Congressional Research Service — Deficit Financing, the Debt, and “Modern Monetary Theory” — Grant A. Driessen and Jane G. Gravelle

Explaining persistently low interest rates despite large deficits and rising debt has been one of the central challenges of macroeconomists since the end of the Great Recession. This dynamic has led to increasing attention to Modern Monetary Theory (MMT), presented as an alternative to the mainstream macroeconomic way of thinking, in some fiscal policy discussions. Such discussions are at times restricted by a difficulty, expressed by policymakers and economists alike, in understanding MMT’s core principles and how they inform MMT’s views on fiscal policy. MMT suggests that deficit financing can be used without harmful economic effects in circumstances of low inflation rates and low interest rates, conditions that currently exist despite indications that the country is at full employment.

This report surveys the available MMT literature in order to provide a basic understanding of the differences (or lack thereof) between the defining relationships established in MMT and mainstream economics. It then explores how such distinctions may inform policy prescriptions for addressing short- and long-run economic issues, including approaches to federal deficit outcomes and debt management. Included in this analysis are observations of how policy recommendations from MMT and mainstream economics align with current U.S. economic and governance systems.

In mainstream macroeconomic models, the asset market is characterized by the sensitivity of investment to interest rates, a determinant of investment returns. Money is typically defined as cash and close substitutes, and used for transactions and held as an asset. In the short run, the capital stock (equipment and other factors of production outside of labor) is assumed to be fixed, and output is dictated by the employment level. Fiscal and monetary policy decisions can be used to expand or contract the short-run economy (with distinct effects for each), and those decisions help to inform growth, the stock of capital and labor, and other decisions in the long run. In general, expansionary fiscal policies, including stimulus policies and other programs that increase net deficits and debt, are thought to be helpful when addressing negative shocks in demand, but they may crowd out private investment and reduce long-term growth if used when the economy is otherwise in balance. Persistent increases in real debt (which occurs when the stock of debt grows more quickly than the economy) are viewed as unsustainable, as they would eventually lead to a lack of real resources to borrow against.

Though some MMT adherents have disputed the notion that the model can be viewed through the basic macroeconomic framework, efforts to do so reveal a few key distinctions. In the MMT model of short-run behavior, investment decisions are insensitive to interest rates, and are instead a function of current consumption levels. MMT holds a much broader view of money, asserting that monetary value can be created by financial institutions in a way that renders monetary policy ineffective in dealing with short-run economic fluctuations. MMT supporters therefore prefer a larger fiscal policy role in managing business cycles than mainstream economists, generally claiming that fiscal borrowing constraints are less imposing than mainstream economists believe in countries with a sovereign currency, and call for direct money financing of fiscal policy actions by the central bank. The translation of the MMT approach to long-run output is unclear, though a jobs guarantee supported by MMT adherents would likely change the nature of the relationship between employment and output levels.

Full alignment with the economic and political system supported by MMT would likely involve a dramatic shift in the roles and powers of U.S. fiscal institutions. Adopting an MMT framework would involve much more fiscal policy to account for a reduced monetary policy role. Policymakers would also likely need to execute fiscal policy decisions more quickly than has been done in the past in assuming an increased role in economic management.

Projections of future debt growth due to spending pressures from social programs have led to a current concern about deficit financing, recognizing the institutional challenges in conducting tax and spending fiscal policy. MMT is largely focused on short-run management of the economy, with tax and spending policies aimed at maintaining a fully employed economy without inflation. The MMT approach appears to implicitly assume that a high level of debt will not be problematic because it can be financed cheaply by maintaining low interest rates. Underlying this policy is the assumption that Congress can act quickly to counteract deficit-driven inflation with tax increases or spending cuts that would allow the economy to maintain low interest rates on public debt.

I have not read the complete report yet, but I would be surprised if the MMT economists and legal scholars don't respond to it.

From the introduction, it seems to be to be a struggle in translating what is basically an theoretical approach based on institutional arrangements into a neoclassical  theoretical approach based on "natural" market forces and spontaneous organization.

This endeavor is difficult to impossible owing to vastly different methodological frameworks based on different presuppositions from which assumptions are derived. In other words, "You can't there from here" based on the differences is foundations.

But it is not just institutional matters either.

The MMT approach appears to implicitly assume that a high level of debt will not be problematic because it can be financed cheaply by maintaining low interest rates. Underlying this policy is the assumption that Congress can act quickly to counteract deficit-driven inflation with tax increases or spending cuts that would allow the economy to maintain low interest rates on public debt.

This is misleading. Actually, MMT proponents, both economists and legal scholars, have shown how ad hoc Congressional action is not the only factor involved. Nor is it the most salient one.

Good design of automatic stabilization, including tax policy, is much more significant, and the job guarantee plays a prominent role in this instead of being a policy add-on.

Moreover, the central bank sets the policy rate by choice, not market forces. The problem with central banks' monetary policy so far is that central banks don't have a good theory of inflation (and have admitted as much). It is therefore not surprising that their policy choices have been ineffective. MMT argues that fiscal policy is more suited to the task anyway.

In addition, money is endogenous in the MMT view, and the actions of banking and finance play a major role in changes in the money supply. Government regulation can address this, too.

Conventional economics distinguishes between cost-push (supply side) and demand-pull (demand side) inflationary pressure. Monetary policy, however, generally assumes demand-pull inflation — "too much money pursuing too few goods." Most recent inflation has been supply side induced, owing to shortages or bottlenecks in accessibility of real resources. This is especially the case when a cartel controls the oil price, for instance.

Thus, it should only be necessary for Congress to address inflationary pressure ad hoc is other institutional measures have failed. This would also indicate that the design of institutional arrangements needs to be revisited, perhaps owing to changing conditions in the context of a world economy.

Congressional Research Service

Deficit Financing, the Debt, and “Modern Monetary Theory”
October 21, 2019

Grant A. Driessen, Analyst in Public Finance, and Jane G. Gravelle, Senior Specialist in Economic Policy