Does modern monetary theory (MMT) apply outside the US?

Modern monetary theory argues that a government can self-fund itself to boost demand in a recession.

The operation of treasury issuance and their purchasing by the central bank can be executed by any country issuing treasuries in its own currency.

In effect, countries lend to themselves in recessions. Governments raise expenditure by issuing treasuries to markets whereas central banks lend to markets in return of treasuries.

Many are concerned that such a process of money creation would lead a country to the Weimar hyperinflation. Nevertheless, central bank independence had not existed in Weimar Republic.

Do we owe to ourselves?

Modern monetary theory advocates argue that a government can self-fund itself to boost demand in a recession. This argument has been widely discussed by the economists. Many asserted that such an approach merely applies to the US due to the dollar's reserve currency feature.

Potential output is an economy's total production capacity. In a recession, demand to the goods and services fall below the potential output. Sellers reduce their prices in order to be able to sell a higher portion of their capacity. Therefore, recessions are deflationary in nature.

Any government in the world can and should self-fund itself to exit a recession. The only constraint is inflation as suggested by the advocates of modern monetary theory. Monetary and fiscal authorities aim to restore demand at the level of potential output. For this purpose, governments raise expenditure by issuing treasuries whereas central banks lend to markets in return of treasuries. In effect, countries hence lend to themselves in recessions.

Success of both policies are interdependent. If monetary policy does not adequately expand, cost of government borrowing would rise and, thereby, constrain fiscal policy. If fiscal policy does not adequately expand, monetary expansion may not pass through consumption, particularly while interest rates are stuck at the zero lower bound. Since monetary tools are all lending-based, a central bank cannot ensure that borrowers will spend funds. Instead, they may inflate an asset price bubble via purchasing financial assets or just keep funds as liquidity buffer against shocks.

When inflation is above the target, the mechanism runs the other way. The government cuts spending by dampening public debt and the central bank sucks liquidity by selling treasuries. As a result, the country would reduce debt to itself.

Any country issuing treasuries in its own currency can lend to itself to fill the negative output gap. The only constraint is inflation which signals recovery. The government would stop raising expenditure and the central bank would stop buying treasuries when inflation hits the target. At that point, the negative gap between potential and actual output would close up.

Stagflation

Countries experiencing stagflation, recession alongside with high inflation, may not utilize the MMT approach. In times of a recession, the country would have to choose between restoring spending or lowering inflation. A lower inflation requires conditions of a recession, an actual output below its potential (capacity of production). To attain the target, authorities would need to deliberately maintain the negative output gap. Therefore, the country could not raise the money supply raising the debt to itself.

Countries experiencing high inflation and recession meanwhile have to be careful in policy execution. A too wide negative output gap might fuel delinquencies and imperil the financial system. Against drastic shocks, keeping inflation steady might be more favorable to recession. Authorities can close the negative output gap by maintaining the current level of inflation. The MMT mechanism would apply in that case as well. As long as actual output does not surpass potential output, inflation would remain at its current level. Once the output stabilizes at its steady growth, authorities can gradually reduce inflation via a deliberate contractionary policy.

Central bank independence and hyperinflation

Many are concerned that such a process of money creation would lead a country to the hyperinflation of Weimar Republic. This argument does not distinguish between the monetary policy status of today and past. Against the risk of high inflation, central bank independence was introduced and has been widely successful. Governments thereby can not control the money supply anymore. They cannot boost demand over the potential output and prompt a higher inflation.

What if the government raised expenditure by issuing more treasuries? A central bank would squeeze the money supply, initially by selling treasuries and later raising interest rates. An independent central bank would thus ensure an inflation at the target. A higher cost of borrowing due to the surging treasury supply would also deter the government to raise further debt after recovery.

Change accounting instead of taboos

Notwithstanding its coherence in theory, the MMT mechanism may not function as expected due to the psychological constraints on fiscal policy. Governments and parliaments are reluctant to raise the unpopular public debt-to-GDP ratio. As elaborated above, in a successful recession strategy, countries lend to themselves. That is, debt does not surge in reality. The central bank creates money in return of the treasuries issued by the government. The government raises expenditure through the central bank money.

Nevertheless, modern monetary theory (MMT) may not always persuade people. Too few people would adhere to the ''public debt does not matter' position despite a 1000% public debt-to-GDP ratio. Therefore, changing the central bank accounting would be more helpful instead of trying to convince the people. A central bank can write ''transfers'' to the debit side of its balance sheet and transfer funds to consumers. Thus, neither budget deficit nor public debt would surge.

A 1000% public debt-to-GDP ratio is not a dream, indeed. Governments do not run deficit just to stabilize output fluctuations. Authorities will need to contain all private debt through leverage tools since the surging indebtedness imperils the financial system in bust times. As a lower debt depresses expenditure, governments will need to restore demand via piling up budget deficits.

Conclusion

In recessions, a central bank should be able to transfer funds t consumers without creating debt. It would register transfers to an account called ''transfers'' on the debit side. Thus, the government would neither run deficits nor raise debt to boost spending. Once inflation hits the target, the central bank would stop transfers. At that stage, an independent central bank would ensure the inflation at the target via interest rate and capital buffer tools. If banks extensively raise the money supply via stirring up the money multiplier, the central bank would constrain bank leverages via introducing a capital buffer.