Modern Money Theory: A Reply to Palley

Abstract

Modern Money Theory (MMT) has explained why monetarily sovereign governments have a very flexible policy space that is unconstrained by hard financial limits. It has provided institutional and theoretical insights about the workings of economies with monetarily sovereign and non-sovereign governments. It has also provided policy insights with respect to financial stability, price stability and full employment. Yet there have been many critics of MMT, including Palley (2014). Critiques of MMT can be grouped into five categories: views about the origins of money and the role of taxes in the acceptance of government currency, views about fiscal policy, views about monetary policy, the relevance of MMT conclusions for developing economies, and the validity of the policy recommendations of MMT. This paper addresses Palley's criticism of MMT using the circuit approach and national accounting identities, and by progressively adding additional economic sectors.

Notes

¹We use the term ‘sovereign government’ to indicate a government that issues its own currency. As we will discuss, a monetarily sovereign government can choose among alternative exchange rate regimes—fixed, managed, and floating—which impacts domestic policy space. A government that promises to convert its own currency on demand and at a fixed exchange rate is constrained by its ability to obtain that to which it promises to convert. In that sense, we can say that it is ‘financially constrained’ even though operationally it cannot run out of its own currency. The problem is that it can be forced to default on its promise to convert (to a foreign currency or to a precious metal). For some purposes, it is useful to separate floating currency regimes from fixed and managed exchange rate regimes. Many of those who adopt MMT make such a distinction, arguing that only floating currency regimes are ‘fully’ sovereign in the monetary sense. However, many of the principles we outline in this article apply to all currency-issuers—but it must be kept in mind that when a government promises to redeem its currency its policy space can be limited.

²See footnote 1. With a fixed exchange rate, access to foreign reserves can act as another constraint.

³Note the similarity to Keynes's argument that saving does not finance investment.

⁴More formally, with FA financial assets, FL financial liabilities, S saving, and I investment. Δ(FA – FL) is net lending (or net financial accumulation), (S – I) net saving by the domestic private sector, and (T – G) net saving by the government (fiscal balance).

⁵We discuss below the fact that inflation can result before full employment, and that fiscal policies can contribute to inflation by creating full employment. We note also that Keynes reserved the term ‘true inflation’ to indicate the situation where additional spending must cause inflation because the elasticity of output has fallen to zero when all resources are fully employed. This seems to be the scenario Palley has in mind. However, his argument that budget deficits at full employment means there must be ‘true inflation’ in Keynes's sense is flawed.

⁶We do not mean to imply that government decisions have no impact. For example, a ‘trickle up’ policy to move income to the rich might increase the private sector's net saving desire, resulting in bigger budget deficits at full employment; a policy that uses New Deal-style job creation to achieve full employment might instead be consistent with a balanced budget. In other words, government policy can affect the private sector's behavior.

⁷This has nothing to do with a multiplier view of the monetary process. As the economy grows, more advances from private banks are requested and more cash is needed by the population for transaction purposes. Thus, once banks have granted advances, banks might need additional reserves to meet reserve requirements, settlement requirements and withdrawals from customers. The rise in the monetary base is a residual effect in the causal chain of events (Lavoie, 2006).

⁸Again notice the parallel to Keynes's argument that saving does not finance investment.