The Covid pandemic has challenged every modern societal practice and turned it upside down. Countries have shut down their airspaces to international flights. Working from home is now the norm in major service industries. People who used to wear masks to fight off pollution are donning them to fight the community spread of a virus. Pollution, as we have known it, is no longer an issue as birds sing and wildlife re-enters our neighbourhoods.
Also, budget deficits don’t seem to matter any more. Last week, Europe agreed to stimulate its economy by injecting 750 billion euros. Japan, in May, approved $1.1 trillion in extra spending. America, in March, agreed to a whopping $2.5 trillion Coronavirus stimulus package, amounting to nearly 56 per cent of its annual budget. Now, there’s talk of an additional stimulus injection of over $1 trillion as Covid cases continue to rise and a wobbly U.S. economy may have to see parts of it shut down again.
Economists who argue that budget deficits, in the traditional sense, don’t matter are said to promote the so-called Modern Monetary Theory (MMT). A key leader in this movement is Stephanie Kelton, a professor of economics and public policy at Stony Brook University, and an advisor to the Bernie Sanders campaign. She was named by Politico as one of the 50 people most influencing the policy debate in America.
Income inequality
Kelton’s idea of using government funds for lowering income inequality is not new. Even classic libertarian economists, the late Nobel Laureate Milton Freidman among them, were in favour of programmes guaranteeing a Universal Basic Income (UBI). The rationale was that people at the lowest levels of income spend, rather than save, any money that they have, and this not only helps address poverty, but it also stimulates the economy.
We have seen Friedman’s UBI theory tested well during the last four months as Covid devastated the average American household. Forced to stay at home, Americans, with little saved up for a rainy day, found themselves short of money to buy food, clothing, and pay for housing.
The CARES Act, which pumped $2.5 trillion into the economy, sent out one-time checks of $1,200 per person for anyone who filed income taxes. The unemployment insurance programme has been so generously funded with bonus payments of $600 a week, over and above their regular unemployment benefit, that for the last four months, workers are receiving more money each week sitting at home than they would be earning at work. Small businesses were allowed to apply for $350 billion in loans, all of which would be forgiven if 75 per cent of the money was used to pay employees to stay at home.
A just economy
Where Kelton’s idea is revolutionary is not that government spending lowers inequality. From the time when John Maynard Keynes popularised the idea that governments are integral to economic development, this idea has never been in dispute. But Kelton takes a radical turn in arguing that governments could finance such heavy spending through borrowing, indefinitely even, to reach policy goals. For example, she says that deficits should be used to build a more just economy that works for the many and not just a few.
So, could India simply begin printing money to fund its anti-poverty programmes? Could France and Germany borrow indiscriminately to fund their favourite climate change initiatives?
Kelton effectively concedes that these countries could not practice MMT because they are not truly independent when it comes to their currencies. France and Germany are dependent upon the ECB to make decisions on the Euro’s money supply. While India is independent - the RBI does control the destiny of the rupee after all - India cannot borrow from foreign investors in its own currency. To fund expansion, Indian entities borrow in dollars and pay back their obligations in dollars.
Service debt
So, for Kelton’s idea to work, a country must be able to borrow in its own currency. The US, Japan, and the UK all enjoy this privilege. These countries can print as much money as they want because the deficits are simply funded by the surpluses of someone else, domestic or abroad. There will always be sufficient demand for the currency, this theory goes, that even if some don’t want to be in on the action, others would line up to lend to these countries.
In such a scenario, these countries never have to pay back their debt. All they do is to service the debt by paying interest on the amounts borrowed, which is what investors truly want - a regular rate of return. And should these countries want to borrow even more money, they would simply print more of it.
So what would reign in MMT? Inflation. When governments have borrowed so much money and flooded the market, the value of the currency will fall, and the price of goods and services will begin to rise. If inflation goes beyond a certain set threshold, it is time to dial back MMT efforts.
Fiscal stimulus
A drop in the currency’s value would also destabilise foreign exchange markets. Stephen Roach, a Yale University senior fellow, and former Morgan Stanley Asia chairman, told MarketWatch last month that the dollar could decline 35 per cent against its major rivals. “This massive shift to fiscal stimulus is going to blow out the national savings rates and the current-account deficit.” So, MMT is not without its limits.
Until just six months ago, MMT was considered to be such a fringe idea that it was pooh-poohed by traditional economists as pure fantasy. But Covid has made governments resort to unprecedented actions both on the fiscal side (by embracing deficits for many years to come) and on the monetary side (by driving interest rates to zero and engaging in quantitative easing). Extraordinary times require extraordinary measures.
But would governments resort to MMT as standard policy after the pandemic subsides - to address broader policy goals such as narrowing income inequality? No one knows.