A Skeptic’s Guide to Modern Monetary Theory

By N. Gregory Mankiw*

Harvard University

December 12, 2019

Prepared for the AEA Meeting, January 2020

*Harvard University, Cambridge MA 02138. (e-mail: [email protected]). I am grateful to

macroeconomics, dubbed Modern Monetary Theory (MMT) by its proponents. MMT burst on

the scene in an unusual way. From its name, one might guess that it arose at top universities, as

prominent scholars debated the fine points of macroeconomic theory. But that is not the case.

Instead, MMT was developed in a small corner of academia and became famous only when some

high-profile politicians—particularly Senator Bernie Sanders and Representative Alexandria

Ocasio-Cortez—drew attention to it because its tenets conformed to their policy views.

This history is enough to make academics like me skeptical, but it is not sufficient to

reject the theory. Even ideas that arise in unusual ways can be right. So I recently tried to figure

out what MMT was all about. I wanted to identify the key differences between this new approach

to macroeconomics and the approach in mainstream textbooks, such as my own.

Fortunately, there was an ideal vehicle for this endeavor. In 2019, Red Globe Press

published a new textbook, simply titled Macroeconomics, written by three MMT proponents:

William Mitchell and Martin Watts (both of University of Newcastle, Australia) and L. Randall

Wray (Bard College). This brief essay explains what I have learned about MMT from this

textbook treatment.

At the outset, I should admit that I found the task of figuring out MMT to be vexing. As I

studied it, I was often puzzled about what precisely was being asserted. I hasten to add that the

problems I had could have been of my own making. Perhaps after forty years in the profession, I

am too steeped in mainstream macroeconomics to fully appreciate MMT. I raise this possibility

because MMT proponents may say that I missed the nuances of their approach. But what follows

is my honest reaction to MMT after a sincere effort to understand it.

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 MMT begins with the government budget constraint under a system of fiat money.

According to Mitchell, Wray, and Watts (hereafter MW&W), the standard approach, which

relates the present value of tax revenue to the present value of government spending and the

government debt, is misleading. They write, “The most important conclusion reached by MMT is

that the issuer of a currency faces no financial constraints. Put simply, a country that issues its

own currency can never run out and can never become insolvent in its own currency. It can make

all payments as they come due.” (MW&W, p. 13) As a result, “for most governments, there is no

default risk on government debt.” (MW&W, p. 15)

When reading these words, my reaction alternates between languid concession and

vehement opposition. To be sure, a currency-issuing government can always print more money

when a bill comes due. That ability might seem to release the government from any financial

constraints. Certainly, if an individual were granted access to the monetary printing press, his or

her financial constraints would become much less binding. But I am reluctant to reach a similar

conclusion for a national government, for three reasons.

First, in our current monetary system with interest paid on reserves, any money the

government prints to pay a bill will likely end up in the banking system as reserves, and the

government (via the Fed) will need to pay interest on those reserves. That is, when the

government prints money to pay a bill, it is, in effect, borrowing. The money can stay as reserves

forever, but interest accrues over time. An MMT proponent will point out that the interest can be

paid by printing yet more money. But the ever-expanding monetary base will have further

ramifications. Aggregate demand will increase due to a wealth effect, eventually spurring

inflation.

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 Second, if sufficient interest is not paid on reserves, the expansion in the monetary base

will increase bank lending and the money supply. Interest rates must then fall to induce people to

hold the expanded money supply, again putting upward pressure on aggregate demand and

inflation.

Third, the increase in inflation reduces the real quantity of money demanded. This fall in

real money balances, in turn, reduces the real resources that the government can claim via money

creation. Indeed, there is likely a Laffer curve for seigniorage. A government that acts as if it has

no financial constraints may quickly find itself on the wrong side of this Laffer curve, where the

ability to print money has little value at the margin.

Faced with these circumstances, a government may decide that defaulting on its debts is

the best option, despite its ability to create more money. That is, government default may occur

not because it is inevitable but because it is preferable to hyperinflation.

This discussion brings us to the theory of inflation. I have been adopting the mainstream

view, explained most simply by the quantity theory of money, that a high rate of money creation

is inflationary. Proponents of MMT question that conclusion. They assert that “no simple

proportionate relationship exists between rises in the money supply and rises in the general price

level.” (MW&W, p. 263)

This assertion overstates the case against the mainstream view. In U.S. decadal data since

1870, the correlation between inflation and money growth is 0.79. Cross-country data exhibit a

similarly strong correlation. (Mankiw, 2019, pp. 109-110)

Nonetheless, mainstream macroeconomists also go beyond the most simplistic quantity

theoretic reasoning. They stress that money demand can be unstable, that distinguishing

monetary and nonmonetary assets is difficult in a world of rapid financial innovation, that

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expected future money growth can influence current inflation when people are forward-looking,

and that various factors beyond monetary policy influence aggregate demand and inflation. They

also acknowledge that, under current policy arrangements, central banks target interest rates in

the short run and inflation in the longer run and that monetary aggregates play a small role. But

these ideas refine the quantity theory of money rather than refute it.

MMT proponents advance a very different approach to inflation. They write, “Conflict

theory situates the problem of inflation as being intrinsic to the power relations between workers

and capital (class conflict), which are mediated by government within a capitalist system.”

(MW&W, p. 255) That is, inflation gets out of control when workers and capitalists each

struggle to claim a larger share of national income. According to this view, incomes policies,

such as government guidelines for wages and prices, are a solution to high inflation. MMT

advocates see these guidelines, and even government controls on wages and prices, as a kind of

arbitration in the ongoing class struggle. (MW&W, pp. 264-265)

Mainstream theories of inflation emphasize not class struggle but excessive growth in

aggregate demand, often due to monetary policy. This idea also appears in MMT. Its proponents

admit that “all spending (private or public) is inflationary if it drives nominal aggregate demand

above the real capacity of the economy to absorb it.” (MW&W, p. 127)

The advocates of MMT, however, make this possibility seem more hypothetical than real.

We are also told that “capitalist economies are rarely at full employment. Since economies

typically operate with spare productive capacity and often with high rates of unemployment, it is

hard to maintain the view that there is no scope for firms to expand real output when there is an

increase in nominal aggregate demand.” (MW&W, p. 263)

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 At the risk of seeming like the boy with the hammer who thinks everything is a nail, let

me connect this observation from MMT with mainstream new Keynesian research, some of

which I participated in a while back.

Let’s first recall the work on general disequilibrium from the 1970s. (Barro and Grossman,

1971; Malinvaud, 1977) These theories took wages and prices as given and aimed to understand

the allocation of resources when markets failed to clear. According to these theories, the

economy can find itself in one of several regimes, depending on which markets are experiencing

excess supply and which markets are experiencing excess demand. The most interesting regime

is the so-called “Keynesian regime” in which both the goods market and the labor market exhibit

excess supply. In the Keynesian regime, unemployment arises because labor demand is

insufficient to ensure full employment at prevailing wages; the demand for labor is low because

firms cannot sell all they want at prevailing prices; and the demand for firms’ output is

inadequate because many customers are unemployed. Recessions result from a vicious circle of

insufficient demand.

Now fast forward to the next decade. Because so much of the Keynesian tradition

assumed that wages and prices fail to clear markets, subsequent new Keynesian research, mostly

during the 1980s, aimed to explain wage and price adjustment. This literature explored various

hypotheses: that firms with market power face menu costs when changing prices; that firms pay

their workers efficiency wages above the market-clearing level to promote worker productivity;

that wage and price setters deviate from perfect rationality; and that there are complementarities

between real and nominal rigidities. (Yellen, 1984; Mankiw, 1985; Akerlof and Yellen, 1985;

Blanchard and Kiyotaki, 1987; Ball and Romer, 1990)

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 There is an important but often neglected relationship between these two lines of new

Keynesian research. In particular, one can view the later work on wage and price setting as

establishing the centrality of the Keynesian regime highlighted in the earlier disequilibrium

research. When firms have market power, they charge prices above marginal cost, so they always

want to sell more at prevailing prices. In a sense, if most firms have some degree of market

power, then goods markets are typically in a state of excess supply. This theory of the goods

market is often married to a theory of the labor market with above-equilibrium wages, such as

the efficiency-wage model. As a result, the Keynesian regime of generalized excess supply is not

just one possible outcome for the economy, but the typical one.

This logic brings me back to MMT. The conclusion that “economies typically operate

with spare productive capacity” can be interpreted as meaning that economies are usually in the

Keynesian regime of generalized excess supply. In that sense, MMT is akin to new Keynesian

analysis.

At this point, it is worth distinguishing the natural level of output and employment from

the optimal level. The natural level is the level where the economy finds itself on average and

toward which the economy gravitates in the long run, whereas the optimal level is the level that

maximizes social welfare. When generalized excess supply is the norm due to pervasive market

power, the natural level is below the optimal level.

Inflation tends to rise when output and employment exceed their natural levels, even if

they remain below their optimal levels. After all, price setters do not aim to maximize social

welfare. They aim to maximize private welfare, and they do so by hitting their target mark-ups of

prices over marginal cost.

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 Here is where MMT economists diverge from new Keynesians. An MMT economist

might say that policymakers should aim for the optimum. If price setters are thwarting that goal

by raising prices, policymakers can fix that problem by using price guidelines or price controls.

A new Keynesian would admit that, in a world of pervasive market power, private price setting is

not first-best. But while getting the government involved in price setting might improve the

allocation of resources from the standpoint of simple theory, the complexity of the economy and

the history of price controls suggest that this solution is not practical.

In the end, my study of MMT led me to find some common ground with its proponents

without drawing all the radical inferences they do. I agree that the government can always print

money to pay its bills. But that fact does not free the government from its intertemporal budget

constraint. I agree that the economy normally operates with excess capacity, in the sense that the

economy’s output often falls short of its optimum. But that conclusion does not mean that

policymakers only rarely need to worry about inflationary pressures. I agree that, in a world of

pervasive market power, government price setting might improve private price setting as a matter

of economic theory. But that deduction does not imply that actual governments in actual

economies can increase welfare by inserting themselves extensively in the price-setting process.

Put simply, MMT contains some kernels of truth, but its most novel policy prescriptions

do not follow cogently from its premises.

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References

Akerlof, George A. and Janet L. Yellen. 1985. "A Near-Rational Model of the Business Cycle

with Wage and Price Inertia.” The Quarterly Journal of Economics. Suppl., 100, pp. 823-

838.

Ball, Laurence, and David Romer. 1990. “Real Rigidities and the Non-Neutrality of Money.”
The Review of Economic Studies. 57:2, pp. 183-203.

Barro, Robert J. and Herschel I. Grossman. 1971. “A General Disequilibrium Model of Income
and Employment.” American Economic Review. March, 61:1, pp. 82-93.

Blanchard, Olivier Jean and Nobuhiro Kiyotaki. 1987. “Monopolistic Competition and the
Effects of Aggregate Demand.” American Economic Review. September, 77:4, pp. 647-
666.

Malinvaud, Edmond. 1977. The Theory of Unemployment Reconsidered. Oxford: Blackwell.

Mankiw, N. Gregory. 1985. “Small Menu Costs and Large Business Cycles: A Macroeconomic

Model of Monopoly.” The Quarterly Journal of Economics. May, 100:2, pp. 529-537.

Mankiw, N. Gregory. 2019. Macroeconomics, 10th edition, New York: Worth Publishers.

Mitchell, William, L. Randall Wray, and Martin Watts. 2019. Macroeconomics, London: Red

Globe Press.

Yellen, Janet L. 1984. “Efficiency Wage Models of Unemployment.” American Economic

Review, May, 74: 2, pp. 200-205.

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