UPDATE (2/5/21: A little while ago I posted this tweet on Twitter
So I thought I would re-up this post from July 2020 about MMT in response to a tweet asking me what might be a better criticism of MMT.
I am finishing up a first draft of a paper on fiat money, bitcoins and cryptocurrencies that will be included in a forthcoming volume on bitcoins and cryptocurrencies. The paper is loosely based on a number of posts that have appeared on this blog since I started blogging almost nine years ago. My first post appeared on July 5, 2011. Here are some of my posts on and fiat money, bitcoins and cryptocurrencies (this, this, this, and this). In writing the paper, it occurred to me that it might be worthwhile to include a comment on Modern Monetary Theory inasmuch as the proposition that the value of fiat money is derived from the acceptability of fiat money for discharging the tax liabilities imposed by the governments issuing those fiat moneys, which is a proposition that Modern Monetary Theorists have adopted from the chartalist school of thought associated with the work of G. F. Knapp. But there were clearly other economists before and since Knapp that have offered roughly the same explanation for the positive value of fiat money that offers no real non-monetary services to those holding such moneys. Here is the section from my draft about Modern Monetary Theory.
Although there’s a long line of prominent economic theorists who have recognized that acceptability of a fiat money for discharging tax liabilities, the proposition is now generally associated with the chartalist views of G. F. Knapp, whose views have been explicitly cited in recent works by economists associated with what is known as Modern Monetary Theory (MMT). While the capacity of fiat money to discharge tax liabilities is surely an important aspect of MMT, not all propositions associated with MMT automatically follow from that premise. Recognizing the role of the capacity of fiat money to discharge tax liabilities, Knapp juxtaposed his “state theory of money” from the metallist theory. The latter holds that the institution of money evolved from barter trade, because certain valuable commodities, especially precious metals became widely used as media of exchange, because, for whatever reason, they were readily accepted in exchange, thereby triggering the self-reinforcing network effects discussed above.[1]
However, the often bitter debates between chartalists and metallists notwithstanding, there is no necessary, or logical, inconsistency between the theories. Both theories about the origin of money could be simultaneously true, each under different historical conditions. Each theory posits an explanation for why a monetary instrument providing no direct service is readily accepted in exchange. That one explanation could be true does not entail the falsity of the other.
Taking chartalism as its theoretical foundation, MMT focuses on a set of accounting identities that are presumed to embody deep structural relationships. Because money is regarded as the creature of the state, the quantity of money is said to reflect the cumulative difference between government tax revenues and expenditures which are financed by issuing fiat money. The role of government bonds is to provide a buffer with which short-term fluctuations in the inflow of taxes (recurrently peaking at particular times of the year when tax payments become due) and government expenditures.
But the problem with MMT, shared with many other sorts of monetary theory, is that it focuses on a particular causal relationship, working through the implications of that relationship conditioned on a ceteris-paribus assumption that all other relationships are held constant and are unaffected by the changes on which the theory is focusing, regardless of whether the assumption can be maintained.
For example, MMT posits that increases in taxes are deflationary and reductions in taxes are inflationary, because an increase in taxes implies a net drain of purchasing power from the private sector to the government sector and a reduction in taxes implies an injection of purchasing power.[2] According to the MMT, the price level reflects the relationship between total spending and total available productive resources, At given current prices, some level of total spending would just suffice to ensure that all available resources are fully employed. If total spending exceeds that amount, the excess spending must cause prices to rise to absorb the extra spending.
This naïve theory of inflation captures a basic intuition about the effect of increasing the rate of spending, but it is not a complete theory of inflation, because the level of spending depends not only on how much the government spends and how much tax revenue it collects; it also depends on, among other things, whether the public is trying to add to, or to reduce, the quantity of cash balances being held. Now it’s true that an efficiently operating banking system tends to adjust the quantity of cash to the demands of the public, but the banking system also has demands for the reserves that the government, via the central bank, makes available to be held, and its demands to hold reserves may match, or fall short of, the amount that banks at any moment wish to hold.
There is an interbank system of reserves, but if the amount of reserves that the government central bank creates is systematically above the amount of reserves that banks wish to hold, the deficiency will have repercussions on total spending. MMT theorists insist that the government central bank is obligated to provide whatever quantity of reserves is demanded, but that’s because the demand of banks to hold reserves is a function of the foregone interest incurred by banks holding reserves. Given the cost of holding reserves implied by the interest-rate target established by the government central bank, the banking system will demand a corresponding quantity of reserves, and, at that interest rate, government central banks will supply all the reserves demanded. But that doesn’t mean that, in setting its target rate, the government central bank isn’t implicitly determining the quantity of reserves for the entire system, thereby exercising an independent influence on the price level or the rate of inflation that must be reconciled with the fiscal stance of the government.
A tendency toward oversimplification is hardly unique to MMT. It’s also characteristic of older schools of thought, like the metallist theory of money, the polar opposite from the MMT and the chartalist theory. The metallist theory asserts that the value of a metallic money must equal the value of the amount of the metal represented by any particular monetary unit defined in terms of that metal. Under a gold standard, for example, all monetary units represent some particular quantity of gold, and the relative values of those units correspond to the ratios of the gold represented by those units. The value of gold standard currency therefore doesn’t deviate more than trivially from the value of the amount of gold represented by the currency.
But, here again, we confront a simplification; the value of gold, or of any commodity serving as a monetary standard, isn’t independent of its monetary-standard function. The value of any commodity depends on the total demand for any and all purposes for which it is, or may be, used. If gold serves as money, either as coins actually exchanged or a reserves sitting in bank vaults, that amount of gold is withdrawn from potential non-monetary uses, so that the value of gold relative to other commodities must rise to reflect the diversion of that portion of the total stock from non-monetary uses. If the demand to hold money rises, and the additional money that must be created to meet that demand requires additional gold to be converted into monetary form, either as coins or as reserves held by banks, the additional derived demand for gold tends to increase the value of gold, and, as a result, the value of money.
Moreover, insofar as governments accumulate reserves of gold that are otherwise held idle, the decision about how much gold reserves to continue holding in relation to the monetary claims on those reserves also affects the value of gold. It’s therefore not necessarily correct to say that, under a gold standard, the value of gold determines the value of money. The strictly correct proposition is that, under a gold standard, the value of gold and the value of money must be equal. But the value of money causally affects the value of gold no less than the value of gold causally affects the value of money.
In the context of a fiat money, whose value necessarily reflects expectations of its future purchasing power, it is not only the current policies of the government and the monetary authority, but expectations about future economic conditions and about the future responses of policy-makers to those conditions that determine the value of a fiat money. A useful theory of the value of money and of the effect of monetary policy on the value of money cannot be formulated without taking the expectations of individuals into account. Rational-expectations may be a useful first step to in formulating models that explicitly take expectations into account, but their underlying suppositions of most rational-expectations models are too far-fetched – especially the assumption that all expectations converge on the “correct” probability distributions of all future prices – to provide practical insight, much less useful policy guidance (Glasner 2020).
So, in the end, all simple theories of causation, like MMT, that suggest one particular variable determines the value of another are untenable in any complex system of mutually interrelated phenomena (Hayek 1967). There are few systems in nature as complex as a modern economy; only if it were possible to write out a complete system of equations describing all those interrelationships, could we trace out the effects of increasing the income tax rate or the level of government spending on the overall price level, as MMT claims to do. But for a complex interrelated system, no direct causal relationship between any two variables to the exclusion of all the others is likely to serve as a reliable guide to policy except in special situations when it can plausibly be assumed that a ceteris-paribus assumption is likely to be even approximately true.
[1] The classic exposition of this theory of money was provided by Carl Menger (1892).
[2] In an alternate version of the tax theory of inflation, an increase in taxes increases the value of money by increasing the demand of money at the moment when tax liabilities come due. The value of money is determined by its value at those peak periods, and it is the expected value of money at those peak periods that maintains its value during non-peak periods. The problem with this version is that it presumes that the value of money is solely a function of its value in discharging tax liabilities, but money is also demanded to serve as a medium of exchange which implies an increase in value above the value it would have solely from the demand occasioned by its acceptability to discharge tax liabilities.
Uneasy Money 