Modern Monetary Theory

by bruce bartlett
Alex Wong/Getty Images

bruce bartlett was a policy advisor to President Reagan and a deputy assistant secretary of the Treasury in the George H.W. Bush administration.

Published May 24, 2019


In recent months, a number of Democrats and others on the political left have become enamored with some economic propositions they have dubbed Modern Monetary Theory, or MMT. I don’t think it is an insult to any of its proponents to say that it is a fringe theory among academic economists. It has gotten the attention it has thus far not via debate at academic conferences or articles in scholarly journals, but rather because it has policy implications that are very, very attractive to politicians. It offers them a way to pay for expensive programs such as the Green New Deal and Medicare-for-all without having to cut other spending or raise taxes. The government, some MMT fans argue, can simply create money to finance deficits without concern that it will lead to inflation.

When I hear people talk about MMT this way I have a strong sense of déjà vu because I was involved in an earlier effort to use a fringe economic theory to obtain something for nothing — specifically, the theory that huge tax cuts wouldn’t add to the budget deficit because they would so stimulate economic growth that the same revenue would be collected at a lower tax rate.

Déjà Vu All Over Again

I’m talking, of course, about the Laffer curve, named for the economist Arthur Laffer. I learned it straight from him while on the staff of Rep. Jack Kemp back in the 1970s. He and Laffer’s Boswell, Jude Wanniski of the Wall Street Journal, were regular visitors to Kemp’s office, where we often had impromptu seminars on how to enact the 30 percent tax rate reduction Kemp had co-sponsored with Sen. William Roth in 1977.

Our principal problem was that the Republican Party in those days actually cared about deficits and the importance of at least trying to balance the federal budget. Moreover, inflation was arguably the nation’s most serious economic problem at the time, and budget deficits were widely believed to be inflationary. Any policy that would make inflation worse was clearly a non-starter, politically.

If Republicans had greater numbers in the House and Senate, they might have pushed through sufficient spending cuts to pay for a big tax cut. But in the 95th Congress, Republicans had just 38 seats in the Senate and 143 in the House. In any event, while Democrats of that era couldn’t be sold on spending cuts, they were, if anything, even more conservative than most Republicans about opposing a tax cut that would add to the deficit. Indeed, much of the opposition to the Kennedy-Johnson tax cut enacted in 1964 had come from deficit-averse southern Democrats.

There at the Creation

The Laffer curve argument in Kemp’s office actually predated Laffer’s arrival in Kemp’s orbit. Its true father was the economist Norman Ture, who had been deeply involved in the Kennedy-Johnson tax cut as a Congressional staffer. It was undoubtedly Ture’s doing that during floor debate House Ways and Means Committee chair Wilbur Mills asserted, “The tax reductions, after a brief transitional period, will actually increase revenues above the levels that would have been achieved in the absence of tax reductions.”

Although the official revenue estimate from the Joint Committee on Taxation showed large revenue losses from the 1964 tax cut, Kennedy himself often implied that a Laffer curve effect was possible. Indeed, Kennedy sounded so much like Republican Treasury Secretary Andrew Mellon, who slashed taxes in the 1920s, that the New Republic teased him about it (“Andrew Mellon on Tax Cuts,” March 23, 1963).

When I arrived in Kemp’s office in late 1976, Ture had already done a revenue estimate of an early Kemp tax plan called the Jobs Creation Act that included only a small personal tax cut but a very large one for businesses. Ture projected positive net revenues even in the first year of the tax cut, with net revenues rising continuously thereafter. I was disinclined to believe this, but I used it in my work of persuading Republicans in the House to co-sponsor Kemp’s legislation. I tried to make sure they understood that I was speaking theoretically, but there’s no question I downplayed the impact on the deficit.

What I did believe is that a tax cut would not lose nearly as much revenue as standard revenue-estimating methods showed. The Treasury and the JCT basically said that, if you cut rates by, say, 10 percent, revenues would fall 10 percent. I thought that expanded economic activity might recoup a third of that lost revenue, a view shared by the Congressional Budget Office.

The problem was that, when it comes to revenues, the CBO is not Congress’s official estimator. It defers to the JCT, which in effect assumed that even a really large tax cut would have no effect on output or employment.

Nevertheless, the politics were such that just diminishing the impact of a tax cut on the deficit would do a great deal to aid its passage. For one thing, it showed that it had a highly stimulative economic effect even if it didn’t pay for itself.

Where Monetary Policy Fits In

An interesting footnote to the Laffer argument that I was not aware of at the time has to do with his idea of how monetary policy affects the economy, which is very similar to the MMT view. Back in 1971, Laffer had been chief economist for the White House Office of Management and Budget. He estimated, based almost entirely on monetary effects, that the GNP would be $1.065 trillion in 1971.

In Laffer’s view, increases in the money supply affected nominal output almost instantaneously. So based on the money supply data in hand, Laffer got his forecast, which was well higher than that of other government economists including those at the Council of Economic Advisers and the Federal Reserve Bank.

Although later data showed that Laffer actually sharply underestimated growth, the controversy pretty much destroyed his academic reputation. Even Milton Friedman, the godfather of monetarism, thought that the money supply only affected the economy with a considerable lag, and rejected the Laffer model in an interview with Hobart Rowen of the Washington Post. The New York Times published a satirical poem about Laffer’s money machine. Here’s the first stanza (M is the money supply):

They laughed at Laffer’s money machine.
Such a quaint econometric model has seldom been seen.
Four simple equations led Laffer to say,
Output and M go up almost the same day.

I have often wondered whether Laffer’s expansive view of the impact of tax cuts on the economy was based on an underlying assumption that the Fed would accommodate the increased deficit by increasing the money supply sufficiently to offset upward pressure on interest rates. It would help explain why some mainstream Republican economists such as Herb Stein, a member of the CEA in 1971, were so hostile to Laffer’s tax ideas. They thought it was more magic money machine nonsense.

Keynes Behind the Curtain

Of course, no economist denied the possibility that tax rates may be so high as to diminish revenue below what more moderate rates might bring in. Even John Maynard Keynes thought so. In “The Means to Prosperity” (1933) he wrote, “Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”

In any event, the issue was never about the theory but about the precise impact of a particular tax cut. There is no question that the Reagan tax cut lost hundreds of billions of dollars in revenue and never came close to paying for itself even when Reagan’s 11 major tax increases from 1982 to 1988 are accounted for. On the other hand, the tax cut was undoubtedly a major reason the transition from high inflation to price stability in the early 1980s was relatively quick and painless compared to contemporary expectations.

Always lost in debate about the economic impact of the Reagan tax cut is its powerful Keynesian underpinnings. His big increase in defense spending, which largely involved purchases of goods and services accommodated by an easy Federal Reserve policy, was textbook Keynesianism.

Keynes, however, is the bête noire of all conservatives. There is no more cutting epithet that one conservative economist can hurl at another than that he or she is a Keynesian. Ironically, the main conservative criticism of Keynes is that he promised something-for-nothing — government programs and services that effectively cost taxpayers nothing because they were paid for with budget deficits.

Empirical studies have long shown that tax cuts have a much weaker expansionary effect than an equal amount of increased government spending on goods and services. Even many liberals miss this critical point, making the mistake of supporting policies such as tax rebates or increased transfer programs that have virtually no stimulative effect.

Republicans could still have claimed a Keynesian justification for the 1981 tax cut, as JFK had done for his tax cut in 1963. One reason they didn’t is because empirical studies have long shown that tax cuts have a much weaker expansionary effect than an equal amount of increased government spending on goods and services. Even many liberals miss this critical point, making the mistake of supporting policies such as tax rebates or increased transfer programs that have virtually no stimulative effect.

MMT Reinterpreted

One problem is that tax cuts and transfers tend to be saved and thus do not increase spending in the economy. In the short run, spending, whether for investment or consumption, is what drives growth. A key reason is that it stimulates monetary policy to become more effective by causing money to be spent more quickly, something economists call “velocity.” Velocity is defined as GDP divided by the money supply. When it rises, it is stimulative, exactly like an increase in the money supply; when it falls, it has a depressing effect just like Fed tightening. The economic boom of the 1990s was largely due to an increase in velocity, and the depressed economic conditions since then are due to a fall in velocity.

MMT advocates are partially on the right track in seeing the economic importance of the money supply. But the way MMT is most likely to be stimulative is by raising inflationary expectations. As Keynes explained clearly in The Treatise on Money (1930), inflation stimulates spending in the short run because people and businesses will buy things now that they think they will need in the future before prices go up. To the extent they are right, MMT advocates tell us nothing that wasn’t explained much better by Keynes.

Another place to find antecedents of MMT is in the old Soviet Union. According to the economist Franklyn D. Holzman’s 1962 book, Soviet Taxation, the nation had pretty much a pure MMT system — all Soviet businesses had unlimited overdraft privileges at the central bank and just wrote checks for whatever they needed. Taxation existed for the sole purpose of withdrawing excess purchasing power from the economy and keeping inflation in check.

Of course it must be remembered that all wages and prices were set by the state. The government could raise whatever revenue it needed without taxation simply by adjusting prices; all revenue flowed to state-owned enterprises. It could also achieve whatever distribution of income it chose by adjusting wage rates. Therefore, there was no need for taxation in the traditional sense; taxation was in effect an “open market” operation such as the Fed carries out when it buys or sells Treasury securities. (When people/businesses sell their bonds to the Treasury for cash the money supply increases, and vice versa.)

In my view, these theoretical aspects of MMT have almost nothing to do with its political popularity. That is due to the belief by many progressives that they need not pay for any of their programs with taxes or other spending cuts — that the money supply can simply be expanded to pay for everything, at least up to the point where inflation becomes a problem.

I understand the lure of something-for-nothing. The Laffer curve set off an orgy of Republican tax cuts that just kept on going and going, long past the point where there was any rational economic justification for them. The same snake oil was proffered by the Trump administration to falsely assert that the 2017 tax cut paid for itself and will not increase the debt by trillions of dollars.

I think we need more government spending for a variety of things and have no problem with using deficits to pay for them in the current environment. I also think it is unwise for the Fed to be tightening monetary policy; it could afford to monetize higher deficits to some extent.

But I also think we need to keep a close eye on inflation. Although it has been startlingly low for some years, I think it is foolish to believe it is permanently dead, as some MMT advocates assert. One need not accept MMT to believe any of the things I believe we should do. What’s more, I think it risks poisoning the well of good policy to make it a central part of a progressive agenda.

The Laffer curve magic was not necessary to favor a tax cut in the 1970s. Alan Greenspan did so while completely rejecting the Laffer curve as a marketing device. By the same token, MMT is not necessary to justify a progressive agenda. Polls show that there is strong support for higher taxes on the wealthy. I say let’s raise them and leave MMT in our back pocket.

main topic: Monetary Policy