A recent theory making the rounds in political-economic circles is Modern Monetary Theory (MMT). The strongest proponents of MMT don’t seem to have a consensus as to the details of the theory. The basic commonality in these theories boil down to the need for governments to spend money, oftentimes by borrowing, to achieve low levels of unemployment. In contrast, the standard wisdom, new-Keynesian, says that lowering interest rates is the best way to stimulate demand.
Naturally, this theory has been a hit among the politicians who would like to increase government spending. Even if MMT fully worked, there is the question of whether MMT permits unlimited spending, and if not, whether certain spending increases welfare above other spends (is a billion dollar highway better for the public than a billion dollar of debt forgiveness?).
The most popular and self-consistent version I’ve seen of Modern Monetary Theory is Abba Lerner’s theory of functional finance. The overarching thesis is that the government needs to directly apply the changes it wants to see in the economy. If there isn’t enough demand, the government itself must spend; if there is too much inflation, the government itself must cut back.
But the most systematic version, the version that I believe the most, is the one view put forward by Paul Krugman in his columns. Krugman explains all the empirical patterns we’re seeing today squarely within the standard new-Keynsian framework. Krugman says that Modern Monetary Theory applies best when interest rates are very low, which is the case across the globe today, but not very common throughout history in general. The technical term for this is the Zero Lower Bound, or ZLB.
To review new-Keynesian macroeconomics, there is a single optimal level of “demand” in the economy that results in stable inflation and lowest stable unemployment. Too low demand results in unemployment; too high demand results in inflation spiraling upwards. Normally, the interest rate is not too low, and the central bank controls “demand” normally. If demand is too low, the central bank lowers interest rates (thereby reducing savings, increasing the nominal value of assets) to stimulate spending, and vice versa.
When interest rates are too low, this normal mechanism doesn’t work anymore. Interest rates cannot be set much below zero, and even as you approach this bound many things in economics starts becoming quite strange (undesirable). In this case of the world, the alternative way for the government to create extra demand is by spending it themselves, and here you have MMT.
At the actual ZLB, which you see in Japan and the Eurozone, this really is the standard policy procedure. The government indeed needs to spend more to push up demand, and there aren’t easy alternatives.
The difference between MMT and new-Keyensian economics occurs when the interest rate is above zero, which it seems to be floating above right now. In such a case, new-Keynsians say the most effective thing to do is to lower interest rates to stimulate demand, and the private sector knows best how to allocate this demand. If you detected a twing of libertarianism in that ideology, you aren’t wrong. MMT supporters, on the other hand, say that the government should spend more. If you detected a twinge of state-directed-economy there, you aren’t wrong either.
