"The Deficit Myth" by Stephanie Kelton, a Review

On June 2nd, 2020, the Washington Post reported that Republican senators Ron Johnson (R-Wis.) and James Lankford (R-Okla.) wanted to eliminate Columbus Day and replace it with Juneteenth: a holiday celebrating the liberation of Texan slaves two years after the Emancipation Proclamation. 

This may seem uncharacteristic for two Republican senators. However, the Post reported they wanted the "exchange" because it would save money (or, more accurately, not raise federal spending). If the federal government were to add a holiday without subtracting one, it would add roughly 660 million to federal spending in paid leave for federal employees.

So, adding a federal holiday for the emancipation of slaves and removing a federal holiday for a genocidal colonizer backed by an oppressive monarchy came down to the budget. 660 million dollars, in the mind of these senators, was too much to add. Hence, one holiday should be removed in exchange.

This thinking is not exclusive to Republicans. Democrats have their fair share of quid pro quo agreements and federal "pay-for"s. They often advocate for increased taxes to make up the difference between money-in and money-out of the government's wallet.

This intuitively makes sense. If a household needs to budget their income and allocate money responsibly, the government should be expected to do the same. Tax increases, spending cuts, trimming government programs---these all seem to be responsible ideas. That's why, even in the midst of the Monica Lewinsky scandal, Bill Clinton maintained strong approval ratings for his budget surplus.

Perhaps this common-sense approach is why Stephanie Kelton's book: The Deficit Myth---and the paradigm shift it advocates---are so jarring. It may also be why mainstream economists tend to disregard the book and its theory.

As someone who was trained in neoclassical economics and has even written somewhat critically of Dr. Kelton's ideas, I was skeptical. But the book forced me to grapple with Kelton's Modern Monetary Theory (MMT) and what it means for the US budget deficit-- and the economic system at large.

What is This Book About?

Before critiquing the actual contents of the book, I want to explain the underlying theory. The entire text is predicated on the 'modern' nature of money in the post-gold standard world. Because money is increasingly digital and valued against nothing other than trust in the government to pay its dues, the nature of economics--- Kelton and other MMTers claim---has changed. 

Roughly speaking, the book is based on 4 theoretical components.

First, Modern Monetary Theory essentially says that monetary sovereigns---countries which print their own money, often denominate debt in their own money, and do not tie their own money to another currency---can spend money into the economy up until the point where spending outpaces real resources. As Kelton refers to it, each economy has its own internal "speed limit". If a country spends too much and there are too many dollars chasing too few goods demand will rise and there will be inflation. 

Second, Modern Monetarists do not care much if money is being spent by the government on-deficit. After all, they claim the deficit is only a running count of how many dollars have been spent into the economy without being taxed out. So, if inflation gets too high because spending is outstripping the internal "speed limit" of the economy, the government can simply tax out that excess liquidity.

Third, Many economists believe that when the economy gets below 4% unemployment, tightness in the labor market will produce inflation, MMTers challenge that belief. They claim full employment is not only possible, but desirable. This difference of opinion is rooted in fundamental disagreements about the "natural rate" of unemployment-- which I will not get into here for the sake of brevity. You can read more about this disagreement from an MMT perspective here.

The last component in this theory is the role of foreign debt. You may have heard some public trepidation over how much money the US owes China. Modern Monetarists say that given the modern reality of fiat currency, we need not fret over this issue. If China called in all its debt today, the Fed would simply move the money the Chinese have in Treasury securities to a different account at the Fed. This, according to MMTers, will have no impact on the real economy, as there is the same amount of money in circulation as before, but now the Chinese are no longer earning interest on that money. It is analogous to shifting dollars from a savings account (appreciating securities) to a checking account (spendable dollars). 

In summary: MMTers believe that deficit spending is no big deal; they believe that the only restriction on spending is inflation (not federal debt or deficit); they believe that the 5% unemployment number is a myth; and they claim foreign debt is simply an accounting issue.

Now, with the theoretical precepts laid out, we can move to Kelton's arguments in the book and what other economists have to say about them.

Should we fear Government Debt?

Kelton's book is designed to debunk a handful of "myths" about government spending. These myths shape how economists and pundits alike think government spending should be managed. Each myth is designed to elucidate the point that governments need not worry about deficit spending. Rather, Kelton emphasizes the role of inflation and the real constraints on the economy of which the government needs to be wary. This is the central thesis of the book.

In fact, the reason MMT is attracting so much attention is because it implies that more deficit spending in the US (and other monetary sovereigns like Japan) is not a bad thing.

Indeed, as the primary constraint on spending in MMT is inflation---and because the world has largely been fighting a battle with too little inflation for the last decade---Kelton's insistence that the government has "fiscal space" to expand, seems true.

Here, one needs to be careful. Kelton makes it abundantly clear in her book this does not mean the government can spend as much as it wants. Rather, due to the lackluster inflation of the past decade---despite the 2008 stimulus and 2019's historically low unemployment---she contends there must be productive slack in the economy. This slack, says Kelton, can absorb the dollars spent by the government into projects to increase employment and productivity.

Naturally, this sounds too good to be true. And it is certainly quite controversial for this reason. Economists are eternally wary of "free lunches"

Prominent Austrian economist Robert Murphy, who has critiqued MMT extensively, contends MMT is actually correct that "governments issuing fiat currencies need only fear price inflation, not insolvency". In other words, a government which prints its own money can't go bankrupt. But, he disputes the claim that spending money on deficit (printing bills to settle obligations) is only a problem at Kelton's proposed 'full employment'. 

Murphy says, where MMTers believe increased spending will bring "idle" resources and labor back into the economy, the reality is that new government spending will warp price signals in the market and introduce the economic inefficiencies which will create the next recession. Further, he explains that government spending will also siphon off some of the resources and labor that are already being used. Therefore, the spending will, at least partially, stifle private economic activity.

Murphy, like many Austrian economists, is adamantly opposed to inflation, viewing it as a hidden tax on dollar-denominated wealth. This is essentially true, but becomes an issue only when inflation significantly outpaces growth. For example, the Fed currently aims for 2 % inflation, which is the same as saying they aim for 5% nominal growth over 3% real growth. In this case, inflation is still "stealing" wealth from people, but at a rate which most economists agree is helpful. So MMT is simply stating---in line with mainstream economics---some inflation is necessary and even good. However, when harmful amounts of this inflation occurs and how it is created are the points of contention.

This brings us to two fundamental questions: is inflation---as Milton Friedman once famously said--- "always and everywhere a monetary phenomenon" (i.e caused by too much money in circulation)? And separately, if inflation is caused by an economy using its real resources fully-- how does MMT explain the stagflation of the 1970s, where the link between real resources and inflation seemed broken?

By addressing these two points, we can ascertain what Kelton means when she says inflation is the real constraint on deficit spending.

Friedman and the Quantity Theory of Money

Friedman was the face of the "Monetarist" movement and theorized a direct and proportional relationship between the quantity of money in circulation and price inflation. This relationship can be expressed with the following formula:

M * V = P * T

Where M = Money supply, V = Velocity of money (the rate at which money is exchanged), P = the general Price level, and T = the volume of Transactions in the economy. The amount of money in the economy multiplied by how fast that money is exchanged is equal to the general price level of the economy multiplied by its volume of transactions.

For simplicity's sake (also for theoretical reasons which are not pertinent here), we take V and T as fixed. Therefore there must be a direct and proportional relationship between M and P. Whenever M goes up, P must inevitably go up for the equality to hold. Hence, money supply expansion causes proportional price inflation. A more nuanced analysis of this can be found here.

To this theoretical analysis, an MMTer would likely respond with contemporary data. Since the 2008 financial crisis, the direct relationship proposed between the quantity of money in circulation and the price level (inflation) has been tenuous at best. Even as central banks the world over have expanded their money supply, inflation has remained low. Inflation has been so low in fact, that central banks are struggling to induce the desired 2% rate.

Kelton makes the above argument in her book, claiming that contemporary data demonstrate slack in the economy. She implies there must be a decoupling somewhere in the quantity theory of money. Perhaps she has a point here. I would say the jury is still out on this relationship. For instance, despite the issues of the last decade, there is still a 0.79 correlation in US decadal data since 1870 between inflation and money growth. That correlation (which has been roughly replicated in multi-country data) should not be ignored. I have not read MMT literature which disputes this correlation-- but just because I have not read it, does not mean it doesn't exist.

The relationship between money quantity and inflation is, at least recently, tenuous. But in the long-run it is relatively robust. Perhaps this discrepancy will be resolved in the future.

What of the second issue: stagflation?

Stagflation is the Wrong Kind of Inflation

In the 1970s, Keynesian economists were baffled by massive inflation coupled by economic stagnation and unemployment. The Philips Curve, the gospel of Keynesian economists which proposed a stable and inverse relationship between inflation and unemployment (more unemployment means less inflation), was broken.

So how can Kelton claim that inflation will only happen when unemployment is not just low, but nearly zero? Indeed, Kelton asserts in her book that the major inflation risk will come from too many dollars chasing too few real resources. In 1979 when inflation was rampant, unemployment in the US reached 9%-- far beyond the 4-5% over which inflation should not occur. This peculiar contradiction would seem to disprove Kelton's assertion.

Kelton explains away this problem by adding a Keynesian nuance to inflation. As she said in an interview with CNBC, "the U.S. economy hasn’t experienced what we might call 'demand-pull' inflation for almost a century. The types of inflation that have been important in the U.S. have almost always come on the cost side, what we call 'cost-push' inflation. They come about because of things like oil price shocks ... housing ... or health care.”

Indeed, in the 1970s, the inflation in the US economy came largely from an external oil-price shock. This shock is called cost-push inflation because it is caused by the exogenous increase (shock) in the price of some important good (oil in the 1970s).

On the other hand, demand-pull inflation is caused by too much spending in the economy. In other words, Kelton says that inflation which results from government spending is actually difficult to achieve in the US. Further, she claims it will continue to elude the Fed until fiscal policy (spending by congress) is used to bring more unemployed people into the economy and engage unused real resources. Demand-pull inflation is the inflation which MMTers are concerned about. And it is the inflation the US has been struggling to induce.

Something Else About Debt

So far, this analysis has focused on inflation as the primary constraint on debt. But what about the neoclassical objection to national debt? Neoclassical economists claim that debt crowds out private investment, that increased interest payments on government bonds will become unserviceable, and that higher levels of debt will make investors less confident the US will pay it back.

When neoclassical economists say government debt crowds out private investment, they mean the government is borrowing too much money from people in the economy. They propose that money which would normally be used for private investment is instead funneled into government treasuries to support government spending. By reducing private investment, government spending would also inadvertently reduce wages by taking money away from investments which could be used to increase worker productivity. 

Kelton objects to this characterization of deficit spending. She invokes her tutelage under the the British Economist Wynne Godley. He demonstrated that there are two "buckets"---as Kelton calls them---one which belongs to the government and one which belongs to the "nongovernment". Inevitably, in this very simple system, any spending on deficit from the government bucket is moved into the nongovernment bucket as a surplus. This simple but revolutionary insight is stated on page 106 as the following equality:

Government deficit = Nongovernment surplus

According to Godley's "stock-flow consistent" (p. 107) model, all money spent into the economy by the government is a surplus to all nongovernment entities. Further, if the government spends $100 dollars and taxes $90, there is necessarily a $10 surplus in the nongovernmental sector. As Kelton rightly points out the "CBO [Congressional Budget Office] would report that the government had run a fiscal deficit, and it would record a minus $10 in its annual budget report" (p. 107). But this, Kelton says, is the wrong way to think. Instead, she writes, "their red ink is our black ink": those ten dollars are not debt, but a surplus for the nongovernmental sector.

The common critique of this logic also brings us to the second neoclassical fear of government debt: that interest rates and hence interest payments on treasures will increase-- eating up too much of the government's fiscal space. 

As Robert Murphy correctly points out in his critique of MMT: "as the government borrows and spends more, the equation [G - T = S - I] tells us we might see lower private consumption, rising interest rates, and real resources being siphoned out of private investment". A note before we proceed: this equation takes as given that Investment (I) is I(r), or Investment multiplied by the interest rate. Hence, the question becomes: what does the above National Income Accounting equation assume? It assumes the interest rate moves naturally based on market forces (to maintain the equality condition r and I must move in opposite directions). Murphy believes this---as do most neoclassical economists---because the interest rate is commonly understood to be the economy's market-clearing price for borrowing. 

Before I move on to the MMT response to this, I would highly recommend reading Murphy's critique in full, as he explains why some of the MMT logic, borne out of simple accounting tautologies, may be flawed.

What does MMT say about the natural interest rate? As MMT economist and professor at the University of Newcastle, Bill Mitchell points out on his blog: 

"We have seen that the central bank necessarily administers the risk-free interest rate and is not subject to direct market forces. The orthodox macroeconomic approach argues that persistent deficits reduce national savings … [and require] … higher real interest rates and lower levels of investment spending ... Unfortunately, proponents of this logic which automatically links budget deficits to increasing debt issuance and hence rising interest rates fail to understand how interest rates are set ... Clearly, the central bank can choose to set and leave the interest rate at 0 per cent, regardless, should that be favourable to the longer maturity investment rates."

In other words, the interest rate need not change at all if the Fed decides so. Or, as Kelton says in her book: "The interest rate is a policy variable" (p. 112). Now, this is not to say that the Fed should do anything-- only that it can. As many an Austrian economist would claim: when the Fed manipulates the interest rate, it warps the natural market rate for loaning money. Whether or not this natural rate exists is important. But, the MMT nuance is a good one: the Fed is not bound by market forces practically hence, neither is the interest rate.

What of the last point, that too much debt will scare investors and lead to a financial crisis? Kelton has a practical (and relatively simple) response to this fear. She writes "Treasury auctions [where the government sells its bonds] are always oversubscribed ... the primary dealer market [for treasuries] is a real-world market established by the federal government for the purpose of dealing exclusively in newly issued government securities ... In other words, the government created the primary dealer market for the sole purpose of placing US Treasures in private hands" (pp. 119- 120, emph. added). 

This is the big secret of the US Treasuries market: the deck is stacked. Kelton points out these primary dealers are even backstopped by the Fed. Which means that having enough liquidity to pay the price agreed upon through the bidding process is never a problem-- and it never will be. There will never be a hiccup in the Treasury Bill market because it's not really a market. It's a game the Fed and Treasury play to issue bonds for private use. It only looks like a market from the outside.

What does it mean if the deck is stacked? Private investors and foreign governments will likely not lose trust in the American government to pay its debts. Indeed, even as overall US debt has increased, Treasury auctions remain over-subscribed. There is a global demand for dollars, that demand will not be stifled if the government can never default on its liabilities. 

All of this is to say that investors will likely never get scared and refuse to buy government bonds. The game is rigged, there is no way the Treasury can lose because it's playing a game financed by its own bank denominated in the currency it issues by fiat.

The logic is simple, but it has powerful implications.

What Does it All Mean?

In the end, Stephanie Kelton's book shines new light on some of the assumptions which have shaped fiscal policy in the US since the 1970s. Her book, while at times overstating its case, is overall a welcome voice in the economic debate.

It is worth stating that MMT does have serious limitations. For one, a country hoping to adopt MMT-inspired policies must be a monetary sovereign. There are only a handful of countries which meet this criteria. Further, there seems to be no response to the robust relationship (in the long-run) between money quantity and price inflation. If this relationship is not broken through rigorous analysis, MMT inspired policies could cause inflation well before the economy reaches full employment.

There are also some simple clarifications the MMT crowd could make. For instance: What is the role of fractional reserve banking in the MMT framework? How do we determine when the economy is at true full employment and how do we levy taxes quickly enough to respond? How would MMT ensure that additional spending would not siphon resources from other economic projects? And perhaps most importantly: How do we calculate which spending will lead to the desired level of output to offset inflation?

Fundamentally, MMT is restricted by economic orthodoxy. While it proposes new and exciting ideas, it is often pulled from the ecstatic heights by well-known economic realities. 

Perhaps the best response to this book is a tacit inclusion of its best precepts into our political framework. The US obviously has some fiscal space. Hence, the best course of action is to increase smart deficit spending. We should seek to spend additional federal dollars on projects which grow the economy and bring people out of poverty, while maintaining a meticulous watch over inflation.

We would do well to consider Kelton's insights-- if only to protect those whose economic maladies are not solved by complex models from ivory towers or punishing austerity masquerading as "fiscal responsibility".