MMT 101 – Modern Monetary Theory on “Fiscal Sustainability”

MMT makes clear that a currency-issuing government can always spend sufficiently to ensure full employment alongside low, stable inflation. It can always purchase what is available for sale in its own currency. The point – which, on a little reflection, should be obvious – is that the availability of real resources, not revenue, is the constraint on a currency-issuing government’s fiscal policy. Or, put another way, inflation is the constraint.

Does it follow, then, that MMT suggests a high public-debt-to-GDP ratio can have no macroeconomic consequences? Actually, that would be a poor specification of the issue. The “fiscally sustainable” level of public debt will depend on the average rate of interest paid on that debt. If the average rate of interest on public debt is a policy variable – and MMT shows that it is – then the more appropriate question is whether MMT recognizes that high debt service as a proportion of GDP can have macroeconomic consequences, since the same level of debt service can correspond to a lower or higher level of public debt. And the answer to that question is clearly yes. Emphatically, MMT does make clear that there can be macroeconomic consequences from a high debt-servicing ratio. Obviously, a level of debt service that feeds into spending beyond the capacity of the economy to respond at stable prices can be inflationary.

But this in no way negates MMT’s central point that a currency-issuing government can always spend sufficiently to ensure full employment alongside low, stable inflation. Even if, as a result of policy incompetence, debt-servicing requirements happened to lift demand to levels that threatened excessive inflation, this would simply mean that full employment could be maintained with less public spending. The public/private mix in aggregate demand could tilt more toward private spending without causing unemployment. In fact, under MMT’s preferred policy regime, full employment would be maintained automatically whatever the fiscal tightening required to maintain price stability. Actually, the job guarantee would maintain full employment irrespective of the overall level of aggregate demand.

More fundamental to the question of fiscal sustainability, however, is that there is never any good reason for debt-servicing requirements to become excessive when, as is the case for a currency issuer,

the average rate of interest on public debt is a policy variable.

Claims to the contrary ultimately rely on the myth of the “bond vigilante”; that is, the idea that private-market participants can pressure the currency issuer into setting a higher rate of interest on its debt than the currency issuer itself wishes to set. The understanding of monetary operations provided by MMT makes abundantly clear that such appeals to bond vigilantes are groundless.

Why, it may be wondered, is it always the case that the currency issuer dictates the terms on which it spends, including interest rate(s) and term(s) to maturity? At the most basic level, it is because

the monetary authorities cannot do a reserve drain until they have done a reserve add.

And if they do execute a reserve add – or if sufficient reserves already exist in the system due to previous reserve adds – then some agents will be holding financial assets that are earning little or no interest and so will not refuse newly issued public debt (short-term, if necessary) that offers an interest rate even a smidgeon above the rate paid on reserves.

So, the currency issuer gets to set the rate of interest and other terms of its debt. If an increase in government spending is necessary to maintain full employment, this can always be carried out. After all, the resources are available for sale in the government’s own currency. Purchasing them will not bid up prices. If, to the contrary, there happens to be full employment and demand-side inflation, MMT (like most other macroeconomic theories) prescribes a tightening of fiscal policy. Either way, full employment, under MMT’s preferred policy regime, would always be maintained, as already noted, via the job guarantee’s automatic-stabilizing mechanism.

Functional finance will not only correspond to sensible fiscal policy, but, as Scott Fullwiler has pointed out, will in fact result in fiscal policy that turns out, as a side effect, to be “Ricardian” in the sense that the term is used in mainstream macroeconomics. Roughly speaking, so long as the average nominal rate of interest on public debt is set below the average rate of growth in nominal GDP over the longer term, fiscal policy will likely be sustainable in the mainstream sense.

Further reading

For more on why the currency issuer always dictates the terms on which it spends see:

Exercising Currency Sovereignty Under Self-Imposed Constraints

For an explanation of why functional finance would in fact be “Ricardian” see:

Scott Fullwiler – Paul Krugman—The Conscience of a Neo-Liberal?