Policy Paper 03/2019

Modern Monetary Theory: Background and implications for emerging markets

Modern Monetary Theory (MMT) is an increasingly debated economic concept. While mainly brought into the current public discussion by politicians in the US, the concept does have some hetherodox theoretical foundations, which date back to the beginning of the 20th century.

The theory claims that budget deficits can be financed by the central bank creating thereby fiscal space, whereby the monetisation of debt is not an issue of concern, as long it does not lead to high inflation. In the current discussion, the proponents foresee the potential for a massive increase in public investments (be it for a “New Green Deal” or a “Job Guarantee Programme”), essentially without creating any harm, as inflation and interest rates are considered to be at very low levels for a very long time in developed markets.

As the main policy instrument to influence aggregate demand and inflation would be fiscal policy (i.e. spending and taxation), this leaves politicians in charge in a (very likely) situation of increasing inflation when real resources are fully employed. Would the government (parliament), as a reaction, cut expenditures or raise taxes, to bring inflation down again and pay the corresponding political price? There is nothing against a temporary fiscal impulse to offset weak demand. However, it‘s another matter to have fiscal policy as the only tool to steer the level of inflation, like MMT proposes. Indeed, the central bank would have no role any more in influencing inflation, as it is just the liquid window of the Treasury. In effect, this would mean the end of independent central banks, as their function would merely consist of monetising debt. Such a concept seems not convincing, even in the current low-inflation environment in developed economies.

How relevant is this theoretical approach for emerging markets like Ukraine? Taking into account their specific economic and financial situation, not really in our view. These countries are often dollarized to a significant extent (including public debt), which clashes with some basic assumptions of the theory. They usually feature high and volatile inflation, which makes a discussion about raising output in a non-inflationary manner via a monetary stimulus pointless. The high inflation rates imply high nominal interest rates – again a major difference to the environment of zero interest rates found in developed markets. Thus, as long as Ukraine and other emerging economies are having trouble with these issues, the MMT discussion is much ado about nothing, from this perspective.

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