A relatively new school of thought called “Modern Monetary Theory” (MMT), which holds that governments that issue their own currencies do not have to worry about financial constraints on spending, has gained adherents among American progressives.

Newly elected Rep. Alexandra Ocasio-Cortez (D-N.Y.) has cited MMT in support of her claim that the U.S. government can afford a single-payer health care system.

ADVERTISEMENT

Many mainstream economists are sympathetic to a few of the claims made by MMT proponents, but only under very limited circumstances. Even that assessment may be too generous, as the entire theory is deeply flawed.

Proponents of MMT (and more government spending) are often viewed as fans of expansionary fiscal and monetary policy, arguing that the risks resulting from aggressively printing money and/or increasing the public debt are overstated.

Strictly speaking, however, true MMT only makes this claim in cases where the economy is not operating at full employment. When economic output pushes up against the limits of our productive capacity, even MMT proponents acknowledge that more spending financed by debt or money creation can lead to high inflation.

So, then, what exactly is wrong with the MMT approach to policy?

The basic problem is that MMT proponents mix up the roles of fiscal and monetary policy. They argue that monetary policy should play a supporting role, holding down interest rates to reduce the cost of public borrowing.

Meanwhile, the thinking goes, fiscal austerity should be the tool used to hold down inflation when aggregate spending begins to exceed the productive capacity of the economy.

Unfortunately, there is a long history suggesting that this approach will not work. In 1968, President Johnson raised taxes and balanced the budget, in the hope and expectation that this would hold down inflation. Instead, inflation got even worse, as monetary policy was still highly expansionary. It is monetary policy that determines the price level, not fiscal policy.

In the early 1980s, Paul Volcker’s Federal Reserve was finally able to end the great inflation expansion of 1966-81, and did so solely via a contractionary monetary policy. Indeed, even as the Fed was successfully bringing inflation sharply lower, the Reagan administration was adopting a highly expansionary fiscal policy, pushing the budget deficit dramatically higher.

Since the early 1990s, the Fed has been targeting inflation — at first implicitly, then after 2012 with an explicit 2-percent target. Personal Consumption Expenditure (the Fed's preferred measure of inflation) has averaged roughly 1.9 percent.

This is almost certainly not a coincidence, as inflation was much higher during the previous 25 years and much lower under the pre-war gold standard. There is nothing “normal” about 2-percent inflation — it reflects intentional Fed policy actions.

If MMT proponents are right that fiscal policy determines inflation, it would mean that Congress caused inflation to move toward a 2-percent trend line after 1990. Given what we all know about the dysfunction on Capitol Hill, where no one even pretends that they are adjusting the budget deficit to target inflation, how likely does that seem?

When the economy is depressed and interest rates are zero, it may seem like monetary policy is ineffective and fiscal policy is more powerful. This is why mainstream economists will often have a bit of sympathy for MMT, under very limited circumstances.

In my view, even that limited support is unwarranted. In 2013, we saw how even at the zero bound for interest rates, monetary policy is still more powerful than fiscal policy.

A dramatic $500 billion reduction in the budget deficit did not lead to the growth slowdown predicted by many Keynesian economists. It was fully offset by expansionary Fed actions and much more aggressive forward guidance.

Unfortunately, the underlying model used in MMT is based on false assumptions about the inflation process. If you start to rely on a flawed theory as a guide to policy, there will eventually come a time when it will lead policymakers astray, as happened when President Johnson relied on an MMT-type theory and accidentally triggered the greatest peacetime inflation in American history.

Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University.