The last few months of 2018 saw a real bout of jitters in the financial markets. Growth was slowing everywhere and share prices were in full retreat. There were fears that this was the start of Global Financial Crisis 2.0.
In the end, central banks managed to calm things down. The US Federal Reserve abandoned plans for increases in interest rates , the European Central Bank put back the date at which it expects to start raising the cost of borrowing, the Bank of Japan left rates negative and the People’s Bank of China eased lending constraints on commercial banks.
The policy action did not stop the flow of bad economic news, which has continued pretty much unabated during the first three months of 2019. But it has changed the mood of the financial markets.
It would be a mistake, though, to assume that all is now well, because that is far from the case. The mood remains nervous and that’s not just because another recession is a matter of when not if. Nor is it even that central banks are ill-equipped to deal with the next crisis when it comes, although they clearly have much less firepower than a decade ago.
Rather, it is that another severe downturn would call into question the way in which governments have run their economies since the mid-1970s. Put simply, this has involved giving control of inflation priority over full employment, making independent central banks rather than finance ministries responsible for demand management, and setting rules that limit – other than during recessions – the size of deficits that governments can run.
This conventional wisdom survived the crash of 2008-09 because even though central banks slashed interest rates and pumped money into their economies through quantitative easing, they did so while abiding by inflation targets. Finance ministries played second fiddle and deemed it vital that they reduce borrowing even if this meant unpopular austerity programmes.
But economics goes in cycles, even if these cycles are sometimes extremely long. Dario Perkins of TS Lombard notes that in the 1930s economists came to the conclusion that central banks had done all they could. Cutting interest rates when they were already low was like “pushing on a piece of string” and, as a result, governments needed to use the power of the state to shorten dole queues.
Full employment was only finally achieved during the second world war when balancing the books mattered far less than military victory. Governments spent what they felt they had to spend.
There are now echoes of this era. In the US, Donald Trump has shown he doesn’t care too much for central bank independence and thinks you should grow the economy first and worry about the deficit later. From the other side of politics, there is a group of radical Democrats who are campaigning for a Green New Deal and see the fight against climate change as today’s equivalent of the battle against fascism. The policy debates of the 1930s are once again raging, with modern monetary theory (MMT) part of the argument.
MMT turns the post-1970s orthodoxy on its head. It says a government that issues its own currency can’t go bust. There is no need for people to be unemployed because they can be put to work through higher public spending financed by the central bank. Under MMT, full employment is the main goal of policy and the central bank is subservient to the finance ministry.
There have been economists arguing for MMT for many decades but it has now gone viral as the result of support from Alexandria Ocasio-Cortez, the rising star of the Democratic party. For the radical left, the attraction is obvious: MMT can be used to offer job guarantees and to fund the Green New Deal. The fact that Trump is unbothered by the size of the US budget deficit makes MMT an easier political sell.
It’s not quite as easy as that, inevitably. MMT’s new prominence has not gone unnoticed and there is now push back against it, not just from conservatives such as Jerome Powell, the Fed chairman, but also from economists from the progressive side of politics, such as Paul Krugman and Larry Summers.
The principle argument against MMT is that it would lead to inflation, and potentially very high levels of inflation. Creating money in itself does not lead to higher levels of activity: that will only be the case if the economy is operating at less than full capacity and there is sufficient capital – physical and human to put the money to productive use. If that is not the case, inflation will start rising because there will be too much money chasing too few goods.
MMT supporters have two answers to this critique. Firstly, the use of MMT is akin to pumping up a flat tyre; once it is fully inflated there is no need to carry on pumping. Secondly, there are ways of mopping up excess demand: regulations, controls and – most importantly – taxation. That requires finance ministries to know how much spare capacity exists in their economies, to know when the moment has come to stop spending, and to be able to resist the temptation to keep going for longer than they should. It also requires a degree of faith in government because once people think the value of money is collapsing the game is up.
All that said, the MMT debate is welcome and healthy. The likelihood of another recession; the constraints on conventional monetary policy; the threat of deflation and the need to fund the transition to a low-carbon economy all point in the same direction: a much bigger role for fiscal policy, however financed.