When firebrand New York congresswoman Alexandria Ocasio-Cortez arrived in Washington early last year, she sent the economics profession into a flat spin with her suggestion that an extravagant environmental and social program – her “Green New Deal” – could simply be financed with budget deficits.
“We will finance the investments for the Green New Deal the same way we paid for the original New Deal, World War II, the bank bailouts, tax cuts for the rich, and decades of war – with public money appropriated by Congress,” a briefing note from her office declared.
Channelling what is known as “Modern Monetary Theory” (MMT), she argued that governments did not have to aim for balanced budgets and said there should be a “conversation” about the harm caused by budget surpluses. Federal Reserve chairman Jerome Powell tartly responded that “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong,” while former Treasury secretary Larry Summers dismissed it as “voodoo economics”.
But with governments around the world now showing a readiness to do “whatever it takes” to combat the COVID-19 pandemic, the idea that governments can sustain levels of debt far greater than previously thought is being reconsidered.
While MMT remains a passion of the left-wing fringe, there is a growing acceptance of debt and deficits in the economic mainstream.
Nothing in economics could be more mainstream than the annual conference of the American Economic Association. As he stepped down as the association’s president in January last year, former IMF chief economist Olivier Blanchard dropped a bombshell.
“What do I want you to go away with? Not the notion that debt is good but that debt might not be so bad,” he said. Blanchard showed that over most of the post-war period, the interest rate on US government debt was less than the economy’s nominal growth rate. Moreover, the same was true of most other advanced nations.
“If the future is like the past, this implies that debt rollovers, that is the issuance of debt without a later increase in taxes, may well be feasible. Put bluntly, public debt may have no fiscal cost,” he said. Blanchard did not go as far as Ocasio-Cortez or the Modern Monetary Theorists who suggest the only real constraint on government spending should be the danger of inflation in an over-stretched economy. But his analysis broadened the debate about whether high levels of government debt imposed unacceptable costs.
The starting point for MMT is that governments are in a radically different position to households and businesses. Households and businesses are users of money, while government creates it. While everyone else has to earn, borrow or invest to obtain money, government simply creates currency every time it spends. Government does not tax in order to cover its spending: it taxes in order that its spending does not create excessive demand and hence inflation. When there is a budget deficit, the government is putting more money into the economy than it is taking out. If governments ran persistent budget surpluses, it would leave the private sector in perpetual deficit.
MMT holds that a government which borrows in its own currency is never in a position where it cannot finance something, whether that is the employment of all idle labour at a guaranteed minimum wage or, as we see now, a response to the COVID-19 virus. Where countries get into sovereign debt trouble is when they don’t control their currency, whether that is Indonesia borrowing US dollars in the 1990s or Greece borrowing euros in the GFC.
MMT has been around for decades. One of its principle theorists is the University of Newcastle’s Bill Mitchell, who argues it is not so much a policy prescription as a description of the way monetary and fiscal policy actually works.
It has been a choice of governments to make central banks responsible for monetary policy and charge them with meeting an inflation target, Mitchell says. It could equally decide to control inflation itself, while charging the central bank with managing public debt.
Although currency issuing governments face no financial constraints, they are limited by the real world. To the extent that their spending and that of the private sector is greater than the available supply, inflation will result. Faced with rising inflation, a government might raise taxes to reduce demand. While critics point to Zimbabwe and Venezuela as the object lessons of what happens when governments create the money they need to finance whatever they want, Mitchell argues it is the collapse of production, not government spending that generates hyper-inflation in these nations.
Another prominent theorist is Stephanie Kelton, who is economic advisor to former US presidential candidate Bernie Sanders, whose policies included free universal health care and a shift to 100 per cent renewable energy by 2030.
Former US Treasury Secretary Larry Summers has been a trenchant critic of MMT, saying there is abundant evidence of governments coming to grief through excessive debt, but in recent papers written with Barack Obama adviser Jason Furman, he has accepted one of its central tenets: “Countries that borrow in their own currencies and run independent monetary policies have substantial latitude on fiscal policy,” he says. Summers quickly adds that the latitude is not unlimited, but is far greater than conventionally thought.
The reality is that the United States has been accepting large deficits for years. Even before the coronavirus crisis, this year’s deficit is expected to surpass US$1 trillion.
Economists who were critical of the 2008-9 stimulus and the build-up of debt that resulted are now saying debt should not be a concern in fashioning government response to the COVID-19 crisis.
Another former IMF chief economist, Kenneth Rogoff, whose argument that national growth rates were impaired once debts surpassed 90 per cent of GDP was used to justify austerity campaigns in many countries after the GFC, commented last week that the United States should consider itself at war.
“The whole point of not relying on debt excessively in normal times is precisely to be able to use debt massively and without hesitation in situations like this,” Rogoff said.
Similarly, Harvard’s Greg Mankiw, who was chairman of the Council of Economic Advisers during the presidency of George W. Bush, commented “There are times to worry about growing government debt. This is not one of them.”
In Australia, the belief in balanced budgets runs deep, with former Treasurer Peter Costello having set the terms of debate with his denunciation of Labor fiscal management as the economy emerged from the recession of the early 1990s. There has been no parallel to the US debates of the past year. Treasurer Josh Frydenberg argues that Australia is able to afford the support being offered because of its good fiscal management, while admitting that he is “very conscious of the debt burden to be carried by generations to come”.
However, it is a fair bet that the vilification of “debt and deficit” has lost its political potency for years to come.