Review: The Deficit Myth by Stephanie Kelton

This article originally appeared in luckbox magazine, July 2020.

In January, the Congressional Budget Office (CBO) released its Budget and Economic outlook for 2020 to 2030. It is horrific reading. Federal budget deficits are projected to rise from $1.0 trillion this year to $1.3 trillion over the next 10 years.

Federal debt will rise to 98% of GDP by 2030, “its highest percentage since 1946,” the CBO says. “By 2050, debt would be 180% of GDP—far higher than it has ever been.” And that was before Covid-19 hit. Now those numbers will be much, much worse.

On top of this, politicians have been announcing grand schemes for further spending: $47 billion on free college tuition, $1 trillion for new infrastructure, $1.4 trillion to write off student loan debt, at least $7 trillion on the Green New Deal and $32 trillion on Medicare for All. By one estimate, these new proposals total an estimated $42.5 trillion over the next decade.

Adding these new spending proposals to the flood of red ink the CBO projects just from following the current path, the federal government is set to face a serious fiscal crisis in the not-too-distant future.

Keep printing

Or, perhaps not. There is an idea afoot in economics that, as Bernie Sanders’ former economic advisor Stephanie Kelton argues in her new book The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, could revolutionize the field in the same way that Copernicus did to astronomy by showing that the earth orbited the sun.

Modern Monetary Theory (MMT) states that “in almost all instances federal deficits are good for the economy. They are necessary.” That being so, we don’t have to worry about this coming deluge of red ink, indeed:

“Rather than chasing after the misguided goal of a balanced budget we should be pursuing the promise of harnessing what MMT calls our public money, or sovereign currency, to balance the economy so that prosperity is broadly shared and not concentrated in fewer and fewer hands.”

Most people would say the government taxes people to raise money to pay for the functions it performs. Not so, argues Kelton. Indeed, “the idea that taxes pay for what the government spends is pure fantasy.” Instead, “it is the currency issuer—the federal government itself—not the taxpayer, that finances all government expenditures.”

It does so by printing money. So, while you or I might have to worry about running up vast debts, “Uncle Sam has something the rest of us don’t—the power to issue the U.S. dollar,” Kelton writes.

Galloping inflation

This is hardly revolutionary. Governments and economists have known for centuries that a monetary sovereign—a body which issues the currency its liabilities are denominated in—can meet whatever liabilities it incurs simply by issuing a sufficient nominal amount of currency. The idea that a monetary sovereign, like the federal government, could go “bankrupt” is, thus, not strictly true.

The trouble is that excessive issue of currency erodes its real purchasing power as postulated by the equation of exchange (MV=Py), one of the few genuinely useful, and universally accepted, equations in economics.

The equation of exchange states that the money supply in an economy (M) multiplied by the number of times it is spent in a given period (velocity of circulation, V) equals the price level (P) multiplied by output (y). This is a truism. It is just another way of saying that nominal spending (or aggregate demand, MV) equals nominal income (Py), or MV=Py. Because all spending is someone else’s income, this is true by definition. The equation becomes more interesting when we make assumptions about its component variables. Assume that y is fixed by real factors and V is constant (the old monetarist assumptions), it follows that any increase/decrease in M must be offset by an increase/decrease in P—inflation, in other words. These real resource constraints—the determinants of y—determine society’s standard of living. If M increases faster than y, the nation just gets more inflation and a boost in nominal GDP, not more goods and services and an increase in real GDP. This is basic economics.

Indeed, when the University of Chicago’s Booth School of Business surveyed a group of economists last year on the questions “Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt” and “Countries that borrow in their own currency can finance as much real government spending as they want by creating money,” not a single one of them agreed with either statement. Even Kelton acknowledges this:

“Just because there are no financial constraints on the federal budget doesn’t mean there aren’t real limits to what the government can (and should) do. Every economy has its own internal speed limit, regulated by the availability of our real productive resources—the state of technology and the quantity and quality of its land, workers, factories, machine, and other materials. If the government tries to spend too much into an economy that’s already running at full speed, inflation will accelerate. There are limits.”

This is fatal to Kelton’s claim for any great novelty for MMT. She writes: “There is absolutely no good reason for Social Security benefits, for example, to ever face cuts” because “our government will always be able to meet future obligations because it can never run out of money.” Again, technically, this is quite correct, but only in nominal terms.

If inflation kicks in then, in real terms, that money might not buy very much. The effect will be a very real cut in what a Social Security check can buy. Kelton raises this question: “The question is, What will that money buy?” But she instantly dismisses it with a boilerplate about how, “We need to make sure that we’re doing everything we can to manage our real resources and develop more sustainable methods of production as the babyboom generation ages out of the workforce.” You don’t say?

Nothing new

So, what’s the point of MMT? Where is the Copernican revolution we were promised?

There isn’t one. What we have is a list of the left’s favorite spending priorities: Social Security, education, healthcare, child poverty, infrastructure, climate change … all paid for by borrowing, which isn’t a problem because we can finance it by printing money. We are offered examples, but where Kelton’s theory is just underwhelming, her history is actively bad. We are told that:

“As a share of gross domestic product (GDP), the national debt was at its highest—120%—in the period immediately following the Second World War. Yet, this was the same period during which the middle class was built, real median family income soared, and the next generation enjoyed a higher standard of living without the added burden of higher tax rates.”

True, the federal government ran up a considerable debt defeating Nazi Germany and Imperial Japan—money well spent. But with victory over Japan in 1945, federal government spending fell sharply: by 73% between 1945 and 1948 in real terms. In seven of the 15 years to 1960, the federal government ran a budget surplus. And when there were deficits they weren’t large, averaging 1.0 percent of GDP. The economy grew faster than government so that federal government spending fell as a share of GDP from 41% in 1945 to 17% in 1960. That Golden Age that Kelton talks about was one of mostly sound federal government financial management.

We also are told that deficits “didn’t dissuade John F. Kennedy from landing a man on the moon.” Again, this is true, but these deficits were accompanied by inflation which rose from 1.4% in 1960 to 12.3% in 1974. These examples hardly support Kelton’s case for vast deficits and their essential harmlessness.

There is an old joke: What does a parrot have in common with the Holy Roman Empire? The parrot isn’t holy, Roman, or an empire. Modern Monetary Theory is much the same. It isn’t very modern; throughout history people have been saying that we would be rich if only we had more of the medium of exchange. It isn’t monetary policy so much as a way of escaping the inevitabilities of fiscal policy. And its theoretical basis is a banal truism. It is simply the latest in a long line of claims to have found a Magic Money Tree for government.

John Phelan is an economist at the Center of the American Experiment.