Modern Monetary Theory (MMT) tells us that governments should finance public spending by creating money. To avoid inflation, MMT supporters say, the government should use taxes to siphon off excess purchasing power, which would allow the public sector to significantly expand its operations, thereby eliminating the scourge of underemployment.
In an era of skyrocketing national debt and subdued inflation, what was once a marginal school of thought with few adherents has captured the public imagination. Refuting MMT’s claims requires a bit of history, which shows that there is nothing “modern” about its prescriptions.
The promoters of MMT, who are mostly journalists and public intellectuals rather than professional economists, start from a few obvious truths: Governments cannot default if their debts are denominated in their own currency, and they can create a demand for their currency by imposing taxes obligations. From these premises, proponents of the theory jump to extraordinary conclusions: They argue that there are too many unused resources even in healthy economies, and that fiat finance is the key to mobilizing these resources. It sounds like a click trap: “Learn this weird trick to jumpstart the economy!” “
Similar measures have been tried before, right here in America, and they have worked. But that’s not good news for MMT fans, because understanding why currency financing worked then means seeing why it won’t work now.
A popular myth about the first US fiat currencies claims that various colonial and state governments created hyperinflationary catastrophes after experimenting with currency financing. But while New England and the Carolinas sometimes did damage before the War of Independence, most colonies managed to issue their own currency.
E. James Ferguson, historian of American public finances, explains how it worked: “Governments have met the expenses by issuing a paper medium…. [i.e., hard money, such as gold and silver coins] to those who held it, but accepting it for taxes or other payments.
This system had two major advantages. First, because hard money was scarce in the colonies, fiat money provided Americans with an indispensable medium of exchange. Second, controlled depreciation – a gradual decline in the purchasing power of money, which redistributed wealth from users of paper money to issuers – functioned as a uniform and relatively light form of indirect taxation. This has helped governments raise revenue at a time when the assessment of direct taxes was prohibitive.
These practices lasted until the beginning of the national period, between the ratification of the Articles of Confederation and the Constitution. Rampant inflation was rare. The settlers who became citizens were very happy with the foreign exchange financing. In fact, freedom-loving Americans viewed fiat currency as a way to preserve their freedom. “Most people thought of paying in cash to mean permanent debts, heavy taxes, in short, oppression,” Ferguson observes. “Freedom in their minds was associated with paper money.” It meant debt that was never paid off – just rolled over. Permanent public debt in Britain’s case came to be identified with empire, commercialism, and other forms of “great game” in the art of government – all things Jeffersonians, at least. , wanted to avoid.
Economic historian Edwin J. Perkins agrees. “Most governments have withdrawn or refinanced through debt the fiat currencies issued in the 1780s at face value, or roughly, through tax collections or mortgage payments from private borrowers.” writes Perkins.
Money entered into circulation in two ways. The first was through state-authorized “land banks”, which granted short-term mortgages for the improvement of agricultural or commercial operations. The second was through tax anticipation invoices, usually reserved for financial or war emergencies. It worked because, to paraphrase a popular economic maxim, it was “timely, targeted and temporary”.
If anything, this system worked too much finally, at least in the eyes of the Founding Fathers. Men like Alexander Hamilton, Robert Morris, and George Washington longed for a stronger national government and saw local traditions of public finance as an obstacle to their plans for centralization. Although the nationalists prevailed with the ratification of the Constitution, that does not change the impressive record of foreign exchange financing during the pre-constitutional period.
But this record also explains why financing in fiat currency, under the guise of MMT, will not work today. The first funding in US currency was monitored by several political feedback mechanisms.
The first was local democratic control. Because of the much smaller populations, legislatures were easier to discipline.
Second, jurisdictional competition. If a legislature let monetary financing get out of hand in one place, a jurisdiction whose government had its books in order was never too far away.
Third, economic independence. Due to the prevalence of agriculture, subsistence farming and bartering with neighbors offered an outside option, especially in rural areas.
Fourth, the foreign exchange financing met specific needs. Relatively small and focused governments could use fiat money as a more secure financing mechanism.
None of these conditions no longer exist. MMT advocates think their system can work nationally, but they are wrong. It is much more difficult for citizens to discipline the tax authority today, whether by “voting with their feet” or “moving in the hills”. And because MMT would transform the fiscal and monetary landscape across the country, it is anything but “timely, targeted and temporary.”
Also, even assuming taxes can keep inflation low, does anyone trust today’s inane politicians to pass unpopular levies? Without the economic backing mechanisms, MMT is exactly what its critics claim: a sure-fire way to turn a functioning economy into a financial basket.
Currency financing may be as American as apple pie, but MMT is not. The political and economic circumstances that once made it attractive are gone and will not return. Our tax process is indeed broken, and persistent unemployment is certainly a social disease. But MMT offers a cure worse than the disease. Finance through fiat money should remain in the history books.