If you think Modern Monetary Theory is a rationale for ignoring federal budget deficits and spending whatever’s necessary to fund an ambitious progressive agenda — everything from tuition-free college to Medicare-for-All — you’re correct, in part. It’s certainly been used that way by the political left, much as supply-side economics has been used by the right to justify tax cuts for the one percent. But as Stephanie Kelton, an economics professor at the State University of New York at Stony Brook and the most visible (and persuasive) advocate of MMT, makes strikingly clear in The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, much of what underpins the theory is widely accepted by mainstream economists — if not mainstream politicians and the public. Indeed, while the terminology is different, one can make the case that MMT builds on fundamental precepts of Keynesian economics seasoned with a dash of Milton Friedman’s provocations. Read this excerpt with an open mind, and you may just begin to doubt the “common sense” of fiscal prudence.
— Peter Passell
illustrations by michal dziekan
Published January 24, 2021
*Published by PublicAffairs of the Hachette Book Group ( 2020). All rights reserved.
When I arrived in Washington in 2015, I was the only staffer on the U.S. Senate Budget Committee who looked at the world through the lens of a currency issuer. I knew the federal government wasn’t like a household or a private business. I knew Uncle Sam could never run out of money. I knew that inflation, rather than insolvency, was the relevant punishment for overspending. I also knew I was alone in this thinking.
Everyone else fell into one of two camps: deficit hawks or deficit doves. While Washington insiders depicted them as polar opposites, I saw them as birds of a feather. Both considered the long-term fiscal outlook a problem that needed to be fixed. Most Republicans wanted to slash entitlements, while most Democrats wanted to raise taxes. Different paths to the same destination.
As word spread that I would be heading to the nation’s capital to advise the Democrats, journalists fired off articles with headlines like “Sanders Hires Deficit Owl.” I had coined that term in 2010, as a way to distinguish the views held by modern monetary theory (MMT) economists like me from those of the more deficit-anxious birds. Most of the senators on the committee had never heard of MMT. When I met with the members of the committee for the first time, no one was rude, but I could sense that there was reticence about expanding the deficit aviary.
I looked for ways to help the committee without reinforcing myths and misunderstandings about our nation’s finances. One of the most eye-opening things I learned came from a game I would play with members of the committee (or their staffers). I’d start by asking them to imagine that they had discovered a magic wand with the power to eliminate the entire national debt with one flick of the wrist. Then I’d ask, “Would you wave the wand?” Without hesitation, they all wanted the debt gone. Then, I’d ask a seemingly different question: “Suppose that wand had the power to rid the world of U.S. Treasuries. Would you wave it?” The question drew puzzled looks. Eventually, everyone would decide against waving the wand.
They loved U.S. Treasuries, as long as they thought of them as financial assets held by the private sector. But they hated the very same securities when they considered them obligations of the federal government.
Eventually, I’d point out that I had asked two versions of the same question. Some of them told me they understood that waving the wand entailed eliminating the entire U.S. Treasury market, but they wanted the debt wiped out anyway, because it scares voters.
It’s So,Ooo,Ooo,Ooo,OOO Big
Of course voters are terrified! It’s virtually impossible to get through the workweek without encountering some form of hysteria over fiscal deficits and the national debt. A debt clock towers over pedestrians on West 43rd Street in New York City, delivering the daunting numbers in real time. Social media circulates breaking news alerts to report the latest dire projections from the Congressional Budget Office.
MYTH: One way or another, we’re all on the hook. REALITY: The national debt poses no financial burden whatsoever.
The truth is, we’re fine. The debt clock simply displays a historical record of how many dollars the federal government has added to people’s pockets without subtracting (taxing) them away. Those dollars are being saved in the form of U.S. Treasuries. If you’re lucky enough to own some, congratulations! They’re part of your wealth. While others may refer to it as a debt clock, it’s really a U.S. dollar savings clock. But you won’t hear that from anyone in Congress. Think about what would happen if a member of Congress returned to his or her district and tried to convince a roomful of panicked constituents that everything they deeply fear about our ballooning national debt is really a big nothing- burger.
Even if their own thinking wasn’t so broken, there are reasons members of Congress might not want the rest of us to see the so called debt for what it really is.
I remember being struck by this during a meeting with members of the Budget Committee. The Congressional Budget Office had projected that the fiscal deficit would stand at $1.1 trillion and the gross federal debt would reach $27.3 trillion in 2025. Mike Enzi, the committee’s chairman, suggested that the CBO be required to write the numbers out in long form: $1,100,000,000,000 and $27,300,000,000,000.
Once politicians like Senator Enzi succeed in making us anxious about the sheer size of this thing we label debt, they can weaponize that fear in a number of ways. By persuading voters that something must be done about these big scary numbers, politicians can push for cuts to popular programs like Social Security and Medicare. People will fight tooth and nail to protect them. Unless, of course, they can be convinced that there is no alternative. MMT shows that we don’t need to fix the debt. We need to fix our thinking.
China, Greece and Bernie Madoff
I can read the latest CBO report and not panic over the projected increase in the national debt. I don’t agonize over “my share” of the national debt, and I never worry about the U.S. ending up like Greece. I don’t fret over the possibility that China might one day shut off the spigot and starve the U.S. of the dollars we need to pay our bills. Heck, I don’t even think we should be referring to the sale of U.S. Treasuries as borrowing, or labeling the securities themselves as the national debt. So, let’s try to fix our thinking.
It was at a campaign stop in Fargo, North Dakota where Obama told a small crowd that America was relying on “a credit card from the Bank of China.” His choice of words was important because it taps into two of our basic anxieties. For one thing, there’s the fear of relying on borrowed money to pay the bills. Hearing that our country is running up trillions of dollars in credit card debt is enough to make anyone worry. Learning that we owe that money to a foreign nation — an adversary even – only heightens the anxiety.
In 2018, the U.S. exported $120 billion in U.S. manu factured goods to China, while China shipped $540 billion of its products to the U.S. The difference gave China a $420 billion mer chandise trade surplus.
It’s not that we don’t have anything to worry about when it comes to our international trading partners. But relying on China to pay our bills isn’t one of them. To see why, let’s take a step back and think about how China (and other foreign countries) end up holding U.S. government bonds.
What happens first is that China decides it wants to sell some of what it produces to buyers outside China. The U.S. does that, too, but America exports less than it imports. In 2018, the U.S. exported $120 billion in U.S. manufactured goods to China, while China shipped $540 billion of its products to the U.S. The difference gave China a $420 billion merchandise trade surplus. Americans paid for those goods with U.S. dollars, and those payments were credited to China’s account at the Federal Reserve.
Like any other holder of U.S. dollars, China has the option to sit on those dollars or use them to buy something else. Uncle Sam doesn’t pay interest on the dollars that China keeps in its checking account at the Fed, so China usually prefers to move them into what is effectively a savings account at the Fed. It does this by purchasing U.S. Treasuries. It’s still just sitting on its U.S. dollars, but now China is holding what I call “yellow” dollars instead of green ones.
The dollars don’t originate from China. They’re coming from the United States. We’re not really borrowing from China so much as we’re supplying China with dollars and then allowing those dollars to be transformed into U.S. Treasury securities. Terms like borrowing are misleading. So is labeling those securities the national debt. There is no real debt obligation.
Although China is the largest foreign holder of U.S. Treasuries, it owned less than 7 percent of the publicly held total at the time of this writing. Still, some people worry that this gives China enormous leverage over the U.S. because China could decide to sell off its holdings. The worry is that Uncle Sam could lose access to affordable financing if China refuses to keep buying Treasuries.
There are a number of problems with this thinking. For one thing, China can’t avoid holding dollar assets without wiping out its trade surplus with the United States. That’s not something China wants to do, since shrinking its exports to the U.S. would slow its economic growth. And even if it does decide to hold fewer U.S. Treasuries, this won’t leave Uncle Sam strapped for cash.
Remember, the U.S. is a currency issuer, which means it can never run out of dollars.
Even though it can’t happen to the United States, it is possible for a country to lose access to affordable financing. That’s what happened to Greece in 2010. But that’s because Greece undermined its monetary sovereignty by abandoning the drachma in favor of the euro in 2001. All of the Greek government’s existing debt was redenominated into euros, a currency that the Greek government could not issue. Lending to Greece was now a lot like lending to an individual U.S. state — say Georgia or Illinois.
As the 2008 financial crisis spread through Europe, tax revenues fell off a cliff. At the same time, the Greek government was making larger payments to support the ailing economy. That pushed Greece’s budget deficit to more than 15 percent of its GDP in 2009.
To cover those deficits, Greece had to borrow. The problem was that lenders weren’t willing to buy Greek government bonds unless they got a substantial premium for the obvious risk they were taking in lending billions of euros to a borrower who might have trouble paying it back. From 2009 to 2012, the interest rate on ten-year Greek government bonds rose from less than 6 percent to more than 35 percent!
Compare that with what happened in currency-issuing countries like the U.S. and the UK. Their fiscal deficits more than tripled from 2007 to 2009. And yet the average interest rate paid on ten-year government bonds fell from 3.3 percent to 1.8 percent in the U.S. and from 5 percent to 3.6 percent in the UK. That’s because both countries have a central bank that acts on behalf of the government as a monopoly supplier of the currency.
The government can strip markets of any influence over the interest rate on government bonds. That’s exactly what the Fed did during and immediately after World War II, and it’s what the BOJ is doing today.
Still, isn’t there some limit? Surely the U.S. debt can’t go on rising forever. To some people, finding new investors to purchase a never-ending mountain of government debt can start to look like a fraudulent pyramid scheme. The kind run by the notorious huckster Bernie Madoff. It isn’t.
Madoff was defrauding investors. The U.S. Treasury is not.
The U.S. could not end up like Greece, desiring to make scheduled payments to bondholders but lacking the authority to instruct its central bank to clear the payments. That’s because the federal government can always meet its obligation to turn those yellow dollars back into green dollars. All it has to do is change the relevant numbers on the Federal Reserve’s balance sheet.
Since our lawmakers have not yet had the benefit of MMT’s insights, they view debt service as a growing financial burden on the federal government. In truth, paying interest on government bonds is no more difficult than processing any other payment. To pay the interest, the Federal Reserve simply credits the appropriate bank account.
Right now, lawmakers look at rising interest expenditure the way we might look at a rising cable bill — it means less money to spend on everything else. So, when the CBO says that the federal government is on track to “spend more on interest payments than the entire discretionary budget … by 2046,” many lawmakers begin to panic. They think it shrinks the amount of money that’s left over, forcing them to spend less on other priorities. That’s just not true. There is, however, only so much room in the economy to safely absorb higher spending. That’s the constraint Congress needs to worry about.
The limit is our economy’s capacity to absorb that additional spending without pushing inflation higher. Every dollar that is paid in the form of interest becomes income to bondholders. If a high percentage of interest income was spent back into the economy, it could potentially push aggregate spending above potential, fueling some inflationary pressure. Even if bondholders aren’t spending enough of their interest income to fuel ordinary price inflation, they might still fuel asset price inflation by using their interest income to bid up the prices of commodities, real estate, stocks and so on.
The idea that the rest of us are personally liable for some portion of the national debt is preposterous. The truth is, the entire national debt could be paid off tomorrow, and none of us would have to chip in a dime.
We Could Pay It off Tomorrow
In April 2016, Time magazine devoted its cover to the U.S. national debt. It began, “Dear Reader, You Owe $42,998.12. That’s what every American man, woman and child would need to pay to erase the $13.9 trillion U.S. debt.”
The idea that the rest of us are personally liable for some portion of the national debt is preposterous. The truth is, the entire national debt could be paid off tomorrow, and none of us would have to chip in a dime.
That’s not how most economists see it.
Some do, however, argue that faster growth would help us deal with our “debt problem” because the problem is really the ratio of debt to the size or our economy. The trick, then, is to keep the debt ratio from heading north in perpetuity. For decades, conventional thinking held that the U.S. debt was on an unsustainable path because the formal models used to evaluate the debt trajectory all showed the ratio rising steadily higher into the indefinite future.
Today, some of the most influential economists in the world are telling us the debt might be sustainable after all, at least for now. For example, in January 2019, Olivier Blanchard, the former chief economist of the International Monetary Fund, made this the focus of his presidential address at the annual meeting of the American Economic Association. Blanchard explained that the debt trajectories for many countries, including the United States, appear to be on a sustainable path, at least in the near term. That’s because Blanchard expects interest on the debt to remain below the economy’s growth rate, which ensures that the debt ratio will not head off to infinity.
Blanchard argues we’re safe until financial markets push the interest rate above our economy’s growth rate, putting us right back on an unsustainable debt trajectory unless the budget has moved into surplus in the interim. Until then, we can relax and perhaps even safely increase the size of the fiscal deficit.
Blanchard’s more cautious take on sustain ability rests on the possibility that interest rates could eventually jump higher, leading to the kind of debt crisis that unfolded in Greece or Argentina.
These were important findings, but it should be pointed out that economist Scott Fullwiler (University of Missouri—Kansas City) made a similar observation 13 years earlier. The difference is that Fullwiler looks at debt sustainability through the MMT lens. Blanchard’s more cautious take on sustainability rests on the possibility that interest rates could eventually jump higher, leading to the kind of debt crisis that unfolded in Greece or Argentina. But the U.S. is not like Greece (which borrows in euros) or Argentina (which defaulted on U.S. dollar-denominated debt). It can’t lose control of its interest rate.
This is a critically important insight that distinguishes the MMT perspective on debt sustainability from more conventional thinking. Under MMT, it is inflation — not the relationship between interest rates and growth rates — that matters. Still, it’s easy enough for the U.S. (and other monetary sovereigns) to satisfy the conventional criteria for sustainability.
Just look at Japan. At 240 percent, Japan’s debt-to-GDP ratio is the highest in the developed world. Imagine the horror Senator Enzi would experience at the thought of more than a quadrillion (yen) in debt. That’s a lot of zeroes! But Japan, like the U.S., is fine, at least when it comes to debt sustainability, because it’s a currency-issuing government with a central bank that can clear every payment obligation that comes due. Financial markets can’t push Japan into crisis because the Bank of Japan (BOJ) can override any unwanted move in interest rates. It could also, essentially, retire the entire debt using nothing more than a computer keyboard at the BOJ.
Most of the world’s leading central banks focus on setting just one interest rate — a very short-term interest rate known as the overnight rate. They rigidly fix this rate and then allow longer-term rates to reflect market sentiment about the expected future path of the short-term policy-determined rate. That leaves investors with some influence over the interest rate that the U.S. government pays on Treasuries. But — and this is really important — the government can always strip markets of any influence over the interest rate on government bonds. Indeed, that’s exactly what the Fed did during and immediately after World War II, and it’s what the BOJ is doing today.
To keep a lid on interest rates, the Fed formally committed to maintaining a low-interest- rate peg of 0.375 percent on short-term Treasury bills and implicitly capped the rate First Quarter 2021 93 on long-term Treasury bonds at 2.5 percent. Even as deficits exploded and the national debt climbed from $79 billion in 1942 to $260 billion by the time the war ended in 1945, the federal government paid just 2.5 percent interest on long-term bonds. To hold rates at 2.5 percent, the Fed simply had to buy large quantities of U.S. Treasuries.
This required an open-ended commitment by the Fed, but it was an easy commitment to fulfill since the Fed purchases bonds simply by crediting the seller’s account with reserves. Coordination with fiscal policy officially ended in 1951, with an agreement known as the Treasury-Federal Reserve Accord, which freed the Fed to pursue independent monetary policy.
For more than three years, the Bank of Japan has been engaged in a policy known as yield curve control. In addition to anchoring the short-term interest rate, the BOJ committed to pinning rates on ten-year government bonds near zero. In carrying out that policy, the BOJ has purchased massive amounts of government debt, buying up ¥6.9 trillion in June 2019 alone.
As a result, the BOJ now holds roughly 50 percent of all Japanese government bonds. So half of its debt has already been essentially retired. And the BOJ could easily go all the way to 100 percent. Overnight.
To some, this might seem preposterous. How can the BOJ manufacture ¥500 trillion out of thin air to buy back the rest of the debt without devastating inflationary consequences? Most economists are trained to accept some version of the quantity theory of money. Strict adherents, such as followers of Milton Friedman, will likely scream, “Zimbabwe!” “Weimar!” or “Venezuela!”
Economist Eric Lonergan, a hedge fund manager in London, knows better. He correctly observes that swapping government bonds for cash has no effect on the private sector’s net wealth.
While net wealth is unaffected, buying the bonds does have an effect on income. When the BOJ replaces bonds with cash, the private sector loses out on any interest that would have been paid. So, retiring the debt siphons interest income out of the private sector. With this in mind, Lonergan asks, “Why on earth would the Japanese household sector rush out and buy things when their interest income has fallen, their wealth is unchanged, and they are used to falling prices?”
The short answer is, they wouldn’t. If anything, transferring all of the outstanding government debt to the central bank’s balance sheet would tend to push prices lower, not higher. I would think twice about stripping the private sector of all of its interest-bearing government bonds at once, but the Japanese government could certainly pull it off. The U.S. could do it, too.
Fiscal surpluses suck money out of the economy. Fiscal deficits do the opposite. As long as they’re not excessive, deficits can help to maintain a good economy by supporting in comes, sales and profits.
A Life Without Debt?
Just think of it. No one comparing Uncle Sam to a spendthrift who’s running up the credit card and borrowing from China. No fear of losing access to the bond market and being forced into default like Greece. No economists arguing about whether interest rates will be low enough to keep the debt on a sustainable path. And best of all, no more stress about how to cover “your share” of the national debt.
We actually did it once. It was 1835, and it was the only time in U.S. history when the public debt was paid all the way down. That was long before the Fed was created, so the debt wasn’t gobbled out of existence by the central bank. It happened because the government ran fiscal surpluses from 1823 to 1836. As bonds matured, the government simply paid them off.
By 1835, the U.S. was debt-free. It was also headed for one of the worst economic downturns the country has ever experienced. Fiscal surpluses suck money out of the economy. Fiscal deficits do the opposite. As long as they’re not excessive, deficits can help to maintain a good economy by supporting incomes, sales and profits. They’re not imperative, but if they disappear for too long, eventually the economy hits a wall.
Each and every time the government substantially reduced the national debt, the economy fell into depression. Could it have been a remarkable coincidence? As we see from MMT, government surpluses shift deficits onto the non-government sector. Eventually, the private sector reaches the point where it can’t handle the debt. When that happens, spending grinds sharply lower and the economy falls into depression.
The U.S. experienced one brief period of sustained fiscal surpluses relatively recently. It happened during Bill Clinton’s presidency, and many Democrats still look back on it as a crowning achievement. The surpluses began in 1998, and by 1999 the White House was ready to party like it was, well, 1999.
The White House was preparing to feature the news in its annual Economic Report of the President. But instead of shouting it from the rooftops, White House officials quietly tucked it away. They were worried about the broader implications of wiping out the entire U.S. Treasury market. It was a return to the love-hate relationship many public officials have with the national debt. On the one hand, the White House would have loved to eliminate the national debt. On the other, it couldn’t risk getting rid of all Treasuries.
Taxes aren’t important because they help the government pay the bills. They’re important because they help to prevent government spending from creat ing an inflation problem.
What worried policymakers the most was the prospect of depriving the Federal Reserve of the key instrument it relied on to conduct monetary policy — government debt. When the Fed wanted to raise interest rates, it sold some of its Treasuries. Buyers paid for those bonds using a portion of their bank reserves. By removing enough reserves, the Fed could move the interest rate up. To cut rates, the Fed would do the opposite.
But the Great Recession changed the way the Fed conducts monetary policy, proving Treasuries were not a crucial tool. In November 2008, the Fed launched the first of three rounds of a massive bond-buying program called quantitative easing. By the time it was over, the Fed had gobbled up some $4.5 trillion in bonds. In addition to using quantitative easing to push longer-term interest rates lower, the Fed also changed the way it managed its short-term interest rate. Instead of buying and selling Treasuries to add and subtract reserves, the Fed simply started paying interest on reserve balances. Today, the Fed can adjust the short-term interest rate simply by announcing that it will pay a new rate.
• • •
Times have changed. Taxes aren’t important because they help the government pay the bills. They’re important because they help to prevent government spending from creating an inflation problem. Similarly, bond sales aren’t important because they allow the government to finance fiscal deficits.
If we really want to make the national debt disappear, the most straightforward option is to simply let the central bank buy up government bonds in exchange for bank reserves. The thing we call the national debt is nothing more than a footprint from the past. What matters is not the size of the debt (or who holds it) but whether we can look back with pride, knowing that our stockpile of Treasuries exists because of the many (mostly) positive interventions that were taken on behalf of our democracy.