health care spending is rising as new treatments and diagnostic procedures are invented. The result is that the burden that these programs impose on young people is increasing and will continue to do so. Because she realizes that issues come down to real resource use rather than accounting matters, Kelton ought to understand that if the government directs an ever-larger share of real resources to the elderly, there are going to be fewer resources available to the young. Put it this way: if money-printing were the solution for entitlements, then it would be feasible to lower the age of eligibility for Social Security and Medicare to 35 instead of 65.

Large deficits today make for political strife tomorrow. Tomorrow, the recipients of government spending will expect to continue to receive benefits. In addition, those who accept government paper claims in the form of money or bonds also will expect to be able to obtain resources using those claims. But the government paper claims do not increase the resources that will be available. For a given amount of real resources, more paper claims on those resources will lead to political conflict, inflation, or both.

Assessing the Current Experiment

Orthodox monetary theory has its problems. It exaggerates the difference between money and low-interest, short-term government bonds. It offers an account of money, inflation, and unemployment that is too simplistic and deterministic.

The Deficit Myth offers an alternative to orthodox monetary theory. But it is an alternative with even more conceptual deficits.

As it happens, the United States is now experimenting with a very large increase in deficit spending, financed by money creation. This experiment is not being conducted in the name of Modern Monetary Theory. It is instead an attempt to mitigate the economic losses caused by the novel coronavirus. But this experiment will help us assess the validity of MMT. If we get through the next several years without a significant increase in inflation, such an outcome would confound the skepticism that I have expressed here.