Modern Monetary Theory (MMT) preaches fiscal stimulus and monetization of public debt in good times and bad to support full employment. The emergency response to the COVID-19 crisis is not MMT; it is large but temporary governmental support for economies that have suffered a severe external shock. There are, however, examples of countries that have adopted MMT-like policies on a continuous basis, even during expansions. Italy during the 1970’s is one, and it has yet to escape the negative consequences.
MMT postulates that, in countries with unilateral control of their currencies, monetary and fiscal policy can work in tandem to promote full employment at all times. The government spends what it takes to support aggregate demand and job creation, and the central bank monetizes much of the government’s debt and maintains a liberal monetary environment to promote borrowing and growth. The only variable that must be watched is inflation. So long as it remains within an acceptable range, MMT contends there’s no reason for government officials to worry about the size of annual budget deficits, or even about the level of accumulated public debt. It is only when inflation threatens to get out of hand that fiscal restraint might become necessary.
Across the globe, national governments are setting aside budget rules to spend what it takes to limit the damage from COVID-19 pandemic and the deep recession it set in motion. In the U.S., Congress recently passed the costliest economic stimulus bills since the New Deal, and the government is paying for them largely with money created by the Federal Reserve. However, there is an understanding here and elsewhere that the current policy is an aberration. When the crisis recedes, so too will the support. MMT’s proponents are urging otherwise; they want to make today’s once-in-a-century crisis response the new normal.
In the U.S. context, MMT would shift responsibility for controlling inflation from the independent Federal Reserve to an elected Congress. The House and Senate would be expected to pass strategically-timed tax increases to head off signs of hyper-inflation. It is an arrangement that does not inspire confidence.
For several years in the 1970’s, Italy followed an MMT-like playbook after the collapse of the Bretton Woods exchange rate system. The government greatly expanded government spending in response to the demands of the country’s powerful labor unions. Between 1969 and 1977, social welfare payments, including pensions, rose by 400 percent, while the national economy tripled. At the same time, with the lira untethered from the dollar, the Bank of Italy had, for the first time in many years, wide discretion over the money supply. It promptly used it to monetize the government’s rapidly growing obligations.
Monetary accommodation of public debt was a consequence of both official policy and political expectations. Starting in 1975, the central bank was obligated to purchase government debt instruments that remained unsold at public auctions. More generally, bank officials believed it was part of their mandate to facilitate implementation of the government’s fiscal plans. In 1973, the bank’s long-serving governor, Guido Carli, responded to critics of the liberal monetary regime he was implementing by claiming a tighter policy would be “an act of subversion, for it would bring about a paralysis in institutions,” and would lead to insufficient societal resources for funding the government’s payroll and pension obligations.
The combination of expansive government spending and easy money proved disastrous for the country’s long-term stability and growth. Between 1970 and 1980, annual inflation in consumer prices was 13.9 percent, up from 4.0 percent during the 1960’s. Simultaneously, cumulative public debt escalated rapidly, from 36.6 percent of GDP in 1970 to 53.5 percent in 1980. With the public debt soaring, interest rates jumped too, from an average real level of 3.3 percent in the 1960’s to 7.4 percent in the 1970’s.
European leaders responded to the destabilization that floating exchange rates introduced into the common market with the exchange rate mechanism (ERM) of 1978. The ERM allowed the lira and other currencies to float against each other, but within an expected range. To bring inflation under control, the Italian government agreed to a “divorce” between the treasury and the central bank, which allowed the Bank of Italy more leeway to forgo purchasing government-issued debt.
With more independence, the countries’ monetary authorities were able to shift to a tighter policy regime. The result was lower annual inflation but at a cost of high and growing burdens of public debt as interest rates on government bonds rose rapidly. Between 1980 and 1990, debt services payments grew from 5 percent of GDP to nearly 10 percent annually, and cumulative public debt rose from 53 percent of GDP to nearly 92 percent over the same period. This decade marked the beginning of a long period of slower economic and wage growth that persists today.
Some younger Italians and those with short memories long for monetary sovereignty and the return of the lira. The straightjacket of the euro, adopted in 1999, has delivered price and interest-rate stability but stagnant wages and less competitive industries. They believe a new divorce -- this time from the European Central Bank (ECB) -- would allow currency devaluation to jumpstart a strong export-led recovery.
That may be so (presuming the turbulence of the rupture could be managed), but it would also leave the government exposed to the collective judgment of public markets on the soundness of its currency. Public debt was at 135 percent of GDP as of 2018; the pandemic and global recession could push it to 160 percent or more. The only reason Italy can service its debt today is because the ECB is buying much of its newly-issued debt instruments on secondary markets. Leaving the euro would eliminate that backstop and all but ensure a disruptive and damaging default.
MMT remains on the fringes of policy discourse; even Sen. Bernie Sanders found it too exotic to embrace during his two runs for the presidency. If it is ever does get serious consideration, the Italian case should serve as a warning. Once the central bank becomes an instrument of never-ending government expansion, the cascading destructive effects can last for generations.
James C. Capretta is a Contributor at RealClearPolicy and holds the Milton Friedman Chair at the American Enterprise Institute.