American progressives  have a real problem. Somehow, they must figure out how to finance the huge new social programs they would like to impose on us. Lately, a number of leftist economists have suggested a true insanity as a solution. It is called Modern Monetary Theory, or MMT.

The Progressive Program Finance Problem

The growth in government  progressives would like to create literally beggars the imagination. Their proposed Green New Deal alone would cost anywhere from $5 trillion to $10 trillion per year, depending on who you believe. Unfortunately, the Green New Deal appears to be a work in progress. It is too vague and amorphous to pin down its actual cost. To give you some scale on how enormous this program would be, our annual GDP is currently around $20 trillion. That means the Green New Deal would absorb between 25 percent and 50 percent of GDP every year. Their next most costly proposed program is Medicare-for-all, or the socialization of medical care. It would only cost $3.3 trillion per year ($32.6 trillion in its first ten years). or 16 percent of current GDP. If both programs were enacted, they would absorb between 41 percent and 66 percent of GDP every year. If this does not terrify you, I question your sanity.

Those two proposed programs do not exhaust Democrats’ suggestions for added spending. Sen. Elizabeth Warren (D-MA) would have the federal government relieve college students of a large fraction of their $1.57 trillion student debt. Then, to “solve” the problem, she would give free tuition to any qualifying college student. Many progressives are advocating a universal basic income for everyone, typically of $1,000 per month. It has been added as a plank of the California Democratic Party platform.

How can Democrats possibly finance these programs? At least some progressives are catching on to the fact they can not be financed simply by increasing top marginal tax rates. I explained the reasons for this in the post Curious, Erroneous Progressive Ideas About Taxes. The solution suggested by some progressive (read Keynesian) economists such as Paul Krugman and Stephanie Kelton is Modern Monetary Theory.

What Is MMT?

Keynesians  have always been comfortable with increasing government economic demand to goose the economy. Modern Monetary Theory or MMT is a rational for essentially unlimited government economic stimulation. If the federal government controls the national money supply, there is no reason it can not spend as much as it wants.

Since the government through the Federal Reserve controls the “printing” of money, i.e. the quantity of money in circulation, politicians can require the Fed to use newly created money to buy government bonds. This gives the government a new supply of fiat money to finance anything it wants. Progressive politicians need never depend on tax revenue to finance government programs. Oh, happy days are here again!

To see why MMT is madness on steroids, we should review what the economic functions of money are.

The Functions of Money, and the Problem of Inflation

Money  serves three major functions in the economy. If any one of these functions suffers, so will economic output and the welfare of everyone. These functions are the following:

1. Money provides a medium of exchange. This allows people who produce different things to procure what they do not produce themselves without bartering. Because they can do this, they can specialize in their economic activity. This allows for the division of labor that is a source of productivity.
   
   
2. Money provides a store of value. Possessing money, an individual can retain the value of his income without having to immediately consume it. This allows investment or savings that is redirected by banks to investment.
   
   
3. Money gives us a unit of account for different goods and services. That is, it provides us with a common measure for discerning the relative worth of goods and services. Goods and services more highly valued by people will be priced higher than those of lower value. In this way, money is a conduit of signals to producers and consumers alike of what should be produced and bought. See my post Chaotic Economies and Adam Smith’s Invisible Hand for how goods and services are valued.

In order for the monetary system to fulfill these three functions, prices should not change rapidly. If they do change rapidly through inflation or deflation, the relative values of various goods becomes confused. This destroys the signals prices give to both producers and buyers. If that happens, producers no longer know what they should produce and how much. Consumers can not know how much they should pay for goods. If there is high inflation, debtors gain by paying back loans in cheaper dollars. However, this is at the expense of creditors, who receive repayment in dollars that will buy less than the dollars lent out. If there is deflation, the effects are exactly the reverse. Either inflation or deflation (negative inflation)  destroys money’s function as a store of value.

If inflation is high enough, the value of money earned on one day can be very different from that earned on another, and prices from one day to another can be confused. This confusion destroys money’s value as a medium of exchange. Hyperinflation in the past has caused fiat money to be abandoned and replaced by precious metals, foreign currencies, or barter.

By looking at average prices of goods weighted by their quantities produced, and doing this for different years, one can construct a price index that relates the average value of a dollar for one year to that of another. Using this price index, we can express average prices in one year to those in another. If we choose dollars of a base year in which to express prices of all others, we are using constant dollars of that base year. The exact method by which these price indices are constructed can be found here in a PDF.

For a particular year, we can relate the GDP in constant dollars as the sum of all transactions, t; the price index P relating prices of that year to the constant dollars of the base year; the quantity of money in circulation M; and the velocity of money V. The velocity of money is defined as the average number of times a dollar changes hands in that year. The relation is given by the following equation.

By definition of the velocity of money, the total current dollar value of the year’s transactions must equal the number of dollars in circulation, M, times the velocity of money, V. From this equation we can derive the following:

where the the symbol ΔP represents the difference of the price index of the current year from that of the previous year. Similar definitions apply for the terms ΔM, ΔV, and Δt. Multiply each term in the equation by 100% and you get the percent change in that quantity from the previous year. In particular, 100%×ΔP/P is the inflation rate if positive, and the deflation rate if negative. Let us call the equation above the inflation equation.

Clearly, the inflation rate increases with increases in the quantity of money and in the velocity of money, and decreases with an increase in the constant dollar GDP, t.

What then can we expect if the government adopts MMT as its monetary doctrine? The first thing to happen will be the supply of money M will greatly increase, causing an increase in inflation if not cancelled by a decrease in the velocity of money and/or an increase in the GDP. However, as inflation picks up, people will want to get rid of their dollars and buy something before the dollars in their possession lose their value. Therefore the velocity of money will go up, increasing the inflation rate even further. In addition, as prices become less reliable as signals of what should be produced, errors in economic decisions will be made that will decrease the real GDP. This result will heighten inflation even further as the last term in the inflation equation becomes positive with a negative Δt. If we were to follow the dictates of MMT and increase the money supply enough to finance the Green New Deal and Medicare-for-all, we would need to increase it anywhere from 40% to 70% of GDP (see The Progressive Program Finance Problem above). Such an increase in the quantity of money would certainly set off a hyperinflation.

Historically, hyperinflation always has ended in economic stagnation, many times even in deep depression. Venezuela’s current economic collapse is the most recent example of this. We can expect the same kind of economic collapse should we follow MMT.

How Say’s Law of Markets Shows MMT Is Madness

Among the many progressive misunderstandings  MMT reveals is a misapprehension about what creates economic growth. Keynesians — who are the predominant progressive economists — always look to growth in government economic demand to increase the economy’s output. The whole purpose of MMT from the progressive perspective is to increase the country’s output to supply their new and expanded programs. They think they can do this by simply increasing the money supply to allow increased government demand. They believe increased government demand would then motivate producers to provide the increased goods and services government wants.

However, demand is never the cause of economic growth. Demand for new goods and services always follows the production of those goods and services. It almost seems inane to point this out, but before any economic output can be consumed, it must first be produced. Economic transactions between buyers and sellers are exchanges of real wealth; money is only an accounting tool to show how much wealth can be exchanged. Even more fundamentally, if I have a massive increase in demand, I must first produce enough wealth to pay for the wealth I am demanding. The government acts as our agent. If it massively increases its demand, it must first take wealth from us (represented by money).

Simply creating fiat money — as opposed to taxing it from us — does not allow an exchange of real wealth between the government and suppliers. Instead, an increase in the money supply to demand goods causes inflation, according to the inflation equation above. This is because we now have more dollars without increasing the total supply of goods that can be exchanged.

The observations in the last two paragraphs are what underlie Say’s Law of Markets. Published by Jean-Baptiste Say in 1803 in his book A Treatise on Political Economy, or the Production, Distribution, and Consumption of Wealth, this law in Say’s words states:

“A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value”

Beginning with John Maynard Keynes himself, Keynesians have constantly misunderstood and misrepresented Say’s Law of Markets. They assert the law says the supply of a good will create its own demand. This may or may not be the case, depending on the quality of good or service provided. More often than not this is in fact the case. If it is, then supply and demand of the good can continue into the future.  If not, the provider will cease production of the good or service as sales fail. However, even if supply of the good does not create its own demand, the law still holds. Why? Because to produce the good, the provider must hire workers and buy goods to produce his own output. This increases aggregate demand on the economy’s outputs.

There is empirical support for Say’s Law to be found from business cycles. According to economist Mark Skousen in chapter 2 of his book The Making of Modern Economics,

According to business-cycle statistics, when a downturn starts, production is the first to decline, ahead of consumption. And, when the economy begins to recover, it’s because production starts up, followed by consumption. Economic growth begins with an increase in productivity, an increase in new products and new markets. Hence, production spending is always ahead of consumption spending and is therefore a leading indicator.

Skousen, Mark. The Making of Modern Economics: The Lives and Ideas of the Great Thinkers (Kindle Locations 1419-1422). M.E. Sharpe. Kindle Edition.

What is the lesson of all this for the supporters of Modern Monetary Theory? What they should learn is that supply of goods and services they want for their progressive programs can not be increased simply by government’s creation of new fiat money. If they increase government demand without  equivalent new production, then an equivalent supply of goods and services must be taken from other parts of the economy. The economy’s total supply of goods and services will be unchanged, but now there will be more fiat money chasing those outputs. The result, as we have already noted, would be hyperinflation and the destruction of our economy. Modern Monetary Theory is true insanity.

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