Thursday, February 18, 2010

MMT is broken

Modern Monetary Theory (MMT) opines that decreases in interest rates portend inflation expectations, which finally leads to inflation. It also assumes that low or zero interest rates stoke inflationary pressures by making the price of credit cheaper. All things being equal, this means a greater demand for credit should follow.

Except there is a problem here, both on the supply and demand sides. Richard Koo has termed this a "balance Sheet Recession" whereby households and corporations are loathe to take on new debt in favor of cleaning up their own balance sheets. Banks are loathe to lend as assumptions for future capital needs are uncertain and access to capital markets are equally unknown.

SO BANKS DO NOT LEND AND THE CREDIT CHANNEL (via monetary policy through rate action) IS BROKEN.

Only FISCAL policy can fix this problem.

1 comment:

Tom Hickey said...

I don't think that you have properly characterized the MMT position. MMT holds that monetary policy is relatively ineffective even if understood properly, and wrong as it is understood in the mainstream.

MMT favors a fiscal approach based on the principles of functional finance proposed by Abba Lerner (1943), adapted for the "modern," i.e., post-1971 monetary system, which is based on the non-convertible flexible rate monetary regime in place since Nixon closed the gold window.

This approach is based on fiscal policy rather than monetary policy for stabilizing full employment and real capacity utilization along with price stability. See L Randall Wray, Understanding Modern Money (1998) for the background.