Economy & Business

What The Deficit Myth Lacks

The Federal Reserve building in Washington, D.C., May 1, 2020. (Kevin Lamarque/Reuters)
Economist Stephanie Kelton’s supposed epiphany fails to convince.

Early in her new book, The Deficit Myth, economist Stephanie Kelton describes the “Copernican moment” that led her to Modern Monetary Theory (MMT). As a young economist, Kelton read Warren Mosler’s book Soft Currency Economics, which posits that currency-issuing governments need not finance their spending by taxing and borrowing. In Mosler’s view, based on the early 20th-century theory of “chartalism,” a currency begins circulating not because it is a useful medium of exchange, but because a government compels its use. The government then has a monopoly on the currency, so the only reason for taxing or borrowing is to effect certain economic outcomes (e.g., moving interest rates). As Kelton read Mosler’s work, her head spun, she tells us. She was in shock. Just as Copernicus “changed our understanding of the cosmos,” she says in the book’s introduction, so MMT will transform “how we understand the deficit and its relationship to the economy.”

Kelton, who advised the 2016 Bernie Sanders presidential campaign and teaches at Stony Brook University, wrote The Deficit Myth in order to share her epiphany with the uninitiated. Before elucidating her Theory of Everything, Kelton gives fair warning of the shock and awe that will follow: “You should probably sit down. Are you ready?” (I tend to read while seated anyway.)

With Mosler’s theory of money as its foundation, MMT holds that a currency-issuing government faces no financial constraints on its spending. Because the government can create as much currency as it pleases, it can fund all its spending by printing money, rather than taxing or borrowing. The Deficit Myth posits this as an incontrovertible truth, which, in some sense, it is. The fact that governments can derive revenue from “seigniorage” — the difference between the cost of printing currency and the value of that currency — has long been known to economists. Most undergraduate economics students learn it in their introductory macro courses.

Those students then learn that seigniorage carries an inflation tax, because expanding the supply of currency increases prices. In 1995, two years before Kelton had her epiphany, an academic study pegged the maximum possible amount of revenue from money printing at 4 percent of GDP, with a cost of 266 percent inflation.

But Kelton rejects the quantity theory of money, instead arguing that inflation arises when growth surpasses “real resource constraints,” i.e., the stock of labor and capital. So long as the economy is below its “internal speed limit” (elsewhere called “full potential”), an additional dollar of government spending will expand production, argues Kelton. Should spending exceed the internal speed limit, governments can simply increase tax rates in order to reduce aggregate demand.

Far from groundbreaking, the MMT model of inflation simply restates the Phillips Curve, which posits a permanent tradeoff between inflation and unemployment. Since its introduction in the 1950s, though, the Phillips Curve has been undercut by both theory and empirics. Milton Friedman pointed out in the late 1960s that only expectation-defying inflation can increase demand. Once expectations are baked in, unemployment will revert to the mean. In short order, the stagflation of the 1970s showed that an expanding money supply would erode purchasing power irrespective of the unemployment rate.

Recent history shows the opposite is also true: Low unemployment can coincide with low inflation. Kelton takes this not as an indictment of her model but as evidence in its favor. She argues that the natural rate of unemployment has been perennially overestimated, and that low labor-force participation understates the true number of jobless Americans. Kelton might be right on those points, but, as elsewhere in the book, she draws unreasonable conclusions from reasonable premises.

Given the recent bout of low inflation, Kelton proposes doing away with unemployment altogether with a federal jobs guarantee. Any joblessness at all, says Kelton, is “evidence of a deficit that is too small.” An employment guarantee would ensure that the economy operates at full capacity, while raising living standards for everyone. Voila. MMT solved the economy.

In a chapter titled “An Economy for the People,” Kelton waxes poetic about the possibilities of a jobs program: The People will get paid at least $15 an hour, and they won’t work at the DMV — no, sir. They’ll build wind turbines and care for the elderly. And it will all spur economic growth by employing workers who would otherwise be idle.

It never occurs to Kelton that employment may not be an end in itself. Employment is beneficial insofar as it increases consumption, output, and, most importantly, productivity. The employment program envisioned in The Deficit Myth would have a negligible effect on output, because by definition it would employ workers in the production of goods and services that private firms consciously avoid. If the alternative-energy industry has largely flopped, why would government-backed clean-energy initiatives fare any better? An employment program would increase wages, but the attendant consumption would be almost entirely inflationary if not matched with an increase in output, and it would divert low-skilled workers from the private sector into the public sector, putting a permanent drag on productivity.

This neglect of the supply side is a constant throughout The Deficit Myth. In Kelton’s view, all output is created equal; the task of the policymaker is to stimulate demand to increase output. But in the long run, growth depends not on using as much labor and capital as possible, but on making those factors as productive as possible. Much as the neoliberal emphasis on globalization and financialization has distracted from the hard work of innovation, so too would MMT’s money-financed stimulus divert resources from productive firms to quixotic government programs.

While the prescriptive side of The Deficit Myth has little to offer, the descriptive side is a useful contribution to the fiscal-policy debate. Kelton is right on one crucial point: By all measures, the U.S. has substantial fiscal space. If historically low Treasury yields are any indication, the federal government has a long way to go before it risks defaulting on its debt, and central bankers have tended to be overly hawkish during the past decade. Kelton’s post-Keynesian views on deficits and interest rates will find a receptive audience among Americans who have seen few harms from ballooning fiscal deficits.

Indeed, the U.S. Congress appears to be having its own Copernican moment. The $2 trillion coronavirus spending package passed unanimously in the Senate without the usual Republican calls for fiscal prudence, and most Fed governors have likewise abandoned calls for moderation. The Deficit Myth even won an endorsement from former White House communications director Anthony Scaramucci.

Policymakers are right to take a more dovish stance on the federal debt. But they shouldn’t confuse MMT’s directional accuracy on that question with its soundness as a macroeconomic model. No number of accounting identities can belie the basic fact that in the long run, only innovation can spur growth. Federal capture of the economy is harmful not primarily because it is fiscally irresponsible, but because it moves the factors of production from the hands of innovators to the hands of bureaucrats.

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