KOLB: The Demise Of Modern Monetary Theory

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Charles Kolb Charles Kolb was deputy assistant to the president for domestic policy from 1990-1992 in the George H.W. Bush White House
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As inflation ravages the U.S. economy, Americans are quickly discovering that the modern monetary theory (MMT) fad is over.

MMT economists and advocates argued that deficits didn’t matter: since the U.S. dollar functions as the principal global reserve currency (a currency they assumed everyone, everywhere just wanted to hold forever), the U.S. government could borrow without limit, since it borrows in its own currency.

Need more money? Print it.

Need another $5 trillion to fund Biden’s “Build Back Better” program? Print it.

Deficits don’t matter when there are no constraints on borrowing. The sky’s the limit.

Most teenagers without a Ph.D. in economics, however, can readily appreciate a different economic and financial reality when they get their first credit card.

Worried about a faltering housing market after the Great Recession, the Fed accommodated the housing and equity markets through several rounds of quantitative easing, which it stopped and then resumed during the COVID pandemic. The result is a bloated Fed balance sheet exceeding $8 trillion – a balance sheet that will, gradually, have to be unwound.

Fortunately, wiser heads like Republican senators as well as Democratic Sens. Joe Manchin and Kyrsten Sinema prevailed and stopped the MMT nonsense before it brought even more inflationary harm to everyday Americans. Now we’re assessing the damage from the last decade of monetary- and fiscal-policy excesses and how reversing those excesses will affect all Americans and the global economy.

The principal actor, of course, will be the Federal Reserve, which has begun to raise interest rates in earnest. But even with the Federal Funds rate now at 1.50-1.75%, interest rates, when offset by inflation exceeding eight percent, are still significantly negative.

Interest rates represent the price of money, and when that price is negative (meaning that your bank effectively pays you to borrow, and you pay your bank to hold your savings) massive asset-price distortions in equities, housing and cryptocurrencies arise. Investors assume greater risks seeking higher yields.

These distorted monetary and fiscal policies have brought us to where we are today: the highest inflation rate in 40 years, the possibility of a near-term recession and the likelihood of longer-run stagflation.

While both political parties share the blame for this situation, the Biden administration’s fiscal policies created the tipping point.

Months before Russian president Vladimir Putin invaded Ukraine, former Clinton economic adviser and Obama Treasury Secretary Larry Summers warned the Biden economic team that passing its $5 trillion “Build Back Better” legislation on top of earlier massive pandemic-relief spending and the American Rescue Plan would unleash serious inflationary pressures.

Summers was correct. What no one knows today is just how high the Fed will have to raise interest rates to tame today’s inflation beast.

Optimists (those observers who once labelled today’s inflation “transitory”) believe (or hope) that a couple of months of Fed rate hikes will temper inflationary expectations. Pessimists (those observers who for years have cautioned against monetary- and fiscal-policy excess) fear the battle will be longer.

Americans now see daily – when they purchase milk or fill their gas tanks – how inflation touches them directly. The real wage gains of the past few years have been eliminated, and no amount of White House spin or damage control can change this picture.

MMT was a siren that lured the Fed and others into complacency. There’s no question that the Fed has been behind the curve for years. Its credibility will now be tested as Chairman Jerome Powell and his colleagues try to engineer an economic “soft landing.”

The recent market sell-offs are signaling turbulent economic times ahead. Moreover, political and economic uncertainties show few signs of abating: war in Ukraine, aggressive Chinese foreign policies, supply-chain restructuring, ongoing Middle East tensions and an overall reassessment of globalization.

Our economic future will not be determined by abstract academic theories like MMT. Moreover, the Fed by itself cannot engineer a future soft landing out of today’s mess. We will need to watch carefully the trends emerging from the billions of spending and hiring decisions made daily by individuals and corporations.

When automobile companies like Tesla and real-estate firms like Compass and Redfin announce major layoffs, it would be wise to pay close attention to these, and perhaps other, canaries in the coalmine.

Charles Kolb served as Deputy Assistant to the President for Domestic Policy from 1990-1992 in the George H.W. Bush White House