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Finally making some sense of MMT, exchange rates, and the international economy

One relatively late-to-develop aspect of Modern Monetary Theory (MMT) has been the theory of the exchange rate in the economy envisioned by MMT proponents. As I have said before, the key points advocated by MMT are: 1) functional finance (fiscal policy in service of macroeconomic stabilization goals, not vice-versa); 2) chartalism; and 3) government employer-of-last-resort programs to achieve full employment and low inflation. For some readers, I should explain that chartalism argues that the value of state money comes from the imprimatur of a government, rather than an “anchor” such as gold backing.* Several points are made by MMT advocates regarding exchange rates in response to critics who argue that its tenets cannot be applied because exchange rates matter in various ways, at least in some subset of countries:

1) Flexible exchange rates, especially floating rates, permit the lack of a budget constraint in spending for a wide range of open economies. A high proportion of economies have currencies that are rather flexible. MMT advocates do not claim that their theory of no government budget constraint applies in its simplest form to countries with fixed exchange rates or to members of currency unions.

2) A worldwide system of fixed rates would not be all that desirable for a variety of reasons. Hence, what is true for an individual country is not all that likely to work even if the “collective action” problem is solved and a cooperative solution somehow reached. Even Keynes’s envisioned progressive post-World War II economic system perhaps would have been geared excessively to seeking zero current account balances.

3) Currency pegs and currency unions in fact bring the risk of currency crashes and fiscal crises. These can in turn contribute to banking crises. So, such problems do not falsify MMT as long as they occur under such non-MMT conditions, which are nonetheless well understood by MMT advocates and Post Keynesians.

4) The situation is far different in regard to the existence of fiscal constraints when a substantial amount of government debt has been issued that must be paid back in foreign currency or when the government must issue only foreign-currency-denominated bonds–circumstances that bring true constraints on spending.

5) Fiscal space is sometimes lacking in a way that seem to some observers to contradict MMT. But a central bank that does not in practice coordinate with the fiscal policymakers does not imply a different kind of system to which MMT does not apply, but rather a hawkish central bank that frustrates attempts to reach close-to-full employment. Consolidated government and central bank balance sheets, which seem to suggest to some skeptical readers of MMT that fiscal and monetary policy are perfectly coordinated, merely describe basic facts that are true regardless of the macroeconomic-policy philosophies of monetary and fiscal authorities respectively. In some economically unhappy countries, the appropriate institutions of government finance are utterly lacking, but even in many of these cases, needed institutions could be set up, given the political will to do so.

Of course, when I mention fiscal constraints, I do not mean to include mere “identities” in an economic model that say, for example, that a given deficit implies net liability issuance of one kind or another.

The so-called “policy trilemma” that would appear to require exchange rate flexibility to permit domestic policy space in the absence of capital controls is under attack and in reality “running out of reserves” may be the actual constraint for open economies, rather than the need for either a) capital controls or a b) flexible currency. I do not see MMT enthsiasts disagreeing much as this idea from stock-flow-consistent (SFC) macroeconomics gradually makes inroads on the hard-and-fast “trilemma” doctrine. I will not elaborate here but refer the reader to a previous post with some links.

I hope this defense helps to make sense of MMT as it applies to various kinds of (open) economies for some economists and others who raise profound doubts about the theory in relation to currencies and exchange rates.

Some concrete examples: Lately, Japan is an example of a country that appears to prove MMT points about interest rates and fiscal sustainability when depression conditions call for strong stimulation. Brazil is an example of the freedom afforded by a public debt largely composed of debt in the home currency. Puerto Rico, a US “territory,” is a case where debt essentially exists in a non-sovereign currency, more or less as in individual US states, but with some interesting differences, resulting in painful fiscal austerity when conditions inevitably worsened. On the other hand, Venezuela is a developing country where natural disasters and adverse developments in the energy industry have been the key causes of economic catastrophe in recent years, not built-in lack of sustainability in systems that merely rely on deficit spending and a sovereign currency as the US after all does. The ballooning of fiscal deficits there in the past 5 or 10 years has been endogenous, driven by forces beyond the fiscal policy stance. Hence, one should not blame the dire and unfortunate material situation that emerged in that country on economic populism, Keynesian economics, new fiscal laxity, or–perhaps least of all–the ideas that make up MMT. Hence it does not make the case for fiscal constraints. Finally, China is an example of a country has come close to setting its exchange rate and its key interest rates for many years but has increasingly come under “balance-of-payments pressures” whose timing is not coincidental to the gradual and partial opening of its capital markets. It still holds vast reserves. Hence, it appears to be a case that illustrates the policy trilemma to a great extent, though an article by Stefan Angrick in the post mentioned above argues convincingly that in general the East Asian post-crisis cases show that his claim of greater policy autonomy based on the “compensation principle” seems to hold, with sterilization of excess reserves occurring in various ways.

*For a recent statement of some MMT tenets with some clarifications that bear on the issues discussed above, you might take a look at “Outside Money: The Advantages of Owning the Magic Porridge Pot,” a Levy Institute working paper by L. Randall “Randy” Wray


In writing the above lines, I draw upon ideas from André Martins Biancarelli, Marc Lavoie, Jan Kregel, Claudio Sardoni, Renato de Souza Rosa, Randy Wray, and others who have spoken and written compellingly on the relevant issues in my opinion in recent years. Of course, these individuals most likely will not agree with everything said here.


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