The noise around Modern Monetary Theory (MMT) might have settled- the concept, however, remains timeless. Modern Monetary theory (MMT)- a concept which says that as long as the economy is printing its own currency, it can go beyond its foreseeable revenue streams to spend. Simply put, such governments do not rely on taxes or borrowing for spending since they can print as much as they need and are the monopoly issuers of the currency. Here’s the catch- the very necessary condition of “as long as the economy is printing its own currency”. While the term was coined by Bill Mitchell, an Australian economist in the 90s, it caught the maximum limelight when the covid induced crisis demanded of support from monetary and fiscal policy.

Let’s try to deep dive this further. In the book The Deficit Myth, Stephanie Kelton argues that a nation’s budget is not similar to household budget (though it is conventionally assumed to be!). Nations can sustainably spend more than they earn, households cannot. What then differentiates budgeting of a nation from a household? The catch lies in the fact that nations can print their own currency. For example, US can print more dollars, India can print more INR to fund expenditure. The problem, however, doesn’t end here.

Printing excess money – Walking on a tight rope

If economies were to print excess money, inflation would arise. To that extent, it is believed that government should not worry about their deficit but instead about the consequential inflation that can eat up the growth as demand slows. It will be a case of too much money chasing too few goods. However, to get rid of this trap, productivity of the economy needs to go up so that number of goods increases with same pace of growth as money. This shifts the argument from how much is spent to where is it that the money is spent.

As we know, output= C+I+G+X or output is sum total of private consumption (C), Government expenditure (G), Investments (I) and Net exports (X). Usually, it is the investments that have a bigger multiplier meaning that for every INR 1 spent in investments, output can grow by more than INR 1. Thus, investments become a good way to fuel the productive capacity, everything from hard infrastructure to soft technical skills will fall in this category.

MMT as a tool to counter recession

The other use case for MMT is when output is very low- a typical case of recession. In that case, as the cycle revives and output moves up, extra supply will take care of extra money without deadly inflation. For example, if India’s potential output is 8% and the economy is stuck at 5%, then fuelling up the economy to 8% will not affect inflation. During a time of sub optimal output, MMT is a good tool to use. After all, unemployment, hunger, civil strikes and the other extreme repercussions of economic slowdown are better avoided. The policy maker’s dilemma is to choose the right kind of deficit- while financial deficits can be taken care of, humanitarian deficits have longer scars.

Can India adopt MMT?

Now, let’s shift the lens to real world. Can India adopt MMT? The good part is Indian government borrows fully in INR and therefore it can print its own money. However, India as a country is not independent of rest of the world. Our Balance of Payments requires flow of money to the Indian economy. Our currency is pegged to dollar. In fact, in the Bretton Woods era, when dollar was pegged to Gold, even US didn’t enjoy monetary sovereignty. India’s current Fiscal deficit is close to 6.5% of GDP and the current account deficit is close to 2.5% of GDP. The latter is mostly getting financed by flow of foreign resources to the domestic market. In the first order, more money calls for weaker rupee which has an effect on our ratings. In the second order, the flows could weaken as rating worsens creating a vicious cycle. To my mind, MMT is not a fair game. Net importers whose currencies are pegged in a foreign currency cannot exercise a free hand.

The sustainability of debt is also a question. While it is generally accepted that as long as borrowing cost of the government is below the nominal growth, debt can be considered sustainable. However, while the Indian central bank attempts to help the Government by keeping rate low, its actions are also determined by global policy landscape (Think of the recent May 4 hike by the federal reserve!). To think inversely, the current inflation has increased nominal GDP keeping yields lower but what happens when inflation corrects but rate cycle doesn’t turn globally? That will not be too palatable.

Fisher Effect and Money Supply

The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. When the real interest rate is positive, it means the investor is able to beat inflation. In a vacuum, as per the Fischer parity, when inflation goes up by 1%, interest rate goes up by 1%. Central banks break this vacuum by introducing the concept of money supply, allowing for the rates to go up by lesser. If the money supply is perennially increased (given that most fiscal expenditure is sticky), the movement in rates will have to be extreme. This will put the debt sustainability under threat.

The U.S. Treasury has a unique ability to borrow at lower rates, which arises in part because of the safety and liquidity benefits that come from its debt being issued in the world's reserve currency. Eventually, interest costs on government debt become as large as the state's revenue, at which point investors, no longer believing the government to be solvent, will refuse to buy bonds or lend to the government at manageable interest rates. So while the United States almost certainly could stomach more debt at present, interest costs will eventually subsume all other government revenues. There lies the problem. Even if US could perpetually print, it will disturb the global equilibrium. Other economies will have pass through inflation. US demand can potentially disproportionately grow, making other economies desperate for a market share in its imports, leading to geopolitical issues. Economies should be allowed to grow as per their potential, their human capital, technology and other inputs and not by their unfair power to artificially grow.

Conclusion

Clearly, MMT as a process has its merits but it is not fully suited for economies whose exchange rate is less market determined. That only leaves US as an exception. The whole Greek fiasco is attributed to Greece giving up its monetary sovereignty when it accepted Euro as its currency- something it can’t print. But in the current financial environment, which country can protect its currency anyway? The case for MMT is only strong in a global crisis like scenario when it is used as a coordinated policy tool globally.

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