LONDON (Reuters Breakingviews) - Is money more like gold or like motor oil? The answer to that fundamental question helps determine how large fiscal deficits should be, and how best to find the money to close the gap between tax revenues and government expenditures.
Up to a century or so ago, many economists would have said that money is not merely like gold. For them, real money actually was gold, silver or some other scarce and valuable material. Transactions might be paid for with paper or by changing the balances of bank accounts, but the notes and numbers only had any worth because they could be exchanged for the real thing.
In this gold-standard thinking, government deficits are basically as bad as private deficits. When more gold flows out of than into official coffers, the authorities will eventually run out. Then they will try to claim that the fake money is as good as gold. The almost inevitable results are vast over-issuance of so-called money and a breakdown of economic trust.
The golden idea of money should have been firmly discredited by John Maynard Keynes and his followers. Almost a century ago, they pointed out the simple fact that the primary function of money is to pay for things. In other words, it lubricates the economy. The economy should have enough of the lubricant to keep operating smoothly. Otherwise, parts of the engine grind to a halt.
Banks do most of the work on money supply. Their loans are supposed to finance both new activity and create new deposits. They can mess up though. Keynes noted the tendency of lenders to take lubricant out of the economy just when it starts to shudder. These monetary cutbacks worsen economic downturns.
Governments can compensate by adding lubricating liquidity. In this Keynesian perspective, fiscal deficits measure the amount of monetary motor oil the government is adding to the economic engine.
In principle, few current economists would disagree with this analysis, even if they find the metaphor a bit too greasy. The consensus, at least outside of Germany, is that fiscal deficits of 1 or 2 percent of gross domestic product are needed in normal times, with larger gaps required when bankers panic.
Yet most economists still struggle to kill off gold-money thinking, instinctively clinging to the idea that money is inherently something valuable and non-political. The exception is a school of economics known as Modern Monetary Theory. The initials are starting to appear more often, especially in left-wing political circles.
Exactly what counts as MMT is disputed, but there are two policy ideas that unite most of its leading proponents, including Steve Keen and Stephanie Kelton. First, forget about the size of fiscal deficits. What matters is that governments spend enough to keep the economy humming along as efficiently as possible. As long as the expenditures mobilise otherwise unused economic resources, the government is simply doing what banks are supposed to do - creating enough money to activate all of a currency zone’s economic potential.
Of course, excessively large government deficits can be harmful, bringing undesirable inflation of consumer or financial asset prices, or a debilitating increase in the trade deficit. However, there is nothing especially governmental about these risks. Money created through additional bank lending has the same undesired effects.
The second MMT idea is more political - big-spending governments are basically a good thing. For example, many MMT proponents call for large governmental job-creation programmes. These, they say, will not even increase deficits over the long run. They will reduce welfare payments and increase taxable incomes.
As a monetary theory, MMT’s political bias is optional. However, many opponents feel uneasy with the whole idea that money is always no more than “a creature of the state”, as the hyper-Keynesian economist Abba Lerner asserted in 1947. They prefer to believe that politically independent central banks can use monetary policy both to maintain the value of money and to keep the economy running smoothly.
Their faith is misplaced. Central banks’ policy interest rates and financial regulation are inevitably political, and they are rarely effective unless the economy is already running smoothly.
A more practical complaint about the MMT approach is that its big deficits will lead to mountains of unaffordable government debt. On this front, the critics can relax, at least in theory. As Lerner pointed out, governments which have the power to create money do not need to borrow. On the contrary, government borrowing is usually an inefficient way to keep the economy well lubricated, as it exposes the country to whims of creditors.
The authorities have several better ways to push money directly into the economy. They can print new notes, add to bank account balances or, as in quantitative easing, buy financial instruments from investors. In Lerner’s model of Functional Finance, the choice is pragmatic. There is nothing sacred or gold-like about the money supply. While governments could print too much money, triggering runaway inflation and a currency crisis, their impulse should be checked by taxpayers’ tolerance for higher prices.
In practice, Lerner’s fully flexible approach to money creation is impossible in most jurisdictions. One legacy of gold-thinking is a legal ban on direct government money-creation. MMT enthusiasts would do well to follow their logic to the same conclusion as Lerner. Money is meant to lubricate the economy, and debt-free fiscal deficits are likely to do that job better than the current variety.
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